As the year-end quickly approaches, there is still time to do year-end tax planning to generate significant tax savings. As many of you know, changes to the tax laws in 2013 made many tax rates (subject to cost of living adjustments) and certain tax breaks permanent.
But some tax breaks expired in 2013 (discussed in more detail below) and Congress has not as yet revived them making year-end planning more complicated and frustrating.
The President has signed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). Some tax breaks have been made permanent, some have been extended through 2016, and some have been extended through 2019. See Expired Tax Provisions below for more details.
This 2014 tax year will again be challenging as taxpayers will have to deal with the following recent tax law changes:
- Higher marginal income tax rates
- Higher capital gain tax rates
- Restoration of the phase out of itemized deductions and exemptions: If your adjusted gross income exceeds applicable thresholds, certain itemized deductions are reduced. The applicable thresholds for 2014 are $254,200 for singles, $279,650 for head of household and $305,050 for joint filers
- The new 3.8 % Medicare tax on unearned income, including interest, dividends and capital gains. etc. For more details please read 2013 Sneaky New Tax – Not Too Early to Plan for 3.8 % Medicare Tax on Investment Income
- The new 0.9% tax on earned income in excess of $200,000 for single taxpayers and $250,000 for married taxpayers filing jointly
- Same Sex Couples: The recent Supreme Court decision in Windsor may result in same-sex couples with dual income paying more income taxes filing jointly than if they were still able to file singly. For more details on the tax implications for same-sex couples please read Same-Sex Marriage Tax Guide: 16 Essential Tax Rules and Tips
It is important to know that this year-end tax guide only provides an overview of various tax strategies and some of the more important tax provisions and by no means covers all tax minimization techniques. Each taxpayer situation is unique and as a result tax strategies and projections should be developed for each client for the greatest results.
Where To Begin:
As a starting point, it is essential to know the customary year-end planning techniques that can cut income taxes. It all starts with a tax projection of whether you will be in a higher or lower tax bracket next year. In some cases it is imperative to project income and expenses for multiple years to smooth income out over time to avoid higher tax brackets over an extended period. This type of planning is beyond the scope of this discussion and should be explored directly with tax counsel.
Once your tax bracket for this year and next year are known, there are two basic income tax planning considerations:
- Should income be accelerated or deferred?
- Should deductions and credits be accelerated or deferred?
However, life is never that simple. Tax laws always make for some real guesswork. As discussed below, when it comes to certain deductions that have tax threshold limitations, bunching of deductions to one year may force these deductions into a tax year where the tax bracket is lower than the other tax year in question. This may be the only way to get a tax break for these deductions.
As a further irritant, year-end tax projections must take into account the maddening alternative minimum tax and the new parallel universe of the 3.8% Medicare tax.
For discussion purposes, the following strategies assume that the taxpayer’s income will be higher next year. Where income will be taxed at a higher tax bracket next year, accelerating income to this year results in less taxes being paid. At the same time, deductions and tax credits deferred into next year will become more valuable as they offset income taxed at a higher marginal bracket.
Usually accelerating income to the current year and deferring deductions must take into account the impact on cash flow and the time value of money when paying taxes on income a year earlier. However, due to our current low-interest rate environment, time value of money implications are quite minimal and may not be a significant consideration.
If a taxpayer expects income to decrease next year they should use the opposite approach.
Important: Be sure to remember that the following lays out the basic ideas for income acceleration and deduction/credit deferral where income projects to be taxed at a higher level next year.
For taxpayers who think that they will be in a higher tax bracket next year, here are some targeted forms of income to consider accelerating into this year.
- Bonuses: Receive bonuses before January 1 of the following year. If your employer allows you the choice, this may result in some significant income tax savings to you.
- Accelerate billing and collections: If you report income on a cash basis method of accounting, immediately sending out bills to increase collections before the end of the year may result in significant tax savings if you know income will be much higher next year.
- For Salary and Wages and Earned Income: Take Into Account the New 0.9% Wage Tax: High income earners will pay an extra 0.9% in social security taxes on earned income above certain thresholds. Where earned income is low this year and is going up next year, accelerating earned income into the current year may cut this wage tax on earned income entirely.
- Passive Income: Taking Into Account the 3.8% Medicare Tax: Also where income this year will be below the new 3.8% Medicare tax threshold, accelerating this passive income into the current year may completely avoid this Medicare tax. For more on this read 2013 Sneaky New Tax – Not Too Early to Plan for 3.8 % Medicare Tax on Investment Income.
