Seven End-of-Year Tips for Reducing Your Income Tax
The approaching end of year is an ideal time to explore opportunities to reduce 2015 income taxes. Effective planning generally considers ways to time (defer or accelerate) income and deductions to produce the optimal overall result.
With top federal rates of 39.6 percent on ordinary income, 20 percent for long term capital gains and qualified dividends, phase-out of itemized deductions and personal exemptions, and the 3.8 percent surtax on net investment income (NII) (where income exceeds specified thresholds), our current tax environment provides many opportunities for tax-wise planning.
Here are some commonly considered strategies to discuss with your tax and financial advisors before the year comes to a close.
1. Increase contributions to retirement plan accounts
Contributions to tax deferred retirement vehicles such as a 401(k), 403(b), or IRA can be one of the most effective year-end tax savings strategies. Contributions to IRAs are tax deductible, and contributions to employer sponsored plans are made pre-tax. In addition to reducing taxable income for the current year, earnings compound over time tax deferred and can accumulate more toward retirement savings goals. Employer-sponsored plans are particularly good opportunities if contributions are matched. Consideration should be given to increasing plan contributions or making catch up contributions (if over age 50). Year end is also the time to review the types of plans available, or consider any changes to existing plans.
2. Evaluate distribution options for IRAs and qualified plans
Individuals over age 70 ½ generally must take their required minimum distribution (RMD) from their IRAs and other qualified plans by year end to avoid penalty tax. Individuals who attain age 70 ½ in the current tax year may delay taking their first RMD until their required beginning date (April 1 of the following year). RMDs from qualified plans, but not IRAs, can be deferred until year of retirement (if later), provided the participant is not a greater than 5 percent owner of the business.
For purposes of the NII tax, investment income does not include distributions from tax-favored retirement plans; however, modified adjusted gross income (MAGI) includes taxable distributions, including RMDs. Individuals nearing their MAGI threshold, or already exceeding it with other income, may have an opportunity to plan their RMDs to avoid or reduce exposure to the NII tax.
An IRA or qualified plan interest often comprises a significant value of an individual’s wealth and estate. Year end planning can also include a review of beneficiary designations and a discussion of testamentary distributions options aimed at deferring or mitigating income taxes upon death.
3. Fund Roth IRA or complete Roth conversion
Consider funding a Roth IRA, or converting a traditional IRA or employer sponsored plan to a Roth account. While income limits may preclude some individuals from making Roth contributions, anyone can do a Roth conversion (there is no longer an income cap). Roth contributions are after tax dollars, and income tax must be reported on amounts converted for the tax year. However, unlike traditional IRAs, Roth accounts do not impose mandatory distributions, and distributions are not subject to income tax or included in MAGI for purposes of the NII tax. Conversions can also be timed to keep MAGI below NII tax thresholds each year. Current and future income tax implications should be evaluated, and also, in some cases estate planning objectives, since a Roth conversion could make future wealth transfer more tax efficient.
4. Fund permanent life insurance and tax deferred annuities
Increases in top income tax rates, along with the NII surtax, has enhanced the appeal of tax-deferred investments — and the unique income tax benefits of cash value life insurance and deferred annuities. Life insurance offers income tax- deferred growth of policy cash value, tax-favored access to cash value, and income tax-free death proceeds. Tax-deferred annuities permit control over the timing of income recognition. In addition, accumulating cash value inside life insurance and deferred annuities is not subject to the NII tax. By increasing exposure to life insurance products, an individual may be able to mitigate current and future income tax impact. In a higher tax environment, the tax deferral features of permanent life insurance and deferred annuities become increasingly attractive.
5. Increase charitable contributions
The holidays are a popular time for giving, and charitably inclined individuals can also utilize it as a time to reduce their tax burden. The value of donated property can be deducted as a charitable contribution (subject to AGI limits) without triggering capital gains tax on any built up appreciation, and eliminating NII tax. For a charitable deduction to apply to the current year, the contribution must be made by December 31. Also make sure the charity is a qualified 501(c) 3 tax-exempt organization that is eligible for tax deductible contributions.
If extended by Congress for 2015, IRA owners may also benefit from the Charitable IRA Rollover opportunity, which permits individuals age 70 ½ or older to make tax free distributions (up to $100,000 annually) from their IRAs directly to qualifying charities. Distributions are excluded from income and reduce AGI, but they are not deductible. This may reduce the account owner’s tax liability more than if taxable distributions were received, then contributed to charity on a tax-deductible basis. These transfers can also satisfy the RMD requirement for the current year.
6. Review taxable gains and losses from brokerage accounts
Investment accounts should be reviewed before year end to determine if realized capital gains can be offset by available unrecognized losses in the account. Income taxes may be lowered through “tax loss harvesting” — selling losing investments (that no longer fit the investment strategy) and applying the loss against investment gains realized during the same year.
Even though capital gains rates have increased for higher income individuals, for most taxpayers they are still significantly lower than ordinary income rates. Consideration can be given to shifting to investments that generate capital gain instead of ordinary income. Converting investment income taxed at ordinary income rates into qualified dividend income (taxed at the same favorable rates as long term capital gains) can achieve tax savings and result in higher after tax income.
7. Make annual gifts to lower bracket family members
Consider reducing income tax exposure by shifting some income to family members who are in a lower tax bracket. Gifts of appreciating or dividend producing property (e.g., stock) to a lower bracket individual may result in capital gains being taxed at a lower rate, and perhaps excluded from the NII tax. However, be mindful that the “kiddie tax” rules will tax any unearned income over $2,100 (for 2015) at a parent’s marginal rate if the child is under age 19 (or a full-time student under age 24).
For federal gift tax purposes, every individual can transfer each year (either cash or property) up to an allowable exclusion amount, to as many individuals as they choose, without incurring gift tax or using any lifetime gift exclusion. For 2015, the annual gift exclusion is $14,000 per person ($28,000 for married taxpayers). Since the annual exclusion expires each December 31 if not used, individuals should not waste this tax-free opportunity to reduce their taxable estate well as their current income. Annual exclusion gifts can also be useful in funding section 529 education accounts for children and or grandchildren, or to help working children establish Roth IRA accounts.
These are just few of the strategies that can be considered to improve your income tax situation come April 15. Be sure to work with your tax and financial advisors to determine which strategies may be most appropriate for your circumstances.
For informational purposes only – please talk to your tax professional about your individual situation. Neither Penn Mutual nor HTK offer Tax or legal advice.