Another year is winding down. Before the hustle and bustle of the holidays sets in, it’s a good time to brainstorm ideas to lower your 2014 tax bill. Here’s an overview of what’s happening in the world of tax — and 10 simple tax-saving strategies that you can implement before year end.
Setting the Current Federal Tax Scene
Here’s some important information for taxpayers about the 2014 tax year:
Income Tax Rates. The 2014 federal income tax rate picture for individuals is the same as in 2013, except that the tax rate brackets have been adjusted slightly for inflation. Specifically, the federal income tax rates are still 10 percent, 15 percent, 25 percent, 28 percent, 33 percent and 35 percent for most folks. High-income individuals face a top rate of 39.6 percent, but that rate only affects singles with taxable income above $406,750, married joint-filing couples with income above $457,600, and heads of households with income above $432,200.
Capital Gains Tax Rates. For most individuals, the federal income tax rate on long-term capital gains and dividends will be either zero percent or 15 percent. The zero-percent rate applies to gains and dividends that would otherwise fall within the 10 percent or 15 percent brackets. However, the maximum rate on long-term capital gains and dividends rises to 20 percent for singles with taxable income above $406,750, married joint-filing couples with income above $457,600, and heads of households with income above $432,200.
Medicare Surtax. Higher-income individuals can get hit by an additional 0.9 percent Medicare tax on wages and self-employment (SE) income. The 0.9 percent tax is charged on salary and net SE income above $200,000 for an unmarried individual and above $250,000 for a married joint-filing couple.
Net Investment Income Tax. Higher-income individuals can also see all or part of their net investment income, including long-term capital gains and dividends, socked with a 3.8 percent Medicare surtax, which the government calls the net investment income tax (NIIT). However, the NIIT does not apply unless your modified adjusted gross income (MAGI) exceeds $200,000 if you are unmarried, or $250,000 if you are married and file jointly with your spouse. The NIIT applies to the lesser of your net investment income or the amount by which MAGI exceeds the applicable threshold.
Itemized Deduction Phase-out Amounts.You can potentially lose up to 80 percent of your itemized deductions — including write-offs for mortgage interest, state and local income and property taxes, charitable donations and miscellaneous itemized deductions — if your adjusted gross income (AGI) exceeds the applicable threshold.
For 2014, the AGI thresholds for itemized deductions are $254,200 for singles, $305,050 for married joint-filing couples, and $279,650 for heads of households. The total amount of your affected itemized deductions is reduced by 3 percent of the amount by which your AGI exceeds the applicable threshold. However, the total reduction cannot exceed 80 percent of the total affected deductions you started with.
Personal and Dependent Exemption Phase-out Amounts. Your personal and dependent exemption write-offs can also be reduced or even completely eliminated if your AGI exceeds the applicable threshold. The thresholds are the same as for the itemized deduction phase-out rule explained immediately above.
Game the Standard Deduction
If the combined total of your annual itemized deductions is usually close to the standard deduction amount, consider the strategy of bunching together expenditures for itemized deductions every other year. Itemize in those years to deduct more than the standard deduction figure. Then claim the standard deduction in the years that your itemized deductions are lower.
Over time, this drill can save substantial tax dollars by increasing your cumulative write-offs. That’s because you’ll claim higher itemized deductions in alternating years and relatively generous standard deductions in the other years. So regardless of what happens with tax rates, you’ll come out ahead.
For 2014, the standard deduction is $12,400 for married joint-filing couples, $6,200 for singles, and $9,100 for heads of households. For 2015, the projected standard deduction amounts are $12,600, $6,300, and $9,250, respectively.
Prepay Deductible Expenditures
If you itemize deductions, it could make sense to accelerate some deductible expenditures to produce higher 2014 write-offs. This generally works if you expect to be in the same or lower tax bracket next year.
If you Game the Standard Deduction(above), prepaying deductible expenditures makes sense in the alternating years in which you itemize. This strategy can maximize deductible expenditures in the years that you itemize your deductions — and minimize deductible expenditures in the years that you claim the standard deduction.
