BY Catherine Lightfoot, CPA, CHBC, Director, Healthcare, EEPB
Remember the Y2K drama? As the year 2000 approached, many believed computer systems originally coded in two-digit date format (MM/DD/YY) would not interpret the “00” correctly and throw us back to 1900, causing a major malfunction with profound business implications. It is now Deja vu in the tax arena with respect to the U.S. Tax Cuts and Jobs Act (TCJA). As several TCJA-related rules are scheduled to expire or fully sunset, effective January 1, 2026, we will potentially return to 2018 tax law—unless Congress takes action. The current “noise” in Washington is mostly around taking away, not giving back, perceived tax breaks for the rich. So, we cannot count on last-minute extensions! This article focuses on three key areas to consider during the twenty-four-month timeline.
Estate and gift tax exemptions
In 2023, the annual exclusion for gifts is $17,000, and the estate and gift tax exemption is $12.92 million. Both are adjusted annually for inflation. When TCJA sunsets, the estate and gift tax exemption will be cut in half to approximately $6 million.
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For example, an individual has an estate worth $15 million. Through tax planning, they gifted roughly the $12 million allowed under current law. When TCJA sunsets on 1/1/26, this person’s taxable estate going forward (assuming no growth) would only be $3 million (15m minus the 12m gifted). If the same person did not do any estate planning before TCJA sunsets, on 1/1/26 they would potentially have a taxable estate of $9 million (15m minus the reduced exemption of 6m).
With the estate tax as high as 40%, some planning could save your family significant tax dollars over the next two years.
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Qualified Business Income (QBI) deductions
The QBI deduction is available to “pass-through” entities, including S corporations, partnerships, limited liability companies, and sole proprietors. The deduction is 20% of net income but subject to various limitations based on wages paid, unadjusted basis of qualified property and taxable income. Healthcare is considered a Specified Service Trade or Business (SSTB) with additional restrictions imposed. Regardless, some can work through these limitations and recognize sizable tax deductions. A business could reduce its net income to be within the phase-out income ranges by increasing retirement contributions or via strategic planning for equipment expenditures. Once in the phase-out range, a portion of the QBI deduction would still be available. Since the 20% deduction is something the company does not have to pay for, it is an incredible tax advantage.
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Bracket management and ROTH conversions
After TCJA sunsets, our highest tax bracket will go from 37% to 39.6%. More importantly, tax brackets will shrink. The current tax system comprises various brackets, ranging from 10% to 37%. Every taxpayer starts at 10% and moves through the remaining brackets as their taxable income increases.
For example, one person may have $40,000 of taxable income and another $400,000 of taxable income, but both of them will pay the same amount of 10% tax on that portion of their taxable income.
When brackets shrink, a taxpayer will get to the higher brackets faster and stay in some of the middle ones longer. The 10%, 15%, and 25% (which was 22%) brackets will remain roughly the same. All are adjusted for inflation through the years. The 28% bracket (which was 24%) will be much smaller, taking the taxpayer to the 33% bracket much faster.
For example, a married couple (filing jointly) that has $400,000 of taxable income would pay $15,837 more in taxes for 2026 just because of the bracket and tax rate changes.
Other than increasing your withholding, what should you do to prepare for this change?
First, income recognition will be cheaper in 2024 and 2025 than in 2026 forward. This is not for capital gain income, which is taxed at a favorable 20% under current law and will not be changed by the sunset of TCJA. Ordinary income for extra business ventures and similar earnings is what you should shift to the lower bracket years; also, saving high deductions (unless they help you qualify for QBI) to years after 2025 when tax rates will go up.
Second, consider converting taxable IRAs to ROTH accounts while tax rates are lower. IRA conversion is a detailed discussion best held with your financial advisor. Here, we will only review the aspect of IRA conversion related to the tax brackets.
Traditional IRAs produce the same after-tax result as ROTH IRAs, provided the annual growth rates are the same and the tax rate in the conversion year is the same as the tax rate during the withdrawal year.
For example, visualize a simple algebra formula: A x B x C = D and A x C x B = D. Applying this formulaic analogy to IRA conversions, if the tax rate is the same in the year of conversion as the year of withdrawal, there will be no tax savings.
Tax savings come if you are in a lower bracket in the conversion year than when distributions are withdrawn. The “sweet spot” is for those somewhere between the 22% and 24% bracket. Since the 24% bracket increases to 28% and shrinks in 2026, someone with a significant tax planning opportunity may only have two years to do so.
Conclusion
The TCJA sunset is on the horizon. The ways to mitigate tax law changes is advance planning and exercising favorable deductions while they are still available. The three key areas discussed are a good starting point, but it is also wise to seek professional accounting counsel to maximize tax savings for your particular situation. Don’t panic, take action. We made it through Y2K by extensive preparation, and the same preparedness will help cushion any TCJA mishaps.