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Tax law changes for 2013 and beyond Now that the 2013 tax filing season is over (unless you filed for an extension), it's time to start focusing on tax planning for 2014. The first thing to keep in mind is that while the American Taxpayer Relief Act of 2012 (ATRA), which made lower ordinary-income tax rates permanent for most taxpayers, some taxpayers previously in the 35% bracket now face a higher 39.6% rate. Then there’s the alternative minimum tax (AMT), which was designed to ensure wealthy taxpayers with “excessive” deductions would pay some income tax. The top AMT rate is lower than the top regular income tax rate on ordinary income (salary, business income, interest and more). (See the Chart “2014 individual income tax rate schedules.”) But the AMT rate typically applies to a higher taxable income base. So if you plan only for regular income taxes, it can result in unwelcome tax surprises. You also need to consider the various tax deductions or credits that could reduce your tax liability. There’s some more tax law certainty on this front, too, because ATRA makes some breaks permanent - though it extends others only temporarily. On the other hand, income-based phaseouts and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate. That’s why it’s important to review your income, expenses and potential tax liability throughout the year, keeping in mind the many rates and limits that can affect income tax liability - and keeping an eye out for additional tax law changes. Only then can you time income and expenses to your advantage. Before you take action to time income or expenses, determine whether you’re already likely to be subject to the AMT - or whether the actions you’re considering might trigger it. Many deductions used to calculate regular tax aren’t allowed under the AMT and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:
Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability. With proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. ATRA makes planning for the AMT easier because it includes long-term AMT relief. Before the act, unlike the regular tax system, the AMT system wasn’t regularly adjusted for inflation. Instead, Congress had to legislate any adjustments. Typically, it did so in the form of a “patch” — an increase in the AMT exemptions. ATRA sets higher exemptions permanently, which will be “automatically” adjusted for inflation in future years. In other words, the IRS will issue adjustments annually; Congress won’t have to legislate them. Also annually adjusted will be the income phaseout ranges for the exemption as well as the AMT tax brackets. Even with permanent AMT relief in place, it’s critical to work with your tax advisor to determine whether: You could be subject to the AMT this year. Consider accelerating income and short-term capital gains into this year, which may allow you to benefit from the lower maximum AMT rate. Also consider deferring expenses you can’t deduct for AMT purposes until next year — you may be able to preserve those deductions. Additionally, if you defer expenses you can deduct for AMT purposes to next year, the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax consequences of exercising ISOs. You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because you’ll likely pay a relatively lower AMT rate. ANow that the 2013 tax filing season is over (unless you filed for an extension), it's time to start focusing on tax planning for 2014. The first thing to keep in mind is that while the American Taxpayer Relief Act of 2012 (ATRA), which made lower ordinary-income tax rates permanent for most taxpayers, some taxpayers previously in the 35% bracket now face a higher rate. (See “Top ordinary-income tax rate of 39.6% has returned”) Then there’s the alternative minimum tax (AMT), which was designed to ensure wealthy taxpayers with “excessive” deductions would pay some income tax. The top AMT rate is lower than the top regular income tax rate on ordinary income (salary, business income, interest and more). (See the Chart “2014 individual income tax rate schedules.”) But the AMT rate typically applies to a higher taxable income base. So if you plan only for regular income taxes, it can result in unwelcome tax surprises. You also need to consider the various tax deductions or credits that could reduce your tax liability. There’s some more tax law certainty on this front, too, because ATRA makes some breaks permanent - though it extends others only temporarily. On the other hand, income-based phaseouts and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate. That’s why it’s important to review your income, expenses and potential tax liability throughout the year, keeping in mind the many rates and limits that can affect income tax liability - and keeping an eye out for additional tax law changes. Only then can you time income and expenses to your advantage. Before you take action to time income or expenses, determine whether you’re already likely to be subject to the AMT - or whether the actions you’re considering might trigger it. Many deductions used to calculate regular tax aren’t allowed under the AMT and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:
Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability. With proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. ATRA makes planning for the AMT easier because it includes long-term AMT relief. Before the act, unlike the regular tax system, the AMT system wasn’t regularly adjusted for inflation. Instead, Congress had to legislate any adjustments. Typically, it did so in the form of a “patch” — an increase in the AMT exemptions. ATRA sets higher exemptions permanently, which will be “automatically” adjusted for inflation in future years. In other words, the IRS will issue adjustments annually; Congress won’t have to legislate them. Also annually adjusted will be the income phaseout ranges for the exemption as well as the AMT tax brackets. Even with permanent AMT relief in place, it’s critical to work with your tax advisor to determine whether: You could be subject to the AMT this year. Consider accelerating income and shond prepay expenses that will be deductible this year but that won’t help you next year because they’re not deductible for AMT purposes. Also, before year end consider selling any private activity municipal bonds whose interest could be subject to the AMT. If you pay AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year. In effect, this takes into account timing differences that reverse in later years. But the credit might provide only partial relief or take years before it can be fully used. Fortunately, the credit’s refundable feature can reduce the time it takes to recoup AMT paid. Timing income and expenses Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase it. When you don’t expect to be subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year typically is a good idea. Why? Because it will defer tax, which is usually beneficial. But when you expect to be in a higher tax bracket next year the opposite approach may be beneficial: Accelerating income will allow more income to be taxed at your current year’s lower rate. And deferring expenses will make the deductions more valuable, because deductions save more tax when you’re subject to a higher tax rate. Warning: Timing strategies could be especially important for higher-income taxpayers who now may face a higher marginal ordinary-income tax rate on taxable income and a new Medicare tax on earned income. Also keep in mind that the adjusted gross income (AGI)-based reduction limiting the benefit of many deductions returned in 2013. (See Deduction reduction and exemption phaseout are back.”) Its impact should be taken into account when considering timing strategies. Whatever the reason you’d like to time income and expenses, here are some income items whose timing you may be able to control:
