Year-End Tax Planning for Individuals
Once again, tax planning for the year ahead presents a number of challenges this year, primarily due to the passage of the law known as the Tax Cuts and Jobs Act of 2017 (TCJA). Changes include the nearly doubling of the standard deduction, elimination of personal exemptions and the reduction or elimination of numerous itemized deductions. Let’s take a closer look.
General Tax Planning
General tax planning strategies for individuals this year depend upon how 2018 is shaping up and what is expected for 2019. This determines the optimal timing for receipt of income and payment of deductible expenses. With the significant increase in the standard deduction, bunching of itemized deductions is an effective strategy for many. This allows an individual to take the standard deduction in one year and itemize in another. Since the standard deduction does not cost anything, this strategy can maximize the tax savings associated with deductible expenses paid.
Timing of Income Recognition and Expense Deductibility
If you expect to be in the same or a lower marginal federal income tax bracket in 2019, as you are this year, it will usually make sense to defer the recognition of income and accelerate deductions. However, if you expect to be in a higher bracket next year, you will likely benefit by recognizing income before the end of the year and paying deductible expenses in 2019. Some items on which you may be able to affect the timing of income and deductions are
- Sales of investments on which you have an unrealized gain or loss. For more on this, see Investment Gains and Losses
- Year-end bonuses.
- Paying deductible expenses such as charitable contributions and medical expenses using a credit card. Expenses are deductible in the year that they are charged on a credit card, not when the credit card bill is paid. Expenses paid by check are deductible in the year the check is mailed or otherwise dispatched for delivery. For example, if you charge a deductible medical expense in December, but pay the bill in January, it can be taken as a deduction on your 2018 tax return.
- If your company grants nonstatutory stock options, consider exercising some of them, if you think your tax bracket will be higher in 2019. Generally, exercising nonstatutory options is a taxable event. Exercising incentive stock options (ISOs) late in the year is rarely a good strategy. The best time to exercise these is generally during the early part of the calendar year.
- If you’re self-employed, the timing of billing your clients or customers and your persistence in collections can help you accelerate or defer income.
If you anticipate being in a higher tax bracket next year, accelerating income into 2018 may be a good idea. However, taxpayers whose earnings are close to the adjusted gross income (AGI) threshold amounts ($200,000 for single filers and $250,000 for married couples filing jointly) that make them liable for the 0.9% additional Medicare tax or 3.8% net investment income tax (NIIT) should not accelerate income to trigger those taxes unless the income tax savings in 2019, will justify it. The long-term consequences of this strategy must not be overlooked, since it converts tax-free account withdrawals in retirement to taxable income.
Caution: Taxpayers close to threshold amounts for the NIIT should pay close attention to one-time income spikes such as those associated with Roth IRA conversions or sales of a home or other large assets that may trigger the tax.
Taxpayers whose income exceeds the additional Medicare tax threshold amounts ($200,000 single filers and $250,000 married filing jointly) should consider switching Roth retirement contributions to a deductible or excludible retirement vehicle. This might also help you avoid the 3.8% NIIT as well. Taxpayers should remain mindful of the long-term consequences of doing this, since it will result in account withdrawals in retirement becoming taxable.
In cases where tax benefits are phased out over a certain AGI amount, a strategy that considers the timing of income and deductions might allow you to claim larger deductions, credits and other tax breaks in either 2018 or 2019, depending on your situation. Roth IRA contributions, conversions of traditional IRAs to Roth IRAs, child tax credits, higher education tax credits and deductions for student loan interest are examples of these types of tax benefits.
Some other strategies a taxpayer might consider include:
- Manage the timing of your federal deduction for state and local taxes. The cap on this deduction is $10,000 for most people. If you are below the cap, you may pay a state estimated income tax installment in December instead of on the January due date. However, make sure the payment is based on a reasonable estimate of your state income tax. You may also pay your entire property tax bill, including installments due in year 2019, by year-end, provided the tax has been assessed. You will not be able to do this, if your property tax is paid from a mortgage escrow account.
- Pay 2019 tuition in 2018, to take full advantage of the American opportunity tax credit, which is worth up to $2,500 per student to cover the cost of tuition, fees and course materials paid during the taxable year. Forty percent of the credit (up to $1,000) is refundable, which means you can get it even if you owe no tax.
- Try to bunch your medical expenses. For example, you might pay medical bills in whichever year they would do you the most tax good. Medical expenses are deductible only to the extent they exceed 7.5% of AGI in 2018. In 2019, the threshold reverts to 10% of AGI. By bunching these expenses into one year, you have a better chance of exceeding the threshold in that year, thereby maximizing your deduction. Most people will benefit from accelerating medical deductions into 2018.
- If you own a business, consider setting up a retirement plan, if you don’t already have one. It doesn’t actually need to be funded until you pay your taxes, but allowable contributions will be deductible on your 2018 return.
- If you are an employee, and your employer has a 401(k) plan, contribute the maximum amount ($18,500 for 2018), plus the additional catch-up contribution of $6,000, if you are age 50 or over, assuming the plan allows this and income restrictions don’t apply.
- If you have earned income, you can make a contribution of up to $5,500 to an IRA for 2018. An additional catch-up contribution of $1,000 is allowed, if you are age 50 or over. The level of your income and whether you are covered by a retirement plan are factors in determining whether you may contribute to a Roth IRA or are restricted to a traditional IRA and whether you may deduct a contribution to a traditional IRA.
