Accelerate deductions, harvest losses and time your investment income if you’re teetering close to the Medicare surtax line.
Taxpayers who deploy such year-end planning strategies could significantly lower the 2014 tax bite from Uncle Sam. But they’d better act fast.
The deadline for claiming current year deductions, in most cases, is Dec. 31. And it won’t be clear which moves you should make until you’ve completed a thorough financial review, said John Napolitano, a certified financial planner and certified public accountant with U.S. Wealth Management.
In years where tax rates remain unchanged, as they have in 2014, it is generally good policy to defer income and accelerate deductions where possible, assuming your personal income also remained relatively stable.
“It’s back to the old-school strategy of accelerating deductions and deferring income,” said Napolitano. “With higher rates from last year still in effect, you want to delay as much income as possible.”
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To that end, taxpayers can defer receipt of year-end bonuses until January, delay stock option exercises and postpone the realization of capital gains from the sale of appreciated assets until 2015.
The self-employed can also delay billings until late December, thereby ensuring that payment will be received next year.
To accelerate deductions into 2014, taxpayers can prepay their 2015 property and state income taxes in December, max out contributions to their 401(k) plan and individual retirement account, prepay their January mortgage payment in December and bundle out-of-pocket medical expenses.
You must fund your 401(k) by Dec. 31 to count as a 2014 deduction, but you can make prior-year contributions to your traditional IRA all the way up to the filing deadline on April 15, 2015. Roth IRAs, which are funded with after-tax dollars, do not provide a tax deduction, but your earnings grow tax-free.
Give to charity
You can also lower your tax burden by channeling your inner philanthropist.
You’ll get twice the benefit from your charitable contribution if you donate appreciated stock or property instead of cash.
Not only will you avoid the capital gain, but you’ll get to claim a write-off that may be equal to the asset’s fair market value, said Roger Oprandi, a certified financial planner with Ameriprise Financial Services.
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“If you have highly appreciated stock, it’s a wonderful way to donate to charity,” he said.
Retirees age 70½ and older can also satisfy their annual minimum distribution requirement by donating up to $100,000 to charity directly from their IRA.
You cannot claim a deduction for the amount donated, but it will lower your gross income, upon which you are taxed. Retirees must otherwise report IRA distributions as ordinary income.
A perennial crowd-pleaser, tax-loss harvesting cuts your capital gains bill down to size. The Internal Revenue Service allows taxpayers to offset all of their capital gains with losses realized in a given year.
Any additional losses can be deducted up to $3,000 per year against ordinary income, while losses in excess of that limit can be carried forward to future tax years to reduce capital gains or ordinary income until the balance of the losses are used up.
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Consider harvesting losses if your income is projected to be higher this year than next, said Martin Durbin, a certified public account and financial advisor at Aperture Retirement Designs. Conversely, wait until January to dump your dogs if you’re likely to need more write-offs in 2015 to offset higher income.
It bears noting that some financial advisors believe the benefit of tax-loss harvesting is overstated, while others suggest the cumulative effect of harvesting losses every year can inadvertently subject investors to a higher capital gains rate later on.
Consider your own financial picture, projected income and need for an immediate deduction before deciding whether tax-loss harvesting is right for you.
Taxpayers who straddle the Medicare surtax line may also be able to save some coin by managing their passive income and capital gains.
The 3.8 percent surtax applies to net investment income from taxable interest and dividends, long- and short-term capital gains, annuity income, passive rental income and royalties for taxpayers above an income threshold ($250,000 for married joint filers and $200,000 for single filers).
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Distributions from retirement accounts, such as 401(k)s and IRAs, are not subject to the Medicare surtax, but unbeknownst to many investors, they can indirectly push a larger percentage of your investment income into surtax territory, said Michael Kitces, a certified financial planner with Pinnacle Advisory Group.
Indeed, a fair number of taxpayers are caught in the “crossover zone,” meaning their combined ordinary income and investment income pushes them just over the surtax line, such that only a portion of their unearned income gets taxed at the higher rate.
“If you think you might be subject to the AMT or have been in the past, consult a tax professional. Charitable contributions and other deductions could very well be disallowed.”
By taking an IRA distribution above and beyond the required minimum if they are 70½, they effectively add to their ordinary income, said Kitces, which pushes more of their surtax-eligible investment income over the line.
Taxpayers in the crossover zone can also keep more of their money out of surtax territory and potentially even avoid it entirely by deferring capital gains (or delaying the sale of appreciated stocks) until next year.
Beware the AMT
Before making any year-moves, however, be sure to estimate your 2014 income, said Oprandi at Ameriprise. Depending on how much you bring in, you may be subject to deduction phaseouts.
Worse, if you fall into the Alternative Minimum Tax, a parallel tax system with its own set of rules and rates, you may not be eligible to claim deductions at all. (State and local property taxes, for example, are not deductible under the AMT.)
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“If you think you might be subject to the AMT or have been in the past, consult a tax professional,” said Oprandi. “Charitable contributions and other deductions could very well be disallowed.”
Year-end tax planning can be effective, but it also takes time.
The sooner you get started, the more opportunities you will have to reduce what you owe to Uncle Sam.