Many federal employees and retirees were shocked as to the decrease in the lack of their refunds or the amount of their balance due when they filed their 2018 federal income tax returns last spring.
The Tax Cuts and Jobs Act of 2017 (TCJA) resulted in several tax law changes affecting individuals. TCJA took effect on Jan. 1, 2018 and will remain in effect through Dec. 31, 2025. Tax year 2019 is the second year in which TCJA affects individual taxpayers.
This column presents some tax planning moves, based on entries on several lines on the 2018 Form 1040 that will hopefully reduce one’s 2019 federal tax liability, as well as to avoid any surprises when employees and annuitants file their 2019 returns next spring. With less than four weeks remaining in 2019, now is the time for employees and annuitants to implement these moves.
1. 2018 Form 1040 page 2
In the first six lines of Form 1040 page 2, an individual is asked to list the various types of income received during 2018. Line 1 is wages, and if a federal employee had a large balance due (more than $1,000) when he or she filed his or her 2018 federal income tax return, then the employee’s 2018 Form W2 Box 12d should be reviewed to find out how much the employee contributed to the traditional Thrift Savings Plan (TSP).
Traditional TSP contributions are deducted from an employee’s gross salary, thus lowering the taxable salary resulting in instant federal (and in many states, state and local) income tax savings. Additional traditional TSP contributions (if possible) for 2018 would have resulted in a larger refund or a smaller balance due. For 2019, employees can contribute $19,000 to the TSP ($25,000 if they are over age 49 as of Dec. 31, 2019). Most employees have at least one more pay date in December to contribute additionally to the traditional TSP.
A note of caution, however.
If an employee’s expected marginal tax rate when the TSP account is withdrawn in the future will be higher compared to the marginal tax bracket when TSP contributions are made, then the Roth TSP may be a better choice. Roth TSP contributions are taxed before they are contributed via payroll deduction to the TSP and will not be taxed when they are withdrawn. In addition, Roth TSP earnings grow at least tax-deferred, and assuming a qualified Roth TSP withdrawal is made, the accrued earnings will also not be taxed when withdrawn. Finally, a large refund (more than $1,500 on one’s federal income tax return, as shown on line 19) would be an indication that the employee can afford to contribute more to the Roth TSP in 2019. The result would be that given relatively the same amount of 2018 taxable income compared to the amount of 2019 taxable income, there would less of a tax refund on the 2019 income tax return but more tax-free income in the future in the form of qualified Roth TSP distributions.
2. Standard deduction on itemized deductions from Schedule A
2018 Form 1040 line 8 asks for the individual’s standard deduction or itemized deductions from Schedule A. As a result of TCJA’s passage, the standard deduction has doubled for both single and married tax filers, and on the 2018 federal income tax returns more than 25 million individual taxpayers claimed the standard deduction rather than itemizing on Schedule A. For 2019, the standard deduction is $12,200 for single filers and $24,400 for married couples filing jointly.
The most common itemized deductions are the state and local taxes (SALT) and real estate taxes (limited to $10,000 per filer), charitable donations and mortgage interest. Since charitable donations are controllable as to when they can be made, it may be advantageous to “bunch” charitable contributions into one year. The purpose would be to exceed the amount of the standard deduction when adding the state and local taxes, real estate taxes (limited to $10,000), mortgage interest paid and charitable contributions. Donating shares of appreciated securities (like stocks) could significantly increase the amount of one’s charitable contributions. Any charitable contribution must be made before Dec. 31, 2019.
3. Capital gains and losses from Schedule D. 2018 Form 1040 Schedule 1 line 13
This line asks for any net capital gains or losses as shown on Schedule D. Any capital losses can be applied against capital gains dollar for dollar, with any excess losses up to $3,000 applied other (ordinary) income). Net capital losses in excess of $3,000 are carried forward to Schedule D for use in 2019, resulting in overall tax savings. This is because up to $3,000 of losses in any tax year are applied against other income, such as wages and interest income.
