Midyear Tax Moves to Save on Your 2013 Return

Shelving your taxes until next spring could cost you money, especially this year. The tax law passed earlier in the year as part of the deal to avert the fiscal cliff imposes a new 39.6% marginal rate on taxable income over $400,000 ($450,000 for married couples). Taxpayers in this bracket will pay 23.8% on dividends and long-term capital gains — not the 15% rate that applies to most investors.

Other changes reach down the income chain. Taxpayers with adjusted gross income of $250,000 or more ($300,000 for married couples) will effectively pay higher marginal rates because Congress resurrected phaseouts of itemized deductions and personal exemptions. And taxpayers with modified adjusted gross income of $200,000 or more ($250,000 for married couples) face a new 3.8% surtax on net investment income.

That tax could hit people like Mike and LaVerna Leach of Virginia Beach, Va. Mike is a retired Marine helicopter pilot who receives about half of his retirement income from his investment portfolio; LaVerna is a watercolor artist who owns her own business. Mike says they sold some property last year to beat the tax increase and will probably check in with their tax adviser, Cynthia Jeanguenat, before year-end to see whether they need to do anything else.

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There are ways to mitigate these tax hikes, especially if you act now.

Make your investment portfolio more tax-efficient. Mike says he doesn’t expect to make major changes to his portfolio because he doesn’t want to “let the tax tail wag the investment dog.” That’s good advice. But it’s important to pay close attention to the types of investments in taxable accounts and the types in tax-deferred accounts, such as your 401(k) plan. Savvy investors often keep investments that generate a lot of taxes, such as taxable bonds, real estate investment trusts and high-turnover mutual funds, in their tax-deferred accounts; they keep index funds and other tax-efficient investments in their taxable accounts. Higher tax rates make that even more important.

If you need income from your taxable account, consider municipal bonds, suggests Greg Womack, a certified financial planner with Womack Investment Advisers, in Edmond, Okla. Interest on muni bonds is exempt from federal taxes and, in most cases, from income taxes of the state in which the bonds were issued. In addition, munis are exempt from the 3.8% investment surtax, which makes them even more attractive, Womack says. Keep in mind, though, that in­terest from some types of muni bonds is subject to the alternative minimum tax.

It is also a good time to review your portfolio for potential losses you could use to offset capital gains. If you were planning to sell appreciated investments this year, ditching some of your losers will help you lower or eliminate taxes on the gains.

Take advantage of tax-deferred accounts. The new tax rates and phaseouts are tied either to adjusted gross income or to taxable income. (AGI is the amount before subtracting the value of exemptions and deductions; taxable income is the amount that’s actually taxed.) So it’s more important than ever to look for ways to hold down both figures. One of the most effective strategies is to max out your contributions to tax-deferred retirement plans.

In 2013, employees younger than age 50 may contribute up to $17,500 to a 401(k) plan; workers 50 and older may contribute an additional $5,500.

Contributing to a health savings account will reduce both AGI and taxable income; the money grows tax-deferred, and it can be withdrawn tax-free for qualified medical expenses. To be eligible for an HSA, you must be covered by a high-deductible health insurance policy, either through your employer or on your own. In 2013, a high-deductible plan is one with a deductible of at least $1,250 for individual coverage or $2,500 for a family.

You may contribute $3,250 to an HSA this year for individual coverage or $6,450 for a family; if you’re 55 or older, you can kick in an additional $1,000. That’s considerably more than the $2,500 maximum you can put in a medical flexible spending account, another tax-favored way to pay health care expenses. And unlike flex plans, which come with a use-it-or-lose-it proviso, HSAs let you roll over unused funds for future years.

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Give appreciated assets to your adult children. Are your kids struggling to pay off student loans? If you’re willing and able to help, give them appreciated stocks or mutual funds instead of cash. When they sell, they may pay lower taxes on the gain than you would owe. The long-term capital gains rate for taxpayers in the 10% or 15% tax bracket (with taxable income up to $36,250 for singles or $72,500 for married couples) is 0%.

Giving appreciated securities to family members “is a way to diversify across tax brackets,” says Greg Rosica, a tax partner with Ernst & Young. You can give securities valued at $14,000 per person in 2013 without filing a gift tax return; if you’re married, you and your spouse can give $28,000 to any number of people.

To qualify for the special rate for long-term gains, the securities must have been held for more than 12 months. For gift securities, however, the holding period includes the time that you owned the assets, so your children don’t have to wait a year to sell their stocks or funds, Rosica says. But if your children are younger than age 19 or full-time students younger than age 24, note that they will be subject to the “kiddie tax,” which means investment income exceeding $2,000 will be taxed at your tax rate.

