This year's tax planning is going to be heavily focused on accelerating deductions and maximizing tax credits, according to Evan Stephens, a tax manager at the business consulting and accounting firm Sensiba San Filippo.
“However, taxpayers should be advised that a number of tax benefits available in 2013 are not yet available in 2014, as Congress has let some very popular provisions lapse for 2014 and has yet to reinstate them into law for 2014,” he said. “These include bonus deprecation, larger Section 179 deductions, and a number of tax credits, such as the Research and Development Credit.”
Stephens recommends practitioners consider the following tips for their clients:
• Pay your real estate taxes, personal property taxes and state income taxes before year end in order to push down your taxable income by increasing you itemized deductions. However, be aware that these deductions can phase out and/or be limited by alternative minimum tax.
• Reduce income by taking advantage of other tax-exempt investment vehicles, such as muni bonds, which are tax-free for federal purposes, and, in most states, home-state bonds are also state tax-exempt for state purposes. However, be wary that investing in municipal bonds that have a private activity element (bonds funding new sports stadiums, etc.), as they are still taxable for Alternative Minimum Tax purposes.
• Congress has not yet committed to reinstating the added benefits of bonus depreciation on fixed asset purchases for 2014. However, there is still a much smaller benefit through a Section 179 deduction of up to $25,000.
• A small blip in the code allows for a much larger, $500,000 Section 179 benefit, for non-calendar year taxpayers whose tax years begin in 2013, but end in 2014. This may benefit some taxpayers who do not carry a calendar year end.
• Congress has not yet reinstated the Research and Development credits or nonbusiness energy credits, but given these programs’ popularity will likely do so before year end. Taxpayers should be sure to keep up with the latest legislation, as some believe these will likely be extended into 2014 at some point in the coming year.
• The business energy credits remain. These credits are for taxpayers that install solar, geothermal, combined heat and power (CHP), geothermal heat pump, fuel cell, microturbine or transition energy property for use in their business. The credit can be as much as 30 percent of the cost of the property.
“Long-term capital gains still maintain their preferential rates, but are subject to the additional 3.8 percent Medicare investment tax,” Stephens said. “Short-term capital gains are subject to ordinary income rates and the 3.8 percent Medicare investment tax.”
He recommends considering tax deferral mechanisms for significant tax gains, such as Section 1031 like-kind exchanges for real property sales or structuring the sale as an installment sale. “An installment sale will spread the gain over several tax periods in order to minimize or entirely avoid the Medicare tax on investment income,” he noted.
“Taxpayers should also consider realizing losses on existing stock holdings while maintaining the investment position by selling at a loss and repurchasing at least 31 days later or swapping it out for a similar but not identical investment. This is often referred to as loss harvesting,” said Stephens. “However, if the 31-day repurchase is not adhered to, the sales are considered a wash sales transaction and the losses are disallowed.”
Finally, Stephens urges his clients to maximize contributions to their tax savings and retirement vehicles such as 401K, 403(b), 457 plans, 529 plans, Health Savings Accounts, SEPs, and Keogh plans.
“If self-employed, set up a self-employed retirement plan,” he said. “Revisit decisions to contribute to a traditional versus a Roth retirement plan. Distributions from Roth IRAs and 401(K)s are not subject to regular tax or the Medicare investment tax and, therefore, are a more attractive retirement savings vehicle for high net worth individuals. On the contrary, if a taxpayer is hovering around the threshold for the new Medicare tax, he or she should consider moving Roth contributions to a traditional retirement plan. Maximizing contributions to a traditional plan could reduce taxable income below the threshold and, therefore, avoid an additional 3.8 percent tax on investment income.”
Showing posts with label TAX PLANNING. Show all posts
Showing posts with label TAX PLANNING. Show all posts
Wednesday, August 27, 2014
Friday, August 15, 2014
Tax Breaks, Pitfalls of Renting Your Second Home
FROM FOXBUSINESS.COM
Owning a vacation home can be a wonderful thing, providing you and your family a private getaway with all the comforts of home.
It also could net you some extra money if you rent it when you're not there.
But if you're not careful, it also could cause you some tax troubles.
"If you have a vacation home, it can make a tax difference as to whether it was used as personal residence or not used at all by the owners," says Mark Luscombe, principal federal tax analyst at CCH in Riverwoods, Illinois, a provider of tax information and services.
Basically, the amount of time you personally spend at your second home determines how much tax you might owe on rent, as well as deductions you can claim against the property.
There are three basic second-home tax situations.
You rent the property to others most of the year.
You rent the property to others for a very short time.
You use the property yourself and rent it when you're not there.
Here's a closer look at the tax implications of these scenarios.
Second Home as Full-Time Rental
You used to enjoy spending all your free time at your beach house, but now that the kids are grown and gone, you and your spouse have found other ways to vacation. So you've decided to lease out the vacation home more than you use it.
Of course, since taxes are involved, you must meet some specific requirements to take tax advantage of your rental vacation property. If you limit your personal use of your second home to 14 or fewer days, or 10 percent of the time it's rented, you've essentially turned your second home into an investment.
