The question: To save or defer income and expenses:
Answer: Think about timing & The Alternative Minimum Tax
Maximizing deductible expenses for a given year typically allows you to minimize your income tax — but not always.
If you’re subject to the alternative minimum tax (AMT) this year, you may be better off deferring certain expenses if you can. In some circumstances, accelerating or deferring income where possible might save, or at least defer, tax. No matter what your situation, plan carefully to find the best timing strategies for you.
The AMT TAX
When timing income and deductions, first consider the AMT — a separate tax system that limits some deductions and disallow others, such as:
* State and local income tax deductions,
* Property tax deductions, and
* Miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) for, such as professional fees, investment expenses and unreim- bursed employee business expenses.
You must pay the AMT if your AMT liability exceeds your regular tax liability. You may be able to time income and deductions to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate.
Planning is a little easier now that the AMT brackets and exemptions are annually adjusted for inflation. Before, Congress had to legislate any adjustments, which they often were slow to do. This left uncertainty about what the AMT situation would be the next year, inhibiting the ability to effectively implement timing strategies.
Home-related breaks
Consider both deductions and exclusions:
*Property tax deduction. Before paying your bill early to accelerate the itemized deduction into next year, review your AMT situation. If you’re subject to the AMT this year, you’ll lose the benefit of the deduction for the prepayment.
*Mortgage interest deduction. You generally can deduct interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.
Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn’t deductible and rates may be higher. Warning: If the home equity debt isn’t used for home improve- ments, the interest isn’t deductible for AMT purposes.
*Home office deduction. If your use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses, and the depreciation allowable to the space. Or you may be able to take the simpler “safe harbor” deduction. (Contact your tax advisor for details.) For employees, home office expenses are a miscellaneous itemized deduction, and you’ll enjoy a tax benefit only if these expenses plus your other miscella- neous itemized expenses exceed 2% of your AGI. (If your Self Employed- we will cover this in coming chapters)
*Rental income exclusion. If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won’t be deductible.
*Home sale gain exclusion. When you sell your principal residence, you can exclude up to $250,000 ($500,000 for married couples fling jointly) of gain if you meet certain tests. Warning: Gain that’s allowable to a period of “nonqualifed” use generally isn’t excludable.
*Home sale loss deduction. Losses on the sale of a principal residence aren’t deductible. But if part of your home is rented out or used exclusively for your business, the loss attributable to that portion may be deductible.
*Debt forgiveness exclusion. This break for homeowners who received debt forgiveness in a foreclosure, short sale or mortgage workout for a principal residence expired Dec. 31, 2013.
Health-care-related breaks
If your medical expenses exceed 10% of your AGI, you can deduct the excess amount. Eligible expenses may include:
* Health insurance premiums
* Long-term care insurance premiums
(limits apply),
* Medical and dental services,
Prescription drugs, and
* Mileage (23.5 cents per mile driven for health care purposes).
Consider “bunching” non urgent medical procedures (and any other services and purchases whose timing you can control without negatively affecting your or your family’s health) into one year to exceed the 10% for. Taxpayers age 65 and older enjoy a 7.5% floor through 2016 for regular tax purposes but are subject to the 10% for now for AMT purposes.
Expenses that are reimbursable by insur-ance or paid through a tax-advantaged account such as the following aren’t deductible:
*HSA. If you’re covered by qualified high-deductible health insurance, you can contribute pre tax income to an employer-sponsored Health Savings Account — or make deductible contributions to an HSA you set up yourself — up to $3,300 for self-only coverage and $6,550 for family coverage (for 2014), plus an additional $1,000 if you’re age 55 or older. HSAs can bear interest or be invested, growing tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pre tax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit — not to exceed $2,500 for plan years beginning in 2014. The plan pays or reimburses you for qualified medical expenses. What you don’t use by the plan year’s end, you generally lose — though your plan might allow you to roll over up to $500 to the next year. Or it might give you a 21-month grace period to incur expenses to use up the previous year’s contribution. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Sales tax deduction
The break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes was available for 2013 but, as of this writing, hasn’t been extended for 2014.
