As the year-end quickly approaches, there is still time to do some year-end tax planning. This 2013 tax year will be tough on many taxpayers due to recent tax law changes and the uncertain future of tax reform. Basically, 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.
- The new 3.8 percent 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 percent 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.
As always, 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. Once your tax brackets 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 law uncertainty, always makes 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 the timing into a tax year where the tax bracket is lower than the other tax year in question. But 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. Yikes.
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.
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.
So 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 starting in 2013. 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.
- 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.) Also where income this year will be below the new 3.8 percent Medicare tax threshold, accelerating this passive income 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.
- 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. So 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 percent surcharge on capital gains and how such decision impacts itemized deduction limitations.
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.
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.
- Complete 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 tax savings.
- Accelerate debt forgiveness income with your lender. In addition to being taxed at a lower tax bracket this year, acceleration also may make sense because of the possibility that tax law reform may end this tax break. See Expiring Provisions below.
- Maximize retirement distributions. Remember the minimum required distributions (MRDs) are the amounts distributed each year to avoid the draconian 50% MRD penalty. 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.
- 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. So it really 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.
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). In any event, taxpayers must watch out for 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 it done in the year that you are already above the applicable AGI threshold.
- Where income will be greater next year, taking the standard deduction this year and bunching itemized deductions to next year would yield an optimum tax result.
- For medical expenses, the adjusted gross income (AGI) limitation rises to 10% in 2013 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.
- Postpone paying certain tax-deductible bills until next year to generate a greater tax benefit.
- Pay fourth quarter state estimated tax installment on January 15 of next year.
- Postpone “economic performance” for tax-deductible expenses until next year if you are an accrual basis taxpayer.
- As mentioned above, 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 reduce regular 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.
- Watch net investment interest restrictions.
- 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 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.
- Purchase machinery and equipment before the end of 2013. Even if you are in a higher tax bracket next year, it may make sense to take advantage of the generous current Section 179 deductions and 50% bonus depreciation. These tax breaks may not last past 2013. Or they may be significantly reduced next year.
- 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: Many taxpayers pay both estimated taxes and withholding taxes. If you have fallen behind on quarterly estimates, it may be 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.
- Do not invest 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.
In the past, Congress has extended many, but not all, expiring provisions to future years. However, there is a lot of uncertainty now as there is talk of major tax reform and still out of control budget deficits. Prudence may dictate the possible loss of some of the following tax provisions:
- Sales Tax Deductions: This deduction has an uncertain future. So for those in low or no income tax states or who are contemplating a very large purchase, completion before year-end may be warranted.
- IRA Distributions To Charity: This provision also faces an unknown future. Currently, the tax law allows those age 70 1/2 and older to make required distributions directly to charity. This allows them to avoid income taxation on such distributions. Note: They do not also get a charitable deduction for such contribution.
- Discharge of Principal Residence Debt: Taxpayers who get discharged from debt on their home can avoid being taxed on this form of income. Those taxpayers involved in a foreclosure should complete this transaction before year-end in the event this law is eliminated next year.
- Other Expiring Tax Breaks where the taxpayer may want to consider paying before year-end:
- Residential Energy Property Tax Credit
- Qualified Tuition Deduction
- Contribution of Real Estate for Conservation
- Teachers Classroom Deduction
- Qualified Tuition Deduction
- Van-pooling or Mass Transit Benefits
- Mortgage Insurance Premiums
Final Thoughts and Warnings:
Remember that these are just some of the major year-end income tax strategies and are not all-encompassing. Taxpayers must take into account possible tax law changes for next year and last-minute tax laws enacted before year-end.
Most importantly remember that income tax strategies depend on the specific income or expenses of each taxpayer and their overall income, gift and estate tax setting. This discussion offers some, but not all tax strategies.
The one certainty in this uncertain tax environment is to “run the numbers” to find the best approach for each taxpayer’s particular tax and financial situation.
As always, it is quite beneficial to have tax counsel look at the details of your particular income tax situation to carve out specific tax strategies to cut taxes owed.
I hope this article has been of value to my readers. Please feel free to contact me, ask a question or make comments below.