When it comes to year-end tax planning, you need to have a good understanding of both your own financial situation and the tax rules that apply. For some, that’s going to be a little challenging this year because a host of popular tax provisions, commonly referred to as “tax extenders,” expired at the end of 2013.
While it remains possible that Congress could retroactively extend some or all of the expired provisions, you can’t count on it. Despite this uncertainty, the window of opportunity for many tax-saving moves closes on Dec. 31, so it’s important to evaluate your tax situation now, while there’s still time to affect your bottom line for the 2014 tax year.
Timing is everything. Consider any opportunities you have to defer income to 2015. For example, you may be able to defer a year-end bonus, or delay the collection of business debts, rents, and payments for services. Doing so may allow you to postpone paying tax on the income until next year. If there’s a chance that you’ll be in a lower income tax bracket next year, deferring income could mean paying less tax on the income as well.
Similarly, consider ways to accelerate deductions into 2014. If you itemize deductions, you might accelerate some deductible expenses like medical expenses, qualifying interest, or state and local taxes by making payments before year-end. Or, you might consider making next year’s charitable contribution this year instead.
Sometimes, however, it may make sense to take the opposite approach – accelerating income into 2014, and postponing deductible expenses to 2015. That might be the case, for example, if you can project that you’ll be in a higher tax bracket in 2015; paying taxes this year instead of next might outweigh the fact that the income may be taxed at a higher rate next year.
Additional considerations for higher-income individuals. Changes that first took effect in 2013 complicate planning opportunities for higher-income individuals. First, a higher 39.6 percent marginal tax rate applies if your taxable income is too high ($406,750 single or $457,600 married filing jointly). Prior to 2013, the highest marginal tax rate was 35 percent. If your taxable income places you in the top tax bracket, a maximum 20 percent tax rate on long-term capital gains and qualifying dividends also generally applies (prior to 2013, the top rate that generally applied was 15 percent).
Second, if your adjusted gross income (AGI) is more than certain levels ($254,200 single or $305,050 married filing jointly), your personal and dependency exemptions may be phased out for 2014, and your itemized deductions may be limited as well.
Additionally, a 3.8 percent net investment income tax (unearned income Medicare contribution tax) may apply to some or all of your net investment income if your modified AGI exceeds certain levels ($200,000 single or $250,000 if married filing jointly).
Note: Individuals with wages that exceed $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately) are also subject to an additional 0.9 percent Medicare (hospital insurance) payroll tax.
IRAs and retirement plans. Make sure that you’re taking full advantage of tax-advantaged retirement savings vehicles. Traditional IRAs and employer-sponsored retirement plans such as 401(k) plans allow you to contribute funds on a deductible (if you qualify) or pretax basis, reducing your 2014 taxable income. Contributions to a Roth IRA (assuming you meet the income requirements) or a Roth 401(k) aren’t deductible or pretax, so there’s no tax benefit for 2014, but qualified Roth distributions are completely free from federal income tax, which makes these retirement savings vehicles appealing.
For 2014, you can contribute up to $17,500 to a 401(k) plan ($23,000 if you're age 50 or older), and up to $5,500 to a traditional IRA or Roth IRA ($6,500 if you’re age 50 or older). The window to make 2014 contributions to an employer plan typically closes at the end of the year, while you generally have until the April 15 tax filing deadline to make 2014 IRA contributions.
Roth conversions. Year-end is a good time to evaluate whether it makes sense to convert a tax-deferred savings vehicle like a traditional IRA or a 401(k) account to a Roth account. When you convert a traditional IRA to a Roth IRA, or a traditional 401(k) account to a Roth 401(k) account, the converted funds are generally subject to federal income tax in the year that you make the conversion. If a Roth conversion does make sense (whether a Roth conversion is right for you depends on many factors, including your current and projected future income tax rates), you’ll want to give some thought about the timing of the conversion. For example, if you believe that you’ll be in a better tax situation this year than next (for example, you would pay tax on the converted funds at a lower rate this year), you might want to think about acting now rather than waiting.
If you convert a traditional IRA to a Roth IRA and it turns out to be the wrong decision, you can recharacterize – or undo – the conversion. You’ll generally have until Oct. 15 to recharacterize a 2014 Roth IRA conversion – effectively treating the conversion as if it never happened for federal income tax purposes.
“Tax extenders.” You’ll want to consider carefully the potential effect if tax breaks are or are not extended and stay alert for any late-breaking changes. A professional can help you evaluate your situation, keep you apprised of any legislative changes, and determine whether any year-end moves make sense for you.
Life is a journey; plan for it.