As the end of the year approaches, many of us are focused on taking advantage of year-end tax savings opportunities before another year begins.
While many factors complicate tax planning this year, including political and economic uncertainty, and Congress's all too familiar failure to act on a number of important tax breaks that will expire at the end of 2016, there are still actions you can take to cut taxes this year.
Based on current tax rules, the following tips can help you save tax dollars if you act before year-end. While not all actions will apply in every taxpayer’s particular situation, you’ll likely benefit from many of them.
1. Realize losses on stock, while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later.
2. Postpone income until 2017 and accelerate deductions into 2016. This strategy may enable you to claim larger deductions, credits and other tax breaks for 2016 that are phased out over varying levels of adjusted gross income.
Note: In some cases, it may pay to actually accelerate income into 2016. For example, this may be the case if an individual’s marginal tax rate is much lower this year than it will be next year or if lower income in 2017 will result in a higher 2017 tax credit for an individual who plans to purchase health insurance on a health exchange and is eligible for a premium assistance credit.
3. Consider converting traditional-IRA money invested in beaten-down stocks (or mutual funds) into a Roth IRA, if you’re eligible to do so. Keep in mind, however, that such a conversion will increase your AGI for 2016.
4. Re-characterize the conversion of a traditional IRA to a Roth IRA. If you converted assets in a traditional IRA to a Roth IRA earlier in the year and the assets in the Roth IRA account declined in value, you could wind up paying a higher tax than is necessary if you leave things as is. You can back out of the transaction by re-characterizing the conversion—that is, by transferring the converted amount (plus earnings or minus losses) from the Roth IRA back to a traditional IRA via a trustee-to-trustee transfer. You can later reconvert to a Roth IRA.
5. Ask your employer to defer your bonus until early 2017.
6. Consider using a credit card to pay deductible expenses before the end of the year. Doing so will increase your 2016 deductions even if you don't pay your credit card bill until after the end of the year.
7. Ask your employer to increase withholding of state and local taxes before year-end. If you expect to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding of state and local taxes (or paying estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2016 if you won’t be subject to alternative minimum tax in 2016.
8. Take an eligible rollover distribution from a qualified retirement plan before the end of 2016 if you are facing a penalty for underpayment of estimated tax and having your employer increase your withholding is unavailable or won't sufficiently address the problem.
9. Estimate the effect of any year-end planning moves on the AMT for 2016. Keep in mind that many tax breaks allowed for purposes of calculating regular taxes are disallowed for AMT purposes. These include the deduction for state & local property taxes on your residence, state income taxes, miscellaneous itemized deductions, and personal exemption deductions.
10. Apply a bunching strategy to “miscellaneous” itemized deductions, medical expenses and other itemized deductions. For 2016, the “floor” beneath medical expense deductions for those age 65 or older is 7.5 percent of adjusted gross income. Unless Congress changes the rules, this floor will rise to 10 percent of AGI next year. Taxpayers age 65 or older who can claim itemized deductions this year, but won't be able to next year because of the higher floor, should consider accelerating discretionary or elective medical procedures or expenses (e.g., dental implants or expensive eyewear).
11. Pay contested deductible taxes. You’ll be able to deduct them this year, while continuing to contest them next year.
12. Settle an insurance or damage claim to maximize your casualty loss deduction this year.
13. Take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retirement plan). RMDs from IRAs must begin by April 1 of the year following the year you reach age 70-½. That start date also applies to company plans, but non-5% company owners who continue working may defer RMDs until April 1 following the year they retire. Failure to take a required withdrawal can result in a penalty of 50% of the amount of the RMD not withdrawn.
14. Increase the amount you set aside for next year in your employer's health flexible spending account (FSA) if you set aside too little for this year.
15. Make health savings account (HSA) contributions if you become eligible in or before December 2016. If you do, you can make a full year's worth of deductible HSA contributions for 2016.
16. Install energy saving improvements to your home, such as certain high-efficiency insulation materials, before the close of 2016. You may qualify for a “nonbusiness energy property credit” that won't be available after this year, unless Congress reinstates it.
17. Shelter gifts using the annual gift tax exclusion before the end of the year to save gift and/or estate taxes. The exclusion applies to gifts of up to $14,000 made in 2016 and 2017 to each of an unlimited number of individuals. You can't carry over unused exclusions from one year to the next. The transfers also may save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax.
Concerns Facing Higher Income Individuals
Higher-income earners have unique concerns to address when mapping out year-end plans. They must be wary of the 3.8 percent surtax on certain unearned income and the additional 0.9 percent Medicare (hospital insurance or HI) tax. The latter tax applies to individuals for whom the sum of their wages received with respect to employment and their self-employment income is in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately).
The surtax is 3.8 percent of the lesser of: (1) net investment income (NII) or (2) the excess of modified adjusted gross income (MAGI) over an unindexed threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return and $200,000 in any other case). As year-end nears, a taxpayer’s approach to minimizing or eliminating the 3.8% surtax will depend on his estimated MAGI and NII for the year. Some taxpayers should consider ways to minimize (e.g., through deferral) additional NII for the balance of the year, others should try to see if they can reduce MAGI other than net investment income and other individuals will need to consider ways to minimize both NII and other types of MAGI.
The additional Medicare tax may also require year-end actions. Employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. Self-employed persons must take it into account in figuring estimated tax. There could be situations where an employee may need to have more withheld toward year-end to cover the tax.
A word of caution: Everyone’s tax situation is different
As always, year-end tax planning must take into account each taxpayer’s particular situation and planning goals with the aim of legally minimizing taxes to the greatest extent possible. While many taxpayers will come out ahead by following the traditional approach of deferring income and accelerating expenses, all taxpayers need to consider whether or not that approach applies to their specific situation.