- If you are covered by a high deductible health plan, consider setting up a health savings account (HSA). You can deduct contributions to the account. Investment earnings are tax-deferred until withdrawn, and amounts you withdraw (including account earnings) are tax-free if used to pay medical bills. In effect, medical expenses paid from the HSA are deductible from the first dollar (unlike the usual rule limiting such deductions to the excess over 7.5% of AGI). For amounts withdrawn at age 65 or later that are not used for medical bills, the HSA functions much like an IRA.
- Maximize contributions to section 529 plans, which, starting in 2018, can be used for elementary and secondary school tuition as well as college or vocational school.
Property, as well as money, can be donated to a charity. You can generally take a deduction for the fair market value of the property; however, for certain property, the deduction is limited to your cost basis. If you donate your time to charity, you cannot deduct the value of your services, but you may deduct charity-related travel expenses and some out-of-pocket expenses.
Keep in mind that a written record of your charitable contributions–including travel expenses such as mileage–is required in order to qualify for a deduction. In addition to a bank record (such as a cancelled check) of cash contribution of $250 or more, a donor must get a contemporaneous written acknowledgement from the charity (such as a receipt or a letter) showing the date and amount of the contribution.
Tip: Contributions of appreciated property (e.g. stock) provide an additional benefit, because you avoid paying capital gains on any profit.
Taxpayers age 70½ or older can reduce income tax owed on required minimum distributions (RMDs) from IRA accounts by donating them to a charitable organization in a direct transfer.
Investment Gains and Losses
This year, and in the coming years, investment decisions are often more about managing the timing capital gains than about minimizing taxes per se. For example, taxpayers below the NIIT threshold amounts in 2018, might want to take gains, whereas taxpayers above threshold amounts might want to take losses. Recognizing gains in 2018, that would otherwise likely be recognized in 2019, may help avoid the NIIT in both years.
Caution: Fluctuations in the stock market are commonplace; don’t assume that a down market means investment losses, as your cost basis may be low, if you’ve held the stock for a long time.
Minimize taxes on investments by harvesting unrealized losses. Where appropriate, try to avoid short-term capital gains, which are taxed as ordinary income (i.e. the rate is the same as your tax bracket).
Where feasible, reduce all capital gains and generate short-term capital losses up to $3,000. As a general rule, if you have a large capital gain this year, consider selling an investment on which you have an accumulated loss. Capital losses up to the amount of your capital gains plus $3,000 per year ($1,500 if married filing separately) can be claimed as a deduction against income.
Wash Sale Rule. After selling an investment at a capital loss, you must wait before repurchasing it. If you buy it back within 30 days, the loss will be disallowed. Alternatively, you can immediately purchase a similar (but not the same) investment, e.g. an ETF or other mutual fund with the same objectives as the one you sold.
Before investing in a mutual fund, ask whether a dividend is paid at the end of the year or whether a dividend will be paid early in the next year but be deemed paid this year. Depending on your circumstances, it may or may not be a good idea to buy shares right before the fund goes ex-dividend. For instance, a large capital gain distribution may not cost you any tax, if you already have net capital losses. However, if that is not the case, a reinvested dividend shortly after you buy into a fund could give you a tax liability without a significant change in either the value of your investment or in your cash position. To find out a fund’s ex-dividend date, call the fund directly.
Please call our office, if you’d like more information on how dividends paid out by mutual funds affect your taxes this year and next.
Alternative Minimum Tax
The alternative minimum tax (AMT) applies to high-income taxpayers that take advantage of deductions and credits to reduce their taxable income. The AMT is intended to ensure that taxpayers pay at least a minimum amount of tax.
Although the AMT remains in place after the TCJA, exemption amounts have increased significantly. As such, the AMT is not expected to affect as many taxpayers as it has in the past. Furthermore, the exemption phase-out threshold increases to $500,000 ($1 million for married filing jointly). Both the new exemption and threshold amounts are indexed for inflation.
Any planning actions you take should consider the AMT. Some expenses are deductible for regular tax but not for AMT. The trick is to pay these in a year in which you are not subject to AMT.
If you know you have income this year that is not covered by withholding taxes, there is still time to increase your withholding before year-end and avoid or reduce any estimated tax penalty that might otherwise be due. On the other hand, the penalty could be mitigated by covering the extra tax in your final estimated tax payment and computing the penalty using the annualized income method when you file your return. If you are retired, you may be able to catch up on estimated payments due by withdrawing funds from an IRA and having most or all of the withdrawal withheld.
Year-End Giving to Reduce Your Potential Estate Tax
The federal gift and estate tax basic exclusion is currently set at $11.18 million but is projected to increase to $11.4 million in 2019.
Gift Tax. Sound estate planning often begins with lifetime gifts to family members. In other words, gifts that reduce the donor’s assets subject to future estate tax. Gifts of present interests are exempt from gift tax for amounts up to $15,000 per year per donee in 2018, and the exemption is expected to remain the same in 2019.
Caution: An unused annual exemption doesn’t carry over to later years. To make use of the exemption for 2018, you must make your gift by December 31.
Most gifts of future interests, assets that the donee can only enjoy at some future time, generally don’t qualify for exemption; however, gifts for the benefit of a minor child can be made to qualify. Special treatment is available for gifts to section 529 education plans.
If you’re considering adopting a plan of lifetime giving to reduce future estate tax, don’t hesitate to call our office for assistance.
These are just a few of the steps you might consider. Proper tax planning requires projections that consider the tax consequences of proposed actions over the course of multiple years. Please contact our office for assistance with implementing year-end planning strategies that might be suitable for your particular situation.