Limit on itemized deductions
If your AGI exceeds the applicable threshold, certain deductions are reduced by 3% of the AGI amount that exceeds the threshold (not to exceed 80% of otherwise allowable deduc- tions). For 2014, the thresholds are $254,200 (single), $279,650 (head of household), $305,050 (joint fler) and $152,525 (married fling separately).
If your AGI is close to the threshold, AGI-reduction strategies (such as making retirement plan and HSA contributions) may allow you to stay under it. If that’s not possible, consider the reduced tax benefit of the affected deductions before implementing strategies to accelerate or defer deductible expenses. The limitation doesn’t apply, however, to deductions for medical expenses, investment interest, or casualty, theft or wagering losses.
Additional 0.9% Medicare tax
If you’re thinking about timing income, consider the additional 0.9% Medicare tax. Under the ACA, since
2013, taxpayers have had to pay this tax on FICA wages and self-employment income exceeding $200,000 per year ($250,000 for joint flyers and $125,000 for separate fliers). You may be able to implement income timing strategies to avoid or minimize the tax, such as deferring or accelerating a bonus or a stock option exercise.
Be aware that employers are obligated to withhold the additional tax beginning in the pay period when wages exceed $200,000 for the calendar year — without regard to an employee’s fling status or income from other sources. So your employer might withhold the tax even if you aren’t liable for it — or it might not withhold the tax even though you are liable for it.
If you don’t owe the tax but your employer is withholding it, you can claim a credit on your 2014 income tax return. If you do owe the tax but your employer isn’t withholding it, consider fling a W-4 form to request additional income tax withholding, which can be used to cover the shortfall and avoid interest and penalties.
A CASE STUDY
Making the most of charitable donations
Last year Shirley earned a promotion that came with a significant salary increase and an opportunity for a larger bonus. As a result, she decided to step up her charitable giving. She knew that donations to qualified charities were generally fully deductible for both regular tax and AMT purposes, so she asked her tax advisor how she could maximize both the benefit to charity and her tax savings. He explained that donations may be the easiest deductible expense for her to time to her tax advantage, because she has complete control over when and how much she gives.
For a large donation, her tax advisor suggested she carefully consider which assets to give and the best ways to give them. For example, publicly traded stock and other securities she’d held more than one year could make one of the best donations. Why? Because she could deduct the current fair market value and avoid the capital gains tax she’d pay if she sold the securities.
Shirley also mentioned that her father was charitably inclined but concerned about having enough income through the remainder of his retirement to support his desired lifestyle. Her tax advisor suggested a charitable remainder trust (CRT): For the rest of Leslie’s father’s life, the CRT would pay an amount to him annually (some of which would be taxable). At his death, the CRT’s remaining assets would pass to one or more charities. When her father funded the CRT, he’d receive a partial income tax deduction. If he contributed appreciated assets, he also could minimize and defer capital gains tax.
For the next several weeks, join us in educating you to the world of Tax Planning but please , contact your tax advisor to learn exactly which strategies can benefit you the most.
Week 2 INCOME & DEDUCTIONS (you are reading)
Week 3 FAMILY & EDUCATION
Week 4 INVESTING
Week 5 BUSINESS
Week 6 RETIREMENT
Week 7 ESTATE PLANNING
Week 8 TAX RATES
Anthony Rivieccio is the founder & The CEO of The Financial Advisors Group, celebrating their 18th year as a fee only financial planning firm specializing in solving one’s financial problems. Anthony has been a recognized financial expert since 1986. He has been seen, heard or read by many national and local media outlets including: Klipingers Personal Finance Magazine, The New York Post, News12 The Bronx, Bloomberg News Radio, Bronxnet Channel 67 TV, The Norwood News, The West Side Manhattan Gazette, Labor Press Magazine, Financial Planning Magazine, WINS1010 Radio, The Bronx News newspaper and The Bronx Chronicle. Anthony can be reached at 347.575.504
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