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Income Tax > Tax > Tax Planning Tips Tax Planning Tips Year-End Tax Planning Tips, By Roy Lewis (TMF Taxes)
There is very little you can do after December 31st to reduce your taxes for the current year. So, take stock of your tax issues before the end of the year to see what you can do about them... how you can pay Uncle Sammy only your fair share... and not a penny more.
Contributions to your favorite charity: If you have appreciated stock that you've held for more than one year, you might want to keep the cash in your pocket and donate the stock. You'll avoid paying tax on the appreciation, but will still be able to deduct the full value of the stock. You win, your charity wins, and the only loser is Uncle Sammy.
If you still love the stock and want to maintain a position in the shares after your charitable contribution, you can simply buy new shares in the company. Your charity will be able to assist you with this transaction, and it can really be a great deal for all involved.
Use your credit card: What was that? I thought the Fool was all about getting out of debt? Well, you're absolutely correct. We're not talking about running up your credit card unnecessarily, but if you have year-end deductible expenses (such as business expenses, medical expenses, miscellaneous itemized deductions, etc.), you can use your credit card to make the purchase this year, take the deduction this year, and pay your credit card bill next year.
You see, when you pay with a credit card, the IRS considers the expense deductible in the year that the charge is incurred, not necessarily when you pay the credit card charge.
In fact, going back to the first tip, you can even find charitable organizations that accept credit cards for charitable contributions. If you have the right credit card, you can receive a 30-day "float" that amounts to an interest-free use of the bank's money if you pay it off when the bill comes.
Convert ordinary income into long-term capital gain income: Remember that the long-term capital gains tax rate is a preferred rate. While the tax rate on ordinary income can reach as high as 39.6%, your maximum capital gains rate will only be 20% (and some might pay a capital gains rate as low as 10%). So, when at all possible, try to convert ordinary income and gains into long-term capital gains.
This can be done by simply only selling stock that you've held for more than one year. However, there is another little trick that those of you still investing in mutual funds might find interesting. If you have a mutual fund (that you've held for longer than one year) that you expect will pay out a substantial amount of regular dividends (which are taxed at your normal tax rate), you might want to sell those shares immediately prior to the payout date.
Why? Because the share price of the mutual fund will generally drop by approximately the amount of the dividend. So, if you sell the fund before the payout date, you'll lose the dividend, but you'll get the higher sales price on your shares, which will be treated as long-term capital gains to you. Abracadabra! You've just converted ordinary income into long-term capital gain income, and will pay taxes at a lower rate.
We certainly don't advocate doing this on a whim. But, if you have a mutual fund that you were thinking about getting rid of soon anyway, dumping it before the dividend payout date could save you a few (or even several) tax dollars.
Prepay your state and/or local taxes: If you believe that your tax bracket next year will be no higher than this year, and you won't be bothered by any alternative minimum tax issues, consider making those state/local tax payments before the end of this year. After all, you're going to owe the money anyway, right? So, why not make those payments before December 31st and take the federal tax deduction this year?
You might think that this strategy only applies to people who have fourth-quarter estimated tax payments to make in January, but it really doesn't. If you are a W-2 wage earner and expect a state/local tax balance due, even you can use a state/local prepayment voucher and make your tax payment before the end of the year.
Check the status of taxable gains and losses in your portfolio: See if your investment allocations (the balance among stocks, bonds, mutual funds, cash, etc.) are consistent with your original plans. Significant stock market run-ups can substantially increase your intended weighting in stocks, for example. If that meets with your current plans, great! If it doesn't, you might want to review your portfolio, sell some assets, and redeploy the cash elsewhere.
Obviously, for investments in a tax-deferred environment -- such as an IRA, 401(k), SEP-IRA, 403(b), etc. -- you'll realize no tax consequences if you decide to sell certain stocks... regardless of whether you sell at a profit or loss. But, for investments that are not in a tax-deferred account, your decision of what and when to sell could be critical from a tax standpoint.
Review your portfolio to see if you already have realized gains (from stocks you sold at a profit) over the past year. If so, you might want to sell some shares and take some losses to offset those gains.
If you're a mutual fund investor, you'll likely also be receiving capital gains distributions from your various funds at the end of the year, and those capital gain distributions also qualify as gains that you can offset with stock losses.
