Seven weeks left for year-end tax dodges. Look now to see if you can save a pile of money by the way you time your estimated-tax payments, your portfolio trades and your IRA maneuvers.
Did you know that you might be able to save money by accelerating, not deferring, a capital gain? That pre-retirees in New York can take advantage of a $20,000 retirement freebie? That victims of the alternative minimum tax (there’s a good chance you are one) can enrich themselves with a well-timed Roth conversion?
If you are in the care of a tax professional, your tax planning is no doubt under way. But if you are a do-it-yourselfer at tax time, don’t miss the opportunity. Without spending a nickel, you can get guidance on important year-end decisions by using the tax software you already have.
For this guide to tax planning I made calculations in early November on a downloaded 2014 version of TurboTax, the tax software from Intuit (INTU). Since then Intuit and its main competitor, H&R Block (HRB), have released software for the 2015 tax season. If you are going to be using one of these products next spring to file your taxes, buy now and start experimenting to see the effects of year-end financial moves.
TurboTax has an interesting feature that makes experimentation easy. Go to the “Forms” tab and search for “what-if.” (I haven’t heard back from Block about whether it has something like this.)
The biggest potential payoff for many taxpayers involves working around the alternative minimum tax. The AMT kills a lot of your deductions but has fairly low marginal rates, often 26% or 28%. If you land in this briar patch, make the most of it. Accelerate some income by converting a piece of your IRA to a Roth IRA. Done right, a Roth conversion has you paying tax in at a low AMT rate on income that would otherwise be taxed during retirement at a high regular-tax rate.
Stephen Greenberg, a Cherry Hill, N.J. lawyer, gives just this advice to clients who live in Pennsylvania and have houses on the Jersey shore. Deductions for their stiff New Jersey property taxes protect them from the regular tax and its high marginal rates. So they are, within a certain window of possible incomes, paying federal tax at the marginal rate set by the AMT. He has them convert a sliver of IRA money, just enough to fill the window. “If you can pay at 26% or 28% by accelerating the income it makes a lot of sense,” he says.
For scenario planning, load last year’s return and then update salary, charity, mortgage interest and other numbers by looking at your checkbook and pay stub. You don’t have to nail these down to the last dollar; you only have to get close. See what your combined federal and state tax bill will be.
Now throw in a transaction you are contemplating. Maybe it’s a stock trade that generates a gain or loss. Maybe it’s the idea of paying your Jan. 15 estimated state income tax in December.
Or it could be a $10,000 Roth IRA conversion. To simulate that, invent a 1099-R retirement payout for $10,000 coded 7, which is the code for “normal distributions.”
Take a look at the tax totals with the changed behavior. How much have they gone up or down? The difference tells you your marginal tax rate. Did that $10,000 conversion kick up your combined tax bill by $2,700? Then your marginal rate is 27%.
“Marginal rate” isn’t quite the same thing as “tax bracket.” Your bracket is a simple number you pluck from a table. The 39.6% federal bracket, for example, starts at $464,850 on joint returns. But almost no one’s marginal rate is 39.6%. The reason is that all the complexities of the tax code—the clawbacks, phase-outs, caps, exceptions, deductions, Obamacares and exclusions—kick these numbers around.
Amusing facts: A middle-income family of five can wind up with a 5.3% surcharge on their marginal tax rate that no rich person has to pay. Marginal AMT rates can be 32.5% for taxpayers of modest means and 28% for the rich.
Yes, there are a lot of kinks in the tax law. But don’t throw up your hands. You don’t have to know how any of the kinks work when you’re playing our what-if game. Let the software do the thinking.
I used TurboTax to calculate marginal rates on certain transactions for four imaginary taxpayers. They all are New York City residents filing joint returns.
Sam, age 30, has an $80,000 salary after 401(k) contributions, a $5,000 property tax bill and mortgage interest of $10,000. Next year his income is likely to be considerably higher. A stock he owns will be swallowed in a cash takeover in January. He could sell now for a $10,000 long-term gain. Should he?
Yes. The profit will make his state and city taxes go up by $1,000. It will make his federal tax bill go down. Why? Because he is at a point on the federal tax curve where long-term gains are tax-free, while deducting those local taxes will shelter his salary from federal tax. If he waits until January he’ll probably lose the cap gains free ride.
After Sam deducts the incremental New York tax bill on his federal tax return, he’ll make his combined federal/state tax on the capital gain 8.5% or less. That’s hard to beat.
Sue, age 60, makes $150,000. She pays $10,000 in property tax and has $20,000 of deductions from mortgage interest and charity. What happens if she rothifies $20,000 of IRA money? She’ll pay federal tax on it at the 25% rate, but no state or city tax.
Why? New York has a $20,000 annual exclusion for retirement income. It is aimed at retirees, but there’s nothing to stop someone still in the work force from taking advantage by doing one of those conversions. When you convert, you get a 1099 that looks the same as a 1099 issued to a 73-year-old taking a required distribution. For the exclusion your conversion must take place after you turn 59-1/2.
This is a terrific deal. Sue can use it to shelter $200,000 of IRA money from state tax before she turns 70 and is required by the federal government to start liquidating the IRA. She shouldn’t convert all her IRA, though. By leaving some money in that pot she can use the $20,000 exclusion for the rest of her life.
Many states have retirement exclusions, but they often have restrictions on the source of the money or have income limits. New York’s exclusion has no income limit.
Fran, 50, has a $600,000 salary, three minor kids, a $20,000 property tax bill and $40,000 in interest and charity deductions. What happens if she converts $100,000 of her $5 million IRA? Because she is now paying the AMT, the federal tax rate on the converted amount will be just under 28%, the state/city rate just under 11%. This is a good move if she will be staying in New York, where her combined federal/state marginal rate during retirement is likely to be 39% or higher. If she’s thinking of moving to Florida, probably not, because then her state/city income tax rate would go from 11% to 0%.
Joe, 40, is a renter. He has three young kids, a $180,000 salary and no deductions except his state and local income taxes. A $30,000 long-term gain drops in his lap when a family farm is sold. That is enough to kick him down the AMT chute.
The gain will raise his state tax bill. He could wait and cover that damage with an estimated-tax payment on Jan. 15, or he could pay early and deduct the extra state tax on his 2015 federal return. Which is better?
You’d think that it makes sense to push deductions into a year when your income is high. But, paradoxically, Joe is $766 better off paying the extra state tax next year, when his income will fall back to $180,000, than paying it this year, when his income is $210,000. Why? The answer is complicated. It has to do with the interaction of capital gains and an AMT exemption.
AMT exemption? What’s that? It doesn’t matter. All Joe has to do to get guidance on his estimated taxes is to plug different payment scenarios into his software and look at the bottom lines.
Invest a few minutes in your tax program this Thanksgiving and you might find a way to save a few thousand dollars. Whether this is a socially desirable use of people’s time is another matter.
Some of the presidential candidates are talking about reform—a tax code in three pages or whatnot. That would lessen the demand for tax lawyers. Is Stephen Greenberg worried? Not at all.
“It’s too seductive to the politicians to have tax expenditures,” he says. “They can provide their big donors with special exemptions and exclusions and show them what they have done.” The kinks are here to stay.
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