Perhaps the easiest deductible expense to prepay is your house payment due on Jan. 1. Accelerating that payment into this year will give you 13 months’ worth of deductible interest in 2014. You can use the same prepayment drill with a vacation home. However, if you prepay this year, you’ll have to continue the policy for next year and beyond. Otherwise, you’ll have only 11 months’ worth of interest in the first year you stop (which could work to your advantage if you Game the Standard Deduction, above).
Another item that’s easy to prepay is state and local income and property taxes that are due early next year. Prepaying those bills before year end can decrease your 2014 federal income tax bill, because your itemized deductions will be that much higher.
Consider prepaying expenses that are subject to deduction limits based on your adjusted gross income (AGI), which is the number at the bottom of page 1 of your Form 1040. The two prime candidates are:
Medical costs. For most people, these costs are deductible only to the extent they exceed 10 percent of AGI. However, if you or your spouse will be age 65 or older as of year end, the deduction threshold is a more manageable 7.5 percent of AGI.
Miscellaneous deductions.These count only to the extent they exceed 2 percent of AGI. Examples of miscellaneous deductions include investment expenses, job-hunting expenses, unreimbursed employee business expenses and fees for tax preparation and advice. If you can bunch these kinds of expenditures into a single calendar year, you’ll have a fighting chance of clearing the 2-percent-of-AGI hurdle and getting some tax savings.
Important Note: The prepayment drill can be a bad idea if you owe the alternative minimum tax (AMT) in 2014. That’s because write-offs for state and local income and property taxes, as well as miscellaneous itemized deductions, are completely disallowed under the AMT rules. Before using this strategy, ask your tax adviser if you are in danger of owing AMT in 2014.
Prepay College Tuition Bills
If your 2014 modified adjusted gross income (MAGI) allows you to qualify for the American Opportunity Tax Credit or the Lifetime Learning Credit, consider prepaying tuition bills that are not due until early 2015 if it would result in a larger credit on this year’s Form 1040. Specifically, you can claim a 2014 credit based on prepaying tuition for academic periods that begin in January through March of next year.
American Opportunity Tax Credit. The maximum annual credit is $2,500 per student, but it’s phased out if your MAGI is too high. MAGI refers to AGI from the last line on page 1 of your Form 1040, increased by certain tax-exempt income from outside the United States. The 2014 phaseout range for unmarried individuals is MAGI between $80,000 and $90,000. The range for married joint filers is MAGI between $160,000 and $180,000.
Lifetime Learning Credit. The maximum annual credit is $2,000 per tax return. Like the American Opportunity Tax Credit, the Lifetime Learning Credit is also phased out if your MAGI is too high. The 2014 phaseout range for unmarried individuals is MAGI between $54,000 and $64,000. The 2014 range for married joint filers is MAGI between $108,000 and $128,000.
If your MAGI is too high to be eligible for the Lifetime Learning Credit, you might still qualify to deduct up to $2,000 or $4,000 of college tuition costs — but only if Congress resurrects this break for 2014. If so, consider prepaying tuition bills that are not due until early 2015 if that would result in a higher deduction this year. As with the higher education tax credits, your 2014 tuition deduction can be based on prepaying tuition for academic periods that begin in the first three months of 2015.
Consider Deferring Income
It may also pay to defer some taxable income from this year into next year if you expect to be in the same or lower tax bracket in 2015. For example, if you’re a self-employed, cash-basis taxpayer, you might postpone taxable income by waiting until late in the year to send out some client invoices. That way, you won’t receive these payments until early 2015.
You can also defer taxable income by accelerating some deductible business expenditures into this year. Both moves will postpone taxable income from this year until next year. Deferring income can also be helpful if you’re affected by unfavorable phaseout rules that reduce or eliminate various tax breaks, such as the child credit or higher-education tax credits. By deferring income every other year, you may be able to take more advantage of these breaks every other year. (This also works well in conjunction with the Game the Standard Deduction strategy, above.)
