Year-end tax planning could be especially productive this year. Timely action could nail down a host of tax breaks that won’t be around next year unless Congress acts to extend them, and individuals may be unprepared for taxes due as a result of increased tax rates and new taxes created by the Affordable Care Act.
Planning for new tax rates and hikes
In 2013, the new marginal tax rate for individuals was increased to 39.6%. Married couples who file jointly and have taxable income above $450,000 will be subject to this tax bracket, as well as single individuals with income above $400,000. ($425,000 for head-of-household filers, $225,000 for each married spouse filing separately). An additional Medicare tax of 0.9% on wages and self-employment income, and a net investment income tax of 3.8% are effective for the first time in 2013. Capital gain rates have also increased – moving up to a maxiumum of 20%.
To minimize the impact of these tax hikes, taxpayers should consider taking steps to keep their income below the various threshold levels, if possible, by spreading income over a number of years or offsetting the income with above-the-line deductions. In particular, spikes in income should be carefully managed – keeping a close eye on transactions such as Roth IRA conversions, taxable sales of assets, and the timing of income earned from passthrough S-corporations or partnerships. Specific steps could include:
- If you are over age 70 ½, you can make a tax-free distribution of up to $100,000 from your IRA to a qualified charity. This withdrawal will not be included in your income (helping to minimize income levels) nor will the related contribution be included in your itemized deductions (thus not being subjected to the phase out of your itemized deductions due to income limitations). This opportunity is not available for 2014 under current law.
- Sell stocks that have decreased in value below your original cost in order to utilize those losses. Use caution, however, to not create a net capital loss in excess of $3,000 since any net capital loss in excess of that amount is not deductible in the current year. You can still preserve your investment position in these stocks if you choose, by buying back those securities at least 31 days after the sale.
- Compare the value of assets at year end for any conversions made during 2013 from a traditional IRA to a Roth IRA. If the account value has declined, consider backing out of the transaction in order to prevent paying tax on the conversion at an inflated value. You can “re-characterize” the transaction by transferring the assets (plus or minus investment earnings/losses) back into a traditional IRA account.
- If you became eligible to make health savings account (HSA) contributions this year, consider maximizing the tax benefit by making a full year’s worth of deductible HSA contributions for 2013.
- Prepay eligible expenses for qualified higher education expenses to take advantage of the $4,000 “above-the-line deduction”. Generally, this includes expenses paid for an academic period beginning in 2013 or in the first three months of 2014. This deduction will no longer be available after 2013.
- To avoid the higher tax rates and Medicare tax on undistributed income for trusts, consider making distributions to trust beneficiaries who would not be subject to the Medicare surtax on their individual returns. Distributions can be made up to 65 days after the year end (March 5, 2014) and still count as 2013 distributions.
Higher income earners will also experience a significant decrease in the deductibility of their personal exemptions and itemized deductions. A reinstated limitation reduces itemized deductions when the taxpayer’s adjusted gross income exceeds their applicable threshold limit. This reduction cannot exceed 80 percent of your itemized deductions and certain items, such as medical expenses, investment interest, casualty losses and gambling losses, are excluded. Consider the following:
- Use a credit card to pay for expenses that can generate tax deductions for this year. The expense is still deductible this year even if the credit card balance is paid in the following year.
- Keep good records. In particular, make sure you have the required documentation for charitable contributions. For cash donations of more than $250, be sure you have a copy of your cancelled check and the receipt from the charitable organization. For donated property, a detailed listing, with the fair market value of each item, along with the receipt from the organization will be needed. You will also need to be able to demonstrate that the donated property was in “good” shape for your deduction to count. Additional documentation is required for noncash donations of more than $5,000 – including a qualified written appraisal along with acknowledgements from the appraisal and the charitable organization.
- Consider donating stock that has increased in value to your favorite religious or charitable organization. If you have owned that stock for more than one year, you can generally deduct the full fair market value of those shares without paying tax on the appreciation. As an added bonus, donations of publicly-traded securities are exempt from the requirement to obtain a written appraisal – which saves the cost of obtaining the appraisal.
- Miscellaneous Itemized Deductions, such as expenses for financial planning, tax preparation, and unreimbursed employee business expenses, are deductible only if the total of these items exceeds two percent of your adjusted gross income. Grouping these deductions in alternating years can be an effective tax-planning strategy to reach the threshold level.
If you do anticipate a balance due this year, increase withholding on salaries, bonuses, or retirement distributions at year end to avoid underpayment penalties (tax withholdings are assumed to be paid in evenly throughout the year which minimizes penalty exposure). Additionally, you can submit quarterly estimated tax payments, but be sure to coordinate this planning with “safe harbor” tax payment calculations and Alternative Minimum Tax calculations (for state payments).
Gifts of $14,000 per year, per recipient, can be made tax free without counting this toward the lifetime estate exclusion. There is no limit on the number of individuals to whom the gifts can be made, but you can’t carry over unused exclusions from one year to the next. Those gifts are not tax deductible, but these transfers can minimize future taxable investment earnings and can help achieve estate planning goals.
- Consider making similar gifts at the beginning of each tax year. Each year brings a new exclusion, and an early gift transfers next year’s appreciation and earnings out of your estate.
Another useful tool for reducing your current estate is through contributions to college savings plans, or “529 Plans”. These state-administered investment programs allow investors to save money in an account where the earnings will grow tax-free if used to pay for “qualified higher education expenses”. While these contributions have the effect of reducing your estate, you still maintain control over the account, including making investment choices, arranging for withdrawals, or changing beneficiaries. Contributions to these plans have the added incentive, in most states, of generating state tax deductions.
- Contributions can be made for family members or friends, without regard to age, or income levels.
Obviously, taxes are not the only issue to consider when making decisions about your financial plans. And, in many cases, tax strategies need to be evaluated to determine the effect on your specific set of facts and circumstances. Either way, now may be the time to call your advisor at MarksNelson about these tax law changes and their impact on your total tax liability.