Year-end is here and you’re probably thinking about what you want to do with your money. You might be considering charitable contributions, investments in tax-deferred accounts and other options. Here are some tips to consider as you weigh potential tax moves between now and the end of the year.
If you take advantage of opportunities to defer income to 2019, you could move into a lower tax bracket. For example, consider deferring a year-end bonus or delaying the collection of business debts, rents, and payments for services. This strategy may allow you to postpone payment of tax on the income until next year.
Deductible contributions to a traditional IRA and pre-tax contributions to an employer-sponsored retirement plan such as a 401(k) can reduce your 2018 taxable income. If you haven't already contributed up to the maximum amount allowed, consider doing so by year-end.
This is a fairly simple opportunity that may help you. Tax code revisions partly eliminate the federal tax deduction for state income tax payments. Many people make quarterly estimated tax payments with the fourth quarter payment being due January 15th of the next year.
Also, with the strong equity market, many stock funds have been paying huge capital gain distributions this year, which will cause many people to have large balances due in April for their state income tax. If, however, you prepay your fourth quarter state income tax this year, before December is over, you may be able to deduct it against your federal income taxes.
Likewise, if you are expecting to owe a large balance to your state for your capital gains and other investment income, you could also pay that in December. If you pay the taxes in January or April, when you normally would have done so, you may get no deduction.
Congress did not repeal the alternative minimum tax (AMT), but they raised the exemption significantly and the threshold when the exemption would be phased out. Those changes, plus the fact that most of the deductions which caused people to be in the AMT have been repealed or reduced, change the game quite a bit. The new rules regarding the AMT are:
There is a fair amount of debate among professional tax and financial advisors about how AMT will impact people. Many professionals who assume the AMT will impact their clients are not doing the math fully. Don’t simply assume that because the AMT was not repealed and because you might have been in the AMT in the past that you will automatically be impacted by the AMT moving forward. It is possible that you could avoid the AMT if your tax advisor takes a close look at your situation.
Investors in emerging markets might be seeing losses on their investments. At year-end, a lot of people think it’s the best course of action to take the losses in the current calendar year.
There are different federal capital gains tax brackets: 0% for low-income, 15% for medium income, 20% for high income, and an additional 3.8% Medicare tax for those above certain income thresholds. It’s very difficult for people to know what capital gains tax bracket you’re in based on your income. You need to run analyses to understand which year is best to claim your losses.
Let’s assume you are planning to retire next year but are working this year. You look at your income and see that you are earning $200,000 a year and you are married. You look up your tax bracket on TurboTax and discover that you’re in the 15% capital gains bracket. However, this analysis fails to take into account the fact that you’re in the AMT, which means you are actually in the 20% capital gains tax bracket.
Now let’s assume that by next year you’ll be in the 0% tax bracket. In this scenario, you would be better off taking your losses this year because by next year, you will not get the benefit of tax losses because you’ll be in a much lower tax bracket. How do you do this?
This is called tax-loss harvesting and it’s a fairly simple process. Suppose you have an energy stock that has lost value. You can sell that stock and take the loss but reinvest all the proceeds back into another energy stock. The net effect on your asset allocation is essentially nil. However, the net effect on your tax burden for this year is a substantial reduction in taxes paid. This is about capturing your losses at a time when you can benefit from them as opposed to a future time, when you cannot benefit from them.
This can help taxpayers shift their tax bracket by utilizing a tax planning technique known as "accelerated deductions." If you expect to pay more tax in the current year than what you will pay in the upcoming year, you might want to consider this strategy to help reduce your tax liability in the current year. By itemizing deductions, you can make payments for deductible expenses such as medical costs, qualifying interest, and state taxes before the end of the year. By increasing your deductions in a given year, you give yourself a better chance of paying less tax.
Let’s assume a married couple has been giving $20,000 a year to their favorite charity or church, knowing that they could make this amount part of their standardized deductions. Under the current tax laws, this couple may be limited to a $10,000 deduction for taxes together with their $20,000 deduction for the charitable donation. Together they have $30,000 of deductions.
However, since the standard deduction for married couples filing jointly is $24,000, their $20,000 charitable gift only gave rise to an increase of $6000 above the standard deduction. In effect, $14,000 of the donation would save no tax. So what should they do? This couple should consider prepaying the $20,000 this year to get the full benefit of the deduction.
Another option for leveraging charitable contributions concerns using an IRA distribution. Those who are 70.5 or older are required to make minimum distributions from their IRAs. This strategy involves making a “qualifying charitable contribution” from your IRA to a charity, which amount will come directly off of your gross income, thereby reducing your tax burden.
Gifts from IRA accounts up to $100,000 can be considered a “qualifying charitable distribution.” Contributions up to that amount will come directly off your gross income. The distribution has to come from a traditional IRA and has to go directly from the IRA custodian to the charitable organization, with no intervening possession by the owner of the IRA. In this way, the couple could make a $20,000 charitable contribution and still take the likely $24,000 standard deduction.
Similarly, people who are five years away from being required to take IRA distributions can put $100,000 of appreciated stock into a charitable gift fund before the end of December. For the next five years, the charitable fund could distribute $20,000 a year to a charity. They will get the $100,000 deduction this year and after five years they can use their IRA account to further leverage their charitable contributions.
An increasingly complex and uncertain tax environment makes it difficult for families and individuals to plan for the future. After all, taxation represents a significant variable in how much wealth a family retains versus renders to local, state and federal governments.
It is important to realize that tax planning is much different from tax preparation. The time for tax planning is before the end of the year. Once December 31 arrives, it is too late. The strategy for taxes needs to be proactively executed before the year ends. This is why a tax plan is so critical to wealth preservation.
A comprehensive approach analyzes the impact of taxation on all facets of your financial life, including income, wealth transfer, investments, tax rules for where you live, retirement goals, charitable giving and other areas. It’s critical to develop a custom tax plan designed to maximize your opportunities. An improved tax plan typically produces improved cash flows, net investment performance and after-tax returns.
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