Tax Planning Letter
Dear Clients and Friends
The end of another year is in sight. With that in mind, this may be a good time to review some year-end tax planning strategies that may help reduce your overall income tax burden.
For anyone who has had a change in circumstances during the year such as marriage or divorce, birth or death of a family member, acquisition or sale of a business, promotion or loss of a job or any other major event, year-end planning may take on increased importance.
In prior years, the main concern was that, if you reduced your regular income tax too far, the alternative minimum tax (AMT) would step in to appropriate your hard-earned savings. We now have additional dynamics to consider, when certain thresholds are exceeded, in the form of a 3.8% net investment income (NII) tax levied on investment income, a 0.9% Medicare payroll tax levied on wages and self-employment earnings and a multi-tiered long-term capital gains tax rate structure. In addition, the 39.6% tax bracket returns this year after a long hiatus for taxpayers with high incomes. First I would like to highlight the 2013 changes that would impact certain individuals.
Highlights of 2013 changes
- The 3.8% NII tax now applies to the lesser of: Net Investment income or the excess of modified adjusted gross income (MAGI) over $200,000 for singles and head of household; $250,000 for married filing joint; and $125,000 for married filing separate to most investment income. NII includes interest, dividends, rents, passive activity income, capital gains, annuities and royalties. It does not include tax-exempt interest and any distributions from 401(k), IRAs, ROTHs and pension plans.
- A 0.9% Medicare payroll tax applies to earnings of wages and self-employment income in excess of $200,000 for singles and head of household; $250,000 for married filing joint; and $125,000 for married filing separate.
- A new 39.6% bracket has been introduced for individuals with adjusted gross income (AGI) above $400,000 for singles; $425,000 for head of household; $450,000 for married filing joint; and $225,000 for married filing separate.
- The top rate for long-term capital gains and qualified dividends is increased to 20% from 15%. This top rate is generally aligned with the same income levels at which the new 39.6% income tax bracket starts.
- A key part of health reform takes effect January 1, 2014. Individuals without insurance will owe a tax/penalty on their 2014 return filed in 2015. Although the rule that firms with 50 or more full-time employees must provide affordable health insurance workers or pay a stiff fine has been delayed to 2015. The individual mandate’s start date wasn’t deferred.
Below are several ideas that I have grouped by type of taxpayer. Remember that these items may not all be relevant to your specific situation. Therefore, it is a good idea to check with me before taking any significant steps.
As I have indicated to you in prior communications, tax planning is concerned with the timing and method of reporting income and deductions. Year-end tax planning involves considering at least two years at the same time – this year and the next. The basic philosophy is to defer the payment of tax. Following are some basic principles that can help guide your overall thinking:
- If you expect your tax rate to be higher next year, it might make sense to accelerate income into this year and defer deductions into next year.
- If you think your tax rate might be lower next year, consider deferring income to next year and accelerating deductions into this year.
- If you expect to qualify for the standard deduction in either year, consider shifting qualified expenditures and claiming itemized deductions in the year with the greater income.
- If your deductions might be restricted next year due to the alternative minimum tax (AMT), capital loss rules, and/or passive activity loss rules, try to accelerate some into this year.
For 2013, the dreaded phase out rule for the most popular itemized deductions (including home mortgage interest, state and local taxes, and charitable donations) and personal exemption is revived. The applicable threshold for these phase out are $250,000 for singles; $275,000 for head of household; $300,000 for married filing joint; and $150,000 for married filing separate.
On Medicals, the threshold jumps to 10% of AGI from 7.5% of AGI last year for filers under age 65, unless at least one of the filers is age 65 or older.
Time Capital Gains and Losses
Generally, gains and losses from securities sales are recognized on the trade date and not the settlement date. December trades will be 2013 transactions, even if the settlement date is in January 2014. Sales at a loss can reduce other capital gains, and a net loss of up to $3,000 can be used to offset other ordinary income.
Holding period plays an important role in determining the type of a gain. The 15 percent – or 20 percent in case you fall under 39.6% tax bracket – maximum capital gain rate (Long-term capital gain) applies to the investments held for more than 12 months. Also, for 2013 it could be as low as 0 percent for a single with taxable income under $36,250; head of household with taxable income under $48,600; and for married filing jointly with taxable income under $72,500. On the other hand, investments held less than 12 months are considered as short-term gains or losses. Short-term gains are considered as ordinary income and are taxed at the taxpayer’s marginal tax rate.
Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term losses must be used to offset short-term capital gains before they are used to offset long-term gains. A taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. To do this requires making sure that the long-term capital losses are not taken in the same year that the long-term capital gains are taken. However, this is not just a tax issue. As is the case with most tax planning involving capital gains and losses, investment factors need to be considered. A taxpayer won’t want to defer recognizing gain until the following year if there’s too much risk that the value of the property will decline before it can be sold. Similarly, a taxpayer won’t want to risk increasing the loss on property that he expects will continue to decline in value by deferring the sale of that property until the following year.