Besides the tax savings by selling investments (stocks, bonds, mutual funds, and exchange traded funds) not held in IRAs, TSP or 401(k) retirement plans that have decreased in value – individuals should in particular consider their investments that have decreased in value compared to their current cost basis. Cost basis includes what was paid originally for the investments, plus any reinvested dividends and capital gain distributions. Any capital losses generated from the sale of these assets must occur before Jan. 1, 2020 in order to be considered as recognized losses for 2019.
This approach of selling “losing” investments held in non-retirement portfolios is called tax loss “harvesting”. Individuals should not, however, let the “tax tail” wag the “investment dog”; that is, tax savings should only be part of the reason for selling an investment. Also, individuals should beware of the “wash sale” rules that apply when buying back into the market.
4. Health savings account deduction. 2018 Form 1040 Schedule 1, Adjustments to Income line 25
Those employees and annuitants who own health savings accounts (HSAs) and are eligible to contribute to their HSAs for 2019 because they are covered by a high deductible health plan still have time to contribute to their HSAs for 2019. Contributions to one’s HSA are an adjustment to income, resulting in automatic federal income tax savings. For 2019, employee or annuitants who are single can contribute a maximum $3,500 to their HSAs. Employee or annuitants who file as married filing jointly can contribute a maximum of $7,000 to their HSAs. Under the FEHB program, a HDHP automatically contributes a portion of the employee’s/annuitant’s HDHP premium into the HSA (“premium pass-through”). The difference between the maximum allowed contribution and the “premium pass-through” is the amount the employee/annuitant can contribute on his or her own. The employee or annuitant has until the tax filing deadline of April 15, 2020 to make his or her 2019 HSA contribution.
5. Nonrefundable tax credits from 2018 Form 1040, Schedule 3, Nonrefundable credits, and 2018 Form 1040 page 2, line 12a, Child Tax credit
Tax credits reduce an individual’s tax liability “dollar for dollar” and therefore play an important role in reducing an individual’s tax liability. The following tax credits tend to be overlooked: (1) Foreign tax credit, Schedule 3, line 48. Those individuals who own foreign stocks or mutual funds that are partially or wholly invested in foreign stocks in non-retirement brokerage accounts should be aware of foreign taxes paid (as shown on their 1099-DIV the stock owner or mutual fund owner receives in January). Foreign taxes paid will likely result in a foreign tax credit and should be listed on Schedule 3, line 48; (2) credit for child and dependent care expenses, Schedule 3, line 49 and IRS Form 2441.
Those employees who use the dependent care flexible spending account (DCFSA) and have two or more eligible dependents, requiring dependent care, may want to check IRS Form 2441 if they paid more than $5,000 in child and dependent care expenses during 2019; (3) Education tax credits, Schedule 3, line 50 and IRS Form 8863, line 19. Those employees and annuitants who have dependents attending college or universities should find out if they are eligible to claim the American Opportunity Tax Credit or the Hope Scholarship tax credit; and (4) Child tax credit 2018 Form 1040, line 12a. Those employees with children younger than age 17 may be eligible for the expanded child tax credit of $2,000 per child.
6. IRS Form 8606 (Nondeductible IRAs)
In any year in which an individual contributes to a nondeductible traditional IRA, Form 8606 should be filed. The purpose of Form 8606 is to track after-taxed contributions to the IRA in order to establish “basis” in the IRA. Those nondeductible traditional IRAs with a high-basis are ideal candidates for conversion to a Roth IRA.
During December, it may make sense to convert a traditional IRA to a Roth IRA under the following conditions: (1) the traditional IRA has an established basis together with other IRAs, and when converted will not result in the IRA owner being pushed into a higher marginal tax bracket; (2) the IRA owner is reasonably certain that the taxes paid in converting are lower compared to the taxes paid in the future if the conversion would not take place; and (3) the IRA owner has sufficient liquid assets to pay the taxes due as a result of conversion.
Finally, it is important that traditional IRA owners and their tax advisors carefully analyze a Roth IRA conversion because under the TCJA a recharacterization (“undoing” a Roth conversion) is no longer possible.