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The Unintended Consequences Of The Tax Law

J. Patrick Collins Jr., CFP®, EA

With the passage of the Tax Cuts and Jobs Act, millions of Americans will see two broad themes.  First, personal exemptions are eliminated and itemized deductions are being curbed with the reduction in the state and local tax deduction, elimination of miscellaneous itemized deductions, and the lowering of the mortgage interest deduction.  While the standard deduction was doubled, many individuals are finding that their taxable income (income after deductions), is going to be higher in 2018.   For example, a family with $200,000 of income and $50,000 of exemptions and deductions would have a $150,000 in taxable income.  Under the new tax law, if those exemptions and deductions are reduced to $35,000, their taxable income would increase to $165,000.

The second part of the bill lowers the tax rates across the board, so although a family may see an increase in their taxable income, the tax federal tax rates applied to that income will be lower.  This is how the majority of Americans are still getting a reduction in their overall taxes.  This is also where some issues come about that may not have been considered when Congress was developing the bill.  States often mirror their deductions directly off the federal tax return.  Because that is the case, many individuals and families will be showing higher income on their state tax return (just like the federal) without the corresponding drop in tax rates.  The Wall Street Journal has an article about the dilemma facing states:

State lawmakers must choose whether to conform their systems to the new federal rules, cut tax rates to prevent rising tax burdens or spend potential revenue windfalls.  The outcomes will be determined in state legislative sessions now opening across the country.  “Everyone thought that tax reform was done,” said Nicole Kaeding, an economist at the conservative-leaning Tax Foundation in Washington. “All we’ve done is move it from one capital to 50 capitals.”

The new federal legislation curtailed many tax breaks, such as individual deductions for mortgage interest and tax-preparation fees and business deductions for interest and entertainment expenses. While federal rate cuts more than offset those changes, state tax rates haven’t changed. So if states adopt the new, broader federal income tax base, it could mean higher state taxes for many.

Maryland, my state of residence, is dealing with the issue as we speak.  The Governor has announced he does not want to see state taxes go up.  How he will do that remains to be seen.  It is very well possible that the same phenomenon that happened on the the federal level of having winners and losers could happen again on the state level.  And depending on the legislation, they could be different groups of people!  We will continue to monitor this, but one thing is pretty clear to us.  The idea that overall tax planning will become simplified doesn’t seem to be playing out as hoped.