Consider final steps to cut your tax bill
As the year winds down there’s less uncertainty about the short-term outlook for tax law than we had at the end of last year. With this temporary clarity comes the opportunity to create a sound tax-saving plan – and the time to put your plan into action. Here are several strategies to consider.
Reap tax benefits with retirement savings
When it comes to retirement saving, rule number one is to contribute the maximum amount allowed every year.
Did you know you can make IRA contributions for your spouse when you’re working and your spouse is not? You can add an additional $1,000 when your spouse is over age 50.
If you’re self-employed, establishing a retirement plan such as a SEP or a SIMPLE means a current-year tax deduction in addition to tax-deferred growth. You can contribute 25% of your salary to a SEP plan, up to a maximum contribution of $49,000. The maximum SIMPLE contribution is $11,500, plus an additional $2,500 as a catch-up contribution if you’re over age 50. A federal tax credit may also be available – up to $500 for each of the first three years of your new plan. Remember, credits reduce your tax bill dollar for dollar.
Contact Trinity Tax Associates for guidance in identifying the tax strategies that best fit your situation.
Roth conversions affect taxes
Roth conversions were included in tax planning last year, in part due to the one-time opportunity to defer paying federal income tax on the conversion. If you made the deferral election, remember you will have to report half the income on this year’s return. Current or prior year net operating losses, unused tax credits and deductions that lower your adjusted gross income can help reduce the resulting tax bill.
Haven’t converted to a Roth yet? A potential tax-reducing suggestion: Transfer investments from your traditional IRA to a Roth during a market dip. You’ll capture after-conversion growth without owing additional tax. Are you already taking required withdrawals from your retirement accounts? Then you know required minimum distributions from traditional IRAs increase your adjusted gross income (AGI). In turn, your AGI affects how much of your social security benefits are taxable. One option for reducing the impact is to take only the minimum from your traditional IRA. Use nontaxable Roth distributions or capital gain/loss harvesting in taxable accounts to supplement your income. Alternatively, you can make a qualified charitable distribution from your traditional IRA of up to $100,000. The donation counts toward your required distribution, yet has no effect on your AGI.
Reduce AGI to qualify for tax breaks
Reducing your adjusted gross income could increase eligibility for income-limited deductions and credits.
When your itemized deductions (i.e. expenses such as medical care, mortgage interest, taxes, charitable contributions, casualty losses and other miscellaneous deductions) exceed your standard deductions, advance payments could save you tax dollars. For example, you can choose to make your final estimated state income tax payment in December instead of January. Since itemized deductions are no longer limited by your income, timing the payment of expenses might be more beneficial than you expect. Another reason to double-check deductions is your alternative minimum tax (AMT) exposure. Certain expenses, including state taxes and medical costs, are reduced or eliminated under AMT rules. The AMT calculation also eliminates the standard deduction. In some cases, you may save money if you claim itemized deductions even if they total less than your standard deduction.
Review support provided for relatives
While planning to maximize deductions, remember to take into account the financial support you provide for relatives. Potential tax breaks include dependency exemptions, head-of-household filing status, medical deductions and the dependent care tax credit. Generally, you will need to provide over half of your relative’s living expenses. What if you don’t provide more than 50% of support for your relative? You could enter into an arrangement with other family members who provide help, or you could shift assets you would dispose of anyway to pay for the support. You would then be shifting the related income and tax to your relative. Here’s an illustration of asset and income shifting. Instead of selling stock equity at a gain and using the proceeds to pay for a parent’s living expenses, gift the equity to your parent and let him or her make the sale. Long-term gains could qualify for a zero-percent tax rate if your parent is in the lower tax brackets.
Choose strategies that fit your situation
Other strategies for reducing your federal income tax bill include maximizing
losses by increasing your participation in passive activities, taking steps to write off
worthless securities and bad debts, and harvesting capital losses.
Be aware that Congress might pass legislation before year-end that would require
adjustments to your tax plan. Contact Trinity Tax Associates for guidance in identifying the tax strategies that best fit your situation.
