Tax planning is an activity that is best pursued year-round. You can use the following list of tax strategies to help you better carry out your planning on a regular and ongoing basis.
Before-Tax IRA Earnings. Contributing before-tax earnings to an IRA account can make a big difference in your retirement savings, since you can defer paying taxes on whatever your investment earns in an IRA. If your investment pays dividends or has capital gains distributions (such as some mutual funds), you avoid paying taxes on these gains. If you expect your tax rate to drop after your retirement, because you have less income, your savings could amount to an even bigger nest egg. For 2014, you may contribute up to $5,500 of your earnings or up to $6,500 if you are age 50 or more. The limit can be indexed (increased with the rate of inflation) in $500 increments starting in later years. If you earn an income from wages or your own business and you’re under the age of 70-1/2, you can open a traditional IRA. For lower income earners, the contribution itself may be deductible. Contribution can be made for the prior tax year up until April 15.
But you may find that other tax-deferred retirement investments are a better deal. Some other options are described below. The IRS publication (590) is available at this link.
SEP IRAs. A “Simplified Employee Pension IRA” is a tax-deferred retirement plan provided by sole proprietors or small businesses, most of which don’t have any other retirement plan. Contributions are made by the employer, and unlike the traditional IRA, can be as high as 25% of each employee’s total compensation, with a maximum contribution of $52,000 in 2014(subject to adjustments for inflation). For a sole proprietor, this can be a significant opportunity to save for retirement on a tax-deferred basis. Employees with SEP-IRAs can also invest in regular IRAs.
Aside from the higher contribution limits, SEP-IRAs are subject to the same rules as a regular IRA. Contributions and the investment earnings can grow tax-deferred until withdrawal (assumed to be retirement), at which time they are taxed as ordinary income.
401 (k)s. A 401(k) plan is an employer sponsored plan that lets you contribute a percentage of your salary to a trust account, putting off any taxes on that money until you withdraw it, usually after age 59-1/2. Companies often match some of your contribution, and any taxes on those matching funds are also deferred, as long as the total going into the account does not exceed the limit for the year. As with IRAs, the earnings in the account grow, tax free, until you withdraw the money, and if you expect your tax rate to drop after your retirement, because you have less income, your savings could amount to an even bigger nest egg.
Through automatic payroll deductions, you can usually contribute between 1% and 25% of your eligible pay on a pre-tax basis, up to the annual IRS dollar limit of $16,500 ($22,000 if you’re age 50 or older). In this case, you are making salary-reduction contributions that reduce your take home pay, but also your income tax basis, a significant tax break vs. “after tax” investments.
There are typically IRS penalties associated with early withdrawal of 401(k) assets, but many plans allow you to borrow against your assets. If you leave an employer, you may be able to keep your plan with the employer, or “roll it over” into an IRA, avoiding these penalties. Consult your plan administrator for details.
20% Withholding on Distributions from Qualified Employer Plans. Income tax withholding may apply to distributions made from qualified employer plans. Withholding at a rate of 20% is required on a distribution, unless it is transferred directly from your employer to an IRA trustee or another employer plan. The withholding rules do not apply to distributions from IRAs or Simplified Employee Pensions, also known as SEPs. However, if you wish to roll over a qualified plan distribution to an IRA, be sure to transfer the amount directly from your employer to an IRA trustee or another employer plan. Otherwise, 20% of the distribution will be withheld while 100% of the distribution must be rolled over within 60 days. If you don’t have the money to cover the 20% shortage, income taxes and possibly a 10% penalty will be due on the amount not rolled over.
ROTH IRA. A ROTH IRA is in some respects the opposite of a traditional IRA: You pay taxes on the money that you put into the account up front, but once you reach age 59-1/2, (after having had the Roth IRA for five years), you can withdraw the money, including interest earned, tax free.For some people, paying taxes now to enjoy tax-free income later may actually make more financial sense in the long term. For one thing, the Roth IRA lets you shelter more money for retirement. The annual contribution limit is the same for both a traditional IRA and a Roth IRA, and any contribution to one reduces the allowable contribution to the other, but because your Roth contribution is made with after-tax income, your annual contributions can compound substantially over the years without incurring any future tax liability. Whether the Roth IRA is a better option really depends on what you think your future tax rate will be. If you plan to maintain a high levels of income even in retirement, it may make more sense to pay taxes on your contribution today, while you’re still employed, so you can enjoy the tax-free withdrawals later.
