Tips for Mid-Year Tax Planning
Tax-saving strategies take time to implement, so it is important to not wait until the end of the year. This blog offers several mid-year strategies for individuals to consider, including reducing taxable income, modified adjusted gross income (MAGI), and/or net investment income; contributing to retirement plans; and planning for medical expenses.
In the quest to reduce your tax bill, year-end planning can only go so far. Tax-saving strategies take time to implement, so review your options now. Here are several mid-year strategies to consider.
Consider Your Bracket
The top income tax rate is 39.6% for individuals with taxable income over $400,000 ($450,000 for joint filers). If you expect this year’s income to be near the threshold, consider strategies for reducing your taxable income and staying out of the top bracket. For example, you could take steps to defer income and accelerate deductible expenses.
You could also shift income to family members in lower tax brackets by giving them income-producing assets. This strategy will not work, however, if the “kiddie tax” applies. That tax applies the parents’ marginal rate to unearned income (including investment income) received by a dependent child under the age of 19 (or age 24 for full-time students) in excess of a specified threshold ($2,000 in 2014).
Look at Investment Income
This year, the capital gains rate for taxpayers in the top bracket is 20%. If you have realized, or expect to realize, significant capital gains, consider selling some depreciated investments to generate losses you can use to offset those gains. It may be possible to repurchase those investments, so long as you wait at least 31 days to avoid the “wash sale” rule.
Another tax that higher-income investors need to be concerned about is the 3.8% net investment income tax (NIIT). It applies to taxpayers with modified adjusted gross income (MAGI) over $200,000 ($250,000 for joint filers). The NIIT applies to your net investment income for the year or the excess of your MAGI over the threshold, whichever is less. So, you can lower your tax liability by reducing your MAGI, reducing net investment income or both.
Contribute to Retirement Plans
Deductible contributions to traditional IRAs and pretax deferrals to employer-sponsored retirement plans like a 401(k) plan save taxes in a variety of ways. First, they reduce your taxable income, and thus your income taxes, for the current tax year.
Second, they reduce your adjusted gross income (AGI) and MAGI, which not only can reduce or eliminate your exposure to the NIIT, but also can help you reap maximum benefit from various tax breaks. The benefit of many deductions and credits is reduced if your AGI or MAGI falls within certain ranges or exceeds certain levels. For example, in 2014, if your AGI exceeds $254,200 (singles), $279,650 (heads of households) or $305,050 (married filing jointly), many of your itemized deductions will be reduced and your personal exemption reduced or even eliminated.
Third, traditional IRAs and employer-sponsored retirement plans grow tax-deferred. So you pay no tax as long as the funds are in the account, which reduces your taxes for years to come. Plus, tax-deferred compounding can help your investments grow more quickly. When you start taking distributions in retirement they will be taxable, but if you are not working, you may be in a lower tax bracket.
Plan for Medical Expenses
Beginning last year, the threshold for deducting medical expenses went up from 7.5% of AGI to 10% of AGI (unless you are age 65 or older). You can deduct only expenses that exceed that amount.
One way to save taxes, even if your expenses do not exceed that amount, is to contribute to a tax-advantaged health care account, such as a Health Savings Account (HSA) or a Flexible Spending Account (FSA). Contributions are pretax or tax-deductible and withdrawals used to pay qualified medical expenses are tax-free. Many rules and limits apply, however.
If an HSA or FSA is not an option or will not cover all of your medical expenses, take a closer look at the medical expense deduction. Deductible expenses may include health insurance premiums (if not deducted from your wages pretax); long-term care insurance premiums (age-based limits apply); medical and dental services and prescription drugs (if not reimbursable by insurance or paid through a tax-advantaged account); and mileage driven for health care purposes (23.5 cents per mile driven). You may be able to control the timing of some of these expenses so you can bunch them into every other year and exceed the applicable floor.
Get a Head Start
These are just a few ideas for slashing your 2014 tax bill. To benefit from mid-year tax planning, consult your tax advisors now. If you wait until the end of the year, it may be too late. For help with your midyear tax planning, contact Rob Swenson at [email protected] or call him at 312.670.7444.
In this issue, “Tax Tips” looks at a recent Tax Court determination that the “one-rollover-per-year” limit for IRAs applies on an aggregate basis, as opposed to the “one-per-IRA-per-year” interpretation that the IRS has been following. Also discussed is a case in which the U.S. Supreme Court ruled that severance payments to involuntarily terminated employees were taxable wages for FICA purposes. Finally, it is noted that the IRS has recently clarified the tax treatment of virtual currency.
IRA Rollovers: Handle with Care
Generally, withdrawals from a traditional IRA are taxable, but there is an exception for rollovers. You can withdraw IRA funds tax-free, so long as you reinvest them in the same or another IRA within 60 days. You are allowed one such rollover in any one-year period.
For years, it was assumed (even in the IRS’s own guidance) that the one-rollover-per-year limit applied separately to each of a taxpayer’s IRAs. For example, a tax-free rollover from “IRA 1” to “IRA 2” would not prevent a taxpayer from making another tax-free rollover during the same year from IRA 3 to IRA 4. But in a recent decision, which the IRS plans to follow, the U.S. Tax Court held that the rule applies on an aggregate basis. This means that, regardless of how many IRAs you have, you are limited to one rollover per year.
The Service says it will begin enforcing the rule for rollovers made after December 31, 2014. The one-rollover-per-year rule does not apply to direct transfers from one IRA trustee to another.
Supreme Court: Severance Pay is Subject to FICA Taxes
In U.S. v. Quality Stores, Inc., the U.S. Supreme Court ruled that severance payments to involuntarily terminated employees were taxable wages for FICA purposes, resolving a split among the federal appellate courts. Noting that the severance payments in question were based on employment-related criteria, the Court concluded that they fell within FICA’s broad definition of “wages.”
The Supreme Court observed that IRS rulings provide that severance payments tied to the receipt of state unemployment benefits are exempt from both income tax withholding and FICA taxes. The Court did not address this issue, so it seems – at least for now – that employers can avoid FICA taxes on severance payments through a carefully designed severance program that links severance pay to an employee’s receipt of unemployment benefits.
Tax Treatment of Virtual Currency
An increasing number of people are using virtual currency, such as Bitcoin, to pay for goods and services and even to compensate employees. Recently, the IRS issued Notice 2014-21, clarifying the tax treatment of virtual currency. The notice provides that virtual currency is property for federal tax purposes, which has significant implications for users. Among other things, exchanging property for goods or services can trigger capital gains taxes. Suppose, for example, that you buy two bitcoins for $500 each. A year later, bitcoins are trading for $750 and you use your two bitcoins to buy a $1,500 computer. Because your tax basis in the bitcoins is $1,000, you realize a $500 capital gain.