As the 2014 tax season approaches, taxpayers may find themselves trapped in limbo while Congress is preoccupied with the results of the midterm election, leaving temporary tax provisions up in the air. That said, taxpayers may still want to reassess their tax situation and consider various strategies in order to be well positioned in a time of uncertainty.
For individual taxpayers, the primary goal of tax planning is to minimize taxes. Sound year-end tax planning for 2014 must take into account the many key tax extenders that have expired and may not be retroactively reinstated or extended before year-end, as well as consider each taxpayer’s particular situation and planning goals.
Some of the important tax breaks that have expired at the end of 2013 and have yet to be renewed include:
• The election to claim sales and use taxes as an itemized deduction instead of state income taxes
• Deduction for mortgage insurance premiums (deductible as qualified interest)
• Exclusion of discharge of principal residence indebtedness from gross income
• Credit for health insurance costs of eligible individuals
• Tax-free charitable contributions from IRAs to charitable organizations for those age 70-1/2 and older
• Bonus first-year depreciation deductions for qualifying new purchases
• Generous expensing limits under Code Sec. 179
Many taxpayers will benefit from following the traditional approach of deferring income and accelerating deductions to reduce 2014 taxes, while others will come out ahead by taking the opposite‒accelerating income and deferring deductions. Common practices for deferring income for an individual, for example, are to delay collecting rents, receiving payment for services, accepting a year-end bonus, or collecting business debts until the following year. Similar techniques can be reversed to achieve the opposite effect.
The uncertainty surrounding certain tax breaks is making 2014 year-end tax planning challenging. Putting tax breaks aside; there are certain things you need to understand to be prepared for the coming tax season.
• Inflation adjustments widen tax brackets. Individuals will benefit from wider tax brackets, higher standard deduction amounts, and higher personal exemption amounts.
• Long-term capital gains and qualified dividends. Long-term capital gains are taxed based on the tax bracket you fall into. They will be taxed at a rate of 20% if they would be taxed at a rate of 39.6% if they were treated as ordinary income, 15% if they would be taxed at a rate above 15% but below 39.6% if they were treated as ordinary income, and 0% if they would be taxed at a rate below 15% if they were treated as ordinary income. Qualified dividend income is taxed at the same rates that apply to long-term capital gains.
Tax planning opportunities may arise in matching capital gains and capital losses to take advantage of the above rules and converting investment income into qualified dividend income. There is an additional 3.8% surtax on net investment income for single taxpayers who make more than $200,000 per year and married taxpayers who file jointly and earn more than $250,000.
• Traditional IRA and Roth IRA conversion and recharacterization. The tax you pay on your Roth IRA conversion is based on the value of your Roth IRA at the time of conversion. If the market value of your Roth IRA goes down following the conversion, it makes sense to undo the conversion (recharacterize) and reconvert at a lower value to avoid paying tax on money that is no longer in your Roth IRA.
• Changes in individual’s tax status. Year-end tax planning should also reflect any anticipated changes in an individual’s tax status. For instance, if the taxpayer will end his head of household status next year, he may profit by pulling more income into this year.
• Alternative minimum tax (AMT). Any tax planning involving accelerating expenditures or deferring an item of income to reduce taxable income for tax saving purposes must beware of the AMT and take into account rules that hinder taxpayers from deferring taxable income. The AMT may negate the positive effects of tax planning strategies.
• Economic effects of the time value of money. Decisions regarding accelerating income must consider the economic effects of paying taxes earlier than if income were recognized in later years.