To contribute to a Roth IRA, you must have compensation (e.g., wages, salary, tips, professional fees, bonuses). Your modified adjusted gross income must be less than:
$191,000-Married Filing Jointly
$129,000-Single, Head of Household, or Married Filing Separately (and you did not live with your spouse during the year).
There is a partial phase out for married filing jointly beginning at $181,000 and for others beginning at $114,000. These phaseout limits are for the year 2014 and are indexed for inflation in later years. Although anyone may now convert to a Roth IRA regardless of their income, the income limits for contributing directly to a Roth still remain.
IRA Withdrawals to Pay Medical Expenses and Medical Insurance. You generally pay a 10% penalty if you withdraw funds from your IRA before a certain age. However, you may not have to pay the penalty if the withdrawals are used to pay unreimbursed medical expenses that are more than 7 1/2% of your adjusted gross income. If you lose your job, you may be able to withdraw funds from your IRA without paying the 10% penalty if the withdrawals are not more than the amount paid for medical insurance for you and your family.
Health Savings Accounts (HSA) and Medical Savings Accounts (MSA). For small businesses and the self employed, an MSA is a tax-exempt account established for the purpose of paying medical expenses in conjunction with a high-deductible health plan. Like an IRA, an MSA is established for the benefit of the individual, and is “portable”. Thus, if the individual is an employee who later changes employers or leaves the work force, the MSA does not stay behind with the former employer, but stays with the individual.
* A small business for this purpose is defined as an employer who employed an average of 50 or fewer employees during either of the two preceding calendar years.
* A “high-deductible health plan” is a health plan that:
(1) has a minimum annual deductible of $,2,000 (maximum of $3,000) (self-only) coverage; or
(2) has a minimum annual deductible of $ 4,050 (maximum $6,050), for family coverage (coverage of more than one individual).
In addition, for 2010, the annual out-of-pocket expenses under the plan cannot exceed $4050 for individual coverage and $7400 for family coverage. Out-of-pocket expenses include deductibles, co-payments and other amounts the participant must pay for covered benefits, but do not include premiums.
HSAs are similar to medical savings accounts (MSAs). However, MSA eligibility has been restricted to employees of small businesses and the self-employed while HSAs are open to everyone with a high deductible health insurance plan. Contributions to the HSA by an employer are not included in the individual’s taxable income. Contributions by an individual are tax deductible. Individuals, their employers, or both can contribute tax-deductible funds each year up to the amount of the policy’s annual deductible, subject to a cap of $3050 for individuals and $5,950 for families. Individuals aged 55-64 can make additional contributions. The interest and investment earnings generated by the account are also not taxable while in the HSA. Amounts distributed are not taxable as long as they are used to pay for qualified medical expenses. Amounts distributed which are not used to pay for qualified medical expenses will be taxable, plus an additional 10% tax will be applied in order to prevent the use of the HSA for nonmedical purposes.
Like MSAs, HSA are portable. In addition, individuals over age 55 can make extra contributions to their accounts and still enjoy the same tax advantages. By 2010, an additional $1,000 can be added to the HSA.
Long-Term Care Insurance Contracts. Under the law, you can exclude from gross income amounts received under a long-term care insurance contract for long-term care services. You can also exclude employer-provided coverage under a long-term care insurance contract. Self-employed taxpayers can take long-term care insurance premiums into account in calculating their health insurance deduction. Unreimbursed long-term care services and long-term care insurance premiums are treated as deductible medical expenses subject to current limitations.
Life Insurance Paid before Death of Insured. Certain payments received under a life insurance contract on behalf of a terminally or chronically ill individual (an accelerated death benefit) can be excluded from your income.
Personal and Dependent Exemptions. There are two types of exemptions:
• Personal exemptions for taxpayer and spouse
• Dependency exemptions for dependents
Personal and dependent exemptions reduce your taxable income. For 2009, each exemption equals $3,650 (which remains the same for 2010). You may claim an exemption for yourself, provided you cannot be claimed as a dependent on another taxpayer’s return, for your spouse if you file a joint return, or if you do not file a joint return, provided your spouse has no gross income and is not the dependent of another, and for each dependent child whose gross income is less than $3,600, or for your child, notwithstanding his or her gross income, provided the child is either a full-time student under the age of 24 at the end of the year, or not yet 19 years old at the end of the year.