And for many, it's an investment that can pay off.
"Nearly half of the people who finance their vacation homes are able to cover 75 percent or more of their mortgage by renting it out to travelers," says Jon Gray, senior vice president, Americas, at HomeAway, an online vacation rental marketplace.
HomeAway's 2013 Customer Satisfaction Survey found that second-home owners rent their properties to travelers 18 weeks a year and bring in more than $28,000 in annual rental income. "That's not an insignificant amount of money," says Gray.
Of course, that rental income is taxable. But you also can deduct many costs associated with your rented second home.
Common Rental Expenses
The Internal Revenue Service says the most common rental expenses are:
Advertising.
Auto and travel expenses.
Cleaning and maintenance.
Commissions.
Depreciation.
Insurance.
Interest.
Legal and other professional fees.
Local transportation expenses.
Management fees.
Mortgage interest.
Points.
Property management fees.
Rental payments.
Repairs.
Taxes.
Utilities.
When your deductible rental expenses exceed your rental income, you could wipe out any possible taxable income and even record losses that could help additionally at tax time.
Passive activity pitfalls
Your rental losses, however, could be limited. The IRS usually considers rental real estate as a passive activity; that is, you get income mainly for the use of property rather than for services provided.
And the tax code's passive activity rules mean that generally you can only use passive losses to offset passive income, not ordinary income such as wages. Any excess passive losses are carried forward to the next tax year.
There is one way to get around passive activity rules. If you are an active participant in your rental vacation home, says Luscombe, up to $25,000 of the home's expenses beyond the rental income could be deductible. There are income restrictions and a phaseout of this amount. If you make more than $100,000 ($50,000 if married filing separately), your deductible allowance is limited.
What constitutes active participation? You're deemed to have materially participated in a rental property if you (or your spouse) were involved in its operations on a regular, continuous and substantial basis during the tax year. This includes such things as personally maintaining the property and lining up renters, says Luscombe.
Short-Term Rental Advantages
When you or your family spend time at your second-home retreat as well as rent it for part of the year, the tax rules change. But exactly how much depends on the precise breakdown of the days you and renters are in the house.
The best tax deal is for short-term rentals. These are situations where your property is rented for 14 or fewer days. Money received for two-week-or-less rentals is tax-free.
"This issue comes up every time there is a special event," says Luscombe. Residents head out of town to avoid the increased congestion caused by special events such as the Super Bowl or music festivals, lease their homes to visitors coming in for the festivities, and pocket the payments without any worry about reporting the income.
It doesn't matter if you got $20,000 for the week those football fans leased your condo near the stadium. The IRS isn't entitled to a cent.
Even better, this short-term rental income tax break isn't limited to second homes. If you rent your primary residence for two weeks or less, that income doesn't have to be reported on your tax return.
Hybrid Home Tax Calculations
Tax rules are a bit trickier when you use your vacation home yourself for more than two weeks and also rent it out for a substantial part of the year. As with everything tax, meticulous record keeping is key.
To reduce taxes on any rent you collect, you'll want to deduct eligible expenses. But because the home has shared personal and rental use, you must allocate the costs.
For example, you spent 60 days last year during ski season at your mountain cabin. The hillside hideaway was rented for 180 days the rest of the year. You can deduct 75 percent of your vacation home's qualifying rental expenses against rent you collect: 180 rental days divided by 240 total days of property use.
But you can't claim rental losses in this situation -- only zero out your rental income.
And you'll report the personal portion of your expenses, including mortgage interest and property taxes on your second home, as usual on your Schedule A itemized deductions.
Don't Forget Local Taxes
Finally, don't overlook any state and local taxes that might be assessed on the rental of your home, whether a primary residence or a second home.
"Generally, any short-term rentals, typically called transient rentals, even just for a weekend, have a state and local tax obligation," says Rob Stephens, co-founder of HotSpot Tax Services, a Greenwood Village, Colorado, company that files state and local sales and lodging taxes for owners of vacation rental properties.
In Texas, if you rent your home for fewer than 30 days, you're subject to the state's hotel occupancy tax. It's called the transient occupancy tax in California. Florida counties collect a tourist impact tax on all rentals.
"As a practical matter, it gets very difficult for local jurisdictions to track and monitor this type of rental, so historically, we've seen a pretty high level of noncompliance," says Stephens.
But with state and local governments seeking every possible penny, tax revenue from such rentals is getting more attention. And the same technology that helps folks find short-term vacation home occupants also offers tax collectors a view of who's making potentially taxable residential rental income.
Owning a vacation home can be a wonderful thing, providing you and your family a private getaway with all the comforts of home.
It also could net you some extra money if you rent it when you're not there.
But if you're not careful, it also could cause you some tax troubles.
"If you have a vacation home, it can make a tax difference as to whether it was used as personal residence or not used at all by the owners," says Mark Luscombe, principal federal tax analyst at CCH in Riverwoods, Illinois, a provider of tax information and services.