Give appreciated securities to charity. Donating appreciated stocks or mutual funds to charity has always been a smart strategy for high-income taxpayers, and it makes even more sense now. By giving appreciated assets, you avoid taxes on the gains and still get to deduct the full value of the securities. Now that the top long-term capital gains rate is 23.8%, “pushing the gain off to charity is even more important,” says Tim Steffen, director of financial planning for Robert W. Baird. The charity doesn’t have to pay taxes on the profits when it sells the securities.

Donor-advised funds are another avenue: You get the write-off in the year you donate, but you can decide later which charities will benefit from your philanthropy.

Make charitable gifts from your IRA. Congress extended through 2013 a provision that allows seniors age 70½ and older to transfer up to $100,000 from traditional IRAs directly to charity. Such contributions can count toward required minimum distributions for the year.

Your contribution won’t be deductible, but it will lower your AGI. As in the past, that could qualify you for tax breaks and reduce or even eliminate taxes on Social Security benefits; now, it could also help you avoid new tax hits, such as the phaseout of other deductions, Rosica says.

Check your withholding. Starting this year, taxpayers will owe an additional 0.9% Medicare tax on earned income of more than $200,000 for single filers or $250,000 for married couples who file jointly. For example, if you’re single and earn $225,000 this year, your employer will be required to withhold 1.45% on the first $200,000 and 2.35% on the next $25,000.

Suppose, though, that you’re married and you each earn $150,000. Your employers won’t withhold the extra 0.9% payroll tax because your individual earnings are under the threshold. But you’ll still owe the additional levy on $50,000 of your joint income, notes Heidi Tribunella, associate professor of accounting at the Simon School of Business at the University of Rochester.

That alone won’t trigger an underpayment penalty. But you could run into problems if you also have investment income that’s subject to the 3.8% surtax, says Stephen DeFilippis, an enrolled agent in Wheaton, Ill. To avoid penalties, you may need to adjust your withholding. If you’re self-employed, you may need to adjust your quarterly estimated tax payments to cover the new tax.

Plan ahead for medical deductions. Deducting medical expenses will be more difficult this year. To qualify for a write-off, your unreimbursed medical expenses must exceed 10% of your adjusted gross income, up from 7.5% in the past. For taxpayers 65 and older, the threshold remains at 7.5% through 2016. And remember, you can deduct only expenses that exceed the 7.5% or 10% threshold.

The change will put the deduction out of reach for even more taxpayers. But you may have a better shot if you schedule elective procedures, such as braces for the kids, in the same year that you have other high medical costs, Tribunella says. Some married couples can boost their chances of claiming the deduction by filing separate tax returns, particularly if one spouse has a lower income and high medical expenses. Be aware, though, that you give up other money-saving tax breaks when you file separately.

Make sure you keep track of all qualifying expenses. In addition to items such as hearing aids and eyeglasses, you can deduct a portion of premiums for long-term-care insurance. Also deductible: travel costs for medical services.

Reconsider the home-office deduction. New IRS rules make it easier for self-employed taxpayers to deduct the cost of their home offices. In the past, claiming this money-saving tax break required filling out a 43-line tax form itemizing expenses, such as the percentage of utilities consumed by the home office. The hassle, plus the fact that this write-off was widely viewed as an invitation to an IRS audit, apparently persuaded some self-employed workers to skip a break they deserved.

The streamlined rule allows you to deduct $5 per square foot, up to a maximum of 300 square feet, or $1,500. The requirements for deducting a home office haven’t changed: It must be used regularly and exclusively for your business. And you should still keep a record of the costs of your home office because, in some instances, the itemizing method could deliver a bigger tax break.

Finally, as you plan your tax strategies for 2013, keep an eye on Washington. President Obama has proposed capping itemized deductions at their value for taxpayers in the 28% bracket. That means the tax-saving power of itemized deductions would be reduced for taxpayers in the 33%, 35% and 39.6% brackets. The President’s 2014 budget also proposed capping the amount that taxpayers can contribute to tax-favored retirement savings accounts when they reach $3.4 million (see Obama Proposes Putting a Lid on Retirement Savings Accounts).

Neither plan will be enacted this year. But as lawmakers continue to look for ways to lower the deficit, proposals to limit deductions “have got a lot of people concerned,” says Steffen, of Robert W. Baird. If it appears that Congress will cap deductions next year, he says, high-income taxpayers may want to consider accelerating some of their deductible expenses, such as charitable contributions, so that they occur in 2013.