If you have a child who is married, you may consider the option of taking a dependent exemption for such child if he or she so qualifies as just discussed and have the child file as “married filing separately.” In some cases, the benefit of claiming a dependent exemption may outweigh the benefit of having the child file a joint return with his or her spouse. We recommend that you take the time to figure out the tax using each method in order to determine which way provides the lower overall tax.
Personal exemptions are phased out for taxpayers with AGI in excess of certain threshold amounts. For 2010, the exemption phase-out starts when AGI exceeds $166,800 for singles, $250,200 for joint filers, $208,500 for heads of household, and $125,000 for married couples filing separately.
Married Filing Separately. If you are married and you file a separate return, keep in mind that you must be consistent in claiming the standard deduction or itemized deductions. In other words, if your spouse itemizes deductions, then you also must itemize and cannot claim the standard deduction, even if your total itemized deductions are actually less than the standard deduction available to married persons filing separately.
Limit on Itemized Deductions. Congress placed an additional “overall” limitation on the deductibility of a certain group of itemized deductions. In 2009, this limitation applies only if your adjusted gross income is greater than $166,800 ($83,400 if married filing separately). Itemized deductions that are subject to this limitation include taxes, home mortgage interest, charitable contributions, and miscellaneous itemized deductions. The total of this group of deductions must be reduced by 3% of the amount of your adjusted gross income in excess of $166,800 ($83,400 if married filing separately). This limitation is applied after you have used any other limitations that exist in the law, such as the adjusted gross income limitation for charitable contributions and the mortgage interest expense limitations. Keep in mind that medical expenses, casualty and theft losses (and some other deductions), are not subject to this rule. In addition, the overall reduction can not exceed 80% of of allowable deductions. The Economic Growth and Tax Relief Act of 2001 gradually eliminates this limitation beginning 2006. The limitation is:
* Repealed for 2010.
Business and Travel Entertainment. The total amount of most miscellaneous itemized deductions claimed on Schedule A of Form 1040 must be reduced by 2% of your adjusted gross income. In other words, you can claim the amount of expenses that is more than 2% of your adjusted gross income. Generally, only 50% of the amount spent for business meals (including meals away from home overnight on business) and entertainment will be deductible. This limit must be applied before arriving at the amount subject to the 2% floor.
Charitable Contributions. In order to claim a deduction for a charitable contribution to a qualified organization you are required to have proof of your deduction such as a bank record (such as a canceled check, a bank copy of a canceled check, or a bank statement containing the name of the charity, the date, and the amount) or a written communication from the charity. The written communication must include the name of the charity, date of the contribution, and amount of the contribution. Note that if donating a car or boat to a charity, if the claimed value of the donated motor vehicle, boat or plane exceeds $500 and the item is sold by the charitable organization, the taxpayer’s deduction is limited to the gross proceeds from the sale. Other rules also apply to larger contributions.
Gross Income. One of the most important decisions you have to make in determining your correct taxable income is what payments to include. Keep in mind that a taxable payment is not limited to cash. It may be property, stock, or other assets. Also, you must include in your gross income the fair market value of payments in kind. For example, if your employer provides you with a car that is used for both business and personal purposes, then the value of the personal use of the car is included in your earnings and is taxable to you. Or, assume you assist a group of investors in purchasing a piece of real estate. In consideration for your services, the investors award you an unconditional percentage of ownership in the acquired asset, and you have not invested any of your personal funds. The fair market value of your ownership interest is considered as wages taxable to you in the year of transfer.
Interest and Dividends. Interest that you receive on bank accounts, on loans that you have made to others, or from other sources is taxable. However, interest you receive on obligations of a state or one of its political subdivisions, the District of Columbia, or a United States possession or one of its political divisions, is usually tax-exempt for federal tax purposes. Generally, the interest rates paid on tax-exempt state and local obligations are lower than those paid on taxable bonds. However, keep in mind that you may find these lower rates attractive when you compare them with the after-tax yield from other taxable instruments. For example, if you are in the 35% tax bracket, you would need a 9.2% yield on a taxable bond to match a municipal bond with a 6.0% tax-exempt yield. The 2003 tax laws have changed the treatment of dividends. They are taxed at the same lower rate as capital gains, rather than as income.
