Tax planning needs to be an ongoing process; one that takes into consideration both the continually evolving political, fiscal, and legislative environment and changes in your own personal circumstances, needs, and goals. The following section outlines a number of tax planning ideas that may help you reduce not only this year’s tax bill but your tax liability in future years.
Prepare a Tax Projection
The first step in tax planning is to project what you will pay in taxes this year. Determine your estimated marginal tax rate—the percentage of tax you will pay on your last dollar of income (meaning the tax bracket your last dollar of income falls into, and therefore the highest tax rate you pay). Then, think about whether your marginal tax rate will likely go up or down next year. In doing so, consider the significant difference between the tax rate on your ordinary income (up to 39.6% in 2014, plus, if applicable, 3.8% Net Investment Income Tax (NIIT) on Net Investment Income (NII)) and the rate on your long-term capital gains and qualified dividends (generally 15%, with the highest tax rate at 20% for taxpayers who are otherwise subject to the 39.6% marginal rate on ordinary income, plus, if applicable, 3.8% NIIT on gains and dividends treated as NII).
Consider building out your tax projection to cover the next few years, not just to see what your overall taxable income could be, but to gain a deeper perspective on the composition of that income and how future tax law changes could affect it. You should also look at your investment asset allocation and asset location. The former is about what you own. The latter is about where and in what types of accounts you own your investments. Take care not to make short-term, tax-driven decisions today that may undermine your overall financial goals tomorrow. By doing these analyses and assessments, you can effectively position yourself to determine what, if any, adjustments you should consider for tax and investment planning.
Tax planning often, but not always, involves deferring income and accelerating deductions. It can also involve shifting income to a person in a lower tax bracket and repositioning an appropriate portion of your portfolio from investments that generate ordinary taxable income to those that may create capital gains and produce tax-exempt income. Generally, you want to recognize income in years in which your tax rate is comparatively low and pay deductible expenses when your tax rate is comparatively high. Only when you understand your current situation can you evaluate whether the tax law provides any incentives for taking action this year.
Ways to Postpone or Reduce Income Subject to Tax
Defer interest income. Consider purchasing a short-term certificate of deposit (CD) that matures in the following year. None of the interest earned will be subject to tax in the year you bought the CD, provided any interest received this year would be penalized by the issuer of the CD. Buying tax-deferred U.S. Treasury securities, such as Series EE or Series I bonds, is another way to defer interest income.
Evaluate the effect of the lower tax rate for qualified dividends. For taxpayers subject to the 25%, 28%, 33%, or 35% tax brackets on ordinary income, qualified dividend income—but not interest income—is taxed at a top income tax rate of 15%. For high-income taxpayers who are otherwise in the 39.6% regular income tax bracket (i.e., in 2014, taxable incomes over $406,750 for individual filers, $432,200 for heads of households, $457,600 married filing jointly, and $228,800 if married filing separately), the tax rate is 20% on qualified dividends. Qualified dividends received by taxpayers in the 10% and 15% tax brackets are taxed at a zero rate. These preferential tax rates on qualified dividend income apply to both the regular tax and the alternative minimum tax. The lower tax rates for qualified dividends means that you should consider dividends, as well as long-term capital gains (discussed next) when evaluating the tax considerations in a year-end sale of stock. A number of tests must be met for a dividend to qualify for the reduced tax rates. See Qualified Dividends in chapter 8, Dividends and other corporate distributions, for more information.
Qualify for the lower long-term capital gains rates. The maximum federal income tax rate on gains from sales of most types of investments held longer than 12 months is 15% for taxpayers who are otherwise subject to the 25%, 28%, 33%, or 35% tax brackets on ordinary income. Net long-term capital gains are taxed at a maximum rate of 20% for high income taxpayers who are otherwise in the 39.6% regular income tax bracket (i.e., in 2014, taxable incomes over $406,750 for individual filers, $432,200 for heads of households, $457,600 if married filing jointly, and $228,800 if married filing separately). The rate on net capital gains received by taxpayers in the 10% and 15% tax brackets is zero. The 12-month period begins the day after you buy the property. When selling securities, ignore the settlement date. The trade date determines the date of disposition.