Basically, the amount of time you personally spend at your second home determines how much tax you might owe on rent, as well as deductions you can claim against the property.
There are three basic second-home tax situations.
You rent the property to others most of the year.
You rent the property to others for a very short time.
You use the property yourself and rent it when you're not there.
Here's a closer look at the tax implications of these scenarios.
Second Home as Full-Time Rental
You used to enjoy spending all your free time at your beach house, but now that the kids are grown and gone, you and your spouse have found other ways to vacation. So you've decided to lease out the vacation home more than you use it.
Of course, since taxes are involved, you must meet some specific requirements to take tax advantage of your rental vacation property. If you limit your personal use of your second home to 14 or fewer days, or 10 percent of the time it's rented, you've essentially turned your second home into an investment.
And for many, it's an investment that can pay off.
"Nearly half of the people who finance their vacation homes are able to cover 75 percent or more of their mortgage by renting it out to travelers," says Jon Gray, senior vice president, Americas, at HomeAway, an online vacation rental marketplace.
HomeAway's 2013 Customer Satisfaction Survey found that second-home owners rent their properties to travelers 18 weeks a year and bring in more than $28,000 in annual rental income. "That's not an insignificant amount of money," says Gray.
Of course, that rental income is taxable. But you also can deduct many costs associated with your rented second home.
Common Rental Expenses
The Internal Revenue Service says the most common rental expenses are:
Advertising.
Auto and travel expenses.
Cleaning and maintenance.
Commissions.
Depreciation.
Insurance.
Interest.
Legal and other professional fees.
Local transportation expenses.
Management fees.
Mortgage interest.
Points.
Property management fees.
Rental payments.
Repairs.
Taxes.
Utilities.
When your deductible rental expenses exceed your rental income, you could wipe out any possible taxable income and even record losses that could help additionally at tax time.
Passive activity pitfalls
Your rental losses, however, could be limited. The IRS usually considers rental real estate as a passive activity; that is, you get income mainly for the use of property rather than for services provided.
And the tax code's passive activity rules mean that generally you can only use passive losses to offset passive income, not ordinary income such as wages. Any excess passive losses are carried forward to the next tax year.
There is one way to get around passive activity rules. If you are an active participant in your rental vacation home, says Luscombe, up to $25,000 of the home's expenses beyond the rental income could be deductible. There are income restrictions and a phaseout of this amount. If you make more than $100,000 ($50,000 if married filing separately), your deductible allowance is limited.
What constitutes active participation? You're deemed to have materially participated in a rental property if you (or your spouse) were involved in its operations on a regular, continuous and substantial basis during the tax year. This includes such things as personally maintaining the property and lining up renters, says Luscombe.
Short-Term Rental Advantages
When you or your family spend time at your second-home retreat as well as rent it for part of the year, the tax rules change. But exactly how much depends on the precise breakdown of the days you and renters are in the house.
The best tax deal is for short-term rentals. These are situations where your property is rented for 14 or fewer days. Money received for two-week-or-less rentals is tax-free.
"This issue comes up every time there is a special event," says Luscombe. Residents head out of town to avoid the increased congestion caused by special events such as the Super Bowl or music festivals, lease their homes to visitors coming in for the festivities, and pocket the payments without any worry about reporting the income.
It doesn't matter if you got $20,000 for the week those football fans leased your condo near the stadium. The IRS isn't entitled to a cent.
Even better, this short-term rental income tax break isn't limited to second homes. If you rent your primary residence for two weeks or less, that income doesn't have to be reported on your tax return.
Hybrid Home Tax Calculations
Tax rules are a bit trickier when you use your vacation home yourself for more than two weeks and also rent it out for a substantial part of the year. As with everything tax, meticulous record keeping is key.
To reduce taxes on any rent you collect, you'll want to deduct eligible expenses. But because the home has shared personal and rental use, you must allocate the costs.
For example, you spent 60 days last year during ski season at your mountain cabin. The hillside hideaway was rented for 180 days the rest of the year. You can deduct 75 percent of your vacation home's qualifying rental expenses against rent you collect: 180 rental days divided by 240 total days of property use.
But you can't claim rental losses in this situation -- only zero out your rental income.
And you'll report the personal portion of your expenses, including mortgage interest and property taxes on your second home, as usual on your Schedule A itemized deductions.
Don't Forget Local Taxes
Finally, don't overlook any state and local taxes that might be assessed on the rental of your home, whether a primary residence or a second home.
"Generally, any short-term rentals, typically called transient rentals, even just for a weekend, have a state and local tax obligation," says Rob Stephens, co-founder of HotSpot Tax Services, a Greenwood Village, Colorado, company that files state and local sales and lodging taxes for owners of vacation rental properties.
In Texas, if you rent your home for fewer than 30 days, you're subject to the state's hotel occupancy tax. It's called the transient occupancy tax in California. Florida counties collect a tourist impact tax on all rentals.
