What you need to know about…Year-End Tax Planning.
Author: Lew Wessel
If you are focused on April 15 as “Tax Day,” it’s time to change your thinking. The key date for taxes is December 31, because after that date, your opportunities to better your tax situation are severely limited. Here’s what you need to know to start dealing with your taxes the smart way through year-end tax planning.
Prepare a mock return
Tax planning begins with taking a snapshot of where you are before the tax year ends and all of your income and expenses (deductions) are sealed in concrete. Gather up all your tax information to date using your most recent paystubs, broker statements, Quicken information and the like. Add to this information some well-thought-out estimates for the rest of the year. Now, enter this information into a good tax software package or, better yet, give it to a good tax preparer who will use an even better tax software package. Voila, you have a proforma tax return and are ready to begin the planning process.
If this first step sounds too daunting, relax. The goal in the tax planning process is to be accurate, not perfect. The entire data gathering process shouldn’t take more than an hour or two. The actual planning process where you test out different strategies may take longer, but only if your tax situation is extremely complicated. In that case, it will be well worth the time invested.
Understand the big picture
Now that you have created your proforma tax return, you need to determine three basic facts about your tax situation:
• Adjusted Gross Income (AGI). AGI is your gross income prior to certain adjustments such as IRA or HSA contributions. This number has a tremendous impact on your taxes including, but not limited to, your exposure to the Alternative Minimum Tax (see below), your eligibility for Roth contributions and conversions (in 2009), your eligibility for the Child Tax Credit, the deductibility of passive rental losses and the rate at which Social Security will be taxed.
• Taxable Income and Tax Rate. As I’ve discussed at length in earlier articles, it is critical to know your tax bracket. Just as important is to know, or at least have a best guess, whether your tax bracket will be higher or lower next year. If you think it will be higher next year, then, all things being equal, you’ll want to accelerate income to this year and defer deductions to next year. If you think you’ll be in a lower bracket in 2010, the reverse strategy will be true.
• AMT or Alternative Minimum Tax. A full discussion of the AMT is way too complicated to handle here. For now, it is sufficient to convey that, for most taxpayers, AMT taxable income consists of regular taxable income with an add back for the deductions the taxpayer takes for state income taxes, real estate/property taxes, sales taxes and miscellaneous itemized deductions. If your mock return indicates you will be subject to the AMT, try to shift these expenses to next year, because the deductions will otherwise be wasted.
Understanding these three characteristics of your return will guide your basic tax planning strategy: Is your goal to accelerate or defer income? How aggressive should you be in accelerating or deferring income? Are you in the AMT? If so, some strategies for reducing income, such as increasing state income tax payments will be fruitless.
Let the games begin
Now that you have a basic strategy, you’re ready for tactics. This is the nuts and bolts of tax planning where you play “what if” with items of income and expense (deductions) that you can control prior to year end. These items include, among others:
• Capital Gains and Losses. You control whether and when to sell a stock or bond and recognize the tax gain or loss. Selling for a loss near year-end is called “tax-loss harvesting” and it is a very powerful tool in managing AGI. Capital losses can be used to wipe out all capital gains and up to $3,000 in net capital losses can further reduce AGI. There is a concept called a “wash-sale” that disallows selling and immediately buying back the same stock so as to lock in a tax loss. However, nothing in the tax code keeps you from selling a solid large-cap mutual fund and immediately reinvesting in a different, but very similar large-cap fund. In addition, there is no rule against wash-sale GAINS, so if your intent is to increase your AGI, that is very doable.
• Note: Gains and losses inside your IRA or 401K are not recognized for tax purposes. The tax planning techniques above will only work in a taxable account.
• Charitable Deductions. Again, you control when and how to make these contributions. If you think you’ll be in a higher bracket next year, you might want to make the donation January 2 instead of December 22.
• Estimated State Income Tax Payments. The 4th installment of the 2009 SC Estimated Taxes isn’t due until January 15, 2010, but you are free to pay it in December, 2009 if your planning indicates it will help this year. An additional planning thought: If you have failed to make required federal or state estimated tax payments, there are year-end tactics that can legally make up all of the shortfall and save you some penalties. Consult your tax professional for these ideas.
• Real Estate Tax Payments. In Beaufort County, you can make these payments up to January 15 without penalty, so, once again, it’s your choice whether to take the deduction in 2009 or 2010. If you are subject to the AMT in 2009, you should probably delay payments till 2010.
• IRA Distributions and Conversions. Perhaps this belongs in the advanced tax concepts course, but, to make a long story short, if you are in the unenviable position of having negative taxable income due to a bad year for your business and/or massive deductions, you have the opportunity to take an IRA distribution or make a conversion to a Roth IRA with little or no tax consequence. Even if you are under 59 and a half, a distribution will only cost you the 10 percent early withdrawal penalty if your total taxable income after distribution remains at zero or below. There is no 10 percent penalty in the case of a conversion.
Small business owners
What you need to know about tax planning if you are a small business owner is that this is no place for do-it-yourselfers. There are many terrific tax strategies available to small business owners that can minimize or wipe out your tax bill for 2009. The most important of these are the “179 deduction” which allows for the immediate write-off of capital items up to $250,000 and qualified pension plan contributions which allow for much larger contributions then an IRA or even a SIMPLE plan. Consult a competent tax professional and make a fall tax planning meeting an annual event.
A final thought
Year-end tax planning is definitely the smart way to go. However, please remember to never, ever let the tax tail wag your overall financial planning dog. Many of the tactics mentioned above have possible consequences beyond taxes. These include making bad investment decisions, the reduction of income credits to your Social Security and, perhaps, eliminating the possibility of making an IRA or other retirement contribution for the year. The bottom line in tax planning is not just saving taxes; it’s saving money and increasing your net worth. Keep this in mind and weigh the overall pros and cons before making your tactical planning moves.