Year-End Tax Planning For Individuals
Tax planning is always a good idea, but with the Bush-era tax cuts set to expire and tax rates set to rise to pre-2010 levels, it’s more important than ever. With that in mind, here are some tax planning strategies you can use this year to help you cut your tax bill in 2013.
Accelerating Income
In most years, taxpayers adopt a strategy of deferring income, but with the Bush-era tax cuts set to expire on December 31, 2012, income tax rates and capital gains taxes set to rise, and a 0.9 percent Hospital Insurance (HI) tax applicable to earnings of self-employed individuals or employee wages in excess of $200,000 ($250,000 if filing jointly) effective January 1, 2013, it might make more sense to accelerate income into 2012 instead of deferring it to 2013. Here are some of the ways you can do this:
- Sell any investments on which you have a gain this year and take advantage of the zero percent long-term capital gains tax rate if you’re in the 10% or 15% tax bracket, or a 15% tax rate for higher tax brackets.
- If you are expecting a bonus at year-end, try to get it before December 31. However, keep in mind that contractual bonuses are different, in that they are typically not paid out until the first quarter of the following year. Therefore, any taxes owed on a contractual bonus would not be due until you file a tax return for tax year 2013.
- If your company grants stock options, you may want to exercise the option or sell stock acquired by exercise of an option this year if you think your tax bracket will be higher in 2013. Exercise of the option is often but not always a taxable event; sale of the stock is almost always a taxable event.
- If you’re self employed, send invoices or bills to clients or customers this year in order to be paid in full by the end of December.
Caution: Keep an eye on the estimated tax requirements.
Accelerating Deductions
- Pay a state estimated tax installment in December instead of at the January due date. However, make sure the payment is based on a reasonable estimate of your state tax.
- Pay your entire property tax bill, including installments due in year 2013, by year-end. This does not apply to mortgage escrow accounts.
- Try to bunch “threshold” expenses, such as medical expenses and miscellaneous itemized deductions. Threshold expenses are deductible only to the extent they exceed a certain percentage of adjusted gross income (AGI). By bunching these expenses into one year, rather than spreading them out over two years, you have a better chance of exceeding the thresholds, thereby maximizing your deduction.
For example, you might pay medical bills and dues and subscriptions in whichever year they would do you the most tax good.
Tip: Now is the time to bunch deductible medical expenses. Medical expense deductions are 7.5% of AGI this year, but in 2013 increase to 10% of AGI.
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 2012, 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.
Tip: Accelerating income into 2012 is an especially good idea for taxpayers who anticipate being in a higher tax bracket next year.
Tip: If you know you have a set amount of income coming in this year that is not covered by withholding taxes, increasing your withholding before year-end can avoid or reduce any estimated tax penalty that might otherwise be due.
On the other hand, the penalty could be avoided by covering the extra tax in your final estimated tax payment and computing the penalty using the annualized income method.
If you have any questions about estimated taxes, please call us.
Caution: The Alternative Minimum Tax (AMT) no longer just impacts the wealthy! Do not overlook the effect of any year-end planning moves on the AMT for 2012.
Due to tax changes in recent years, AMT impacts many more taxpayers than ever before and, the tax is not indexed to inflation. As a result, growing numbers of middle-income taxpayers have been finding themselves subject to this higher tax.
Items that may affect AMT include deductions for state property taxes and state income taxes, miscellaneous itemized deductions, and personal exemptions.
Note: Thanks to the “AMT Patch” AMT exemption amounts for 2012 remain the same as 2011 (see below), but are set to drop in 2013. For example, the AMT exemption amount in 2013 drops from $74,450 in 2012 to $45,000 for married filing jointly taxpayers. Here are the 2012 exemption amounts:
- $48,450 for single and head of household filers,
- $74,450 for married people filing jointly and for qualifying widows or widowers,
- $37,225 for married people filing separately.
Please call us if you’d like more information or if you’re not sure whether AMT applies to you. We’re happy to assist you.
Strategize tuition payments
The American Opportunity Tax Credit, which offsets higher education expenses, is set to expire after 2012. It may be beneficial to pay 2013 tuition in 2012 to take full advantage of this tax credit, up to $2,500, before it expires.
Residential Energy Tax 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. 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 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% 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 the Tax Credit?
- Geothermal Heat Pumps. Must meet the requirements of the ENERGY STAR program that are in effect at the time of the expenditure.
- Small Residential Wind Turbines. Must have a nameplate capacity of no more than 100 kilowatts (kW).
- Solar Water Heaters. At least half of the energy generated by the “qualifying property” must come from the sun. The system must be certified by the Solar Rating and Certification Corporation (SRCC) or a comparable entity endorsed by the government of the state in which the property is installed. The credit is not available for expenses for swimming pools or hot tubs. The water must be used in the dwelling. Photovoltaic systems must provide electricity for the residence, and must meet applicable fire and electrical code requirement.