- Redeem U.S. Savings Bonds, Certificates of Deposit or Annuities: Taking these items into income this year may make sense where income projects to be higher next year. (Be sure there are no penalties or surrender charges involved.) This tax strategy may result in this income being taxed at a lower bracket and such income may avoid the 3.8% Medicare tax.
- Capital Gains: Selling appreciated assets if you expect capital gains at a higher rate next year: In such situation it may make sense to sell such assets before the end of the year. For a complete discussion of this issue please see 2012 Year End Tax Planning: Should Taxpayers Sell in 2012 Before Rates Rise?
Example: Mr. Appreciation has low basis stock that has appreciated in value. The rate for capital gains can rise as taxable income increases. Before selling any securities he needs to run the numbers to see if it makes sense to sell this year or next year or spread such sales between the two years.
He also needs to consider in the 3.8% Medicare tax on capital gains and how such decision impacts itemized deduction limitations.
Important Planning Point: If a taxpayer is in the 10% or 15% tax bracket in the current year, it would make sense to sell appreciated assets in this year since a zero tax rate would apply to such long-term capital gain. This special treatment does not apply to sales of collectibles (28% rate) and recapture property (25% rate).
Important Planning Point: If a taxpayer is in the 25%, 28%, 33% or 35% tax bracket, it would make sense to sell appreciated assets this year to be taxed at 15% on capital gains instead of next year when it is expected that the taxpayer will be in the 39.6% bracket and be subject to capital gain tax rates of 20%. This special treatment does not apply to sales of collectibles (28% rate) and recapture property (25% rate).
Important Planning Point: For an older taxpayer or one in ill-health, this strategy may not make income tax sense. When a person dies their assets get a step up in basis to the date of death value. As a result, when the estate sells such assets there is no capital gain. So a sale right before death would trigger a needless capital gain tax. For an extensive discussion of this issue readers may want to explore The Biggest (Tax) Loser: Misguided Gifts of Real Estate By Uninformed Do It Yourselfers, Realtors & Attorneys
Wash Sale Planning Note: The wash sale rules do not apply when selling at a gain, so taxpayers can cash out their gains and then repurchase identical securities immediately afterwards. For more on wash sale rules and how to avoid them, please see the discussion below.
- Roth Conversions: Taking into income the monies in IRA accounts in a year before your tax bracket is due to rise may make for some significant income tax savings. There is no income based limit on who can convert to a Roth IRA. From a long-range planning perspective, a conversion can turn tax deferred growth into tax-free growth. There may also be estate planning benefits with a Roth conversion.
- Maximize Retirement Plan Distributions: Remember the minimum required distributions (MRDs) are the amounts distributed each year to avoid the draconian 50% MRD penalty once a taxpayer reaches 70 ½. However, taxpayers with IRAs can choose to take larger distributions this year to have such income taxed at a lower income tax rate than the one projected in future years. However, be sure to account for the following:
- The lost tax deferral growth if the money were to stay in the retirement plan account,
- Whether the distribution would trigger more of Social Security payments to be taxable,
- Whether the distribution would increase income based Medicare premiums and prescription drug charges, or
- Whether such distribution would impact tax breaks sensitive to AGI limits.
- Electing Out or Selling Outstanding Installment Contracts: Disposing of your installment agreement may bring the deferred income into this year at a lower tax rate than anticipated in future years. It may be helpful to pay tax on the entire gain from an installment sale this year by electing out of installment sale treatment under Section 453(d) of the Internal Revenue Code, rather than deferring tax on the gain to later years. Conversely, in certain situations installment sale treatment may be a better option since it allows for spreading of income over multiple years. The proper strategy depends on the specifics of each taxpayer’s tax situation.
- Take Corporate Liquidation Distributions This Year: Senior or retiring stockholders contemplating the redemption or sale of their shares of stock in their corporation can save considerable taxes by selling their shares this year if their expected tax bracket will be higher in later years. Warning: On the other hand consider carefully the step-up in basis implications for older or infirm taxpayers before considering this tax maneuver. For more insight on this issue read The Biggest (Tax) Loser: Misguided Gifts of Real Estate By Uninformed Do It Yourselfers, Realtors & Attorneys
- Accelerate Debt Forgiveness Income With Your Lender: In the past, acceleration made sense if income is being taxed at a lower tax bracket in the current year, but this provision expired at the end of 2013. It is unclear at this time whether Congress will reinstate this tax break before year-end. Please consult with tax counsel for the latest tax developments.