When selling to recognize a capital loss, do not run afoul of the wash sale rules. A wash sale occurs if you repurchase substantially identical assets within the 61 day period beginning 30 days prior to your loss sale and 30 days after the sale. A wash sale will wipe out any loss you thought you had.
Maximize Retirement Contributions
The best way for most of us to reduce the IRS’s take is to save for the future by contributing to tax-deferred retirement plans. The more money you funnel into an employer sponsored 401(k) or a similar 403(b) or 457 plan, the less the IRS and the state get to tax. If you have an employer sponsored employment plan and haven’t yet contributed the maximum, consider bumping up your year-end contributions. The maximum that you can contribute in 2013 is $ 17,500 or an additional $ 5,500 in case you are 50 or older. An added benefit to the contributions is the employer’s match, which would be a freebie towards your future income and may also qualify you for a tax credit in the current year.
Apart from the contributions in the employer sponsored retirement plans which should be funded by the year-end, some individuals may qualify to make additional contributions to IRA and SEP (simplified employee pension) plans after year-end (April 15, 2014) or to an extended due date of your return in case of a SEP. The maximum you can contribute in IRAs is $5,500 or $6,500 if you are 50 or older. In case of SEP, the maximum contributions can be up to $51,000. Please contact me early next year if you are interested and to find out if you qualify to make these additional contributions.
The $1,500 credit for new windows and doors has expired, but a credit of up to $500 for residential energy property is still available if prior years’ credit were not taken. This nonrefundable credit is available through December 31, 2013 only and can be applied against the installation of energy efficient doors and windows, heat pumps, furnaces, central air conditioning systems and water heaters.
Consider contributing appreciated securities instead of cash. You can deduct the fair market value of long-term capital gain property contributed to charity, even though your basis in that security might be significantly less. Not only do you get a higher deduction, but you also avoid taxes on the gain that would have been recognized if you sold it and donated the proceeds. However, if you’re determined to get rid of securities that have declined in value since you bought them, don’t gift those – instead sell them first to realize the loss, then gift the proceeds. By doing so, you can take the deduction for the gift and at the same time reduce your ordinary income by claiming the loss.
Credit card payments
Using credit card to pay the tax deductible expenditures, including charitable contributions, before year-end secures you a deduction, even if you do not actually pay the credit card company until the following year.
The convenience fees charged by the credit or debit card to pay your income tax, including estimate tax payments, is deductible as miscellaneous itemized deduction.
Individuals must have minimum essential coverage for themselves and their dependents to avoid the tax. This includes coverage provided by an employer that meets minimum federal requirements, coverage purchased through an exchange and federal coverage such as Medicare, Medicaid, Tricare and veterans’ coverage. The open enrollment period to purchase health care coverage through the new Health Insurance market place began October 1, 2013 and can be purchased by March 31, 2014. Certain individuals may be exempt from this individual mandate, including individuals whose income is below the minimum threshold for filing a return ($10,000 for singles and $20,000 for married filing joint), individuals for whom the coverage is too expensive (Cost is > 8% of household income), Filers who go without coverage for less than three months, people who can show that a hardship forced them to go without coverage, individuals outside of US, dependents and members of religious groups opposed to private or public insurance.
Few other tips to reduce your 2013 adjusted gross income (AGI)
Numerous tax breaks (tax credits, deductions, and other tax benefits) are reduced or eliminated if a taxpayer’s adjusted gross income (AGI), or modified AGI (MAGI), exceeds specified thresholds. As year-end nears, taxpayers who do not anticipate being subject to higher rates next year should consider reducing their 2013 AGI by deferring taxable income into 2014, or by accelerating deductions, if doing so will keep their income level for the current year below the relevant phase-out thresholds (or will mitigate the effect of phase outs).
Not all steps listed below will be available or desirable for every individual, but many whose income without planning would be in the range of a threshold may be able to use one or more of the following strategies to keep AGI below the applicable level:
- Convert taxable interest to tax-exempt interest. This will be especially practical where an individual will recognize little or no gain on the disposition of a taxable investment, such as when shifting funds in a taxable money market account to tax-exempt fund. The tax-exempt interest will not be included in AGI (except in determining the taxability of social security benefits), and for some individuals, the after-tax amount received from tax-exempt interest will be at least as much as the after-tax amount received from taxable interest. That’s especially true if the tax-exempt interest is exempt from state or local income taxes as well as federal income tax.
- Convert taxable interest to tax-deferred interest or income. Shifting some funds to US Series EE bonds or inflation-indexed US Series I savings bonds will help you to not recognize any interest earned on these bonds in the current year. The interest earned on these bonds isn’t taxed until the bonds mature or are redeemed, unless the taxpayer elects otherwise. Another possibility would be to shift funds from investments that produce currently taxable income to beaten-down growth stocks, which pay little or no dividends and give the individual the ability to control when any gain on the stocks will eventually be realized by timing their sale to suit his tax goals.
