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End of Year 2014 Tax Planning Issues

Once again, we’re at the 11th hour wondering if Congress will extend more than 50 expired laws offering tax credits and reductions for tax year 2014.

Given that it is so late in the year, any approvals at this point will delay tax filing forms and software such that most Americans should expect slow income tax refunds. A legislative session in December will be the next, and maybe last, chance for Congress to consider the tax breaks.

Pay close attention to news on the tax extenders. Since we have no information today on what may be forthcoming before the end of the year you will have little time to act upon tax strategies for 2014.

What can be done before the end of 2014?

MAXIMIZE DEDUCTIONS: Given that the top marginal rate for the highest earners is 39.6%, it is important to focus on adjusted gross income and identify “above-the-line” deductions.

Contributions to a 401(k) or 403(b) plan will reduce adjusted gross income. Other items in this category are unreimbursed moving expenses, health savings accounts and expenses listed on Schedule C forms for self-employed clients.

  • For 2014, a person can fund up to $17,500 in either a 401(k) or 403(b) plan. If age 50 or older, the limit is $23,000.
  • A SIMPLE can be funded with $12,000, or $14,500 if age 50 or older.
  • A traditional IRA may be tax deductible—and can be funded with $5,500. If age 50 or older, the limit increases to $6,500.
  • Spousal IRA: You can also fund an IRA for a spouse—even if they didn’t work.
  • A ROTH IRA has the same contribution limits as a traditional IRA.
  • BACK DOOR TO A ROTH IRA: if you make too much to contribute directly to a ROTH—you can make a non-deductible contribution to a traditional IRA and then immediately convert that to a ROTH IRA.
  • A Health Savings Account has a family limit of $6,550 and an individual limit of $3,300—both are increased $1,000 if age 55 (NOT age 50) or older.
  • The Flexible-Spending Account annual contribution is limited to $2,500—regardless of age.

The benefits associated with 401(k), 403(b) and IRA’s continue to provide the following benefits:

  1. Income tax deductions
  2. Tax deferred growth of assets in the plan
  3. The ability to leave assets to heirs in a tax deferred manner
  4. Creditor protection

EVALUATE ROTH CONVERSIONS: ROTH IRA conversions may not be as attractive as they once were due to higher income tax associated with the conversion itself. However, this higher upfront tax hurdle may still be worthwhile to consider.

The longer you have between now and when you might retire and/or withdraw funds, the more attractive a ROTH conversion may be. If you have at least ten to twenty years to leave the funds invested in the ROTH, the better the odds are that the move will be beneficial.

Additionally, no one said you had to do a ROTH conversion all at once. Many clients will sit down in the fourth quarter of the year when they have a good idea as to their anticipated tax bracket for the year. They will then choose to convert a specific amount, knowing they can pay the associated income tax out of their pocket.

Or, they will determine how much room they have left in a given tax bracket and convert enough to use up the remainder of those lower rates. Another strategy may be to convert in a year in which you have very low income (maybe due to a new venture startup) or you lost your job.

Furthermore, the IRS allows taxpayers with a Roth conversion to recharacterize the conversion within 18 months—in effect giving you the benefit of hindsight. If you do a conversion and it goes down, you can always change your mind and recharacterize regardless of tax rates.

Finally, a ROTH IRA gives retirees “tax flexibility” once they need funds. Withdrawing funds from a 401(k) might work well in a year when your income is low and having assets in a ROTH may be quite beneficial if you need cash—but are already in a high tax bracket.

Additional Deduction Issues To Consider:

EVALUATE DEDUCTION PHASEOUTS: Many itemized deductions have been phased out for higher income earners. The phase-out limits taxpayers' ability to fully deduct things like charitable contributions, starting at $300,000 adjusted gross income for married filing jointly and $250,000 for single filers. Both thresholds are lower than where the highest tax bracket starts.

BUNCH ITEMIZED DEDUCTIONS: Many expenses can be deducted only above a certain percentage of adjusted gross income. Bunching itemized deductible expenses into one year can help exceed AGI floors.

Consider scheduling your costly non-urgent medical procedures in one year to exceed the 10% AGI floor for medical expenses (7.5% for taxpayers age 65 and older). If possible, load up on controllable expenses in one year and then delay as many expenses as possible the next year. In the third year, attempt to bunch up your deductions again. As with many things that sound good in theory—you may not be able to wait if you need medical attention. Your health is more important than a tax deduction.

To exceed the 2% AGI floor for miscellaneous expenses, bunch professional fees like legal advice and tax planning, as well as unreimbursed business expenses such as travel and vehicle costs.