Deductions and Tax Credit Deferrals:
For taxpayers who think that they will be in a higher tax bracket next year, here are some actions to consider in deferring deductions into next year. Remember, we are assuming that income will be higher next year, so deductions are more valuable next year. (Obviously, if income is higher this year, it is better to have deductions accelerated into this year). With any tax strategy, taxpayers must take into account the impact of the alternative minimum tax.
- Bunch Itemized Deductions Into The Year In Which They Can Exceed The Applicable Threshold: For certain expenses such as elective surgery, dental work, eye exams, it would be better to have this medical work done in the year that you are already above the applicable adjusted gross income (AGI) threshold that applies to these medical expenses.
- For medical expenses, the AGI limitation rises to 10% in 2013 and later years for those under age 65.
- Those over age 65 still have an AGI limitation of 7.5%.
- Taxpayers at age 64 this year and 65 next year may want to bunch elective medical procedures into next year to get over the lower threshold next year.
- Plan For The Phase Out Of Itemized Deductions and Exemptions: If your adjusted gross income exceeds applicable thresholds, certain itemized deductions are reduced. The thresholds for 2014 are $254,200 for singles, $279,650 for head of households and $305,050 for joint filers. So if you are above your threshold for this year, it may make sense to defer deductions into next year.
Planning Note: If your AGI is close to the threshold, strategies such as making retirement plan and health savings account (HSA) contributions may allow you to stay below the threshold. When covered under a high deductible health plan, HSA contributions are $3,300 for self-only coverage and $6,550 for family coverage for 2014. In addition, if you are age 55 or older an extra $1,000 is available.
- Standard Deduction and Itemized Deduction: Where income will be greater next year, taking the standard deduction this year and bunching itemized deductions to next year would yield the best tax result.
- Postpone Paying: Postpone paying certain tax-deductible bills until next year if it generates a greater tax benefit.
- Fourth Quarter Estimated Taxes: Pay fourth quarter state estimated tax installment on January 15 of next year instead of December of this year.
- Postpone Economic Performance: Postpone “economic performance” for tax-deductible expenses until next year if you are an accrual basis taxpayer.
- Watch the AMT: Missing the impact of the AMT can make certain year-end strategies counterproductive. For example, aligning certain income and deductions to cut regular tax liability may not work if the deductions cut regular taxable income but do not cut alternative minimum taxable income. It is very easy to have your tax planning backfire by missing the difference between the regular tax and AMT tax rules.
Example and Important Warning: Do not prepay state and local income taxes or property taxes if subject to the AMT. It will generate no income tax savings and you will have made these payments without gaining a tax benefit.
- Net Investment Interest: Watch net investment interest restrictions
- Passive Income and Loss Limitations: Match passive activity income and losses
- Harvest Tax Losses by Selling Securities or Mutual Funds: Selling shares of stock or mutual funds that have gone down in value can offset other capital gains and generate a tax loss of up to $3,000 against other income.
Warning: If you want to buy back the same security beware of the so-called “wash sale” rules. These rules are complex but with proper planning losses can be taken while avoiding the wash loss limitation rules.
Avoiding Wash Sale Rules: To avoid the wash sale rules, a taxpayer can (1) immediately buy securities of a different company in the same industry, (2) immediately buy shares in a mutual fund that holds securities much like the one sold, or (3) simply wait 31 days to repurchase the same security.
- Purchase Machinery and Equipment Before The End of 2014: Even if you are in a higher tax bracket next year, it may make sense to take advantage of the current Section 179 deductions. Currently, the more generous tax breaks from last year have expired and it is unclear if Congress will revive them before the end of 2014. (See Expired Tax Provisions discussion below for current limits)
Use Credit Cards To Claim Deductions: Expenses charged to credit cards before year-end are deductible this year even though paid next year. Use credit cards to pay:
- Business Expenses
- Medical Expenses
- Property Taxes
- Other Deductions
Increase Withholding Taxes: Many taxpayers pay both estimated income taxes and withholding taxes. If you have fallen behind on quarterly estimated taxes, it is a good idea to increase withholding on your remaining wages to avoid underpayment penalties.
Key Tax Planning Point: The IRS treats withheld taxes as if spread out evenly throughout the year. This strategy can cut or even eliminate penalties for the failure to pay timely.
Be Careful When Investing in Mutual Funds at Year-end: Many mutual funds pay accumulated dividends and capital gains in November and December. This will result in a needless tax bill and a rude surprise come tax time for the unknowing investor.
