By: The Kiplinger Editors | The Kiplinger Tax Letter
On November 04, 2016
It’s time to review your year-end tax plans. There are many opportunities to save taxes. And there are tax traps you’ll want to avoid. With two months left before 2016 comes to a close, this Letter focuses on actions that you can take between now and Dec. 31 to cut your tax bill.
Let’s start with individual tax planning. Look at the overall impact on 2016 and 2017. The end game is to cut your tax bill over both years.
Most will benefit by accelerating write-offs from 2017 into 2016 while deferring taxable income. But if you expect to be in a higher tax bracket next year, consider the opposite.
Filers who claim itemized deductions have flexibility in shifting write-offs.
State and local income taxes are one of the easiest write-offs to manipulate. Mailing your estimate due in Jan. by year-end lets you claim the deduction in 2016.
Interest. If you make the Jan. 2017 mortgage payment on your residence before the end of the year, you’re able to deduct the interest portion in 2016.
Contributions. You can accelerate donations planned for 2017 into 2016, but you must charge them or mail the checks by Dec. 31 to ensure a 2016 write-off.
Medicals. If your 2016 medical costs have topped the 10%-of-AGI threshold (7.5% for folks age 65 or older) or are close to it, think about getting elective procedures this year and paying for them by Dec. 31. Seniors should carefully consider this tax tip because, as we’ve told you before, beginning with 2017 tax returns due in 2018, the threshold for deducting medical costs jumps to 10% of AGI for people age 65 or up.
Some filers can work the standard deduction. If your 2016 itemizations won’t quite hit the standard deduction amount, you can delay taking some of them so you can itemize in 2017. If your itemizations are just over the standard deduction for this year, accelerate some others to 2016 and take the standard deduction in 2017.
There are some special situations that may affect your tax planning:
A quirk in the way Medicare Parts B and D premiums are figured is one.
Married couples with AGIs exceeding $170,000 and singles with over $85,000 of AGI pay higher premiums for coverage. Premiums for 2018 will be based on 2016 income. Consider whether tax moves you make now could push up or down premiums in 2018.
Watch out for the bite of the cutback in itemizations for upper-incomers.
The alternative minimum tax can throw a monkey wrench into your plans,too. The AMT is owed to the extent it exceeds your regular tax liability. It has two rates: 26% on the first $186,300 of alternative minimum taxable income, and then 28%.
Deductions for many items are not allowed for the AMT: Personal exemptions. The standard deduction. If you itemize, you must add back state and local taxes, some medicals if you are age 65 or older, and most of your miscellaneous write-offs.
Paying the Jan. 2017 state income tax estimate in 2016 won’t work for AMT.Ditto for a real estate tax bill due in early 2017. You get no tax benefit from interest on home equity loans unless you use the proceeds to buy, build or renovate a home.
Your investment portfolio provides plenty of tax saving opportunities. Knowing the tax rules inside and out will help you avoid making a blunder that costs you extra tax. Don’t let the tax impact alone dictate the moves you make with your investments. Your decisions should always make economic sense, too.
If you have capital loss carryforwards, search your portfolio for gains.That’s because your net gains…up to the carryover amount…won’t be taxed at all.
See if you can benefit from the 0% rate on long-term gains and dividends. If your taxable income other than gains or dividends is in the 10% or 15% tax bracket, then dividends and profits on the sales of assets owned more than a year are tax-free until they push you into the 25% bracket. That bracket starts at $37,651 for singles and $75,301 for married couples. But be careful. Zero-percent gains and dividends are included in AGI, which can cause more of your Social Security benefits to be taxable and can squeeze some itemized deductions such as medical expenses. Also, your state income tax bill may rise, as most states tax gains as ordinary income.
Keep the 3.8% Medicare surtax at bay. It applies to net investment income of single filers and heads of household who have modified AGIs above $200,000… $250,000 for couples and $125,000 for marrieds filing separately. The tax is due on the lesser of net investment income or the excess of modified AGI over the thresholds. Investment income includes taxable interest, dividends, annuities, gains, royalties and passive rental income, but not retirement plan payouts or tax-exempt interest.