Remember also that you'll receive a preferred tax rate for your long-term capital gains (gains on shares held for more than one year), but you'll pay taxes at your "ordinary" rate on short-term gains. You really don't want to disturb any of your long-term gains unless you can't help it. To protect the preferred tax rate you'll receive with these gains, be careful when looking at what assets to sell and the losses that you might want to take. It's very possible that short-term losses you realize will impact your long-term gains -- not something that you might really want.
So, while you're going through this exercise, make sure to categorize your gains and losses by short-term and long-term components. Try to take short-term losses only against short-term gains. Whenever possible and prudent, allow your long-term gains to be taxed at the preferred tax rate rather than offseting them with short-term (or even long-term) losses. As a rule of thumb, you want to keep your long-term gains intact and use any losses (either short- or long-term) to offset any short-term gains.
Because of the requirements to segregate your profits and losses by short-term and long-term components on the tax return, this can get very tricky. But, it's certainly something to consider and something that you'll really want to pay maximum attention to when looking at your portfolio and deciding which stocks to sell and which to keep.
Be picky when liquidating stocks, mutual funds, or Drip shares that you have purchased over time: You might find that you want to liquidate an investment that you have purchased and/or accumulated over months (or even years). You might still love the investment, and it might still make sense for you to hold it for the long term... so you simply want to sell a portion of that investment. Since you'll be selling less than your entire position in the investment, you'll generally want to sell the shares that will give you the least tax impact. That would be the shares with the highest basis (or cost for tax purposes).
Generally, those would be the shares that you've held for the shortest period of time. By selling the shares with the highest basis, you'll reduce your exposure to that specific investment, generate cash to be used as you see fit, and minimize your tax liability on the sale.
If you find that the shares you want to sell aren't the first ones you acquired, you'll have to do some fancy footwork to "specify" the shares you want to sell. Remember, when you're dealing with most stock investments, you're stuck with the FIFO (First In-First Out) method of accounting for that investment. But, you can overcome the use of the FIFO requirement if you can actually "specify" the shares that you wish to sell. The tax issues regarding "specifying" shares can be a bit complex, so if you're going to use this gambit, make sure that you understand what must be done.
Catch Up Your 401(k) Contributions: As you know, there are maximum limits to 401(k) contributions each year. Generally, your 401(k) contributions must be made throughout the year, but did you know that some 401(k) plans allow for "catch-up" contributions in December if your contribution level is less than the maximum allowed? Using your December bonus to fund the balance of your 401(k) (when allowed) might be a good way to dodge some current taxes. If your employer matches some of your catch-up contributions, you're in even better shape. Not all 401(k) plans allow for this "catch-up" provision, so check with human resources or your company's benefits administrator.
Tax Credit Planning: Tax credits are much more valuable to you than deductions. Don't overlook any of them. Here are just a few of the most common credits -- the list is not inclusive by any stretch of the imagination:
Child Tax Credit: A tax credit of $500 per qualifying child under the age of 17 is available. The credit is phased out when your modified Adjusted Gross Income (AGI) exceeds $110,000 for married-joint filers, $55,000 for married-separate filers, and $75,000 for all other taxpayers.
The HOPE Credit: This is a credit of up to $1,500 per student for qualified tuition and fees paid by the student, or on behalf of the student.
The Lifetime Learning Credit: This is a credit of up to $1,000. The student is not required to be enrolled on at least a half-time basis (which means that part-timers can qualify). Also, the education does not necessarily have to be for the acquisition of a post-secondary degree or specific business purpose.
Child and Dependent Care Credit: If you pay somebody else to care for your child under age 13 to allow you to work, this credit could be available to you. The credit is on an inverted scale with respect to your AGI, which means the higher your income, the lower your credit.
Adoption Tax Credit: If you have recently adopted a child, you could be eligible for this credit. The total credit can amount to $5,000 per adopted child (or up to $6,000 per "special needs" child).
One simple way to cut your taxes is to defer income. If you're expecting a bonus in December, you may want to ask your employer to give it to you in January.
Or if you have consulting income, you can delay billing until the new year. Less income means less taxes. But, deferred income usually makes sense if you expect to be in the same or lower tax bracket next year.
Additional Links:
Common Tax Mistakes
Overlooked Tax Deductions
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