Year-End Tax Planning
As the end of the year approaches, it’s time to consider strategies that can help you reduce your tax bill. But most tax tips, suggestions, and strategies are of little practical help without a good understanding of your current tax situation. This is particularly true for year-end planning. You can’t know where to go next if you don’t know where you are now.
So take a break from the usual fall chores and pull out last year’s tax return, along with your current pay stubs and account statements. Doing a few quick projections will help you estimate your present tax situation and identify any glaring issues you’ll need to address while there’s still time.
When it comes to withholding, don’t shortchange yourself
If you project that you’ll owe a substantial amount when you file this year’s income tax return, ask your employer to increase your federal income tax withholding amounts. If you have both wage and consulting income and are making estimated tax payments, there’s an added benefit to doing this: Even though the additional withholding may need to come from your last few paychecks, it’s generally treated as having been withheld evenly throughout the year. This may help you avoid paying an estimated tax penalty due to under withholding.
Of course, if you’ve significantly overpaid your taxes and estimate you’ll be receiving a large refund, you can reduce your withholding accordingly, putting money back in your pocket this year instead of waiting for your refund check to come next year.
Will you suffer the alternative?
Originally intended to prevent the very rich from using “loopholes” to avoid paying taxes, the alternative minimum tax (AMT) now reaches further into the ranks of middle-income taxpayers. The AMT is governed by a separate set of rules that exist in parallel to those for the regular income tax system. These rules disallow certain deductions and personal exemptions that you are allowed to include in computing your regular income tax liability, and treat specific items, such as incentive stock options, differently. As a result, AMT liability may be triggered by such items as:
- Large numbers of personal exemptions
- Large deductible medical expenses
- Large deductions for state, local, personal property, and real estate taxes
- Home equity loan interest where the financing isn’t used to buy, build, or improve your home
- Exercising incentive stock options
- Large amounts of miscellaneous itemized deductions
So when you sit down to project your taxes, calculate your regular income tax on Form 1040, and then consider your potential AMT liability using Form 6251. If it appears you’ll be subject to the AMT, you’ll need to take a very different planning approach during the last few months of the year. Even some of the most basic year-end tax planning strategies can have unintended consequences under AMT rules. For example, accelerating certain deductions into this year may prove counterproductive since AMT rules may require you to add them back into your income. If you think AMT is going to be a factor, consider talking to a tax professional about your specific tax situation.
Timing is everything
The last few months of the year may be the time to consider delaying or accelerating income and deductions, taking into consideration the impact on both this year’s taxes and next. If you expect to be in a different tax bracket next year, doing so may help you minimize your tax liability. For instance, if you expect to be in a lower tax bracket next year, you might want to postpone income from this year to next so that you will pay tax on it next year instead. At the same time, you may want to accelerate your deductions in order to pay less tax this year.
To delay income to the following year, you might be able to:
- Defer year-end bonuses
- Defer the sale of capital gain property (or take installment payments rather than a lump-sum payment)
- Postpone receipt of distributions (other than required minimum distributions) from retirement accounts
To accelerate deductions into this year:
- Consider paying medical expenses in December rather than January, if doing so will allow you to qualify for the medical expense deduction
- Prepay deductible interest
- Make alimony payments early
- Make next year’s charitable contributions this year
The gifts that give back
If you itemize your deductions, consider donating money or property to charity before the end of the current tax year in order to increase the amount you can deduct on your taxes. As an aside, now is also a good time to consider making non-charitable gifts. In 2013, you may give up to $14,000 ($28,000 for a married couple) to as many individuals as you want without incurring any federal gift tax consequences. If you gift an appreciated asset, you won’t have to pay tax on the gain; any tax is deferred until the recipient of your gift disposes of the property.
Postpone the inevitable
To reduce your taxable income this year, consider maximizing pretax contributions to an employer-sponsored retirement plan such as a 401(k). You won’t be taxed on the contributions you make now, and you may be in a lower tax bracket when you do eventually withdraw the funds and report the income. (Note that if you take withdrawals from the plan before age 59½, you’ll generally be subject to a 10 percent penalty tax in addition to any income tax due, unless an exception applies.)
If you qualify, you might also consider making either a tax-deductible contribution to a traditional IRA or an after-tax contribution to a Roth IRA. In the first instance, a current income tax deduction effectively defers income–and its taxation–to future years (as with a retirement plan, an additional 10 percent penalty tax will apply to withdrawals made prior to age 59½ in addition to any income tax due, unless an exception applies); in the second, while there’s no current tax deduction allowed, qualifying distributions you take later will be tax free. You’ll generally have until the due date of your federal income tax return to make these contributions.