Cost Segregation Study: A taxpayer who recently purchased or built a building or remodeled existing space should consider a cost segregation study. It breaks down the improvements into divisible parts allowing faster depreciation, thus increasing current year deductions.
Expired Tax Provisions:
The President has signed the Protecting Americans from Tax Hikes Act of 2015 (the PATH Act). Here is a list of key provisions.
- Enhanced Child Tax Credit
- Enhanced American Opportunity Tax Credit
- Enhanced Earned Income Tax Credit
- Above-the-line educator deduction
- Sales tax deduction
- Enhanced mass transit and parking pass benefits
- IRA-to-charity — California automatically conforms
- R&D credit
- IRC §179 — enhanced
- Enhanced exclusion of gain on sale of small business stock
- Built-in gains holding period
Extended through 2016:
- Qualified tuition deduction
- Nonbusiness Energy Property Credit
- COD principal residence exclusion
- Mortgage insurance premium deductible as interest
Extended through 2019:
- Bonus depreciation — phases out
- First year bonus depreciation on automobiles — enhanced
- Work Opportunity Tax Credit the past, Congress has extended many, but not all, expired provisions to future years.
The following provides more details of some of these provisions:
Sales Tax Deductions: The deduction for state and local sales taxes in lieu of state and local income taxes is now available for 2015. This provision is especially important to taxpayers in states such as Texas and Florida where there is no state income tax.
Section 179 write-offs for Equipment, Machinery and Other Depreciable Assets: Under the extender legislation, the limit for this write off is $500,000 and phases out dollar for dollar when total asset purchases for the tax year exceed $2,000,000.
Qualified Leasehold Improvement, Restaurant and Retail Improvement Property: Accelerated depreciation for qualified leasehold improvement, restaurant and retail improvement property that allowed a shortened recovery period of 15 year is now available for 2015.
Section 179 For Qualified Leasehold Improvement, Restaurant and Retail Improvement Property: The Section 179 write-off of up to $250,000 for qualified leasehold improvement, restaurant and retail improvement property has now been extended to 2015.
The 50% Bonus Depreciation Allowance: The 50% bonus depreciation allowance is extended to 2015.
IRA Distributions To Charity: The tax-free IRA distributions to charities has now been extended to 2015. This tax provision allows those age 70 ½ and older to make required distributions directly to charity avoiding income tax on such distributions. Note: They do not also get a charitable deduction for such contribution.
Conservation Easements: Enhancements to the rules for donating real property for conservation that encourage farmers, ranchers and other modest-income landowners to make donations to charitable organizations for land conservation purposes.
Discharge of Principal Residence Debt: Previously taxpayers who got discharged from debt on their home could avoid being taxed on this form of income. Congress has now extended this provision to 2015.
Mortgage Insurance Premiums: The deduction for mortgage insurance premiums has been reinstated for 2015.
Mass Transit and Van Pooling: Parity for employer-provided mass transit and parking benefits ($250 a month, up from $130 a month). Transit commuters who run all their commuting costs through their employer’s transit plan should get a retroactive true up—a potential $576 extra tax savings for 2015.
The Research Tax Credit: Available in 2015.
The Work Opportunity Tax Credit: This credit designed to encourage hiring of certain disadvantaged employees (certain veterans, ex-felons and food stamp recipients, etc.) is now available for 2015.
Various Energy-related Tax Incentives: Energy-efficient home improvements tax credit has been reinstated. Taxpayers can get a tax credit (that’s a dollar for dollar reduction in your tax liability) of up to $500 for making energy-efficient home improvement like new windows or upgraded heating and air conditioning equipment.
Tuition and Fees Deduction: Taxpayers can deduct up to $4,000 in qualified higher education and fees but this provision is available only for 2015.
Teacher Supplies: A $250 above-the-line deduction for school teachers for supplies is available for 2015.
Final Thoughts and Warnings:
While this discussion offers some major year-end income tax strategies, it is not all-encompassing nor is it intended to fit every taxpayer situation. Ultimately, year-end tax strategies depend on the specific income and expenses of each taxpayer and their overall income, gift and estate tax situation.
Taxpayers must stay alert for possible last-minute tax laws enacted before year-end and tax law changes for next year that may impact their short and long-range tax planning .
The one certainty in this uncertain tax environment is to “run the numbers” for your particular tax and financial situation with tax counsel to craft specific tax strategies to cut taxes owed.
I hope this article has been of value to my readers. Please feel free to contact me for help, ask a question or make comments below.
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