Our previous blog discussed year-end tax planning for small businesses, noting that pass-through entities cannot accurately estimate their tax liability without first plugging in K-1 income and deductions to the owners' 1040.
This blog will focus on year-end tax planning for individuals; as business owners, and as employees, investors, parents, and all the other attributes that impact the 1040.
The Basic Process
To estimate your tax liability, we gather all your year-to-date tax information, and estimate what your income and deductions will be at year-end. Then, we use our software to create a model of your tax return for each year of the estimate. We can customize any piece of this model tax return, in order to accurately reflect changes in your tax situation for 2015.
This process gives us an "as-is" estimate of your 2015 tax. We compare this to your withholding and estimated tax payments to calculate your expected tax refund or liability.
Many clients make estimated tax payments that we can scale back if income is down. Sometimes we increase these payments for high-income years, but often it is a "safe harbor" payment based on last year's income, so there is no need to make a higher payment when current year income is up.
Planning for the Business Owner
For the owner of a small business, we first plug in the income and deductions created by the business. Then, there are other issues that come up, including the owners' health insurance, fringe benefits, vehicles, and rents or interest charged to the business. When these items are significant to our estimate, we make adjustments in order to arrive at a reasonably accurate estimate of business income flowing to the individual.
This gives the individual an idea how much tax he or she will owe. Frequently business owners will make distributions in order to have enough cash on hand to pay their individual tax liabilities. Also during this process, we usually have recommendations that the business can follow in order to reduce the owners' tax liability. (Some of the business tax strategies are discussed in our previous blog).
Tax Planning Strategies for Individuals
Once we have a basic understanding of the income and deductions expected on the tax return, we can strategize about tax planning opportunities. For individuals, a common strategy is to accelerate deductions and defer or spread out taxable income over multiple years.
Individuals can speed up deductions into the current year by prepaying real estate taxes, state income taxes, charitable gifts, and other deductions that are paid out. Some individuals can "bunch" all these itemized deductions into one year, and then take the standard deduction ($12,600 for joint filers) every other year, when itemized deductions are down. Similarly, medical costs are deductible only to the extent that they exceed 7.5% of AGI, so a common strategy is to bunch these payments into one year, so that the 7.5% floor only applies in one tax year.
High-income clients face unique tax rules that require special attention at year end. First, the Alternative Minimum Tax (AMT) can kick in as AGI approaches and exceeds $82,100 (52,800 for single taxpayers). The AMT is an additional tax designed to prevent tax deductions from reducing tax below a flat rate of 26 to 28% of income. AMT income is recalculated by disallowing most itemized deductions, standard deductions, personal exemptions, and a number of other AMT items. Then, the 28% tax on AMT income is compared with your "regular" income tax, and you pay the greater of AMT versus regular tax.
Second, clients with income over $250,000 (125,000 single) are subject to a 3.8% Net Investment Income Tax. This tax applies to all investment income (interest, dividends, rental activities, passive business income, etc.), to the extent that AGI exceeds the $250,000 threshold.
Third, high-income clients will start to see most of their deductions and tax credits "phased-out" as their income increases. The phase-outs apply at different levels of income, restricting most tax benefits, including the child tax credit ($110,000 for joint filers), the deduction for IRA contributions (starting at $60,000), and your itemized deductions and personal exemptions ($309,900 for joint filers). A full list of the 2015 phase-outs is available online at the Tax Policy Center.
Many year-end tax planning strategies involve timing income and deductions in order to reduce the impact of the AMT, NII Tax, and the phase-outs. Usually, we recommend spreading out income across lower-income years, and comparing deductions taken in different years to see what is the best time to take the deduction. But if you are paying AMT, often you will want to have your income max out the AMT bracket year (a 28% rate) versus another year where AMT does not apply (39.6% top rate).
Given the complexity of the AMT, NII, and deduction phase-outs, we compare the total tax consequences in each year. This allows us to time major cash inflows (like the sale of stock) and outflows (like a charitable gift) to minimize the tax expense.
Reviewing Estate Plans
Many clients also review their estate plans on an annual basis, usually toward year end. Clients are considering the impact of major life changes over the past year - changes in their family, their health, and their assets. We help clients review the impact of these changes on their estate plan, in light of any updates in the tax law.
For clients impacted by the Estate and Gift Tax, the 2015 exemption amount is $5.43 million. Clients who expect to have assets exceeding their exemption(s) may work to reduce the taxable estate using gifts to family, friends, or charity. The 2014 annual gift tax exclusion is $14,000 per donor and per donee, so that a mother and father with 3 children can transfer up to $84,000 out of their estate each year (14,000 per parent * 3 kids = 42,000 * 2 parents = $84,000). This is a flexible tool, as clients can make gifts to anyone (or through a trust, a 529 college savings plan, or other account) in order to reduce their taxable estate each year. A 5-year "catch-up" also allows some taxpayers to speed up 5 years' gifts into 1 year, potentially removing $420,000 from Mother and Father's taxable estate in 1 year. Certainly, there are much more advanced estate planning techniques available, and we are happy to help you understand and minimize the tax consequences of your estate plan.
As always, we recommend working with a qualified tax advisor before attempting any estate or tax planning strategies. December is our tax planning season, so that our clients can close out 2015 in the best possible tax situation. Please feel free to give us a call; we are happy to help answer your questions.