For most individuals, the ordinary federal income tax rates for 2013 will be the same as last year: 10%, 15%, 25%, 28%, 33%, and 35%. However, the fiscal cliff legislation passed early this year increased the maximum rate for higher-income individuals to 39.6% (up from 35%). This change only affects taxpayers with taxable income above $400,000 for singles, $450,000 for married joint-filing couples, $425,000 for heads of households, and $225,000 for married individuals who file separate returns. Higher-income individuals can also get hit by the new 0.9% Medicare tax and the 3.8% Net Investment Income Tax (NIIT), which can result in a higher-than-advertised federal tax rate for 2013.
Despite these tax increases, the current federal income tax environment remains relatively favorable by historical standards. This letter presents some tax planning ideas to consider this summer while you have time to think. Some of the ideas may apply to you, some to family members, and others to your business.
Leverage Standard Deduction by Bunching Deductible Expenditures
If your 2013 itemized deductions are likely to wind up being just under, or just over, the standard deduction amount, consider bunching together expenditures for itemized deduction items every other year, while claiming the standard deduction in the intervening years. The 2013 standard deduction is $12,200 for married joint filers, $6,100 for single filers, and $8,950 for heads of households.
For example, say you’re a joint filer whose only itemized deductions are about $4,000 of annual property taxes and about $8,000 of home mortgage interest. If you prepay your 2013 property taxes by December 31 of this year, you could claim $16,000 of itemized deductions on your 2013 return ($4,000 of 2013 property taxes, plus another $4,000 for the 2014 property tax bill, plus the $8,000 of mortgage interest). Next year, you would only have the $8,000 of interest, but you could claim the standard deduction (it will probably be around $12,500 for 2014). Following this strategy will cut your taxable income by a meaningful amount over the two-year period (this year and next). You can repeat the drill all over again in future years. Examples of other deductible items that can be bunched together every other year to lower your taxes include charitable donations and state income tax payments.
Consider Deferring Income
It may 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 2014. For example, if you’re self-employed and a cash-method taxpayer, you can postpone taxable income by waiting until late in the year to send out some client invoices. That way, you won’t receive payment for them until early 2014. You can also postpone taxable income by accelerating some deductible business expenditures into this year. Both moves will defer taxable income from this year until next year. Deferring income may also be helpful if you’re affected by unfavorable phase-out rules that reduce or eliminate various tax breaks (child tax credit, education tax credits, and so on). By deferring income every other year, you may be able to take more advantage of these breaks every other year.
Take Advantage of 0% Rate on Investment Income
For 2013, the federal income tax rate on long-term capital gains and qualified dividends is still 0% when those gains and dividends fall within the 10% or 15% federal income tax rate brackets. This will be the case to the extent your taxable income (including long-term capital gains and qualified dividends) does not exceed $72,500 for married joint-filing couples ($36,250 for singles). While your income may be too high, you may have children, grandchildren, or other loved ones who will be in the bottom two brackets. If so, consider giving them some appreciated stock or mutual fund shares that they can then sell and pay 0% tax on the resulting long-term gains. Gains will be long-term as long as your ownership period plus the gift recipient’s ownership period (before he or she sells) equals at least a year and a day.
Giving away stocks that pay dividends is another tax-smart idea. As long as the dividends fall within the gift recipient’s 10% or 15% rate bracket, they will be federal-income-tax-free.
Warning: If you give securities to someone who is under age 24, the Kiddie Tax rules could potentially cause some of the resulting capital gains and dividends to be taxed at the parent’s higher rates instead of at the gift recipient’s lower rates. That would defeat the purpose. Also, if you give away assets worth over $14,000 during 2013 to an individual, it will generally reduce your $5.25 million unified federal gift and estate tax exemption. However, you and your spouse can together give away up to $28,000 without reducing your respective exemptions.
Time Investment Gains and Losses
For most individuals, the 2013 federal tax rates on long-term capital gains are the same as last year: either 0% or 15%. However, the maximum rate for higher-income individuals is now 20% (up from 15% last year). This change only affects taxpayers with taxable income above $400,000 for singles, $450,000 for married joint-filing couples, $425,000 for heads of households, and $225,000 for married individuals who file separate returns. Higher-income individuals can also get hit by the new 3.8% NIIT on net investment income, which can result in a maximum 23.8% federal income tax rate on 2013 long-term gains.