NEW HOME OFFICE DEDUCTION SAFE HARBOR: You can deduct some of the cost of your home if you use your home as your primary place of business, use it to meet clients and customers in the normal course of business, or your office is a separate structure not attached to your home. The amount of this deduction has long been a source of controversy, but the IRS has a new safe harbor that allows you to deduct up to $5 per square foot of home office space—limited to 300 square feet or$1,500 per year.

ALTERNATIVE MINIMUM TAX: The AMT was designed to keep the wealthy from taking too many tax breaks, but now it falls most heavily on the affluent. It eliminates certain benefits, such as the personal exemption and state and local tax deductions, and limits the value of others.

Although capital gains aren't penalized by the AMT, having a high proportion of long-term capital gains to ordinary income can trigger the levy.

A taxpayer who plans to make charitable donations over several years might be able to lower the capital gain and avoid the AMT by making several years' worth of gifts of appreciated stock to favorite charities all at once.

If the AMT is unavoidable, it might make sense to postpone donations to a future year, when they will be more valuable—and accelerate state tax payments into this year to reduce the likelihood of triggering the AMT again next year.

NET INVESTMENT INCOME TAX: This flat levy of 3.8% applies on the amount of net investment income, including dividends, capital gains and interest that a taxpayer has above $250,000 of adjusted gross income, or AGI, for most married couples and $200,000 for most singles. It isn't adjusted for inflation.

While the 3.8% surtax typically doesn't apply to quarterly payouts made to investors by master limited partnerships such as the one recently announced by Kinder Morgan, it will apply to the income generated by reorganizations such as the one Kinder Morgan is completing.

The best way to limit this levy is to keep AGI below the threshold. Itemized deductions such as mortgage interest don't help, but putting income into a tax-deductible retirement plan or deferring income to a future year could. Making a charitable gift of appreciated inversion stock (actually, any appreciated stock) could also reduce the portion of a long-term gain that raises AGI.

PERSONAL EXEMPTION PHASEOUT: The PEP restriction takes effect at $305,050 of AGI for most married couples and $254,200 for most single filers.

PEP rescinds the value of the $3,950 deduction that is allowed for each family member as AGI increases. It disappears entirely at $427,550 of AGI for most couples and $376,700 for most singles—if the taxpayer isn't subject to the AMT, which disallows the deduction entirely. As such, the PEP is more likely to affect people with higher incomes from low-tax states who aren't caught by the AMT.

The best way to avoid PEP, is to keep AGI below the threshold, using the same methods that can work for the net investment income tax.

PEASE LIMITATION: This provision takes effect at the same threshold as PEP. It reduces itemized deductions, such as those for mortgage interest, state and local taxes, and charitable donations, by 3% of the amount over the threshold—although it can never take away more than 80% of a taxpayer's itemized deductions. However, itemized deductions for medical expenses, investment interest expense, casualty/theft losses or gambling losses are not reduced by this limitation.

The Pease limitation can add up to 1.2 percentage points to a taxpayer's overall tax rate. Taxpayers who can't keep their AGI below the threshold should review the timing of deductions that are flexible, such as for charitable donations.

KNOW WHERE TO OWN SPECIFIC ASSETS: Due to increases in taxes, certain types of investments may make more sense to hold in one type of account verses another.

If you own assets that spin off lots of income that is taxable at your marginal bracket (real estate, bonds, partnerships)—it might be best to own those in a retirement (tax-deferred) account.

Conversely, assets that produce lower taxation (like qualified dividends) or no taxation (just lots of deferred growth) may be better held in a taxable investment account. Remember, what matters most is not what you make—but rather what you make and keep net of taxes.

MEDICARE SURTAX:;The Medicare surtax is an additional 3.8% tax on unearned net income for individuals making more than $200,000 or married couples with joint incomes of more than $250,000. In its simplest form, unearned income will be capital gains, rental income, property sales, etc.—any income that does not produce a W-2.

If you are above the income thresholds, minimize unearned income to the extent possible. Also, consider when to realize gains, focusing on years when earned income falls below the threshold (the year of a job loss or in retirement).

PAYROLL WITHHOLDING: High income earners also incur an additional 0.9% Medicare payroll tax, taking the Medicare tax to 2.35%. This tax is applied to incomes of more than $200,000 for single filers and more than $250,000 for married couples filing jointly.

Some high earners may be taxed even if they don't reach the cutoff. Payroll departments have been advised to add the additional 0.9% for married employees making more than $200,000 because there's no way for employers to know how much the spouse makes -even if, ultimately, that employee is not subject to the tax. Given this, review withholdings on your W-4 forms to determine if they fall in the gap.

BRIDGE TAX SHORTFALL WITH INCREASED WITHHOLDING: Double check withholding and estimated tax payments owed during 2014 while you have time to bridge the gap. If at risk for an underpayment penalty, increase withholding on salary or bonuses now.