How Capital Gains Are Taxed. Generally, the maximum capital gains rate is now 15% (0% for individuals in the 10% or 15% bracket for the years 2008 through 2010). These capital gains rates apply to individuals, estates and trusts. A capital asset need only be held “more than 12 months” in order to have the lowest capital gain rate apply. The same tax rates apply to dividends for 2008 through 2010.
Limitations on the Deductibility of Travel and Entertainment Expenses. Keep in mind that there are limits on the deductibility of certain expenditures for travel, business meals, entertainment activities, and entertainment facilities. For example, there is a 50% deduction limitation for business-related meals, entertainment, and entertainment facilities. In addition, there are special record-keeping requirements imposed on taxpayers claiming deductions for these items. Special rules also apply to deductions for cars and other property used for transportation, foreign travel, and attendance at foreign locations.
Vehicle Expenses. If you began using a car, van, pickup, or panel truck for business purposes, you may be able to deduct the expenses you incur in operating the vehicle. You generally can use either the actual expense method or the standard rate method to figure your expenses. If you deduct actual expenses, you must keep records of the cost of operating the vehicle, such as car insurance, interest, taxes, licenses, maintenance, repairs, depreciation, gas and oil. If you lease a vehicle, you must also keep records of these costs.
To avoid the burden of figuring actual expenses and of keeping adequate records, you may be able to use the standard mileage rate to figure the deductible cost of operating your vehicle. Keep in mind that you can use the standard mileage rate only for a vehicle that you own. For 2010, the standard mileage rate is 50 cents a mile* for all business miles. These amounts are adjusted periodically for inflation. If you want to use this standard mileage rate, you must choose to use it in the first year you place the vehicle in service for business purposes. Then, in later years, you can choose to continue using the standard mileage rate, or you may switch to the actual expense method. Other standard mileage rates are 16.5 cents a mile for moving and 14 cents a mile for services to a charitable organization.
Club Dues. Dues paid for membership in professional organizations, such as the AICPA (the American Institute of Certified Public Accountants), AIA (the American Institute of Architects), or the ABA (American Bar Association), or public service organizations, such as the Rotary or Kiwanis clubs, may be deductible if paid for business reasons and the organization’s principal purpose is not the conduct of entertainment activities. No deduction is allowed for club dues or assessments paid for membership if the club is organized for business, pleasure, recreation, or social purposes. These clubs include any organization whose principal purpose is the entertainment of its members or guests. The character of an organization is determined by its purposes and activities, not by its name. For example, dues and fees paid to athletic clubs, sporting clubs, country clubs, airline clubs, and hotel clubs are not deductible. Keep in mind that specific business expenses, such as meals and entertainment that occur at a club, are deductible to the extent that they otherwise satisfy certain deductibility standards.
Recordkeeping. Travel and entertainment expenses that are an ordinary and necessary part of your business may not be deducted, unless you meet specific substantiation requirements. The tax law specifically disallows an otherwise allowable deduction for any expense for traveling, entertainment, gifts or listed property, unless these expenses are substantiated either through “adequate records” or “sufficient evidence corroborating the taxpayer’s own statement.” Maintaining “adequate records” is clearly the preferable approach. This rule also applies to deductions for entertainment facilities.
You are required to maintain documentary evidence, such as a diary, log, statement of expense, account book, or similar business records, for (1) any lodging expenditure, and (2) any other expenditure of $25 or more.
Selling Your Home. An individual may exclude from income up to $250,000 of gain ($500,000 on a joint return in most situations) realized on the sale or exchange of a residence. The individual must have owned and occupied the residence as a principal residence for an aggregate of at least two of the five years before the sale or exchange. The exclusion may not be used more frequently than once every two years. The required two years of ownership and use need not be continuous. The test is met if the individual owned and used the property as a principal residence for a total of 730 days (365 days X 2) during the five-year period before the sale. Short temporary absences for vacations or seasonal absences are counted as periods of use, even if the taxpayer rents out the property during those periods.
