By Jason Van Steenwyk
In the end, it’s not about how much you earn, but about how much of it you get to keep. In most cases, this means that you want to minimize your current year tax bill. There are, however, cases where it is better to pay the tax bill now in order to avoid having to pay higher taxes in future years.
November and December are prime time for forward-thinking individuals and business owners to do some tax planning for the year. Moves you make now can pay off very quickly. Here are some of the things you can accomplish now, before the end of the year, to keep the tax man at bay.
- Do an AMT assessment. AMT stands for “alternative minimum tax.” The AMT is a supplementary set of income tax rules designed to ensure that families with significant incomes can’t use deductions and tax loopholes to avoid income tax altogether. When it was first passed in 1969, it was only intended to affect the wealthiest families. But they never indexed it to inflation. As a result, more and more middle class families are falling prey to AMT rules. If you have a lot of deductions, you own your own home, you normally have a significant state income tax liability, or you have several children, and your household income has been on the rise, or you got a bonus, you may well have an AMT liability this year.
- Contribute to an IRA. Provided you meet the income qualifications, a traditional IRA allows you to deduct up to $5,000 in contributions. Double that for married couples, and add another $1,000 each for qualifying individuals over the age of 55. Yes, the rules give you until April 15th, 2012 to make your contribution for tax year 2011, and April 15th, 2013 to make your contribution for 2012. But by contributing early, you give your investments that much more time to compound. You also set yourself up to make manageable monthly contributions to your IRA for 2013. Better yet, you don’t even have to itemize your deductions! Traditional IRA contributions are “above the line” adjustments to income. You can deduct the full contribution, provided you meet the income guidelines, even if you don’t itemize.
- Pay your property tax early. These are normally deductible expenses. But if you are subject to the AMT, that deduction may be disallowed. If 2012 is likely to be an AMT year, but 2013 is not, you may be better off making the payment in 2012.
- Cancel out your capital gains taxes. If you sold property at a gain in 2012, you will probably have some capital gains tax liability. For long-term gains, this tax maxes out at 15 percent of your gains. If you held the property for less than a year, however, expect to pay taxes at your higher marginal income tax rate, which could be as high as 35 percent. However, if you have investments outside of retirement accounts that lost money since you bought them, you can sell some or all of them and cancel out some or all of your capital gains taxes – a technique known as “tax loss harvesting.” If you have excess losses, you can deduct up to $3,000 in losses against income per year, carrying any additional losses forward to future years. Beware, however, of “wash sale” rules. To get the benefit of claiming a capital loss, you cannot repurchase the same or substantially identical securities for 30 days.
- Use your Flexible Spending Account. If you have a flexible spending account at work, you may well lose that money at the end of the year. Now’s the time to schedule that Lasik surgery, or take care of that medical treatment you’ve been putting off. Otherwise, that money goes back to your employer and you lose the opportunity. Check with your HR department for your balance and to learn how the rules apply to you.
- Bunch medical deductions. Did you have substantial medical bills in 2011? You can deduct medical expenses against your income, but only to the extent they exceed 7.5 percent of your income. If you expect more medical spending in the following 2012, try to commit the funds this year, bunching your expenses into a single tax year. This will allow you to maximize your deductions, which would be substantially reduced if you spread them out between 2011 and 2012. Actually, this strategy works with all kinds of itemized deductions. Miscellaneous (non-medical) itemized deductions have to exceed a threshold of 2 percent of your income for you to begin benefitting from the deduction. Whether the applicable threshold is 7.5 percent or 2 percent of your income, you want to concentrate as much deductible spending as you can into one year. Otherwise, you’ll have to get all the way through the threshold amount all over again next year before you can begin taking deductions.
- Give. You can give up to $13,000 per year to any recipient you choose, without incurring any kind of tax liability (subject to a lifetime exemption of $1 million.) If you’re married, you and your spouse can give $13,000 each, for a total of $26,000 per recipient. A deliberate gifting strategy can be a great way to move money out of your taxable estate, as well as protect it from those who may target you in a lawsuit. It may also help you qualify for Medicaid in later years, provided you make the gift more than 5 years before applying for Medicaid benefits.
- Pay down your mortgage. The interest you pay is normally deductible against income. By bumping up your payments in December, you can make a noticeable reduction in your tax bill for this year.
- Put Off Profitable Sales. If you don’t have any capital losses to offset gains, try to put off selling property at a profit until after the end of the year. You may have some losses you can use to offset your gains next year, and you’re putting off the due date on capital gains tax liability.
- Check Your RMDs. If you are over age 70, it’s time to pay close attention to required minimum distribution requirements. The IRS requires you to begin taking money out of your IRAs and 401(k)s beginning on April 1st of the year following the year in which you turn 70½. Thereafter, you must take the distribution by December 31st of each year. This will create an income tax liability for you, since distributions from these accounts are taxable. But the penalty if you miss the deadline is severe: If you blow your RMD, the IRS will assess a penalty of 50 percent of the amount you were supposed to have taken.
Remember, tax planning is complicated – even for professionals. Very few people who don’t do taxes for a living can efficiently keep track of all the tax issues, traps, pitfalls and planning opportunities that may arise. Except for the very simplest of cases, it almost always makes sense to invest in the services of a tax professional.