The federal government has passed a new tax law that will take effect in 2018. One of the changes is that they are limiting deductions for state and local taxes to $10,000.
What does this mean? This means that when you go to pay your taxes for 2018 (filed by April 15th, 2019), you will only be able to deduct $10,000 of your state and local taxes on your Federal tax return. For example, if you paid $13,000 in state taxes and $7,000 in property taxes in 2018, you will only be able to deduct $10,000. So, while in past years you would have been able to deduct the full $20,000, you will be limited to $10,000 in 2018. If your marginal tax rate is 28% (for example purposes), then the net effect will be $2,800 in more tax owed to the Federal government for this particular line item on your 2018 federal tax return.
But the impact of the new tax bill on your total taxes goes beyond just the state and local tax deduction limit. There are other changes to the tax law that will impact your net taxes. For instance, if you are in the 28% tax bracket in 2017, you will likely be in the 24% tax bracket in 2018, saving you 4% of your taxable income. So, you should look at all the changes to the tax law to determine what the net effect on your taxes will be. Here is a website that will allow you to enter your numbers to get a preliminary look: http://www.foxbusiness.com/politics/2017/12/19/tax-calculator-what-tax-reform-means-for.html.
As a result of the change to the state and local tax deduction, people are rushing to prepay their 2018 state and local taxes. The reason is that there is no limit to the deduction in 2017, so if you pay it in 2017, you can deduct it on your 2017 taxes. Local governments are reacting to this rush in different ways. Read more about whether your local jurisdiction is allowing prepayment in this article: https://wtop.com/local/2017/12/jurisdiction-accept-prepayment-real-estate-tax-new-law-kicks/
But should you prepay your taxes if they allow it?
First and foremost, you should consider your specific tax situation to answer this question. But if it turns out that you will benefit from prepayment and your local jurisdiction allows it, you’ll have to come up with that payment quickly – by the end of the week!
From a financial planning perspective, it makes sense to think about saving a potential $2,800 (given the example above). But with this example, you’d have to pay $10,000 by the end of the year. The first question is: Do you have that amount of money laying around? The section question is: Are you willing to forego access to that $10,000 in return for $2,800. The business case is sound, but does it fit into your budget?
With this example, you would pay the $10,000 right now, then have to update your withholdings for state taxes to increase your paycheck by $833.33 per month, slowly getting paid back your $10,000 over the course of the year.
Plugging this scenario into a calculator:
- Cash flow 0: -10,000 <– your initial payment
- Cash flow 1: 10,000+2,800 = 12,800 <– you get your $10k back over the course of the year, plus $2,800 in federal tax refund (that you wouldn’t otherwise receive next year)
- IRR: 28% <– this is the 1-year return for your $10k prepayment
If you are using your emergency fund to pay for this, you are increasing your risk in the case where you would need those emergency funds in 2018. Otherwise, why would you have $10k lying around? Perhaps you got an end of the year bonus or other windfall – these are probably the folks that are really considering this option. But others may be thinking about cashing in investments to prepay their state and local taxes. This comes with a whole set of other considerations – what the investment is for, the investment horizon, short term and long term capital gains taxes, taxes and penalties on qualified accounts, timing, transaction fees, etc.
But your scenario may be different. Your dollar amount might not be $10,000, your tax rate may be different, and your tax benefit may be different, so please run your specific numbers through a cash flow analysis.
– These are just a few items to consider among several.
I encourage you to run the numbers to determine if prepayment is right for you, or call your financial advisor.
Greg Caramanica, CFP®