Identify shares of stock and mutual funds that you want to sell to maximize tax benefits. If you want to sell shares that you purchased at different times, select those in which you have a high tax basis in order to reduce taxable gain or increase a tax loss that can be used to offset other taxable income.
Use your capital losses. If you had capital gains this year, consider offsetting those gains by selling property in which you have unrealized capital losses. You can offset capital losses against capital gains dollar for dollar. You can also use capital losses in excess of capital gains to offset up to $3,000 of ordinary income (for example, wages, interest, etc.) each year. Doing so may save you nearly $1,200 in federal income tax (if you are in the top tax bracket). Any unused capital losses are carried forward for use in future tax years.
Take a capital loss on worthless securities. If you have investments that became worthless during the past year, the tax code treats you as having realized a loss as of the last day of the year. This rule applies only if the investments have no value; even if your investments are worth only pennies, they will not be considered worthless for tax purposes. To ensure that you can utilize the loss on an investment that has dramatically declined in value but is not worthless, sell the investment to an unrelated party before the end of this year.
Don’t be caught by the “wash-sale” rule. If you sell securities to realize a tax loss, make sure you do not purchase the same or substantially similar securities within 30 days before or after the date of sale. If you do, you will not be able to claim the loss on this year’s tax return.
Properly time your year-end investments in mutual funds. Mutual funds generally make distributions to investors holding shares on a record date near year-end. If you want to invest in a fund, but would be subject to tax on such a distribution (that is, your investment will not be held in a 401(k) or other tax-deferred or tax-exempt vehicle), wait until after the record date before making your purchase. If you plan to sell a substantial interest in a mutual fund near year-end, consult with your tax advisor as to how the sale might affect whether dividends from that fund are qualified dividends (subject to the 15% maximum federal tax rate).
Review how investments are allocated among taxable and tax-deferred accounts. Distributions from tax-deferred accounts, such as traditional 401(k) plans, are taxed at ordinary income tax rates. This is true even if the income in those accounts consists of long-term capital gains and qualified dividends that would otherwise have been eligible for the reduced federal income tax rates described earlier in this section. From a tax perspective, it may be beneficial to hold investments that generate long-term capital gains and qualified dividends in taxable accounts, while holding investments that generate short-term gains, interest, and other ordinary taxable income in your tax-deferred accounts. Since there may be significant investment and tax considerations involved in shifting assets, speak with your tax advisor before taking any action.
Review your stock options. Don’t overlook your options or option shares when you do your year-end tax planning. There may be opportunities to avoid or minimize regular income tax or alternative minimum tax (AMT) by taking action this year.
Use flexible spending plans. These plans permit you to pay for eligible health care and dependent care expenses with pretax wages. The amounts you contribute to these plans are not subject to federal income, Social Security, or Medicare taxes. If your employer sponsors this type of plan and you contributed to it during the year, make sure you incur sufficient qualifying expenses by year-end or you will forfeit any unused funds. Your employer may provide you with an option to either use unspent funds to cover expenses incurred up to 2½ months following the end of the plan year (March 15th of the following year for plan years ending on December 31st) or to roll over up to $500 to the next plan year (without reducing your maximum allowed contribution for the new plan year). But your employer cannot offer both options.
Properly characterize alimony. Alimony payments are deductible to the payer and includable in the income of the person who receives them. When the recipient is in a low tax bracket, there may be a net tax benefit that the payer and recipient can share. This will occur only if the payments can be properly characterized as alimony rather than a property settlement or child support. Before you finalize a divorce or separation agreement, discuss with your tax advisor whether a portion of any payments may be deductible alimony.
Review the use of deferred compensation agreements. If you and your employer are willing to defer a portion of your future earnings, you may be able to use a written deferred compensation agreement to defer tax. To obtain the tax benefit, you must accept some risk that you may not receive the payments and be subject to strict rules on when the compensation can be paid. Using certain irrevocable trusts to fund the deferred compensation can minimize certain risks, though it will not protect against the risk that the deferred income may be subject to the claims of your employer’s creditors.