Year-End Investment Decisions
What are year-end investment decisions?
Year-end investment decisions may sometimes result in substantial tax savings. Tax planning may allow you to control the timing and method by which you report your income and claim your deductions and credits. The basic strategy for year-end planning is both to time your income so that it will be taxed at a lower rate, and to time your deductible expenses so that they may be claimed in years when you are in a higher tax bracket. In terms of investment planning, investing in capital assets may increase your ability to time the recognition of some of your income and may help you to take advantage of tax rates that are lower than the ordinary income tax rates. You have the flexibility to control when you recognize the income or loss on many types of investment assets. In most cases, you determine when to sell your capital assets. In some cases, however, shifting potential capital gain income to other taxpayers through gifting may be an appropriate strategy.
How do you use the capital gains tax to lower your taxes?
Capital gains and losses are accorded special tax treatment. Currently, the top long-term capital gains tax rate is 20 percent (for most types of assets), while the top ordinary income tax rate is 39.6 percent–that’s a difference of 19.6 percent. As a consequence, by converting some of your ordinary income to long-term capital gain income, it may be possible for you to reduce your federal income tax liability.
Tip: Long-term capital gains are generally taxed at a capital gains tax rate of 0 percent for taxpayers in the 10 and 15 percent tax brackets, 15 percent for taxpayers in the 25 to 35 percent tax brackets, and 20 percent for taxpayers in the 39.6 percent tax bracket.
Timing your capital gain recognition
Careful timing of when you sell capital assets may help you to reduce your federal income tax liability. For example, if it’s late in the year and you want to sell a capital asset, you can wait until January to sell it so that you realize your capital gain or loss next year (assuming that you have a calendar tax year). This strategy is particularly useful if you are in a higher marginal tax bracket in the current year and expect to be in a lower one in the following year. Timing can also be important because capital gain income increases your adjusted gross income (AGI). Itemized deductions and personal exemptions may be phased out or decreased if your AGI in a given year exceeds a specified threshold.
Plan your year-end capital gain and loss status
Planning the time when you recognize capital losses may also be important. If you expect to recognize a capital gain this year, you should review your portfolio for possible capital losses that can be used to offset the gains. If you have any capital loss carry-forwards, you should review your portfolio for capital gain opportunities to make use of such carry-forwards. In general, net capital losses are deductible dollar-for-dollar against net capital gains. Excess losses are allowed to offset up to $3,000 ($1,500 for individuals filing married filing separate tax returns) of ordinary income per year. Losses over and above the limit may be carried forward indefinitely.
The following strategies may be appropriate:
- Sell capital gain property before the end of the year if you have already realized capital losses for the year that exceed the sum of any capital gains you have realized plus $3,000 ($1,500 for individuals filing married filing separate tax returns).
- If you have gains for the year that exceed your losses, sell property with built-in losses to offset the excess gains.
- If your other allowable deductions for the year exceed your income, you should, to the extent possible, avoid realizing any further capital losses for the year.
- If you’ve held a capital asset for close to 12 months and want to sell it, wait awhile (if possible). You can take advantage of the lower long-term capital gains rates if you hold the asset for over 12 months before selling it.
For more information about capital gains and losses, see Year-End Tax Planning.
How do you select investments to control income?
You can select investments likely to produce ordinary income such as interest, or income that is taxed at reduced rates (certain qualifying dividends or long-term capital gains). You can also select investments likely to produce ordinary or capital losses. You can control when your investment earnings are taxed, bearing in mind that income distributions are generally not taxed until you receive them (assuming that you use the cash method of accounting). By knowing the tax rules, you can lower your taxes.
What about shifting income?
It may be possible to shift potential capital gains to other taxpayers through gifts. If you are in a 25 percent or higher individual marginal tax bracket, the zero percent long-term capital gains tax rate for those in the 10 or 15 percent bracket may provide an incentive for you to transfer appreciated assets to relatives in those lower tax brackets.
Securities offered through Securities America Inc., Member FINRA/SIPC and advisory services offered through Securities America Advisors, Inc. Armstrong Advisory Group and the Securities America companies are unaffiliated. Representatives of Securities America, Inc. do not provide legal or tax advice. Please consult with a local attorney or tax advisor who is familiar with the particular laws of your state. Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013 – September 2013 – AT 711637