- Pay off debts. If an individual has both income-generating investments and debts on which he is paying interest, he should consider selling part of his investments and using the proceeds to pay off the debt. In addition to reducing AGI, this may increase the individual’s net income because the reduction in interest payments often is greater than the reduction in the income received on the investment.
- Increase contributions to Health savings account (HSA). Individuals who are covered by a qualifying high deductible health plan (and are generally not covered by any other health plan that is not a qualifying high deductible health plan) may make deductible contributions to an HSA. For 2013, assuming a full year coverage, the maximum contribution for self-only coverage is $3,250, and for family coverage is $6,450 (a catch-up contribution of $1,000 for 55 or older). Distributions from an HSA to pay for qualified medical expenses are not taxable. These contributions in excess of medical needs can be withdrawn from the HSA and used for any purpose without penalty (but subject to tax) once the individual reaches age 65.
- Pay up to $ 2,500 of student loan interest. A taxpayer should consider deducting up to this amount even if less than that amount is required to be paid in that tax year. Any voluntary interest payments up to $2,500 are deductible in the year paid.
- Defer receipt of year-end bonuses. An employee who believes a bonus may be coming his way may request that his or her employer delay payment of any bonus until early in the following year.
Code Section 179 expensing
To help small businesses quickly recover the cost of capital outlays, small business taxpayers can elect to write off these expenditures in the year they are made instead of recovering them through depreciation. Under the current rules, taxpayers could generally expense up to $500,000 of qualifying property – generally, machinery, equipment, and software – placed in service during the tax year. This annual limit was reduced by the amount by which the cost of property placed in service exceeded $2,000,000. In contrast, for tax years beginning after 2013, the dollar limit is scheduled to plummet under current law to $25,000 unless otherwise extended by Congress. The phase-out ceiling is also scheduled to drop to $200,000 in 2014 unless otherwise extended by Congress.
Under current law, the incentive to allow up to $250,000 of Section 179 expensing of qualified real property is scheduled to expire for property placed in service after 2013. Qualified real property includes qualified leasehold improvements, restaurant, and retail improvement property.
Extension of 50% bonus first-year depreciation
A 50% bonus depreciation deduction is available for qualified property placed in service in 2013. This 50% write-off generally won’t be available next year unless Congress acts to extend it. To qualify for bonus depreciation, the assets must be new and should be placed in service by year-end.
Boosted deduction for start-up expenditures
The Small Business Jobs Act allows taxpayers to deduct up to $10,000 in trade or business start-up expenditures for 2013. The amount that a business can deduct is reduced by which start-up expenditures exceed $60,000. Previously, the limit of these deductions was capped at $5,000, subject to a $50,000 phase-out threshold.
Home Office deduction
Starting in 2013, taxpayers who use their home for business are allowed to compute their deduction using a simplified method. In lieu of actual expenses such as utilities, repairs, depreciation etc., they may compute their qualifying home office deduction at $5 per square foot, up to $1,500 annually.
Five-year carry back of general business credit
Generally, small business’s unused general business credits can be carried back to the previous year and the remaining amount can be carried forward for 20 years. Under Small Business Jobs Act, for the first tax year of the taxpayer beginning in 2010, eligible small businesses can carry back unused general business credits for five years instead of just one and can be carried forward to 24 years instead of 20 years. Eligible small businesses are sole proprietorships, partnerships, and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years. Further, general business credits are not subject to AMT.
Health insurance tax credits to certain small employers
The recently enacted health reform legislation provides small employers with a tax credit for non-elective contributions to purchase health insurance for their employees. To qualify, a business must offer health insurance to its employees as part of their compensation and contribute at least half the total premium cost. The business must have no more than 25 full-time equivalents (FTEs), and the employees must have annual full time wages that average no more than $50,000. However, the full amount of credit is available only to an employer with 10 or fewer FTEs and whose employees have average annual full time equivalent wages of not more than $25,000. The credit can offset employer’s regular tax or its alternative minimum tax (AMT) liability.
Self-employed individuals, including partners and sole proprietors, two percent shareholders of an S corporation, and five percent owners of the employer are not treated as employees for purposes of this credit.
Deductibility of health insurance for the purpose of calculating self-employment tax
The Small Business Jobs Act allows business owners to deduct the cost of health insurance incurred in 2013 for themselves and their family members in calculating their 2013 self-employment tax.
As noted earlier, there are many other considerations in tax planning that are not addressed here, but my intent is that you use this as a primer for your year-end planning. Starting now can make the process less stressful and leave you with some time to take necessary steps before year-end. However, there might be some significant tax law changes before year-end, be sure to find with me- before year end – any other tax opportunity (ies) that may emerge and would be more beneficial and helpful to your specific tax situation.
Sharing a common goal – to defer or avoid paying taxes as much as possible.
Baljinder (Balli) S. Rakkar, CPA