"As a practical matter, it gets very difficult for local jurisdictions to track and monitor this type of rental, so historically, we've seen a pretty high level of noncompliance," says Stephens.
But with state and local governments seeking every possible penny, tax revenue from such rentals is getting more attention. And the same technology that helps folks find short-term vacation home occupants also offers tax collectors a view of who's making potentially taxable residential rental income.
Wednesday, August 13, 2014
Mid-Year Tax Planning Checklist
All too often, taxpayers wait until after the close of the tax year to worry about their taxes and miss opportunities that could reduce their tax liability or financially assist them. Mid-year is the perfect time for tax planning. The following are some events that can affect your tax return; you may need to take steps to mitigate their impact and avoid unpleasant surprises after it is too late to address them.
Did you get married, divorced, or become widowed?
Did you change jobs or has your spouse started working?
Did you have a substantial increase or decrease in income?
Did you have a substantial gain from the sale of stocks or bonds?
Did you buy or sell a rental?
Did you start, acquire, or sell a business?
Did you buy or sell a home?
Did you retire this year?
Are you on track to withdraw the required amount from your IRA (age 70.5 or older)?
Did you refinance your home or take out a second home mortgage this year?
Were you the beneficiary of an inheritance this year?
Did you have a child? Time to consider a tax-advantaged savings plan!
Are you taking advantage of tax-advantaged retirement savings?
Have you made any significant equipment purchases for your business?
Are you planning to purchase a new business vehicle and dispose of the old one? It makes a significant difference whether you sell or trade-in the old vehicle.
Are your cash and non-cash charitable contributions adequately documented?
Are you keeping up with your estimated tax payments or do they need adjusting?
Did you purchase your health insurance through a government insurance exchange and qualify for an insurance subsidy? If your income subsequently increased, you may need to be prepared to repay some portion of the subsidy.
Do you have substantial investment income or gains from the sale of investment assets? If so, you may be hit with the 3.8% surtax on net investment income and need to adjust your advance tax payments.
Did you make any unplanned withdrawals from an IRA or pension plan?
Have you stayed abreast of every new tax law change?
If you anticipate or have already encountered any of the above events or conditions, it may be appropriate to consult with this office, preferably before the event, and definitely before the end of the year.
Did you get married, divorced, or become widowed?
Did you change jobs or has your spouse started working?
Did you have a substantial increase or decrease in income?
Did you have a substantial gain from the sale of stocks or bonds?
Did you buy or sell a rental?
Did you start, acquire, or sell a business?
Did you buy or sell a home?
Did you retire this year?
Are you on track to withdraw the required amount from your IRA (age 70.5 or older)?
Did you refinance your home or take out a second home mortgage this year?
Were you the beneficiary of an inheritance this year?
Did you have a child? Time to consider a tax-advantaged savings plan!
Are you taking advantage of tax-advantaged retirement savings?
Have you made any significant equipment purchases for your business?
Are you planning to purchase a new business vehicle and dispose of the old one? It makes a significant difference whether you sell or trade-in the old vehicle.
Are your cash and non-cash charitable contributions adequately documented?
Are you keeping up with your estimated tax payments or do they need adjusting?
Did you purchase your health insurance through a government insurance exchange and qualify for an insurance subsidy? If your income subsequently increased, you may need to be prepared to repay some portion of the subsidy.
Do you have substantial investment income or gains from the sale of investment assets? If so, you may be hit with the 3.8% surtax on net investment income and need to adjust your advance tax payments.
Did you make any unplanned withdrawals from an IRA or pension plan?
Have you stayed abreast of every new tax law change?
If you anticipate or have already encountered any of the above events or conditions, it may be appropriate to consult with this office, preferably before the event, and definitely before the end of the year.
Monday, August 11, 2014
Tax Planning Strategies for Today
Procrastinators beware: Tax planning isn’t just something you have to deal with at the end of the year and then again in April.
While it’s tempting to pay your taxes and forget about them until next year, a mid-year review can ensure you aren’t overpaying Uncle Sam.
“People should look at their tax exposure mid-year because those that do tend to pay less in taxes than people who do not,” says David McKelvey, partner at accounting firm Friedman. “There are moves that taxpayers can make, but the real value is the ability to plan out actions for the balance of the year.”
Mid-year tax planning can also make life less stressful when April 15 rolls around, especially for those that change tax brackets and might be facing a bigger-than-normal bill.
“Often, individuals will put off tax planning until the end because it is much easier to summarize and estimate finances for the remainder of the year when they are already three-quarters of the way done,” says Megan McManus, CPA and tax manager at accounting and business consulting firm Sensiba San Filippo. “However, for some tax rules and exemptions, there is a limited window of opportunity to take advantage of the rules.”
To help reduce any surprises come tax season and take full advantage of all eligible breaks and credits, experts offer the following tips:
Look at Your Tax Bracket
People with taxable income of more than $400,000 for individuals and $450,000 for couples are subject to the highest income tax rate, which according to McKelvey, currently stands at 39.6%. If you expect to fall into the top tax bracket this year, he says now is the time to create strategies to reduce your taxable income.