Among the ways to minimize the sting of the surtax: Buy municipal bonds. Tax-free interest is exempt from the 3.8% surtax and does not affect the owner’s AGI. If selling property, use an installment sale to spread out a large gain. And, if feasible, do a like-kind exchange of investment realty to defer the gain instead of a taxable sale.
Think about selling some poor performers. Capital losses that you incur can offset your capital gains plus up to $3,000 of other income. Any excess losses are then carried over to the next year and can help offset future capital gains. Taking losses to offset gains can also reduce the tax bite of the 3.8% Medicare surtax.
Don’t run afoul of the wash-sale rule, which bars a capital loss write-off if you buy substantially identical securities within 30 days before or after a sale. Instead, any suspended loss is added to the tax basis of the replacement shares. This rule can apply in surprising ways: For example, selling a mutual fund at a loss within 30 days of the date a dividend is reinvested. Or having your IRA buy shares shortly after you sell the same stock at a loss out of your taxable investment account.
Donate appreciated stock or mutual fund shares to a tax-exempt charity. Provided you’ve owned the property for more than a year, you can deduct its full value. And neither you nor the charitable organization has to pay tax on the appreciation.
However, don’t contribute property that’s fallen in value. If you do, the capital loss is wasted. Taxwise, you’re better off selling it, claiming the capital loss on your tax return and then donating the proceeds to the charity of your choice.
Be wary of buying a mutual fund late in the year for your taxable portfolio.If the fund pays a 2016 dividend after you buy it, you owe tax on the payout this year. However, you aren’t any better off financially because the fund’s share price decreases by a corresponding amount. In effect, you’re prepaying tax to IRS. To avoid this trap, buy the stock after the dividend record date. Ask the fund whether it will pay a dividend.
Take advantage of the gift tax exclusion this year. For 2016, you can give up to $14,000 apiece to a child or other person without gift tax consequences. Your spouse can also give $14,000 to the same donee, making the tax-free gift $28,000. Any unused amount is gone forever. You can’t give extra next year to make up for it.
Pay attention to the required distribution rules for traditional IRAs.
Folks age 70½ and older must take withdrawals by year-end or pay a penalty equal to 50% of the shortfall. You start with your IRA balances as of Dec. 31, 2015, and divide each one by the factor for your age, which you can find in IRS Pub. 590-B. A higher factor applies if you are more than 10 years older than your spouse. The sum of these required withdrawal amounts can be taken from any IRAs you pick. (Similar rules apply to payouts from 401(k) plans, except that people owning 5% or less of a company who work past age 70½ can delay taking payouts until they retire, and the minimum required distribution must be taken from each retirement plan.)
If you’ve turned 70½ this year, you can delay 2016’s payout till April 1, 2017. This special rule doesn’t apply for account withdrawals in subsequent tax years, and the payout for 2016 is still based on your total IRA balance as of Dec. 31, 2015. Take care if you decide to defer the payout to 2017. If you choose this option, you’ll be taxed in 2017 on two distributions: The one for 2016 that you opted to defer and your payout for 2017. This doubling up could push you into a higher tax bracket.
Take advantage of a charitable break for IRA owners that’s now permanent. People age 70½ and older can transfer as much as $100,000 annually from their IRAs directly to charity. If married, you and your spouse can give up to $100,000 each from your separate IRAs. The transfers count as part of your required distribution. Unlike other IRA payouts, these direct gifts are not added to your taxable income, so they don’t reduce the value of your itemized deductions or personal exemptions, or trigger a Medicare premium surcharge. Of course, you can’t deduct the donation.
Consider whether it’s the right time to convert a traditional IRA to a Roth IRA. You will have to pay tax on the converted funds, but once the money is in the Roth, future earnings are tax-free. If you think you’ll be in a low tax bracket this year, you may want to convert only a part of your IRA to push your 2016 taxable income to the top of that bracket but not enough to tip you into the next higher bracket.
Be sure to check your health flexible spending account. You must clean it out by Dec. 31 if your employer hasn’t implemented either the 2½-month grace period or the $500 carryover rule. Otherwise, you will forfeit any money left in the account.
Act fast if you’re considering putting energy-efficient windows in your home.