A larger estimated tax payment may leave you exposed to penalties for previous quarters. However withholding is considered to have been paid evenly throughout the year.

ESTATE & GIFT PLANNING: In 2014 the estate, gift and generation skipping taxes all have a $5.34 million exemption per person. Furthermore, they are now indexed to inflation meaning that they will climb over time.

A husband and wife, with properly drafted bypass trusts can leave their heirs $10.68 million in 2014 before estate taxes start taking a chunk. If you add in a generation skipping transfer trust, you can leave multiple generations of heirs $10.68 million.

These trusts are exempt from estate taxes, creditors, and ex-spouses. Even if you are well below the current $5.34 million limits, these trusts are very effective vehicles by which to manage assets.

Additionally, there are other asset transfer strategies that can be utilized.

  • In addition to the $5.34 million, an individual can also gift $14,000 in any one year without any estate or gift taxes. Spread across many children or grandchildren, this can pass a pretty large amount of value each year.
  • Consider funding education for kids or grandkids. Transfers can be made to either Education Savings Accounts or 529 plans. Additionally, an individual can make gifts for educational needs. These transfers can also be in addition to the stated annual or lifetime limits on gifting.
  • Unlimited gifts can be made for healthcare. However, the gift must be given directly to the care provider—not your heir.
  • Push income to lower tax bracket family members. If you have children who are in a lower tax bracket, it may make sense to gift certain assets to them. They can sell the assets and pay taxes at their lower rate. Many lower income earnings pay zero capital gains tax. As such, there can be real savings by implementing this strategy.

CHARITABLE GIVING: If thinking about year-end contributions to charitable causes, consider giving appreciated stock held for more than 12 months instead of cash. You receive a deduction for the full value of the contribution and don’t have to pay tax on the appreciation. This ultimately puts more value in the hands of the charity.

Additionally, charitably inclined people can front-load charitable donations all at once without deciding where to direct those gifts.

Contributing to a donor-advised fund can be written off this year, even if donations are not made until subsequent years.

Depending on your income, those gifts may be subject to the new phase-out. That doesn't mean they're not worth doing, though. If the gift is large relative to your income, the deduction might be worth more in the new higher tax bracket than previously.

Business owners should evaluate these issues:

SCRUTINIZE HEALTH REIMBURSEMENT ARRANGEMENTS: In the past, many smaller businesses chose to reimburse workers who buy individual health-insurance policies rather than purchase group coverage. Under prior rules, employees often didn’t have to pay tax on the money.

Now, HRAs (different than an HSA—Health Savings Account) violate the rules of the Affordable Care Act. Businesses that have them could be fined up to $100 per employee per day ($36,500 penalty for each worker a year). This may be true even if your business has under 50 employees.

There are also important exceptions to the new penalty. It doesn’t apply to HRAs that have only one participant who is an employee. This means that many very small firms can continue to use HRAs.

Additionally, if the business offers an ACA-approved health plan AND an HRA, and employees in both plans, the firm won’t owe a penalty.

ACT QUICKLY ON DEPRECIATION: The tax code generally requires businesses investing in equipment and property to spread depreciation deductions for these costs over several years.

In the past, Congress has granted more generous write-offs for these business investments. The enhanced Section 179 depreciation, for example, allowed an immediate deduction of up to $500,000 for capital investments rather than just $25,000.

So-called bonus depreciation, another enhancement Congress passed, provided additional incentives.

Both benefits expired at the beginning of 2014, as did other provisions. Such lapses have happened before, and lawmakers have retroactively reinstated the benefits for two years. But the outcome this year is uncertain following the recent election.

One possibility is that Congress will reinstate the provisions for only one year—2014--and then have it expire again, as of Jan. 1, 2015.

Business owners could have just a few weeks to make investments under the more generous rules.

EVALUATE THE “REPAIR REGS”: The Internal Revenue Service issued new regulations for Section 263 of the tax code involving depreciation.

This guidance details which expenditures qualify for an immediate deduction, such as the repair of a broken window, and which must be written off over several years.

The new repair regulation rules take effect in 2014. They apply to all businesses that are buying, building or bettering business property and equipment.

For more info see your CPA or:

http://www.cch.com/wbot2014/WBOT2014DigitalKit.pdf

http://www.grantthornton.com/issues/library/articles/tax/2014/Year-end-tax-guide/Introduction.aspx

http://www.bna.com/quick-tax-reference-app/

Sincerely,

Dave

Dave Sather, President

CERTIFIED FINANCIAL PLANNER™

Warren

Warren Udd

CERTIFIED FINANCIAL PLANNER™