For instance, he says you can take steps to defer income or accelerate deductible expenses to get into a lower bracket. Even if you aren’t a high earner, any moves to reduce your taxable income means less money you’ll owe Uncle Sam. “If you find you may be close to jumping into the higher bracket, steps can be taken to reduce income,” he says. “Increase retirement contributions, harvest losses from investment accounts, look at non-taxable investments and gifts to charities.”
Max Out Your Tax Advantaged Retirement Account
Many employers offer their workers some form of a retirement savings plan that often includes a match offering, and experts say the middle of the year is a great time to make sure you are taking full advantage of your benefits package.
Increasing your retirement contributions can help build your nest egg quicker, but it can also help you pay less taxes, says Sarah Deierlein, an enrolled agent at Tax Defense Network.
"Most people have their highest taxable income during their working years. Therefore, by maximizing your savings and reducing your taxable income now, you will be able to pay tax on the income when you are retired and your taxable income is lower each year," says Deierlein. She noted 401(k) accounts allow for up to $17,500 in contributions or $23,000 if you are 50 or older, and IRAs allow for $5,500 in contributions or $6,500 if you are over 50.
Consider Your Investment Gains and Losses
If you are lucky enough to realize (or plan for) significant capital gains from investments this year, now is an ideal time to sell some underperforming investments to generate losses to help offset your gains.
This move is extremely important if you are a high earner because the capital gains for taxpayers in the top bracket is 20% this year, says McKelvey. He says you may even be able to repurchase those underperformers as long as you wait at least 31 days after selling them.
Check Up on Your Medical Expenses
If you have a lot of out of pocket medical expenses, experts recommend looking into enrolling in a flexible spending account or a health savings account.
These accounts let you cover medical expenses with tax-free dollars and reduce your taxable income for the year. According to McKelvey, you can contribute up to $3,300 per year for individuals and $6,550 per family.
“One thing to note is that the use-it or lose-it policy been amended by The Affordable Health Care Act, meaning that an employee can now have up to $500 from their Healthcare FSA rollover into the next year without losing any funds,” notes McManus.
While it’s tempting to pay your taxes and forget about them until next year, a mid-year review can ensure you aren’t overpaying Uncle Sam.
“People should look at their tax exposure mid-year because those that do tend to pay less in taxes than people who do not,” says David McKelvey, partner at accounting firm Friedman. “There are moves that taxpayers can make, but the real value is the ability to plan out actions for the balance of the year.”
Mid-year tax planning can also make life less stressful when April 15 rolls around, especially for those that change tax brackets and might be facing a bigger-than-normal bill.
“Often, individuals will put off tax planning until the end because it is much easier to summarize and estimate finances for the remainder of the year when they are already three-quarters of the way done,” says Megan McManus, CPA and tax manager at accounting and business consulting firm Sensiba San Filippo. “However, for some tax rules and exemptions, there is a limited window of opportunity to take advantage of the rules.”
To help reduce any surprises come tax season and take full advantage of all eligible breaks and credits, experts offer the following tips:
Look at Your Tax Bracket
People with taxable income of more than $400,000 for individuals and $450,000 for couples are subject to the highest income tax rate, which according to McKelvey, currently stands at 39.6%. If you expect to fall into the top tax bracket this year, he says now is the time to create strategies to reduce your taxable income.
For instance, he says you can take steps to defer income or accelerate deductible expenses to get into a lower bracket. Even if you aren’t a high earner, any moves to reduce your taxable income means less money you’ll owe Uncle Sam. “If you find you may be close to jumping into the higher bracket, steps can be taken to reduce income,” he says. “Increase retirement contributions, harvest losses from investment accounts, look at non-taxable investments and gifts to charities.”
Max Out Your Tax Advantaged Retirement Account
Many employers offer their workers some form of a retirement savings plan that often includes a match offering, and experts say the middle of the year is a great time to make sure you are taking full advantage of your benefits package.
Increasing your retirement contributions can help build your nest egg quicker, but it can also help you pay less taxes, says Sarah Deierlein, an enrolled agent at Tax Defense Network.
"Most people have their highest taxable income during their working years. Therefore, by maximizing your savings and reducing your taxable income now, you will be able to pay tax on the income when you are retired and your taxable income is lower each year," says Deierlein. She noted 401(k) accounts allow for up to $17,500 in contributions or $23,000 if you are 50 or older, and IRAs allow for $5,500 in contributions or $6,500 if you are over 50.
Consider Your Investment Gains and Losses
If you are lucky enough to realize (or plan for) significant capital gains from investments this year, now is an ideal time to sell some underperforming investments to generate losses to help offset your gains.
This move is extremely important if you are a high earner because the capital gains for taxpayers in the top bracket is 20% this year, says McKelvey. He says you may even be able to repurchase those underperformers as long as you wait at least 31 days after selling them.
