Midyear tax planning is usually a dull, albeit worthwhile, affair. This year, though, the summer ritual could keep taxpayers on their toes, thanks to a slew of new taxes plus hikes on old ones for 2013. It's more important than ever to employ strategies to trim payments to Uncle Sam.
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Higher-income taxpayers will bear the brunt of the harsher tax environment. Still, tax-pruning tactics--from stepping up charitable giving to maxing out retirement-plan contributions--will be valuable for any retiree and near-retiree.
First, don't panic. New and higher taxes affect only those taxpayers who exceed certain income thresholds. "For those who don't exceed the thresholds, everything will be the same," says Michael Eisenberg, a certified public accountant in Los Angeles. "And if you're above the thresholds, you may only owe a few extra dollars."
Keeping track of these thresholds can be confusing--they differ from tax to tax. A new 3.8% surtax on certain investment income kicks in for singles with modified adjusted gross income above $200,000 (joint filers, above $250,000). Meanwhile, taxpayers with taxable incomes above $400,000 for singles ($450,000 for joint filers) face a new 39.6% top bracket and owe 20% on long-term capital gains and qualified dividends. (Note that in addition to differing trigger amounts, different definitions of income are in play. The surtax is based on modified AGI, which is AGI plus any income sheltered from tax by the foreign earned-income exclusion. The new top bracket is based on taxable income, which is regular AGI minus exemptions and deductions.)
The trick for those on the cusp of any threshold is to avoid crossing the line. Also, keeping a lid on AGI might hold down the amount of your Social Security benefits that are taxed and reduce the odds that you'll owe an income-related Medicare premium surcharge, says Shomari Hearn, a certified financial planner with Palisades Hudson Financial Group, in Fort Lauderdale, Fla. And with a lower AGI, you're more likely to be eligible for medical expense deductions and other breaks.
Whatever your income, you can trim your tax tab by taking the following steps.
Boost retirement savings. You can reduce AGI and taxable income by maximizing pretax contributions to retirement accounts. You can set aside up to $23,000 in a 401(k) if you're 50 or older. Self-employed taxpayers age 50 and older can contribute $56,500 to a solo 401(k). Older taxpayers can make $6,500 in deductible contributions to a traditional IRA.
Converting traditional IRA money to a Roth IRA can be a double-edged sword. By reducing the size of your traditional IRA, such conversions could reduce your required minimum distributions that would push up AGI and taxable income in later years.
But the conversions will boost your AGI this year, perhaps exposing you to the surtax or top capital-gains rate, says Robert Keebler, a certified public accountant in Green Bay, Wis. To avoid higher rates, try to convert no more than an amount that will take you to the top of your current tax bracket, he says. Although the higher AGI could boost your Medicare premium or your taxes on Social Security benefits, "that's a one-time hit," Keebler says. In the future, tax-free withdrawals from a Roth will not push up your AGI.
Track medical expenses. Taxpayers who are younger than 65 will have a tougher time deducting medical expenses this year: You can write off only those costs that exceed 10% of AGI, compared with 7.5% in the past. Those who are 65 and older--or married couples with at least one spouse who is 65 or older this year--still qualify for the 7.5% threshold.
Taxpayers who are newly retired and living off investments may find themselves eligible for medical deductions for the first time. So may many taxpayers who have flexible spending accounts at work, says Bob Scharin, senior tax analyst at Thomson Reuters, a publisher of business and tax information. Until this year, many employers allowed workers to place as much as $5,000 in pretax money in FSAs; the new health care law limits FSA contributions to $2,500 starting this year. "A couple who is subject to the 7.5% threshold but is paying more out of pocket because they've exhausted their flexible spending accounts could be eligible for a deduction this year," Scharin says. "Make sure you hold on to your receipts."
If you're close to the threshold, consider accelerating elective surgery you were planning anyway. For a list of all deductible expenses, read IRS Publication 502, Medical and Dental Expenses.
Investment maneuvers. The new 3.8% surtax applies to "net investment income," which includes interest, dividends, capital gains, annuity payments, rents and royalties. It does not include tax-exempt interest from municipal bonds, pension payouts or Social Security benefits.
The surtax applies to the smaller of net investment income or the amount by which modified AGI exceeds the thresholds. Say a single taxpayer has $190,000 in salary and $40,000 in capital gains, for a modified AGI of $230,000. Because the amount above the $200,000 threshold is less than the $40,000 in net investment income, the taxpayer would owe the surtax on $30,000--for a tax tab of $1,140.
With the run-up in the stock market, you may need to rebalance by selling appreciated stock. Note whether the sale will push you into a higher income-tax bracket--and into surtax or the 20% capital-gains territory. Tax concerns should not drive investment decisions, but Scharin notes, "if you're going to owe the 20% capital-gains tax, you could be better off making gifts of appreciated stock to an adult child or a parent who needs financial help, or to charity."
An adult child or parent who sells the stock could pay a long-term capital-gains tax rate of 15% or even 0%. (Taxpayers in the 15% income tax bracket--with taxable income of up to $36,250 for singles and up to $72,500 for joint filers--qualify for the 0% capital-gains tax rate.)
As you consider investment moves through the remainder of the year, keep in mind how any carryover capital losses from past years can hold down taxable investment income by offsetting capital gains. If you don't have enough investment losses from past years to offset your gains, keep an eye out over the rest of the year for losers you can sell. "If you don't have enough losses now, you could sell at the end of December to realize a loss," Eisenberg says.
You may be able to reduce your tax tab by making your investments more tax efficient. Keebler says that index mutual funds generate a lot less in capital gains--especially short-term capital gains, which are taxed at your ordinary income tax rate--than actively managed funds that regularly trade securities.
If you need income, consider boosting your allocation of municipal bonds in your taxable account, Hearn says. "They are not subject to federal income tax and are not included in your AGI," he says. Muni bonds also are exempt from the 3.8% surtax.
Profit from good deeds. Once again, Congress is allowing individuals 70 1/2 and older to transfer up to $100,000 from an IRA directly to charity. The donation can count toward a required minimum distribution. You won't be able to deduct the contribution, but this maneuver will lower your AGI compared with taking a taxable distribution and donating it to charity.
Donating appreciated stocks or mutual funds from a taxable account to charity offers several benefits. You avoid the tax on the gain as well as the addition to AGI and taxable income that would come from a sale. You get a deduction of the full market value of the securities (assuming you have owned them for more than a year). And because the securities no longer generate income, you will reduce your taxable investment income going forward. You can place securities in a donor-advised fund if you want. You get the deduction this year, but you can decide at a later date which charities will get your money.
A charitably inclined taxpayer enjoying a capital-gains spike may want to consider creating a charitable remainder trust. You place the property into the trust and take an immediate deduction. When you die, the charity keeps the trust balance. In the meantime, you get income from the trust that keeps your income below thresholds that trigger the new and higher investment taxes, Keebler says.
Keep track of what you spend on charitable work. For example, you can deduct the costs of fund-raising activities. If you drive your car for charity, you can deduct 14 cents per mile. See IRS Publication 526, Charitable Contributions, for more information.