Home Mortgage Interest. Acquisition indebtedness is debt incurred in acquiring, constructing, or substantially improving a qualified residence and secured by such residence. Any such debt that is refinanced is treated as acquisition debt to the extent that it does not exceed the principal amount of acquisition debt immediately before refinancing. Home equity indebtedness is all debt (other than acquisition debt) that is secured by a qualified residence to the extent it does not exceed the fair market value of the residence reduced by any acquisition indebtedness. Interest on such debt is deductible even if the proceeds are used for personal expenditures. You are generally limited to deductions of interest on up to $1 million of debt on a primary and secondary home plus $100,000 of home equity indebtedness. (See IRS publication 936 as this can get complicated.) These limitations are for most taxpayers, but half these amounts ($500,0000 and $50,000) for married filing separately.
Owning More Than Two Homes. If you own more than two homes, keep in mind that you may not deduct the interest on more than two of these homes as home mortgage interest during any one year. You must include your main residence as one of the homes. You may choose any one of your other homes as a qualified residence and may change this choice in a different tax year. However, you cannot choose to treat one home as a second residence for part of a year and another home as a second residence for the remainder of the year if both of these homes were owned by you during the entire year and neither was your main residence during that year.
Points. Points are certain charges sometimes paid by a borrower. They are also referred to as loan origination fees, maximum loan charges, loan discount, or discount points. If the payment of any of these charges is only for the use of money, it is interest. Because points are, in effect, interest paid in advance, generally you may not deduct the full amount for points in the year paid. Points that represent prepaid interest generally must be deducted over the life of the loan. However, you may be able to deduct the entire amount you pay as points in the year of payment if the loan is used to buy or improve your principal residence, is secured by that home, and certain other tests apply.
Home Office Expenses.
To qualify for a deduction for home office expenses you must use the home office exclusively as an office, and it must be your primary place of business. In determining whether you meet this standard, there are 2 qualifying conditions:
* Exclusively and regularly as their principal place of business, as a place to meet or deal with patients, clients or customers in the normal course of their business, or in connection with their trade or business where there is a separate structure not attached to the home; or
* On a regular basis for certain storage use such as inventory or product samples, as rental property, or as a home daycare facility.
The deduction is the pro-rata portion of the house used for the office and includes the business portion of real estate taxes, mortgage interest, rent, utilities, insurance, painting, repairs and depreciation. Note: The amount of depreciation deducted, or that could have been deducted, decreases the basis of your property.
Deferring Gains and Accelerating Losses. Generally it is preferable to defer gains and accelerate losses for the simple reason that the later the taxes are paid, the longer you have the use of the money. In addition, when you recognize a gain or loss it can also affect the tax benefits of your itemized deductions and exemptions. That’s because capital gains and losses are included in figuring your adjusted gross income. Therefore, your capital gains and losses affect the calculation of your itemized deductions and personal exemptions which are phased out after your income reaches a certain level. Miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of your adjusted gross income. Medical expenses are deductible only to the extent that they exceed 7.5% of your adjusted gross income. Capital gains income therefore also has an impact on both of these calculations. Depending on your itemized deductions, the time at which you recognize a capital gain or loss can have a significant impact on your taxes.
Worthless Securities. The deduction for a worthless security must be taken in the year in which it becomes worthless, even if it is sold for a nominal sum in the following year. If you do not learn that a security has become worthless until a later year, you should file an amended return for the year in which it became worthless. Since it may be difficult to determine exactly when a stock becomes worthless, the capital loss deduction should be claimed in the earliest year in which such a claim may be reasonably made. Keep in mind that you should keep any documents indicating the date on which the security becomes worthless. Examples of sufficient documentation are bankruptcy documents and financial statements.
Vacant Rental Property. You may deduct expenses on your rental property during a period in which it is not being rented as long as it is actively being held out for rent. This rule applies to a period between rentals as well as to the period during which a property is being marketed as a rental property for the first time. The IRS can disallow these deductions if you are unable to show that you were actively seeking a profit and had a reasonable expectation of achieving one. However, the deduction cannot be disallowed merely because your property is difficult to rent.