Check Up on Your Medical Expenses
If you have a lot of out of pocket medical expenses, experts recommend looking into enrolling in a flexible spending account or a health savings account.
These accounts let you cover medical expenses with tax-free dollars and reduce your taxable income for the year. According to McKelvey, you can contribute up to $3,300 per year for individuals and $6,550 per family.
“One thing to note is that the use-it or lose-it policy been amended by The Affordable Health Care Act, meaning that an employee can now have up to $500 from their Healthcare FSA rollover into the next year without losing any funds,” notes McManus.
Saturday, August 9, 2014
Staying in the 15% Tax Bracket for Life
Retirees often are blindsided by high tax bills. Retirees are the targets of many of tax increases, though they aren’t explicitly named. Instead, Congress enacts stealth taxes that quietly drain cash from retirees.
Fortunately, you can fight back. Retirees have more control over their tax burden and more flexibility than most taxpayers, especially when you start planning before retirement. Even if you wait, there still are steps to take.
The key to keeping your tax burden low is to reduce your adjusted gross income. That’s the number at the bottom of the first page of the standard Form 1040. AGI is critical, because most of the stealth taxes are based on it instead of taxable income, which is calculated on the second page of the 1040. Taxable income is lower than AGI because of the personal exemptions and either the standard deduction or itemized deductions. Even those are reduced or phased out if your AGI is too high.
The stealth taxes are numerous: phaseouts of personal exemptions and itemized expenses, the 3.8% tax on net investment income, inclusion of some Social Security benefits in gross income, the Medicare surtax, and more. You beat these stealth taxes primarily by reducing AGI. When you can’t reduce AGI, you still reduce the overall tax burden by controlling the types of income you receive.
Retirees often can choose how and when they receive income. By carefully paying attention to the sources of income and the amount of AGI, they have more control over their tax burden. In fact, you can almost determine the tax rate you want to pay. Some planners refer to this as tax bracket management. In this visit, you’ll learn how to keep your tax bracket as low as possible year after year.
Diversify income sources. The key to tax bracket management is tax diversification. Tax diversification recognizes that different types of income are taxed differently. The tax law and your situation can change, so you don’t want only one type of income or tax break. During the working years, most income tends to be ordinary income, whether it is salary or business profits. But in retirement you often can diversify income sources.
Tax diversification is achieved by having your investments in different types of accounts: traditional IRAs and 401(k)s, Roth IRAs and 401(k)s, taxable accounts, annuities, and any others available to you. You’ll also have other sources of income, such as Social Security and perhaps some form of pension. Having different income sources allows you to use all the available strategies.
Reduce or convert traditional IRAs. One of the greatest obstacles to tax bracket management is having too much of your nest egg in traditional IRAs or 401(k)s. Most people don’t realize this until it is too late.
Traditional IRAs (and other forms of tax deferral) are great during the accumulation years. Yet, they create two problems during the distribution years. One problem is that all distributions are taxed as ordinary income, facing your highest tax rate. The other is that after age 70½, minimum distributions are required. As you age, the required distributions increase, and many people in their late 70s and beyond complain that the required distributions far exceed their cash needs and increase taxes.
There are a couple of strategies. One is to take IRA distributions before you need the money. Over time or in a lump sum take money out of the IRA, pay the taxes, and put the rest of the distribution in a taxable account. When you spend the principal in the future it won’t be taxed. You’ll also be able to invest the money so future income and gains receive favorable tax rates, as we’ll discuss.
The other strategy is to convert all or part of the traditional IRA to a Roth IRA. You pay taxes on the converted amount, but future distributions to you and your heirs are tax free.
Most people don’t want to prepay taxes. It goes against one of the longstanding principles of tax planning. But when taxes will be higher in the future, especially when you’ll be faced with an array of stealth taxes, paying taxes now can make sense. In 2010 favorable tax treatment was offered to those who converted traditional IRAs to Roth IRAs that year. The IRS recently reported the results. Conversions increased by nine times over the previous year. Among taxpayers with $1 million or more of income, more than 10% did conversions. That means the taxpayers who receive the most sophisticated advice decided paying taxes early was a good idea when it converted future ordinary income into tax-favored or tax-free income.
An advantage of a Roth IRA is that distributions from it, no matter how large, aren’t included in AGI. That is a big help in avoiding the stealth taxes triggered by higher AGI.
Time IRA distributions and conversions. Consider more than immediate cash needs when deciding how much to distribute from a traditional IRA or 401(k) or how much to convert to a Roth IRA. Consider the rest of your tax picture. Increase distributions or conversions in a year when your tax rate is lower. Perhaps you have high deductible medical expenses, a business loss, earned less income, or have other factors that reduce your tax bill. That would be a good year to increase IRA distributions or conversions, because you’ll be in a lower tax bracket or have deductions to offset the taxes on the IRA transactions.
Delay Social Security. You need to consider a number of factors before deciding when to take Social Security, but income taxes are a reason to defer benefits. Social Security benefits are tax free or mostly tax free unless your AGI is above $44,000. Since delaying benefits increases your benefit, it also increases your potentially tax-advantaged income.