As you evaluate investments held in your taxable brokerage firm accounts, consider the tax impact of selling appreciated securities (currently worth more than you paid for them). For most taxpayers, the federal tax rate on long-term capital gains is still much lower than the rate on short-term gains. Therefore, it often makes sense to hold appreciated securities for at least a year and a day before selling to qualify for the lower long-term gain tax rate.
Biting the bullet and selling some loser securities (currently worth less than you paid for them) before year-end can also be a tax-smart idea. The resulting capital losses will offset capital gains from other sales this year, including high-taxed short-term gains from securities owned for one year or less. For 2013, the maximum rate on short-term gains is 39.6%, and the 3.8% NIIT may apply too, which can result in an effective rate of up to 43.4%. However, you don’t need to worry about paying a high rate on short-term gains that can be sheltered with capital losses (you will pay 0% on gains that can be sheltered).
If capital losses for this year exceed capital gains, you will have a net capital loss for 2013. You can use that net capital loss to shelter up to $3,000 of this year’s high-taxed ordinary income ($1,500 if you’re married and file separately). Any excess net capital loss is carried forward to next year.
Selling enough loser securities to create a bigger net capital loss that exceeds what you can use this year might also make sense. You can carry forward the excess capital loss to 2014 and beyond and use it to shelter both short-term gains and long-term gains recognized in those years.
Sell Loser Shares and Give Away the Resulting Cash; Give Away Winner Shares
Say you want to make some gifts to favorite relatives and/or favorite charities. You can make gifts in conjunction with an overall revamping of your holdings of stocks and equity mutual fund shares held in taxable brokerage firm accounts. Here’s how to get the best tax results from your generosity.
Gifts to Relatives. Do not give away loser shares (currently worth less than you paid for them). Instead, sell the shares and take advantage of the resulting capital losses. Then, give the cash sales proceeds to the relative. Do give away winner shares to relatives. Most likely, they will pay lower tax rates than you would pay if you sold the shares. In fact, relatives who are in the 10% or 15% federal income tax brackets will generally pay a 0% federal tax rate on long-term gains from shares that were held for over a year before being sold. For purposes of meeting the more-than-one-year rule for gifted shares, count your ownership period plus the recipient relative’s ownership period, however brief. Even if the shares are held for one year or less before being sold, your relative will probably pay a lower tax rate than you (typically only 10% or 15%). However, beware of one thing before employing this give-away-winner-shares strategy. Gains recognized by a relative who is under age 24 may be taxed at his or her parent’s higher rates under the so-called Kiddie Tax rules (contact us if you are concerned about this issue).
Gifts to Charities. The strategies for gifts to relatives work equally well for gifts to IRS-approved charities. Sell loser shares and claim the resulting tax-saving capital loss on your return. Then give the cash sales proceeds to the charity and claim the resulting charitable write-off (assuming you itemize deductions). This strategy results in a double tax benefit (tax-saving capital loss plus tax-saving charitable contribution deduction). With winner shares, give them away to charity instead of giving cash. Here’s why. For publicly traded shares that you’ve owned over a year, your charitable deduction equals the full current market value at the time of the gift. Plus, when you give winner shares away, you walk away from the related capital gains tax. So, this idea is another double tax-saver (you avoid capital gains tax on the winner shares, and you get a tax-saving charitable contribution write-off). Because the charitable organization is tax-exempt, it can sell your donated shares without owing anything to the IRS.
Make Charitable Donations from Your IRA
IRA owners and beneficiaries who have reached age 70½ are permitted to make cash donations totaling up to $100,000 to IRS-approved public charities directly out of their IRAs. These so-called Qualified Charitable Distributions, (QCDs) are federal-income-tax-free to you, but you get no itemized charitable write-off on your Form 1040. That’s okay, because the tax-free treatment of QCDs equates to an immediate 100% federal income tax deduction without having to worry about restrictions that can delay itemized charitable write-offs. QCDs have other tax advantages too. Contact us if you want to hear about them.
Be careful—to qualify for this special tax break, the funds must be transferred directly from your IRA to the charity. Also, this favorable provision will expire at the end of this year unless Congress extends it.