A limited credit is available if you install them by Dec. 31. Last year’s tax law extended through 2016 the credit for energy-saving items added to one’s residence, such as windows, insulation, roofs and doors. The credit is 10% with a $500 maximum, and credits taken in prior years count against the $500. Many items are capped. The same urgency doesn’t apply to the 30% credit for residential solar energy systems. The full credit applies through 2019 and then phases out until it ends after 2021.
If you think you’ll be hit by the 0.9% Medicare surtax on earned income...
You may need to jack up withholding. The levy kicks in for single taxpayers and heads of household with earnings over $200,000…$250,000 for married couples. Employers must begin to withhold the tax from worker paychecks in the pay period when wages first exceed $200,000, regardless of the employee’s marital status. This can lead to underwithholding for a couple if each spouse earns less than $200,000 but their combined wages total more than $250,000. The same goes for an employee with a self-employed spouse if the combined earnings will exceed $250,000.
Boosting tax withholding can also help you avoid an underpayment penalty.You’re off the hook from the fine as long as you prepay at least 90% of 2016’s tax bill or 100% of what you owed for 2015 (110% if your 2015 AGI was more than $150,000). You can have more tax withheld from Nov.-Dec. paychecks or a year-end IRA payout. Tax withheld at any point during the year is treated as if paid evenly over the year.
Now let’s turn to practical ways that you and your business can save taxes.
Business owners can shift income and expenses between 2016 and 2017. Professionals can postpone their year-end billings to collect less revenue in 2016 or they can speed them up if they expect to be in a higher tax bracket next year. Firms can juggle their income by shifting some expenses from one year to another. However, the Service will look askance if there’s too much distortion of earnings.
Note the tax rules on year-end bonuses. It may pay to postpone a bonus. But delaying a bonus for a firm’s majority owner won’t work if the amount is set in 2016 and the company has cash to pay it…the owner has constructive receipt of the bonus. Write-offs of bonuses by accrual method firms are limited. They can’t deduct in 2016 bonuses deferred to 2017 by owners of greater than 50% of regular corporations or by owners of any interest in an S corporation, personal service firm or partnership.
Putting assets into service by Dec. 31 can provide large write-offs:
50% bonus depreciation is one. Companies can deduct half the cost of new assets with useful lives of 20 years or less that are put into use this year, including machinery and equipment, land improvements and some farm structures. Leasehold improvements made to the interiors of commercial realty are eligible, too.
Expensing is also available. For 2016, firms can expense up to $500,000 of new or used business assets in lieu of depreciating them…an even better deal than bonus depreciation. The $500,000 limitation phases out dollar for dollar once more than $2,010,000 of assets are placed in service during this year.
Buying a new heavy SUV by Dec. 31 can generate a slew of tax breaks. Up to $25,000 of the cost of a new SUV with gross vehicle weight over 6,000 pounds can be expensed, the balance gets 50% bonus depreciation, and the remainder may qualify for regular five-year depreciation. Used SUVs don’t get bonus depreciation. Say you buy a new large SUV for $65,000 and use it 100% for business this year. $25,000 can be expensed. Half the remaining cost…$20,000…is bonus depreciation. 20% of the $20,000 balance, $4,000, can also be deducted as regular depreciation.
Purchasing a large pickup truck can lead to an even juicier tax break. The cost of a pickup truck with gross weight over 6,000 pounds can be fully expensed as long as the cargo bed is at least six feet long and is not accessible from the cab.
There’s a twist if too many assets are bought in the last quarter of the year.If over 40% of your 2016 business asset purchases are put in service after Sept., regular depreciation on all assets put in use in 2016 is figured on a quarterly basis. So assets that are put in use in late 2016 are eligible for 1½ months of depreciation instead of six months’ worth. Buildings aren’t affected because depreciation for them depends on the month they’re put in use. And 50% bonus depreciation isn’t reduced if a business puts the bulk of its assets in service at year-end. So in our SUV example, even if the midquarter rule applied, the total write-offs would still exceed $45,000.
Owners of regular corporations should weigh taking dividends in lieu of salary if the corporation is in a low tax bracket and the owner is in a high tax bracket. The owner’s preferential rate on dividends plus the corporation’s payroll tax savings from paying dividends instead of salaries can exceed the firm’s forgone tax benefit from not being able to deduct the dividend. This doesn’t work for S corporations. Or for personal service companies, which pay a flat 35% tax on their income.
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