Speak with your tax advisor if you are currently using, or considering entering into, this type of agreement, as the tax rules governing these arrangements are complex. Failure to adhere to these rules may trigger current income tax on amounts deferred, as well as substantial penalties and interest.
Review the special rules for inherited property. Most investment property you inherit will be valued for capital gains purposes as of the date of death. In almost all situations, if inherited property is sold for a price above this value, the gain will qualify for taxation at long-term capital gains rates. This is true no matter how long you or the person from whom you inherited the property held it.
Ways to Accelerate Income
Accelerating income can be the better tax-planning approach if you expect that your tax rate this year will be significantly lower than your rate in the near future. If you were not working for a portion of the current year or anticipate a substantial increase in income next year, you may be in a higher tax bracket next year. If you’re in such a situation, consider the following:
- Redeem savings bonds. If you have not reported interest earned on Series EE savings bonds in prior years, you can redeem the bonds and report all the accrued interest in the current year.
- Accelerate IRA distributions. If you are 59½ or older and have a traditional Individual Retirement Account (IRA), you may be able to increase your income for this year without penalty by making withdrawals from the account. Consult with your tax advisor before making withdrawals.
- Exercise stock options. If you own non-qualified stock options, consider whether, from an investment perspective, this might be a good year to exercise those options. Exercising appropriate options will generate taxable income. Regular taxable income is generally not triggered on the exercise of incentive stock options (ISOs), although do keep in mind that exercising ISOs could trigger AMT liability.
Make the Most of Your Deductions
Identify all above-the-line deductions. There are a number of “above-the-line” deductions that are available whether or not you claim itemized deductions on your tax return. These deductions are particularly valuable because they reduce your AGI, which can help increase the value of other tax breaks. Above-the-line deductions include deductions for moving expenses, self-employed health insurance premiums, and Keogh, SEP, and SIMPLE plan contributions.
Bunch your itemized deductions. Each year you are entitled to take either your itemized deductions or the appropriate standard deduction on your return. Review your tax returns for the last few years. If your itemized deductions have been approximately the same as the allowable standard deduction, you may be able to save taxes by “bunching” your itemized deductions in alternate years.
Properly establish deductions. If you pay deductible expenses by check, make sure the checks are delivered on or before the end of the year. If you send checks by mail, they will be deemed to have met this deadline if mailed by December 31st. If you pay with a standard credit card, the charge date controls. You need not pay the credit card bill before year-end to take the deduction this year.
Evaluate when to incur discretionary medical expenses. Only unreimbursed medical expenses in excess of 10.0% (7.5% if either you or your spouse are age 65 or older) of your AGI may be claimed as a deduction. (For purposes of the AMT, medical expenses are deductible only to the extent that they exceed 10% of AGI, regardless of your age.) If you have the choice to incur medical expenses either this year or next, consider whether bunching these expenses into the same year is feasible and can surpass the threshold. For the year you estimate your medical expenses paid will beat the threshold, consider making additional purchases of discretionary (but not purely cosmetic) medical products and services before year-end. Allowable expenditures include those for prescription drugs, eyeglasses, hearing aids, laser eye surgery, weight-loss programs to combat medically diagnosed obesity, smoking cessation programs, annual physicals, health insurance programs, and certain payments and insurance premiums related to long-term care services. The IRS has ruled that the costs of medically necessary equipment (for example, crutches), supplies (for example, bandages), and diagnostic devices (such as blood pressure monitors), even if not prescribed by a physician, can be deducted as medical expenses.
Consider accelerating deductible tax payments. To increase your deduction for state or local income taxes, you need to make estimated tax payments or increase withholdings on or before year-end. Most state and local property taxes and foreign income taxes are also deductible. If you have control over any of these taxes, consider paying them before year-end, unless you think you’ll be subject to the AMT.
Maximize the residential interest expense deduction. Interest on loans used to acquire, construct, or substantially improve your principal residence and one other residence is, within statutory limits, deductible if paid during the year. (See Amount deductible, in the Home Mortgage Interest section of chapter 24, Interest expense, for more information about the applicable limits.) Interest on an additional $100,000 of home equity indebtedness is also deductible. You may be able to accelerate deductions to this year by making the mortgage or home equity loan payment due in January on or before the end of the current year.
