With your 2013 tax return a not-so-distant memory, you probably aren’t in the mood to think about your 2014 return. But if you want to avoid a tax hangover next spring, make a midyear pledge to lower next year’s bill.
Midyear planning is particularly important for high-income taxpayers and anyone with substantial investment income. A tax law that took effect last year imposes a new 39.6% marginal rate on taxable income over $400,000 ($450,000 for married couples). Phaseouts for itemized deductions and personal exemptions included in last year’s law have increased effective marginal rates for taxpayers with adjusted gross income of $250,000 or more ($300,000 for married couples). And under a provision in the Affordable Care Act, taxpayers with modified AGI of $200,000 or more ($250,000 for married couples) now face a 3.8% surtax on investment income.
Protect your portfolio. With the surtax looming, it’s more important than ever to keep an eye toward the IRS when managing your investments. It’s a good idea to keep investments that generate a lot of taxes, such as taxable bonds and high-turnover mutual funds, in your 401(k) or other tax-deferred accounts, or in a tax-free Roth. Use your taxable accounts for index funds and other tax-efficient investments. If you need income from your taxable accounts, consider investing in municipal bonds, says Tim Steffen, director of financial planning for Robert W. Baird & Co. Interest is generally free from federal income tax, and often state and local taxes, too. If you’re in the 28% tax bracket and invest in a muni bond that yields 2.3%, your taxable-equivalent yield would be 3.2%.
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Do you need to sell taxable investments for income? Take advantage of recent stock market unrest and sell some of your losers. Not only can you capture cash tax-free, but you can use the loss to protect other gains from taxes. If you think a stock is poised to rebound, you can repurchase it, but be mindful of the wash-sale rule. If you sell a stock, bond or mutual fund and buy back the identical security within 30 days, you can’t claim the loss. You can avoid this problem by investing in similar, but not identical, securities.
Beef up tax-deferred accounts. Maxing out on contributions to your tax-deferred retirement plans is one of the most effective ways to lower both your taxable income and your AGI (to minimize the effects of phaseouts of deductions and personal exemptions). In 2014, employees younger than age 50 can contribute up to $17,500 to a 401(k); those 50 and over can sock away up to $23,000. If you or your spouse has a side gig, you can shelter even more income with a SEP-IRA. In 2014, you can contribute up to 20% of your net self-employment income (business income minus half of your self-employment tax), up to a maximum of $52,000.
Postpone IRA withdrawals. Congress is expected to resurrect a popular provision that allows seniors age 70½ and older to transfer up to $100,000 from their traditional IRAs directly to charity. The contributions may count toward fulfilling required minimum distributions for the year.
Lawmakers probably won’t act on the provision until after the November elections, so Steffen says seniors who want to make a charitable rollover should postpone taking withdrawals from their IRAs for as long as possible. When the rollover provision expired at the end of 2011, Congress waited until New Year’s Day 2013 to revive it, making it retroactive for 2012. The IRS allowed seniors who withdrew money from their IRAs in December 2012 to give the money to charity in January 2013 and have it count as a tax-free transfer. Seniors who took withdrawals before that, though, had to pay taxes on the money.
A direct transfer from an IRA to charity isn’t deductible, but because the withdrawal won’t show up in your adjusted gross income, the move could qualify you for tax breaks and reduce or eliminate taxes on your Social Security benefits. It could also help you dodge new tax hits, such as the phaseout of other deductions.
Prepare for Obamacare. Under the Affordable Care Act, taxpayers who don’t have health insurance in 2014 will have to pay a penalty, and the IRS is responsible for collecting it. If you purchase health insurance through one of the exchanges and receive a subsidy to lower the cost, you could end up with an unexpected tax bill. Come return time next year, taxpayers will have to reconcile their projections with their actual 2014 income, says Mark Ciaramitaro, vice-president of health enrollment services for H&R Block.
That’s when things could get sticky. Taxpayers who overestimated their 2014 income will receive the remainder of their subsidy in the form of a tax refund. But if you earn more than you projected, your refund will be reduced by the amount of the overpayment of your subsidy, Ciaramitaro says. If your income turns out to exceed the cutoff for subsidies, you’ll have to repay the entire amount.
This could be a problem if you’re self-employed. If your business is going gangbusters, look for ways to lower your income, such as increasing contributions to your 401(k) plan or IRA. If possible, avoid taking a taxable distribution from a traditional IRA.
Or you can revise your projected income with the federal or state health care exchange from which you bought your policy. The exchange will increase your monthly premiums to reflect the reduced subsidy.
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