Seek tax-advantaged income. Your taxable accounts should seek tax-exempt income, qualified dividend income, and long-term capital gains. Investments that generate ordinary income, such as interest, should be in other types of accounts or annuities whenever possible. It also is wasteful to take short-term capital gains in taxable accounts without a compelling reason.
There’s a catch with tax-exempt interest. It generally is excluded from gross income and therefore AGI. But some of the stealth taxes, such as the Medicare premium surtax and the tax on Social Security benefits, use modified AGI. Modified AGI is regular AGI plus tax-exempt interest and foreign earned income that was excluded from income. So, if your AGI is near stealth tax thresholds, tax-exempt interest might not help.
Use tax-wise investment strategies. Taxable accounts need to be managed with both taxes and investment returns in mind, resulting in higher after-tax returns.
Loss harvesting is an important strategy. When investments decline below the purchase price, sell them and book the loss. In most cases you can buy them back after waiting more than 30 days or immediately buy another investment that isn’t substantially similar. The losses offset capital gains earned during the year. Losses that exceed your gains can be deducted up to $3,000 annually to reduce taxes on other income. When losses for the year exceed gains plus $3,000, you can carry the excess amount to future years to use in the same way.
You also want to avoid owning in your taxable accounts mutual funds that distribute a lot of their gains each year, forcing you to include them in gross income. Look for mutual funds with low turnover ratios or for tax-favored investments such as master limited partnerships.
Avoid selling investments at a gain if you held them for one year or less, unless there is a compelling nontax reason. You want to earn long-term capital gains instead of ordinary income or short-term gains.
Manage your tax bracket annually. When you have tax diversification and the other strategies in place, you are in position to manage your tax bracket, keeping it around 15% to 20% annually.
You’ll have a base automatic income from Social Security and perhaps some annuities and pensions. After age 70½ you’ll also have required minimum distributions from traditional IRAs and 401(k)s. Your taxable accounts might generate qualified dividends, tax-exempt interest, mutual fund distributions, and other income that’s outside your control.
But you have flexibility beyond that you can use to minimize your tax burden while meeting spending needs. You want to focus on keeping AGI as low as possible and minimizing ordinary income.
To meet spending needs that exceed the automatic income, carefully choose the sources. You might sell some assets in taxable accounts at long-term capital gains to raise cash. Or if AGI is too high for the year, consider Roth IRA distributions to avoid triggering a higher tax bracket or stealth taxes. In a year when AGI is low or you have deductions to offset ordinary income, consider taking extra distributions from traditional IRAs or annuities.
With tax diversification and tax bracket management, you can generate substantial cash flow each year while keeping your tax rate at 20% or even less. Many retirees avoid the higher ordinary income tax brackets despite substantial cash flow. You can avoid the stealth taxes and other burdens Congress aims at you.
Fortunately, you can fight back. Retirees have more control over their tax burden and more flexibility than most taxpayers, especially when you start planning before retirement. Even if you wait, there still are steps to take.
The key to keeping your tax burden low is to reduce your adjusted gross income. That’s the number at the bottom of the first page of the standard Form 1040. AGI is critical, because most of the stealth taxes are based on it instead of taxable income, which is calculated on the second page of the 1040. Taxable income is lower than AGI because of the personal exemptions and either the standard deduction or itemized deductions. Even those are reduced or phased out if your AGI is too high.
The stealth taxes are numerous: phaseouts of personal exemptions and itemized expenses, the 3.8% tax on net investment income, inclusion of some Social Security benefits in gross income, the Medicare surtax, and more. You beat these stealth taxes primarily by reducing AGI. When you can’t reduce AGI, you still reduce the overall tax burden by controlling the types of income you receive.
Retirees often can choose how and when they receive income. By carefully paying attention to the sources of income and the amount of AGI, they have more control over their tax burden. In fact, you can almost determine the tax rate you want to pay. Some planners refer to this as tax bracket management. In this visit, you’ll learn how to keep your tax bracket as low as possible year after year.
Diversify income sources. The key to tax bracket management is tax diversification. Tax diversification recognizes that different types of income are taxed differently. The tax law and your situation can change, so you don’t want only one type of income or tax break. During the working years, most income tends to be ordinary income, whether it is salary or business profits. But in retirement you often can diversify income sources.
Tax diversification is achieved by having your investments in different types of accounts: traditional IRAs and 401(k)s, Roth IRAs and 401(k)s, taxable accounts, annuities, and any others available to you. You’ll also have other sources of income, such as Social Security and perhaps some form of pension. Having different income sources allows you to use all the available strategies.
Reduce or convert traditional IRAs. One of the greatest obstacles to tax bracket management is having too much of your nest egg in traditional IRAs or 401(k)s. Most people don’t realize this until it is too late.