If you are considering refinancing an existing mortgage, you should note that only a portion, if any, of prepaid interest in the form of “points” may be deductible in the year you refinance. For this reason, you may want to look at a “no-points” loan if you are refinancing.
Generally, you can deduct the entire amount you pay as points if the loan is used to buy or improve your principal residence and the loan is secured by that home. If you satisfy the requirements for deductibility, try to close on the loan before year-end so you can deduct all the points on this year’s tax return.
Deduct a greater amount of certain capital expenditures. Business owners may be able to save on this year’s taxes by making certain capital expenditures before year-end. While capital expenditures (such as furniture or equipment) must ordinarily be depreciated over a set period of time, Section 179 of the tax code allows you to deduct all or part of the cost—up to specified yearly limits—of certain qualifying property in the year in which the property is purchased and placed into service, rather than capitalizing the cost and depreciating it over its life. This means that you can deduct all or part of the cost up front in one year rather than taking depreciation deductions spread out over many years. You must decide for each item of qualifying property whether to deduct (subject to the yearly limit) or capitalize and depreciate its cost.
Eligible property includes tangible personal property (i.e., tangible property that is not real property) and certain other specified tangible property. See Publication 946, How to Depreciate Property, for further information.
Specified limits. The maximum Section 179 deduction available for qualifying property placed into service during 2014 is $25,000 (down from $500,000 in 2013). The allowable deduction is reduced dollar for dollar once the cost of qualifying property placed into service during 2014 exceeds $200,000 (down from $2 million in 2013). Unlike 2013, the definition of Section 179 property does not include certain qualified real qualified leasehold improvement property, qualified restaurant property, or qualified retail improvement property. At the time this book was published, Congress had been considering legislation that would extend the higher limits that had expired at the end of 2013 at least through 2014; perhaps even permanently, but no such extension had yet been passed. For updated information on tax law changes that occur after this book was published, see our website, ey.com/EYTaxGuide.
Make year-end charitable gifts. Make your contributions in the most tax-efficient manner. In addition to cash, gifts of property (such as clothing, equipment, or investment securities) can qualify for a charitable deduction.
You can claim a charitable deduction for contributions of clothing and household items (for example, furniture, furnishings, electronics, appliances, linens, and similar items) only if the item is in good used condition or better. An exception to this general rule permits a deduction if the amount claimed for the item is more than $500 and a qualified appraisal is obtained.
If investment securities you have held more than one year have appreciated, donate the actual securities, not the proceeds from selling them, to charity. You get a charitable deduction for the value of the securities and avoid paying income tax and, if applicable, the 3.8% NIIT, on the appreciation. This strategy can be even more valuable if you donate property, such as a collectible, that would not qualify for the 15% (20% for high-income taxpayers who are otherwise in the 39.6% regular income tax bracket) maximum federal tax rate on long-term gains (gains on collectibles are taxed at 28%). However, a deduction for the fair market value of appreciated tangible personal property donated to charity is allowed only if the charity uses the property as part of its exempt function (for example, a gift of modern art to a museum).
If investment securities are worth less than your cost, it is usually better to sell them and donate the proceeds. The charity will receive the same value, and you will recognize a capital loss that may be used to offset other income.
You may also want to pre-fund charitable gifts for the next few years. By establishing a private foundation or contributing to a donor-advised fund, you can obtain the full charitable tax deduction this year, while you retain the ability to identify one or more charitable organizations as recipients in the future.
Consider the Impact of the AMT
The AMT was designed to ensure that the highest-income taxpayers pay at least a minimum amount of income tax. The AMT is an alternative income tax calculation that limits or disallows certain deductions, credits, and exclusions available under regular income tax to arrive at AMT income subject to tax at 26% or 28% rates. It is effectively a separate tax system with its own allowable deductions and exclusions, many of which are different than those allowed for regular income tax purposes. You might be subject to AMT if: