The goal of income tax planning is to minimize federal income tax liability. Typically, a taxpayer looks for methods to reduce taxable income, and thus the tax liability, by focusing on income reduction, increasing deductible expenses or implementing various investment planning techniques.
By deferring income to a later year, you may be able to minimize your current income tax liability. However, you must also consider other factors beyond taxes in this approach. Most people are employees and do not have the ability to simply defer income to the next year. While many business owners could do this, they also must examine this approach from a cash flow position as well. For example, deferring for taxes might be beneficial but this must be balanced by proper savings to pay bills during this deferral period.
Certain retirement plans also can help postpone the payment of taxes on earned income. With a 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when the money is withdrawn. This allows for postponement of tax on the salary deferred and tax-deferred growth in the investment earnings. If you have not met the maximum annual contribution of $17,500, or $23,000 for those over age 50, you might choose to increase the deferral for the rest of the year. This is not only beneficial for taxes but also for your 401(k) balance.
You can also minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you’ve made the gift, the dividends will represent income to them rather than to you, which will lower your tax burden. Keep in mind that you can make a tax-free gift of up to $14,000 per year per recipient without incurring federal gift tax. Other ways of shifting income include hiring a family member for the family business.
You can also focus on deductions to lower your taxes. A wise CPA once told me, a person should not spend money to simply create a deduction but should take all deductions to which they are entitled. Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of deductions. If you’re in a higher federal income tax bracket this year than you expect to be in next year, you’ll want to accelerate your deductions into the current year and vice versa. You can accelerate deductions by paying deductible expenses such as property taxes and mortgage interest and making charitable contributions this year instead of waiting until next year.
From an investment position, you should examine losses in your taxable brokerage accounts and harvest these losses. You can offset your investment gains with investment losses and use any remaining investment losses to offset up to $3,000 of ordinary income, such as salary, with any unused investment losses carried forward to next year. While harvesting losses is beneficial, harvesting gains and incurring taxes this year may actually be a good plan too.
Year-end tax planning, as you might expect, typically takes place in October, November and December.
At its most basic level, it is looking at ways to time income and deductions to give the best possible tax result. The above are just a few ways to get ahead on taxes now. When you file your tax return, it is too late to plan appropriately. A person’s professional tax advisor should be on speed-dial during this time of year because taking steps in 2013 can make your filing in 2014 a much more pleasant experience.
Life is a journey; plan for it.
Neil A. Brown is a CPA and CFP with Burkett Financial Services in West Columbia. Reach him at www.uscneil.com or (803) 200-2272.