Traditional IRAs (and other forms of tax deferral) are great during the accumulation years. Yet, they create two problems during the distribution years. One problem is that all distributions are taxed as ordinary income, facing your highest tax rate. The other is that after age 70½, minimum distributions are required. As you age, the required distributions increase, and many people in their late 70s and beyond complain that the required distributions far exceed their cash needs and increase taxes.
There are a couple of strategies. One is to take IRA distributions before you need the money. Over time or in a lump sum take money out of the IRA, pay the taxes, and put the rest of the distribution in a taxable account. When you spend the principal in the future it won’t be taxed. You’ll also be able to invest the money so future income and gains receive favorable tax rates, as we’ll discuss.
The other strategy is to convert all or part of the traditional IRA to a Roth IRA. You pay taxes on the converted amount, but future distributions to you and your heirs are tax free.
Most people don’t want to prepay taxes. It goes against one of the longstanding principles of tax planning. But when taxes will be higher in the future, especially when you’ll be faced with an array of stealth taxes, paying taxes now can make sense. In 2010 favorable tax treatment was offered to those who converted traditional IRAs to Roth IRAs that year. The IRS recently reported the results. Conversions increased by nine times over the previous year. Among taxpayers with $1 million or more of income, more than 10% did conversions. That means the taxpayers who receive the most sophisticated advice decided paying taxes early was a good idea when it converted future ordinary income into tax-favored or tax-free income.
An advantage of a Roth IRA is that distributions from it, no matter how large, aren’t included in AGI. That is a big help in avoiding the stealth taxes triggered by higher AGI.
Time IRA distributions and conversions. Consider more than immediate cash needs when deciding how much to distribute from a traditional IRA or 401(k) or how much to convert to a Roth IRA. Consider the rest of your tax picture. Increase distributions or conversions in a year when your tax rate is lower. Perhaps you have high deductible medical expenses, a business loss, earned less income, or have other factors that reduce your tax bill. That would be a good year to increase IRA distributions or conversions, because you’ll be in a lower tax bracket or have deductions to offset the taxes on the IRA transactions.
Delay Social Security. You need to consider a number of factors before deciding when to take Social Security, but income taxes are a reason to defer benefits. Social Security benefits are tax free or mostly tax free unless your AGI is above $44,000. Since delaying benefits increases your benefit, it also increases your potentially tax-advantaged income.
Seek tax-advantaged income. Your taxable accounts should seek tax-exempt income, qualified dividend income, and long-term capital gains. Investments that generate ordinary income, such as interest, should be in other types of accounts or annuities whenever possible. It also is wasteful to take short-term capital gains in taxable accounts without a compelling reason.
There’s a catch with tax-exempt interest. It generally is excluded from gross income and therefore AGI. But some of the stealth taxes, such as the Medicare premium surtax and the tax on Social Security benefits, use modified AGI. Modified AGI is regular AGI plus tax-exempt interest and foreign earned income that was excluded from income. So, if your AGI is near stealth tax thresholds, tax-exempt interest might not help.
Use tax-wise investment strategies. Taxable accounts need to be managed with both taxes and investment returns in mind, resulting in higher after-tax returns.
Loss harvesting is an important strategy. When investments decline below the purchase price, sell them and book the loss. In most cases you can buy them back after waiting more than 30 days or immediately buy another investment that isn’t substantially similar. The losses offset capital gains earned during the year. Losses that exceed your gains can be deducted up to $3,000 annually to reduce taxes on other income. When losses for the year exceed gains plus $3,000, you can carry the excess amount to future years to use in the same way.
You also want to avoid owning in your taxable accounts mutual funds that distribute a lot of their gains each year, forcing you to include them in gross income. Look for mutual funds with low turnover ratios or for tax-favored investments such as master limited partnerships.
Avoid selling investments at a gain if you held them for one year or less, unless there is a compelling nontax reason. You want to earn long-term capital gains instead of ordinary income or short-term gains.
Manage your tax bracket annually. When you have tax diversification and the other strategies in place, you are in position to manage your tax bracket, keeping it around 15% to 20% annually.
You’ll have a base automatic income from Social Security and perhaps some annuities and pensions. After age 70½ you’ll also have required minimum distributions from traditional IRAs and 401(k)s. Your taxable accounts might generate qualified dividends, tax-exempt interest, mutual fund distributions, and other income that’s outside your control.
But you have flexibility beyond that you can use to minimize your tax burden while meeting spending needs. You want to focus on keeping AGI as low as possible and minimizing ordinary income.
To meet spending needs that exceed the automatic income, carefully choose the sources. You might sell some assets in taxable accounts at long-term capital gains to raise cash. Or if AGI is too high for the year, consider Roth IRA distributions to avoid triggering a higher tax bracket or stealth taxes. In a year when AGI is low or you have deductions to offset ordinary income, consider taking extra distributions from traditional IRAs or annuities.
With tax diversification and tax bracket management, you can generate substantial cash flow each year while keeping your tax rate at 20% or even less. Many retirees avoid the higher ordinary income tax brackets despite substantial cash flow. You can avoid the stealth taxes and other burdens Congress aims at you.
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