There are basic year-end tax planning techniques that can be utilized to successfully manage income taxes. In general, year-end tax planning techniques include:
- Accelerating or deferring income.
- Accelerating or deferring expenses that can be used for tax deductions or tax credits.
- Taking advantage of any tax provisions that are scheduled to expire at the end of the year.
Accelerating income means trying to earn more income in the current year, especially income that might otherwise have been received the year next. Similarly, accelerating deductions means spending money on expenses that will generate a tax deduction in the current year, which will help lower your tax liability.
Deferring income means trying to receive income in the next coming year instead of receiving that same income in the current year. Deferring deductions means holding off on spending money on tax-deductible expenses until the next year.
Accelerating income and/or deferring deductions functions to increase the amount of income that's taxed in the current year; this may be a useful strategy if your income falls in a lower tax bracket this year compared to the next. Deferring income and/or accelerating deductions functions to decrease the amount of income that's taxed this year; this may be a useful strategy if your income this year falls in a higher tax bracket compared to next.
All of these strategies have one factor in common: the timing of income and expenses. The timing of income and deductions depends on a person's accounting method. "Most individuals ... use the cash method of accounting," according to the IRS, and so this article focuses on the rules for cash method taxpayers. Under the cash method of accounting, "you include in your gross income all items of income you actually or constructively receive during the tax year." Similarly, "you deduct expenses in the tax year in which you actually pay them." (All quotations are from Publication 538, Accounting Periods and Methods.)
Accelerating means earning additional income or incurring additional tax-deductible expenses in the current year rather than the year next. Deferring means pushing additional income or additional deductions to the next year rather than the current year. To the extent that income and expenses can be moved from one year to the next, these tactics can be utilized to optimize a person's tax liabilities between two years. Year-end planning is about finding the right year in which to earn additional income or to spend money on more tax deductions.
Normally, people would prefer to defer income and accelerate deductions. A year-end bonus or selling off investments is a good way to push income into the following year. If tax rates are the same in both years, the person has gained the advantage of time. If a person's overall tax rate will be lower in the following year, deferring income has the additional benefit of pushing the additional income into a year with a lower overall rate, thereby reducing tax. The same holds true for deductions, just in reverse. If a person's overall tax rate is the same in both years, accelerating deductions achieves tax savings in the current year rather than waiting for those tax savings to materialize in the year next. If a person's overall tax rate is higher in the current year than it will be in the year next, accelerating deductions produces the additional benefit of yielding potentially larger tax savings in the current year rather than in the next year.
But what if a person's tax rate will be higher in the next year? When tax rates go up between two years, accelerating income has the benefit of locking in a lower tax rate now instead of a higher tax rate next year. By the same token, deferring tax deductions has the benefit of yielding potentially larger tax savings in the next year, where the deductions can offset income taxed at higher rates, thereby squeezing extra tax dollars out of a deductible expense.
Income Deferral Strategies
A deferral strategy shifts income into a later year if tax rates in that subsequent year are lower overall than in the year current. Common income deferral strategies include:
- Ask your employer to pay out any bonuses in January instead of in December.
- Hold off on selling stocks and other investments with taxable gains until next year.
- Hold off on taking distributions from an IRA or other retirement account until January.
Income Acceleration Strategies
An acceleration strategy shifts income into the current year if tax rates in the current year will be lower than in a subsequent year. Most types of income are difficult to accelerate, but some types of income are easier to shift into different years. For example:
- Ask your employer to pay out bonuses this year instead of next year.
- Sell off stocks and other investments with taxable gains this year to absorb capital loss carryovers or to lock-in gains at the 0% or 15% rates.
- Accelerate IRA distributions this year if your tax rate would be higher next year.
- Convert pre-tax retirement savings to a post-tax Roth account to lock-in a known tax liability.
Deduction Acceleration Strategies
Accelerating deductions functions just like deferring income: the tactic attempts to reduce taxes in the current year at a higher tax rate if the overall tax rate is expected to be lower in a subsequent year. Deductions can be accelerated by:
- Paying tax deductible expenses this year instead of next year, such as medical bills, charity donations and property tax.
- Selling off stocks and other investments that have lost value so you can take the losses on this year's return.
- Increasing your 401(k) or IRA contributions.
- Paying college tuition. The IRS permits tuition expenses to be accelerated, as long as classes begin in the first three months of next year. This may be a good strategy if taxpayers need additional tuition expenses to reach the maximum $4,000 limit for the American Opportunity Credit or Tuition and Fees Deduction or to reach the $10,000 limit for the Lifetime Learning Credit.
- Pay medical expenses. This may be a good strategy for taxpayers who are close to reaching or have already reached the 10% of adjusted gross income threshold for deducting medical expenses.
- Pay your 4th state estimated tax payment in December rather than January. This works well for taxpayers who will itemize their deductions and who aren't subject to the alternative minimum tax.
Deduction Deferral Strategies
Deferring deductions attempts to delay making tax-deductible expenses until a subsequent year when tax rates are higher, and thus the deductions can produce more tax savings. For example:
- Defer paying medical bills, charity donations, property tax and other deductions until the next year.
- Consider funding a Roth IRA instead of a tax-deductible traditional IRA. By forgoing the deduction, you'll be locking in a known tax rate on your contribution in return for tax-free investment returns.
AMT Tax Planning
People who are or might be impacted by the alternative minimum tax have additional considerations to think about. The AMT eliminates or reduces the federal tax savings for medical expenses, state and local taxes, property taxes, and miscellaneous itemized deductions. The suggestion here is to pay those expenses when they are due instead of trying to accelerate or defer them. For example, instead of prepaying the next installment of your property tax, wait until the actual due date to pay that since property tax is an adjustment for the AMT calculations. Similarly, anyone impacted by the AMT may want to sell any incentive stock options8 that they exercised during the calendar year since the value of an exercised but unsold ISO is added to your income for calculating the AMT.
New Taxes in 2013 for Higher-Income Taxpayers
Higher-income taxpayers have new taxes, tax rates, and phase-outs to grapple with.
- Additional Medicare Tax of 0.9% on wages and self-employment income,
- Net Investment Income Tax of 3.8%,
- New top marginal tax rate of 39.6%,
- New top capital gains rate of 20% on long-term gains and qualified dividends,
- Phase-out of itemized deductions, and
- Phase-out of personal exemptions.
The Additional Medicare Tax applies if a person has Medicare wages and/or net self-employment income over $200,000 for unmarried persons and over $250,000 for married couples filing jointly. Once the threshold is reached, wages and/or net self-employment income over the threshold is subject to an additional Medicare tax of 0.9%.
The Net Investment Income Tax applies if a person has adjusted gross income (with some modifications) of at least $200,000 for unmarried persons or $250,000 for married couples filing jointly. Once the threshold is reached, a tax of 3.8% is applied to the lower of the following two amounts: net investment income or adjusted gross income over the threshold amount. Strategies for dealing with the net investment income tax include trying to reduce the amount of investment income. For example, capital loss harvesting can work to lower the net amount of gains subject to the 3.8% tax.
Combined, higher-income taxpayers are likely to see a much higher tax liability for 2013. It would be a good idea to get an estimate of your tax liability, see how much has been paid in through withholding and estimated payments, and figure out if any additional tax will need to be paid by April 15th.