Sell Loser Stocks Held in Taxable Accounts
Selling losing investments held in taxable brokerage firm accounts can lower your 2014 tax bill, because you can deduct the resulting capital losses against this year’s capital gains. If your losses exceed your gains, you will have a net capital loss. You can deduct up to $3,000 of net capital loss (or $1,500 if you are married and file separately) against ordinary income, including your salary, self-employment, alimony or interest income. Any excess net capital loss is carried forward to future years and puts you in position for tax savings in 2015 and beyond.
Gift Appreciated Assets to Family Members in Lower Tax Brackets
For 2014, the federal income tax rate on long-term capital gains and qualified dividends is still zero percent for gains and dividends that fall within the 10 percent or 15 percent rate brackets. While your tax bracket may be too high to take advantage of the zero percent rate, you probably have loved ones who are in the lower tax brackets. If so, consider gifting these individuals appreciated stock or mutual fund shares. They can sell the shares and pay zero percent federal income tax on the resulting long-term gains.
Important Notes: Gains will be considered long-term if your ownership period plus the gift recipient’s ownership period equals at least a year and a day. Giving away dividend-paying stocks is another tax-smart idea. As long as the dividends fall within the gift recipient’s 10 percent or 15 percent rate bracket, they will qualify for the zero percent federal income tax rate.
The annual gift tax exclusion is $14,000 in 2014. If you give away assets worth over $14,000 (or $28,000 for married couples) during 2014 to an individual gift recipient, it will reduce your $5.34 million unified federal gift and estate tax exemption.
If your gift recipient is under age 24, the “kiddie tax” rules could potentially cause some of his or her capital gains and dividends to be taxed at the parent’s higher rates. Contact your tax adviser if you have questions about the kiddie tax.
Convert Traditional IRA into Roth IRA
The best scenario for this strategy is when you expect to be in the same or higher tax bracket during retirement. There is a current tax cost for converting, because a Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth account. After the conversion, all the income and gains that accumulate in the Roth account, and all qualified withdrawals, will be exempt from federal income taxes.
In general, qualified withdrawals are those taken after:
You have had at least one Roth account open for more than five years, and
You have reached age 59 1/2.
With qualified withdrawals, you avoid having to pay higher tax rates that may apply during your retirement years. While the current tax hit from a Roth conversion is unwelcome, it could be a relatively small price to pay for the future tax savings. If the Roth conversion idea sounds appealing, contact your tax adviser for a full analysis of all the relevant variables.
Donate Stock to a Charity
If you have appreciated stock or mutual fund shares (currently worth more than you paid for them) that you’ve owned for over a year, consider donating them to IRS-approved charities. You can generally claim an itemized charitable deduction for the full market value at the time of the donation and avoid any capital gains tax hit.
Sell Under-Performing Stock and Donate Proceeds to a Charity
If you’ve owned stocks that are worth less than you paid for them, don’t donate them directly to a charity. Instead, sell the stock, book the resulting capital loss and give away the cash proceeds to a charity. That way, you can generally write off the full amount of the cash donation while keeping the tax-saving capital loss for yourself. Only taxpayers who itemize deductions will gain any tax-saving benefit from charitable donations, however.
Consult with your Tax Pro
These tax-saving tips are generally geared toward deferring income and accelerating deductions to minimize 2014 taxes. This approach may also help minimize or avoid phaseouts of various tax breaks based on a taxpayer’s AGI (or MAGI). As always, however, year end tax planning doesn’t occur in a vacuum. It must take into account each taxpayer’s particular situation and planning goals. While most taxpayers will come out ahead by following the traditional approach of lowering the current year’s taxable income, others with special circumstances may do better by accelerating income and deferring deductions.
To further complicate year end tax planning in 2014, many tax-saving opportunities expired at the end of 2013, such as the higher education tuition deduction, the option to deduct state and local sales taxes and the tax credit for energy-efficient home improvements. If Congress decides to reinstate the expired tax breaks, many more opportunities will be available for individuals seeking to lower their 2014 tax bills. Consult with your tax adviser before year end to devise a tax-saving plan that most effectively meets your tax planning goals and factors in the latest tax rules.