11 Apr Timing income and deductions to your tax advantage
Usually it makes tax sense to accelerate as many deductible expenses into the current tax year as you can and defer income to the next year to the extent possible. This can reduce current-year tax, deferring tax to future years. In some cases it may even permanently lock in tax savings. But there are also situations where this strategy could be costly. To time income and deductions to your tax advantage, you must consider the potential impact on your particular situation.
The alternative minimum tax
When timing income and deductions, first consider the AMT – a separate tax system that limits some deductions and disallows others, such as:
State and local income tax deductions,
Property tax deductions, and
Miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor, including investment advisory fees and unreimbursed employee business expenses.
It also treats certain income items differently, such as incentive stock option exercises. You must pay the AMT if your AMT liability exceeds your regular tax liability. You may be able to time income and deductions to avoid the AMT, or at least reduce its impact.
Consider both deductions and exclusions:
Property tax deduction. Before paying your bill early to accelerate this itemized deduction into 2015, review your AMT situation. If you’re subject to the AMT this year, you’ll lose the benefit of the deduction for the prepayment.
Mortgage interest deduction. You generally can deduct interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.
Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn’t deductible and rates may be higher. Warning: If home equity debt isn’t used for home improvements, the interest isn’t deductible for AMT purposes.
Home office deduction. If your use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses, and the depreciation allocable to the space. Or you may be able to use the simplified option for claiming the deduction. (Contact your tax advisor for details.) For employees, home office expenses are a miscellaneous itemized deduction, and you’ll enjoy a tax benefit only if these expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI.
Rental income exclusion. If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won ’t be deductible.
Home sale gain exclusion. When you sell your principal residence, you can exclude up to $250,000 ($500,000 for married couples filing jointly) of gain if you meet certain tests. Warning: Gain that’s allocable to a period of “non-qualified” use generally isn’t excludable.
Home sale loss deduction. Losses on the sale of a principal residence aren’t deductible. But if part of your home is rented out or used exclusively for your business, the loss attributable to that portion may be deductible.
Debt forgiveness exclusion. This break for homeowners who received debt forgiveness in a foreclosure, short sale or mortgage workout for a principal residence expired Dec. 31, 2014, but Congress might extend it. Check with your tax advisor for the latest information.
Donations to qualified charities are generally fully deductible for both regular tax and AMT purposes, and they may be the easiest deductible expense to time to your tax advantage. For large donations, discuss with your tax advisor which assets to give and the best ways to give them. For example:
Appreciated stock. Appreciated publicly traded stock you’ve held more than one year can make one of the best charitable gifts. Why? Because you can deduct the current fair market value and avoid the capital gains tax you’d pay if you sold the property. Warning: Donations of such property are subject to tighter deduction limits. Excess contributions can be carried forward for up to five years.
CRTs. For a given term, a charitable remainder trust pays an amount to you annually (some of which generally is taxable). At the term’s end, the CRT’s remaining assets pass to one or more charities. When you fund the CRT, you receive an income tax deduction. If you contribute appreciated assets, you also can minimize and defer capital gains tax. You can name someone other than yourself as income beneficiary or fund the CRT at your death, but the tax consequences will be different.
Sales tax deduction
The break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes was available for 2014 but, as of this writing, hasn’t been extended for 2015. (Check with your tax advisor for the latest information.)
Limit on itemized deductions
If your AGI exceeds the applicable threshold, certain deductions are reduced by 3% of the AGI amount that exceeds the threshold (not to exceed 80% of otherwise allowable deductions). For 2015, the thresholds were $258,250 (single), $284,050 (head of household), $309,900 (married filing jointly) and $ 154,950 (married filing separately) If your AGI is close to the threshold, AG I-reduction strategies (such as making retirement plan and HSA contributions) may allow you to stay under it. If that’s not possible, consider the reduced tax benefit of the affected deductions before implementing strategies to accelerate or defer deductible expenses. The limitation doesn’t apply, however, to deductions for medical expenses, investment interest, or casualty, theft or wagering losses.
Tax-advantaged saving for health care
Some of your health care expenses may be deductible (see Case Study I), but you also may be able to save taxes by contributing to one of the following accounts:
HSA. If you’re covered by qualified high-deductible health insurance, you can contribute pretax income to an employer-sponsored Health Savings Account – or make deductible contributions to an HSA you set up yourself – up to $3,350 for self-only coverage and $6,650 for family coverage for 2015. Plus, if you’re age 55 or older, you may contribute an additional $1,000. HSAs can bear interest or be invested, growing tax-deferred similar to an IRA Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit – not to exceed $2,550 in 2015. The plan pays or reimburses you for qualified medical expenses What you don’t use by the plan year’s end, you generally lose – though your plan might allow you to roll over up to $500 to the next year. Or it might give you a 2Y2-month grace period to incur expenses to use up the previous year’s contribution. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Additional 0. 9% Medicare tax
If you’ re thinking about timing income, consider the additional 0.9% Medicare tax. This tax applies to FICA wages and net self-employment income exceeding $200,000 per year ($250,000 for joint filers and $125,000 for separate filers). You may be able to implement income timing strategies to avoid or minimize the tax, such as deferring or accelerating a bonus or a stock option exercise.
Employers must withhold the additional tax beginning in the pay period when wages exceed $200,000 for the calendar year – without regard to an employee’s filing status or income from other sources. So your employer might withhold the tax even if you aren’t liable for it – or it might not withhold the tax even though you are liable for it.
If you don’t owe the tax but your employer is withholding it, you can claim a credit on your 2015 income tax return. If you do owe the tax but your employer isn’t with holding it, consider filing a W-4 form to request additional income tax withholding, which can be used to cover the shortfall and avoid interest and penalties.