And here are some potentially controllable expenses:
Warning: Prepaid expenses can be deducted only in the year to which they apply. For example, you can prepay (by Dec. 31) property taxes that relate to this year but that are due next year, and deduct the payment on this year’s return. But you generally can’t prepay property taxes that relate to next year and deduct the payment on this year’s return. Miscellaneous itemized deductions Many expenses that may qualify as miscellaneous itemized deductions are deductible for regular tax purposes only to the extent they exceed, in aggregate, 2% of your AGI. Bunching these expenses into a single year may allow you to exceed this “floor.” Carefully record your potential deductions throughout the year. If as the year progresses they get close to or start to exceed the 2% floor — and you don’t expect to be subject to the AMT this year — consider paying accrued expenses and incurring and paying additional expenses by Dec. 31, such as:
Medical expenses are another deduction you may be able to bunch. If your medical expenses exceed the applicable AGI floor you can deduct the excess amount. Eligible expenses can include:
Consider bunching non-urgent medical procedures and other controllable expenses into one year to exceed the AGI floor. Bunching may be an especially important strategy now because in 2013 the floor increased from 7.5% to to 10% under the health care act. (For taxpayers age 65 and older, the floor isn’t scheduled to increase until 2017.) If one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly. Also remember that expenses that are reimbursed (or reimbursable) by insurance or paid through one of the following accounts aren’t deductible: HSA. If you’re covered by qualified high-deductible health insurance, a Health Savings Account allows 2014 contributions of pretax income (or deductible after-tax contributions) up to $3,300 for self-only coverage and $6,650 for family coverage. Moreover, account holders age 55 and older can contribute an additional $1,000. HSAs bear interest or are invested and can grow tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year. FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit (not to exceed $2,500 for plan years beginning in 2013 or 2014). The plan pays or reimburses you for qualified medical expenses. With limited exceptions, you have to make your election before the start of the plan year. What you don’t use by the end of the plan year, you generally lose. If you have an HSA, your FSA is limited to funding certain “permitted” expenses. Warning: Before 2013, employers could set whatever limit they wanted — so your contribution limit may have dropped substantially. ATRA extended only through 2013 the break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes. The deduction can be valuable to taxpayers residing in states with no or low income tax or who purchase a major item, such as a car or boat. Check back here to learn if Congress extends the break to 2014 or beyond. In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and bonuses. The Social Security tax applies to earned income up to the Social Security wage base of $117,000 for 2014. Warning: All earned income is subject to the 2.9% Medicare tax (split equally between the employee and the employer). And many higher-income taxpayers will pay additional Medicare taxes under the health care act. If you’re self-employed, your employment tax liability typically doubles, because you also must pay the employer portion of these taxes. Fortunately, there’s no employer portion for the additional 0.9% Medicare tax. The employer portion of self-employment taxes paid (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above the line. As a self-employed taxpayer, you may benefit from other above-the-line deductions as well. You can deduct 100% of health insurance costs for yourself, your spouse and your dependents, up to your net self-employment income. You also can deduct contributions to a retirement plan and, if you’re eligible, an HSA for yourself. Above-the-line deductions are particularly valuable because they reduce your AGI and MAGI, which are the triggers for certain additional taxes and the phaseouts of many tax breaks. Employment taxes for owner-employees There are special considerations if you’re a business owner who also works in the business, depending on its structure: Partnerships and limited liability companies. Generally, all trade or business income that flows through to you for income tax purposes is subject to self-employment taxes — even if the income isn’t actually distributed to you. But such income may not be subject to self-employment taxes if you’re a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest. Whether the additional 0.9% Medicare tax on earned income or the new 3.8% Medicare contribution tax on net investment income will apply also is complex to determine. So, check with your tax advisor. S corporations. Only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. To reduce these taxes, you may want to keep your salary relatively (but not unreasonably) low and increase your distributions of company income (which generally isn’t taxed at the corporate level or subject to the 0.9% or 3.8% Medicare tax). C corporations. Only income you receive as salary is subject to employment taxes, and, if applicable, the 0.9% Medicare tax. Nevertheless, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level, but are taxed at the shareholder level and could be subject to the 3.8% Medicare tax) if the overall tax paid by both the corporation and you would be less. Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully. Estimated payments and withholding You can be subject to penalties if you don’t pay enough tax during the year through estimated tax payments and withholding. To avoid such penalties, make sure your estimated payments and withholding equal at least 90% of your tax liability for this year or 110% of your tax last year (100% if your AGI last year was $150,000 or less or, if married filing separately, $75,000 or less). Here are some more strategies that can help you avoid underpayment penalties: Use the annualized income installment method. This method often benefits taxpayers who have large variability in income by month due to bonuses, investment gains and losses, or seasonal income (especially if it’s skewed toward the end of the year). Annualizing computes the tax due based on income, gains, losses and deductions through each estimated tax period. Estimate your tax liability and increase withholding. If as year end approaches you determine you’ve underpaid, consider having the tax shortfall withheld from your salary or year end bonus by Dec. 31. Because withholding is considered to have been paid ratably throughout the year, this is often a better strategy than making up the difference with an increased quarterly tax payment, which may still leave you exposed to penalties for earlier quarters. Warning: You also could incur interest and penalties if you’re subject to the new 0.9% Medicare tax on earned income and it isn’t withheld from your pay. |