- Solar Panels (Photovoltaic Systems). Photovoltaic systems must provide electricity for the residence, and must meet applicable fire and electrical code requirement.
- Fuel Cell (Residential Fuel Cell and Microturbine System.) Efficiency of at least 30% and must have a capacity of at least 0.5 kW.
While these residential energy credits don’t expire until 2016, why not take advantage of the credit this year and start saving money now? Give us a call today. We’re happy to help you sort out the tax credits available for your “green” home improvements.
Make Charitable Contributions
You can donate property as well as money 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 charitable contribution 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.
Tip: Contributions of appreciated property (i.e. stock) provide an additional benefit because you avoid paying capital gains on any profit.
Investment Gains And Losses
Minimize taxes on investments by judicious matching of gains and losses. Where appropriate, try to avoid short-term gains, which are usually taxed at a much higher tax rate (up to 35% in 2012, but scheduled to rise to 39.6% in 2013) than long-term gains.
If your tax bracket is either 10% or 15% (married couples making less than $70,700 or single filers making less than $35,350), then now is the time to take advantage of the zero percent tax rate on qualified dividends and long-term capital gains. Even if you fall into a higher tax bracket, the maximum tax rate on long-term capital gains in 2012 is only 15%.
Consider where feasible to reduce all capital gains and generate short-term capital losses up to $3,000 as well.
Tip: As a general rule, if you have a large capital gain this year, consider selling an investment on which you have an accumulated loss. Capital losses up to the amount of your capital gains plus $3,000 per year ($1,500 if married filing separately) can be claimed as a deduction against income.
Tip: After selling securities investment to generate a capital loss, you can repurchase it after 30 days. If you buy it back within 30 days, the loss will be disallowed. Or you can immediately repurchase a similar (but not the same) investment, e.g., another mutual fund with the same objectives as the one you sold.
Tip: If you have losses, you might consider selling securities at a gain and then immediately repurchasing them, since the 30-day rule does not apply to gains. That way, your gain will be tax-free, your original investment is restored and you have a higher cost basis for your new investment (i.e., any future gain will be lower).
Note: Starting in 2013, a 3.8 percent Medicare tax will be applied to investment income such as long-term capital gains. This information is something to think about as you plan your long term investments.
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.
Example: You invest $20,000 in a mutual fund at the end of 2012. You opt for automatic reinvestment of dividends. In late December of 2012, the fund pays a $1,000 dividend on the shares you bought. The $1,000 is automatically reinvested.
Result: You must pay tax on the $1,000 dividend. You will have to take funds from another source to pay that tax because of the automatic reinvestment feature. The mutual fund’s long-term capital gains pass through to you as capital gains dividends taxed at long-term rates, however long or short your holding period.
The mutual fund’s distributions to you of dividends it receives generally qualify for the same tax relief as long-term capital gains. If the mutual fund passes through its short-term capital gains, these will be reported to you as “ordinary dividends” that don’t qualify for relief.
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.
Tip: To find out a fund’s ex-dividend date, call the fund directly.
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
It may be time to reevaluate your estate plan. Unless Congress takes action before the end of the year, the federal gift and estate tax exemption, which is currently set at $5.12 million, drops to its pre-2010 level of $1 million ($2 million per couple) in 2013. In addition, the maximum estate tax rate is set to increase in 2013 from 35 percent to 55 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 $13,000 a year per donee.
Caution: An unused annual exemption doesn’t carry over to later years. To make use of the exemption for 2012, you must make your gift by December 31.
Husband-wife joint gifts to any third person are exempt from gift tax for amounts up to $26,000 ($13,000 each). Though what’s given may come from either you or your spouse or from 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.
Tip: If you’re considering adopting a plan of lifetime giving to reduce future estate tax, then don’t hesitate to call us. We can help you set it up.
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 2012 are due the same date as your income tax return. Returns are required for gifts over $13,000 (including husband-wife split gifts totaling more than $13,000) and gifts of future interests. Though you are not required to file if your gifts do not exceed $13,000, you might consider filing anyway as a tactical move to block a future IRS challenge about gifts not “adequately disclosed”.
Tip: Call us if you’re considering making a gift of property whose value isn’t unquestionably less than $13,000.
Income earned on investments you give to children or other family members is 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 5% dividend rate.
Caution: In 2012, investment income for a child (under age 18 at the end of the tax year or a full-time student under age 24) that is in excess of $1,900 is taxed at the parent’s tax rate.
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 need to actually 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 ($17,000 for 2012), 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 $5,000 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 7.5% 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 2012, to qualify for the HSA, your minimum deductible in your HDHP must be at least $1,200 ($1,250 in 2013) for single coverage or $2,400 ($2,500 in 2013) for a family.
Summary
These are just a few of the steps you might take. Please contact us for help in implementing these or other year-end planning strategies that might be suitable to your particular situation.
By Leon Clinton