Tax planning in recent years has taken on greater importance and complexity due to a number of changes to the tax code.
A technical discussion of each of these changes is beyond the scope of this article, but the net result of these changes is that the effective tax rate for high-income individuals has increased significantly in the past few years. Adding to the complexity is the fact that the definition of “high income” (i.e., the income threshold levels required for these taxes to apply) is not consistent for all of these changes. So what’s a person to do?
First, since the net investment income tax (“NIIT”), the additional Medicare surtax, and the exemption and deduction phase-outs are based upon adjusted gross income, or AGI (AGI is generally total income before exemptions and itemized deductions), a key way to mitigate the tax impact of these items is to use strategies to manage AGI below these thresholds.
For example, if you own a business that is reported on your personal tax return, you can look at the timing of business deductions and accelerate them if possible. If your business is on a cash basis you could accelerate payment of expenses prior to the end of the year or defer collection of income until after year end. If you have significant capital gain income, consideration could be given to selling securities with loss positions to offset some or all of that gain.
One of the most powerful tools is maximization of deductible retirement plan contributions. For those individuals with businesses or who are self-employed, this may also provide a good opportunity to revisit your retirement plan to determine if the current plan still best meets your needs. What worked years ago may not be the best plan for you now, and your WK advisor can assist you in evaluating those options.
Regardless of the strategies used to plan around AGI, it is important to note that this planning must take a multi-year approach. Many individuals are focused on accelerating deductions to decrease tax to the lowest possible amount in the current year, with no consideration given to the impact of these actions in future years. Accordingly, such an approach may result in more overall tax over a multi-year time horizon, especially if “saving” some of those deductions for future years would have resulted in AGI in those years below the various thresholds for triggering the NIIT or the Medicare surtax.
In some instances it may even make sense to trigger income in the current year. For example, if income is low or losses are high in the current year, consideration could be given to converting a traditional IRA to a Roth IRA. Tax would be due on the conversion, but the proceeds would be withdrawn tax-free in the future. Depending on current tax rates, expected future tax rates, desire to avoid minimum distribution requirements (which can be done with a Roth), and other factors, this may be an appropriate long-term strategy. The conversion could also be done over a course of years to stretch out income recognition and take advantage of lower tax rate brackets. Your WK advisor can assist with such an analysis.
Finally, ordinary tax rates and capital gains tax rates are functions of your taxable income, which also takes into account exemptions and itemized deductions. Thus, just as one can take actions to plan around AGI, one can accelerate or defer itemized deduction as appropriate. This could include prepayment of state estimated income taxes or “bunching” of charitable deductions. As with AGI planning, this planning must be done using a multi-year forecast.
In our next article in this series, we will focus on one particular itemized deduction that contains significant opportunities for planning—the deduction for charitable contributions. Meanwhile, contact your WK advisor at (573) 442-6171 or (573) 635-6196 if it’s time to revisit your tax situation.