How to cut your tax bill by the end of the year
By Bill Bischoff
With the end of the year approaching, it’s time to make some moves to lower your 2014 tax bill. This is the second installment of our two-part series on that subject. See the first part here.
Strategy: Prepay deductible expenditures
If you itemize deductions, accelerating some deductible expenditures into this year to produce higher 2014 write-offs makes sense if you expect to be in the same or lower tax bracket next year. (See the tables at the end of this column for the 2014 and 2015 federal brackets.)
January house payment
Accelerating the house payment that is due in January will give you 13 month’s worth of deductible interest in 2014 (unless you’ve already been following the prepayment drill). You can use the same strategy with a vacation home.
State and local taxes
Prepaying state and local income and property taxes that are due early next year can reduced your 2014 federal income tax bill, because your total itemized deductions will be that much higher.
Medical expenses and miscellaneous deduction items
Consider prepaying expenses that are subject to deduction limits based on your adjusted gross income (AGI). AGI is the number at the bottom of page 1 of your Form 1040. It includes all taxable income items and a few specific deductions such as the ones for alimony paid and moving expenses.
The two prime AGI-sensitive candidates for the prepayment strategy are medical expenses and miscellaneous itemized deductions.
Medical costs are deductible only to the extent they exceed 10% of AGI for most people. However, if you or your spouse will be 65 or older as of yearend, the deduction threshold is a more-manageable 7.5% of AGI.
Miscellaneous deductions--for investment expenses, job-hunting expenses, fees for tax preparation and advice, and unreimbursed employee business expenses--count only to the extent they exceed 2% of AGI. If you can bunch these kinds of expenditures into a single calendar year, you’ll have a fighting chance of clearing the 2%-of-AGI hurdle and getting some tax savings.
Warning: Prepaying is not a no-brainer
The prepayment strategy can backfire if you will owe the alternative minimum tax (AMT) for this year. That’s because write-offs for state and local income and property taxes are completely disallowed under the AMT rules and so are miscellaneous itemized deductions. So prepaying these expenses may do little or no tax-saving good for AMT victims. Solution: Ask your tax adviser if you’re in the AMT mode before prepaying taxes or miscellaneous deduction items.
Strategy: Give to charity
Prepaying charitable donations that you would otherwise make next year can reduce your 2014 federal income tax bill, because your total itemized deductions will be that much higher. Donations charged to credit cards before yearend will count as 2014 contributions.
Donate appreciated stock; sell losers and donate resulting cash
If you have appreciated stock or mutual fund shares (currently worth more than you paid for them) that you’ve held in a taxable brokerage firm account for over a year, consider donating them, instead of cash, to IRS-approved charities. You can generally claim an itemized charitable deduction for the full market value at the time of the donation and avoid any capital gains tax hit. On the other hand, don’t donate loser stocks. Sell them, book the resulting capital loss, and donate the cash sales proceeds. That way, you can generally deduct the full amount of the cash donation while keeping the tax-saving capital loss for yourself.
Remember: you must itemize deductions to gain any tax-saving benefit from charitable donations, except for donations out of an IRA, as explained immediately below.
If you’ve reached age 70½: stay tuned for news on donations from IRAs
Last year, you could make up to $100,000 in cash donations to IRS-approved charities directly out of your IRA if you were 70½ or older. Such direct-from-your-IRA donations are called qualified charitable distributions, or QCDs. They are tax free and no deductions are allowed for them, so QCDs don’t directly affect your tax bill. However, they count as withdrawals for purposes of meeting the required minimum distribution (RMD) rules that apply to your traditional IRAs after age 70½. So you could avoid taxes by arranging for tax-free QCDs in place of taxable RMDs. The QCD privilege expired at the end of last year, but I expect it to be resurrected for the 2014 tax year when Congress reconvenes. I will notify you if and when that happens. Meanwhile, be prepared to act fast if the QCD break is restored.
Prepay college tuition
If your 2014 AGI allows you to qualify for the American Opportunity college credit (worth up to $2,500 per qualifying student) or the Lifetime Learning higher-education credit (worth up to $2,000 per tax return), consider prepaying college tuition bills that are not due until early 2015 if that would result in a bigger credit on this year’s Form 1040. Specifically, you can claim a 2014 credit for prepaid tuition for academic periods that begin in January through March of next year.
•The American Opportunity credit is phased out (reduced or completely eliminated) if your modified AGI (MAGI) is too high. The phase-out range for unmarried individuals is between MAGI of $80,000 and $90,000. The range for married joint filers is between $160,000 and $180,000. MAGI means “regular” AGI, from the last line on page 1 of your Form 1040, increased by certain tax-exempt income from outside the U.S. which you probably don’t have.
•Like the American Opportunity credit, the Lifetime Learning credit is also phased out if your MAGI is too high. However, the Lifetime Learning credit phase-out ranges are much lower, which means they are much more likely to affect you. The 2014 phase-out range for unmarried individuals is between MAGI of $54,000 and $64,000. The 2014 phase-out range for married joint filers is between $108,000 and $128,000.
Stay tuned for news on “The Extenders”
“The Extenders” is not the name of new TV show. The term refers to list of popular tax breaks that Congress habitually allows to expire before ultimately extending them for another year or two. The following two important extenders expired at the end of 2013, but I expect them both to be resurrected when Congress reconvenes. Check with your accountant or financial advisor before year end to find out if these breaks are extended.
Option to deduct state and local sales taxes instead of income taxes
If you live in a state with low or no personal income tax, you can choose to deduct state and local general sales taxes instead of state and local income taxes on your 2014 return, if this option is resurrected for this year. If it is, you can deduct sales taxes on a major purchase such as a motor vehicle (car, truck, SUV, van, motorcycle, off-road vehicle, motor home, or recreational vehicle), a boat, an aircraft, a home (including a mobile prefabricated home), or a substantial addition to or major renovation of a home. You can also include state and local general sales taxes paid for a leased motor vehicle. So making a major purchase (or motor vehicle lease) between now and yearend could give you a bigger sales tax deduction and cut this year’s federal income tax bill.
College tuition deduction
If your MAGI is too high to be eligible for the Lifetime Learning credit explained earlier, you might still qualify to deduct up to $2,000 or $4,000 of college tuition costs, assuming this break is restored for the 2014 tax year. If so, consider prepaying tuition bills that are not due until early 2015 if that would result in a bigger deduction on this year’s Form 1040. Your 2014 deduction can include prepaid tuition for academic periods that begin in the first three months of 2015.
Don’t overlook estate planning
For 2014, the unified federal gift and estate tax exemption is a relatively generous $5.34 million, and the federal estate tax rate is a historically reasonable 40%. Even if you already have an estate plan, it may need updating to reflect the current estate and gift tax rules. You may also have state estate tax issues that need to be addressed. Finally, you may need to make some changes for reasons that have nothing to do with taxes (births, deaths, and so forth). Contact your estate planning pro if you think your plan might need a tune-up. Now is a good time to do it.