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Year-End Tax Planning for Individuals
Once again, tax planning for the year ahead presents more challenges than usual, this time due to the numerous tax extenders that expired at the end of 2013.
These tax extenders, which include nonbusiness energy credits and the sales tax deduction that allows taxpayers to deduct state and local general sales taxes instead of state and local income taxes, may or may not be reauthorized by Congress and made retroactive to the beginning of the year.
More significant however, is taxable income in relation to threshold amounts that might bump a taxpayer into a higher or lower tax bracket, thus, subjecting taxpayers to additional taxes such as the Net Investment Income Tax (NIIT) or an additional Medicare tax.
In the meantime, let's take a look at some of the tax strategies that you can use right now, given the current tax situation.
Tax planning strategies for individuals this year include postponing income and accelerating deductions, as well as careful consideration of timing related investments, charitable gifts, and retirement planning. General tax planning strategies that taxpayers might consider include the following:
Accelerating Income and Deductions
Accelerating income into 2014 is an especially good idea for taxpayers who anticipate being in a higher tax bracket next year or whose earnings are close to threshold amounts ($200,000 for single filers and $250,000 for married filing jointly) that make them liable for additional Medicare tax or Net Investment Income Tax (see below).
Here are several examples of what a taxpayer might do to accelerate deductions:
In cases where tax benefits are phased out over a certain adjusted gross income (AGI) amount, a strategy of accelerating income and deductions might allow you to claim larger deductions, credits, and other tax breaks for 2014, depending on your situation.
The latter benefits include Roth IRA contributions, conversions of regular IRAs to Roth IRAs, child credits, higher education tax credits and deductions for student loan interest.
If you haven't signed up for health insurance this year, it's not too late to do so--and avoid or reduce any penalty you might be subject to. Healthcare subsidies are also a potential tax planning issue. Please contact us if you need assistance with this.
Additional Medicare Tax
Taxpayers whose income exceeds certain threshold amounts ($200,000 single filers and $250,000 married filing jointly) are liable for an additional Medicare tax of 0.9 percent on their tax returns, but may request that their employers withhold additional income tax from their pay to be applied against their tax liability when filing their 2014 tax return next April.
High net worth individuals should consider contributing to Roth IRAs and 401(k) because distributions are not subject to the Medicare Tax.
If you're a taxpayer close to the threshold for the Medicare Tax, it might make sense to switch Roth retirement contributions to a traditional IRA plan, thereby avoiding the 3.8 percent Net Investment Income Tax as well (more about the NIIT below).
Alternate Minimum Tax
The Alternative Minimum Tax (AMT) exemption "patch" was made permanent by the American Taxpayer Relief Act (ATRA) and is indexed for inflation. It's important not to overlook the effect of any year-end planning moves on the AMT for 2014 and 2015.
Items that may affect AMT include deductions for state property taxes and state income taxes, miscellaneous itemized deductions, and personal exemptions.
Residential Energy Tax Credits
Non-Business Energy Credits
ATRA extended the non-business energy credit, which expired in 2011, through 2013 (retroactive to 2012); however, it has not been reauthorized by Congress. For years prior to 2014, taxpayers could claim a credit of 10 percent of the cost of certain energy-saving property that was added to their main home.
Residential Energy Efficient Property Credits
The Residential Energy Efficient Property Credit is available to individual taxpayers to help pay for qualified residential alternative energy equipment, such as solar hot water heaters, solar electricity equipment and residential wind turbines. In addition, taxpayers are allowed to take the credit against the alternative minimum tax (AMT), subject to certain limitations.
Qualifying equipment must have been installed on or in connection with your home located in the United States.
Geothermal pumps, solar energy systems, and residential wind turbines can be installed in both principal residences and second homes (existing homes and new construction), but not rentals. Fuel cell property qualifies for the tax credit only when it is installed in your principal residence (new construction or existing home). Rentals and second homes do not qualify.
The tax credit is 30 percent of the cost of the qualified property, with no cap on the amount of credit available, except for fuel cell property.
Generally, labor costs can be included when figuring the credit. Any unused portions of this credit can be carried forward. Not all energy-efficient improvements qualify so be sure you have the manufacturer's tax credit certification statement, which can usually be found on the manufacturer's website or with the product packaging.
What's included in this tax credit?
Property, as well as money, can be donated to a charity. You can generally take a deduction for the fair market value of the property; however, for certain property, the deduction is limited to your cost basis. While you can also donate your services to charity, you may not deduct the value of these services. You may also be able to deduct charity-related travel expenses and some out-of-pocket expenses, however.
Keep in mind that a written record of your charitable contributions is required in order to qualify for a deduction. A donor may not claim a deduction for any contribution of cash, a check or other monetary gift unless the donor maintains a record of the contribution in the form of either a bank record (such as a cancelled check) or written communication from the charity (such as a receipt or a letter) showing the name of the charity, the date of the contribution, and the amount of the contribution.
Investment Gains and Losses
This year, and in the coming years, investment decisions are likely to be more about managing capital gains than about minimizing taxes per se. For example, taxpayers below threshold amounts in 2014 might want to take gains; whereas taxpayers above threshold amounts might want to take losses.