Watch out for Alternative Minimum Tax
Recent legislation slightly reduced the odds that you’ll owe the alternative minimum tax (AMT). Even so, it’s still critical to evaluate all tax planning strategies in light of the AMT rules before actually making any moves. Because the AMT rules are complicated, you may want our assistance.
Take Advantage of Generous But Temporary Business Tax Breaks
Several favorable business tax provisions have a limited shelf life that may dictate taking action between now and year-end. Here are the most important ones.
Bigger Section 179 Deduction. Your business may be able to take advantage of the temporarily increased Section 179 deduction. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions. For tax years beginning in 2013, the maximum Section 179 deduction is a whopping $500,000. For tax years beginning in 2014, however, the maximum deduction is scheduled to drop back to only $25,000.
Note: Watch out if your business is already expected to have a tax loss for the year (or close) before considering any Section 179 deduction. You cannot claim a Section 179 write-off that would create or increase an overall business loss. Please contact us if you think this might be an issue for your operation.
Section 179 Deduction for Real Estate. Real property improvement costs are generally ineligible for the Section 179 deduction privilege. However, a temporary exception applies to tax years beginning in 2010– 2013. Under the exception, your business can immediately claim a Section 179 deduction of up to $250,000 of qualified improvement costs for (1) interiors of leased nonresidential buildings, (2) restaurant buildings, and (3) interiors of retail buildings. The $250,000 Section 179 allowance for real estate improvements is part of the overall $500,000 allowance. Unless extended, this real estate break will not be available for tax years beginning after 2013.
Note: Once again, watch out if your business is already expected to have a tax loss for the year (or is close to it) before considering any Section 179 deduction. You can’t claim a Section 179 write-off that would create or increase an overall business tax loss.
50% First-year Bonus Depreciation. Above and beyond the Section 179 deduction, your business can claim first-year bonus depreciation equal to 50% of the cost of most new (not used) equipment and software placed in service by December 31 of this year. For a new passenger auto or light truck that’s used for business and is subject to the luxury auto depreciation limitations, the 50% bonus depreciation break increases the maximum first-year depreciation deduction by $8,000. The 50% bonus depreciation break will expire at year-end unless Congress extends it.
Note: 50% bonus depreciation deductions can create or increase a Net Operating Loss (NOL) for your business’s 2013 tax year. You can then carry back the NOL to 2012 and/or 2011 and collect a refund of taxes paid in one or both those years.
100% Gain Exclusion for Qualified Small Business Stock Issued This Year. The fiscal cliff legislation enacted earlier this year extended the temporary 100% gain exclusion privilege for eligible sales of Qualified Small Business Corporation (QSBC) stock issued in calendar-year 2013. So, there is a short fuse on stock issuances that will qualify for the 100% gain exclusion break, unless Congress extends it.
Note: QSBC shares must be held for more than five years to be eligible for the 100% gain exclusion break, so we are talking about sales that will occur well down the road.
Employ Your Child
If you are self-employed, you might want to consider employing your child to work in the business. Doing so has tax benefits in that it shifts income (which is not subject to the Kiddie tax) from you to your child, who normally is in a lower tax bracket or may avoid tax entirely due to the standard deduction. There can also be payroll tax savings since wages paid by sole proprietors to their children age 17 and younger are exempt from both social security and unemployment taxes. Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA. Children with IRAs, particularly Roth IRAs, have a great start on retirement savings since the compounded growth of the funds can be significant.
Remember a couple of things when employing your child. First, the wages paid must be reasonable given the child’s age and work skills. Second, if the child is in college or entering soon, having too much earned income can have a detrimental impact on the student’s need-based financial aid eligibility.
Don’t Overlook Estate Planning
For 2013, the unified federal gift and estate tax exemption is a historically generous $5.25 million, and the federal estate tax rate is a historically reasonable 40%. Even if you already have an estate plan, it may need updating to reflect the current estate and gift tax rules. Also, you may need to make some changes for reasons that have nothing to do with taxes.
As we said at the beginning, this update is to get you started thinking about tax planning moves for the rest of this year. Please don’t hesitate to contact us if you want more details or would like to schedule a tax planning strategy session.