More tax-savers to consider as year-end approaches
Estimate your tax liability. Adjust your final quarterly voucher or your
withholding to avoid underpayment penalties. Check estimated payments for your C
corporation for the same reason. Consider prepaying college tuition you’ll owe for the following semester. Expenses paid for you, your spouse, or your dependents will count on your current year return if you qualify for education tax credits.
Gather tax identification numbers your business will need to issue year-end reporting
statements. Though two reporting requirements were repealed (the one for rental property owners and the one for payments to corporations), the old rules live on. In addition, penalties for failure to file have increased.
Consider setting up a newly available SIMPLE cafeteria plan for your business. The
plus: pre-tax employee benefits without the need for discrimination testing. Hire your child under the age of 18 to do legitimate work in your business. You get a business tax deduction, and your child can earn up to $5,800 without paying income tax.
Bonus: When your business is a sole proprietorship, you don’t have to pay FICA taxes.
Double bonus: The kiddie tax does not apply to wages.
Start a retirement account for your working child. Boost the tax savings you get from
paying your child to work in your business by gifting the child money for a deductible,
traditional IRA contribution. Get the documentation you’ll need for all your charitable contributions, or you risk losing your deduction. Even gifts under $250 require a bank record or a receipt from the charity.
Unlock the secret to tax rate planning
Do you know your marginal tax rate? More importantly, do you know your real tax
rate? They are not the same, and knowing the difference can be critical to effective tax
The U.S. individual income tax system is based on six tiers of rates: 10%, 15%, 25%,
28%, 33%, and 35%. A common misconception is that a taxpayer falls into just one of
these brackets. But actually if someone’s income is high enough, their tax bill could be
affected by all six. This is because the tax system is graduated; meaning the first taxable
dollars are taxed at the lowest rates first, then move up the scale until the marginal rate is
reached. Your marginal rate is the rate you will pay on your next dollar of taxable
income. Your real tax rate (also called your effective tax rate) is the actual percent of tax
you pay on your taxable income.
For example, the 10% rate is assessed on taxable income from $1 to $8,500 (if filing as
single). The 15% bracket covers income from $8,501 to $34,500. If your taxable
income is $30,000, your marginal (i.e. top tier) tax rate is 15%, but your real tax rate will
be less because the first $8,500 of income is taxed at 10%.
Other factors affect your rate
There are other factors that can affect real tax rate. Personal exemptions and itemized or
standard deductions can lower taxable income and thereby lower one’s overall rate.
Conversely, unearned income such as interest and dividends might raise a taxpayer to a
higher bracket. And some types of income are taxed differently from earned income.
Long-term capital gains are taxed at 15% unless your ordinary income tax bracket is 10%
or 15%, in which case long-term capital gains are not taxed at all.
Here’s the point
Knowing where your income is in relation to the six brackets can make a big difference
in keeping your real tax rate as low as possible.
Say for example your taxable income is at $83,600, which is the top of the single
25% tax bracket. The next dollar you earn above that figure (up to $174,400) will be
taxed at your marginal rate of 28%. So if the timing of a future receipt of income is within
your control, such as from a pending business contract, consider deferring the income to
next year. Another strategy might be to reduce taxable interest income by keeping money
in a tax-exempt investment instead of a taxable one.
Or consider moving savings into Series EE savings bonds, where tax on the interest is
deferred. You might also invest in longer-term CDs which pay interest in the next tax
year. Or defer taking short-term capital gains until next year.
On the other hand if your income is just above a certain tax bracket, your strategy might
be to look for deductions that will bring your income back down into the lower bracket.
Options include such steps as contributing the maximum allowed to your 401(k) plan,
your SEP, or your SIMPLE retirement plan. Another possibility is making a deductible
IRA contribution for you and your spouse.
With the economy causing some household incomes to vary significantly from year to
year, watching your marginal tax bracket is more important than ever. Contact our office
today if you would like more information or a complete analysis of where you stand.