If your tax bracket is either 10 or 15 percent (married couples making less than $73,800 or single filers making less than $36,900), then you might want to take advantage of the zero percent tax rate on qualified dividends and long-term capital gains. If you fall into the highest tax bracket (39.6 percent), the maximum tax rate on long-term capital gains is capped at 20 percent for tax years 2013 and beyond.
Minimize taxes on investments by judicious matching of gains and losses. Where appropriate, try to avoid short-term capital gains, which are usually taxed at a much higher tax rate than long-term gains--up to 39.6 percent in 2014 for high-income earners ($406,750 single filers, $457,600 married filing jointly).
Where feasible, reduce all capital gains and generate short-term capital losses up to $3,000.
Net Investment Income Tax (NIIT)
The Net Investment Income Tax, which went into effect in 2013, is a 3.8 percent tax that is applied to investment income such as long-term capital gains for earners above certain threshold amounts ($200,000 for single filers and $250,000 for married taxpayers filing jointly). Short-term capital gains are subject to ordinary income tax rates as well as the 3.8 percent NIIT. This information is something to think about as you plan your long term investments. Business income is not considered subject to the NIIT provided the individual business owner is materially active in the business.
Please call us if you need assistance with any of your long term tax planning goals.
Mutual Fund Investments
Before investing in a mutual fund, ask whether a dividend is paid at the end of the year or whether a dividend will be paid early in the next year but be deemed paid this year. The year-end dividend could make a substantial difference in the tax you pay.
Depending on your financial circumstances, it may or may not be a good idea to buy shares right before the fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax consequences. Or the market could be moving up, with share prices expected to be higher after the ex-dividend date.
Be sure to call us if you'd like more information on how dividends paid out by mutual funds affect your taxes this year and next.
Year-End Giving To Reduce Your Potential Estate Tax
The federal gift and estate tax exemption, which is currently set at $5.340 million is projected to increase to $5.43 million in 2015 (Bloomberg BNA). ATRA set the maximum estate tax rate set at 40 percent.
Gift Tax. For many, sound estate planning begins with lifetime gifts to family members. In other words, gifts that reduce the donor's assets subject to future estate tax. Such gifts are often made at year-end, during the holiday season, in ways that qualify for exemption from federal gift tax.
Gifts to a donee are exempt from the gift tax for amounts up to $14,000 a year per donee.
Husband-wife joint gifts to any third person are exempt from gift tax for amounts up to $28,000 ($14,000 each). Though what's given may come from either you or your spouse or both of you, both of you must consent to such "split gifts".
Gifts of "future interests", assets that the donee can only enjoy at some future time such as certain gifts in trust, generally don't qualify for exemption; however, gifts for the benefit of a minor child can be made to qualify.
Cash or publicly traded securities raise the fewest problems. You may choose to give property you expect to increase substantially in value later. Shifting future appreciation to your heirs keeps that value out of your estate. But this can trigger IRS questions about the gift's true value when given.
You may choose to give property that has already appreciated. The idea here is that the donee, not you, will realize and pay income tax on future earnings and built-in gain on sale.
Gift tax returns for 2014 are due the same date as your income tax return. Returns are required for gifts over $14,000 (including husband-wife split gifts totaling more than $14,000) and gifts of future interests. Though you are not required to file if your gifts do not exceed $14,000, you might consider filing anyway as a tactical move to block a future IRS challenge about gifts not "adequately disclosed."
Income earned on investments you give to children or other family members are generally taxed to them, not to you. In the case of dividends paid on stock given to your children, they may qualify for the reduced child tax rate, generally 10 percent, where the first $1,000 in investment income is exempt from tax and the next $1,000 is subject to a child's tax rate of 10 percent (0 percent tax rate on long-term capital gains and qualified dividends).
Other Year-End Moves
Retirement Plan Contributions. Maximize your retirement plan contributions. If you own an incorporated or unincorporated business, consider setting up a retirement plan if you don't already have one. It doesn't actually need to be funded until you pay your taxes, but allowable contributions will be deductible on this year's return.
If you are an employee and your employer has a 401(k), contribute the maximum amount ($17,500 for 2014), plus an additional catch-up contribution of $5,500 if age 50 or over, assuming the plan allows this much and income restrictions don't apply.
If you are employed or self-employed with no retirement plan, you can make a deductible contribution of up to $5,500 a year to a traditional IRA (deduction is sometimes allowed even if you have a plan). Further, there is also an additional catch-up contribution of $1,000 if age 50 or over.
Health Savings Accounts. Consider setting up a health savings account (HSA). You can deduct contributions to the account, investment earnings are tax-deferred until withdrawn, and amounts you withdraw are tax-free when used to pay medical bills.
In effect, medical expenses paid from the account are deductible from the first dollar (unlike the usual rule limiting such deductions to the excess over 10 percent of AGI). For amounts withdrawn at age 65 or later, and not used for medical bills, the HSA functions much like an IRA.
To be eligible, you must have a high-deductible health plan (HDHP), and only such insurance, subject to numerous exceptions, and must not be enrolled in Medicare. For 2014, to qualify for the HSA, your minimum deductible in your HDHP must be at least $1,250 for single coverage or $2,500 for a family.
These are just a few of the steps you might take. Please contact me for help in implementing these or other year-end planning strategies that might be suitable to your particular situation.
Larry Phillips III, CPA | 11/07/2014