Year-end tax planning for individuals
Posted On: 11-16-2016 | Posted By: Katie Barthel, CPA
It’s that time of the year again – time to start thinking about the upcoming tax season. You have a few different strategies available to reduce your current year income tax burden. You might be able to: defer your income to be recognized in a later year; accelerate your deductions to be recognized in the current year; or apply for tax credits.
These three strategies are discussed below.
1. Defer income
There are a couple different ways that you can defer recognizing income until next year. If you have well-performing securities in your stock portfolio that you plan to sell in the near future, waiting to make the sale until next year will defer your recognition of the capital gain. Conversely, you can utilize the strategy known as “loss harvesting.” Loss harvesting is where you sell some of your securities at a loss, and use those losses to offset existing capital gains. Just keep an eye out for wash sales – this is when a security is sold at a loss and repurchased shortly before or after the sale. Losses are disallowed in this situation.
If you are self-employed and your business recognizes income on the cash basis, you can choose to delay some of your billings until late December so that you recognize that income in early 2017 when your clients make those payments. On the cash basis, you only recognize income when cash is received. However, keep in mind that your cash-basis customers could be employing the opposite strategy so that they can receive the deduction before year end.
2. Accelerate deductions
PAY EXPENSES EARLY
If you have some deductible expenses that are coming due in the first couple months of the year, you can elect to pay some of those expenses before year-end to utilize the related tax deduction in the current year. Some examples of expenses that you can expedite are:
- home mortgage payments on a first and second home (the interest is deductible);
- student loan payments (the interest is deductible);
- higher education expenses;
- state and local property taxes;
- medical bills; and,
- your fourth quarter estimated state income tax payments.
Keep in mind: many of these expenses are deductible even if they are charged on a credit card by the end of the year. Your tax benefit could be subject to limitations or income thresholds.
If you are self-employed, you may want to purchase and place new equipment in service for your business before year-end. Doing so might allow you to take accelerated depreciation on those assets, lowering your business’s tax liability that gets reported on your personal return. However, we advise you only to buy equipment you need – buying equipment you don’t need solely to take depreciation means your cash will take an unnecessary hit.
CONTRIBUTE MONEY TO YOUR FINANCIAL FUTURE
Contributions to certain retirement plans can be tax-deductible. Traditional IRA contributions of up to $5,500 (or $6,500 if you are 50+) are deductible if you have earned income and neither you nor your spouse is eligible for a retirement plan through one of your employers. If one or both of you are eligible for an employer’s retirement plan, the deduction depends on income thresholds but might still be available. You can make these IRA contributions through April 17, 2017, and still take the deduction on your 2016 tax return.
Contributions to a Health Savings Account (HSA) are also deductible up to the annual limit of $3,350 for individual coverage or $6,750 for family coverage (plus an additional $1,000 if you are 55+). Your insurance plan must be a qualified high deductible health plan for you to be eligible to contribute to an HSA. Contributing money to your HSA through payroll deductions not only saves you income tax, but it saves you Social Security and other payroll taxes. You can contribute to your HSA with after-tax dollars and still receive the income tax deduction, but you would be missing out on the payroll tax savings by doing it that way. After-tax HSA contributions can be made at any point during the year and up through April 17, 2017. The money in your HSA is yours, and if your contributions exceed current year expenses, you can use that money for future eligible medical expenses.
Many states, including Missouri, offer a state income tax deduction for contributions made to a 529 College Savings Plan. In 2016, contributions to one or more plans are deductible on your Missouri income tax return up to $8,000 per taxpayer. These deductions aren’t limited to contributions for your kids. You can contribute for grandkids or family friends, too! Contributions must be made before the end of the year.
DONATE TO CHARITY
Another expense that you can accelerate is contributions you make to a charity. Many charitable organizations hold drives for in-kind donations this time of the year (such as new or used clothing, toys for children, household goods for needy families), and these donations are tax-deductible – just make sure to save your donation receipts! Stock donations can be particularly beneficial because the donation is at fair market value. If you have a stock that has increased in value that you have held for at least a year, you can take a deduction for the full value without ever recognizing the income from the stock appreciation.
If you haven’t yet taken your 2016 required minimum distribution from your taxable Individual Retirement Account (IRA), consider having all or part of your distribution directed to a charity. This is called a “qualified charitable distribution.” By making the distribution in this manner, you do not have to include this distribution in your taxable income. This will reduce your adjusted gross income (AGI), which can affect the phase-out thresholds for other tax benefits. Additionally, itemized deductions can be limited, so simply taking the deduction for your contribution may not provide you with the greatest benefit.
3. Apply for tax credits
If you have a child that goes to college, or if you are taking college classes yourself, you may consider pre-paying some of your tuition bills so that you can take advantage of an educational tax credit. The American Opportunity Tax Credit and the Lifetime Learning credits are available, but both are subject to income phase-outs. The IRS even allows credits for prepayments for any academic session that will begin in January, February, or March 2017. Note: you may take either a deduction or a credit for the education expenses you spend each year. WK can help you determine whether the deduction or the credit is the best option for you if you qualify.
If you paid somebody to care for your child aged 12 and below so that you could work, you may be eligible for the Child and Dependent Care Credit. Only payments for services already rendered are eligible for the credit, so you cannot prepay for care to be given in the following year. This credit is also subject to income phase-outs.
Some states will provide tax credits when you make certain charitable contributions. These credits are useful to taxpayers because the taxpayer can often utilize the federal deduction for the same donation that qualifies him or her for the state tax credit. Check with your particular state’s Department of Revenue for more details. Missouri’s available tax credits are listed here, but the best source on whether a donation qualifies for a credit is usually the charity itself.
Look to the future
Accelerating deductions and deferring income are ways you can reduce your current year tax liability, but remember that doing so might inadvertently increase your tax liability next year. Reducing your current year taxable income might not always be your ultimate goal. You must look at these tax planning strategies using a multi-year approach so that you can get the best tax outcome for the foreseeable future.
By taking a broader view, you can make plans now to reduce your tax liability going forward. Flexible Spending Accounts (FSAs) for health or dependent care are tools that must be considered before year-end. FSAs are “use it or lose it” annual savings accounts, typically provided through your employer, that allow you to save pre-tax dollars to spend on eligible expenses. For example, dependent care FSAs might save you more tax dollars than taking the dependent care credit (discussed above) on your tax return. Ask your employer if they offer FSAs, and if so, you may want to take advantage of these tax-saving tools for next year.
Another tool at your disposal is your employer’s retirement plan. In an employer-sponsored retirement plan, participants can set aside a portion of their pre-tax income as a contribution to their plan. Common forms of these plans are 401(k)s, SIMPLE IRAs or 403(b)s. Tax is paid on the contributed income at a later date when the participant uses that money in retirement. Deferring taxes in such a way is often beneficial to retirees who are in a lower income tax bracket later in life.
If you would like to discuss these tips in more detail, or if you would like to consider other long-term tax planning strategies, please contact your WK advisor at (573) 442-6171 or (573) 635-6196.