2013 Year End Tax Newsletter
by Bass, Solomon & Dowell, LLP
(the following is the text of the 2012 Income Tax Update that first appeared in print on December 15, 2013)
Income Tax Update
A number of tax breaks are set to expire by the end of this year, unless Congress acts to extend them, which does not appear likely. For individuals and businesses, these expiring breaks include:
Individuals – Expiring Tax Breaks:
- Option to deduct state and local sales and use taxes instead of state and local income taxes
- Above-the-line deduction for qualified higher education expenses of up to $4,000
- Tax-free distributions by those age 70-1/2 or older directly from IRAs for charitable purposes
- Teacher’s (primary and secondary) qualified unreimbursed classroom expenses up to $250
- Cancellation of indebtedness of up to $2 million on a qualified principal residence
Businesses – Expiring Tax Breaks:
- 50% bonus first-year depreciation for most new machinery, equipment and software
- $500,000 expensing limitation
- Research tax credit
- 15-year write-off for qualified leasehold improvements, qualified restaurant buildings and improvements and qualified retail improvements.
New Taxes for 2013
Those individuals in higher income brackets have other factors to keep in mind for 2013 as well. Two of the more significant factors are the 3.8% surtax on unearned income and the additional 0.9% Medicare (hospital insurance) tax that applies to individuals receiving wages with respect to employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately):
- The 3.8% surtax is imposed on individuals, trusts, and estates as of January 1, 2013. The 3.8% tax is based on the lesser of: (1) net investment income (NII), or (2) the excess of modified adjusted gross income (MAGI) over an unindexed threshold amount ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case). As year-end nears, a taxpayer’s approach to minimizing or eliminating the 3.8% surtax will depend on his estimated MAGI and NII for the year. Some taxpayers should consider ways to minimize (through deferral, for example) additional NII for the balance of the year, others should try to see if they can reduce MAGI other than unearned income, and others should consider ways to minimize both NII and other types of MAGI.
- The additional 0.9% Medicare tax also took effect on January 1, 2013. The 0.9% Medicare tax is imposed on the earned income in excess of $200,000 for singles, $250,000 for married filing jointly, and $125,000 for married filing separately. Note that employers must withhold the additional Medicare tax from wages in excess of $200,000 regardless of filing status or other income. Self-employed persons must take it into account in figuring estimate tax. There could be situations where an employee may need to have more withheld toward year end to cover the tax. For example, consider an individual who earns $200,000 from one employer during the first half of the year and a like amount from another employer during the balance of the year. He would owe the additional Medicare tax, but there would be no withholding by either employer for the additional Medicare tax since wages from each employer don’t exceed $200,000. Also, in determining whether they may need to make adjustments to avoid a penalty for underpayment of estimated tax, individuals also should be mindful that the additional Medicare tax may be over-withheld. This could occur, for example, where only one of two married spouses works and reaches the threshold for the employer to withhold, but the couple’s income won’t be high enough to actually cause the tax to be owed.
Higher Individual Tax Rates for 2013
In addition to the two new taxes referenced above, the highest tax rate in 2013 rose to 39.6% (up from 35% in 2012). Taxpayers at this higher marginal rate will see tax rates on dividend income and long-term capital gains rise to 20% (up from 15% in 2012), although bear in mind that the new 3.8% surtax on net investment income referenced in the preceding paragraph could apply as well, making the effective Federal tax rate on dividends and capital gains potentially as high as 23.8% (of course, in most situations state income taxes will also apply).
Changes in Filing Status for Same-Sex Couples
The IRS and other Federal agencies also issued guidance on the treatment of same-sex spouses and couples for tax and other purposes in light of the Supreme Court’s landmark Windsor decision striking down section 3 of the Defense of Marriage Act (DOMA). Same-sex couples who were legally married in jurisdictions that recognize their marriages will be treated as married for federal tax purposes, regardless of whether their state of residence recognizes same-sex marriage. Spouses may retroactively apply this rule to open tax years.
Following are two checklists of actions that should be considered before the end of the year, one for individuals and one for businesses.
Individuals – Year-End Tax Planning
o Increase the amount you set aside for next year in your employer’s health flexible spending account (FSA), if you set aside too little for this year.
o If you become eligible to make health savings account (HSA) contributions in December of this year, you can make a full year’s worth of deductible HSA contributions for 2013.
o Look at your portfolio and determine if there is any benefit to realizing capital losses. You may realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later.
o If you might face a penalty for not having enough tax withheld or for paying too little in estimates, increase the amount of Federal and State income taxes withheld from your wages.
o Postpone income until 2014 and accelerate deductions into 2013 to lower your 2013 tax bill. This strategy may enable you to claim larger deductions, credits, and other tax breaks for 2013 that are phased out over varying levels of adjusted gross income (AGI). These include child tax credits, higher education tax credits, the above-the-line deduction for higher-education expenses, and deductions for student loan interest. Postponing income also is desirable for those taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. Note, however, that in some cases, it may pay to actually accelerate income into 2013. For example, this may be the case where a person’s marginal tax rate is much lower this year than it will be next year or where lower income in 2014 will result in a higher tax credit for an individual who plans to purchase health insurance on a health exchange and is eligible for a premium assistance credit.
o If you believe a Roth IRA is better than a traditional IRA, and want to remain in the market for the long term, consider converting traditional-IRA money invested in beaten-down stocks (or mutual funds) into a Roth IRA if eligible to do so. Keep in mind, however, that such a conversion will increase your adjusted gross income for 2013.
o If you converted assets in a traditional IRA to a Roth IRA earlier in the year, the assets in the Roth IRA account may have declined in value, and if you leave things as-is, you will wind up paying a higher tax than is necessary. You can back out of the transaction by re-characterizing the rollover or conversion, that is, by transferring the converted amount (plus earnings, or minus losses) from the Roth IRA back to a traditional IRA via a trustee-to-trustee transfer. You can later reconvert to a Roth IRA.
o It may be advantageous to try to arrange with your employer to defer a bonus that may be coming your way until 2014.
o Consider using a credit card to prepay expenses that can generate deductions for this year (charitable and medical expenses are good examples).
o If you expect to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding of state and local taxes (or pay estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2013 if doing so won’t create an alternative minimum tax (AMT) problem.
o Take an eligible rollover distribution from a qualified retirement plan before the end of 2013 if you are facing a penalty for underpayment of estimated tax and the increased withholding option is unavailable or won’t sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2013. You can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2013, but the withheld tax will be applied pro rata over the full 2013 tax year to reduce previous underpayments of estimated tax.
o Estimate the effect of any year-end planning moves on the alternative minimum tax (AMT) for 2013, keeping in mind that many tax breaks allowed for purposes of calculating regular taxes are disallowed for AMT purposes. These include the deduction for state property taxes on your residence, state income taxes (or state sales tax if you elect this deduction option), miscellaneous itemized deductions, and personal exemption deductions. Other deductions, such as for medical expenses, are calculated in a more restrictive way for AMT purposes than for regular tax purposes in the case of a taxpayer who is over age 65 or whose spouse is over age 65 as of the close of the tax year. As a result, in some cases, deductions should not be accelerated.
o Consider if you should accelerate big ticket purchases into 2013 in order to assure a deduction for sales taxes on the purchases if you will elect to claim a state and local general sales tax deduction instead of a state and local income tax deduction.
o You may be able to save taxes over the course of a 2-year period by applying a “bunching” strategy to miscellaneous itemized deductions, medical expenses and other itemized deductions. Because these are subject to phase-outs, bunching might allow the largest deduction possible.
o If you are a homeowner, make energy saving improvements to the residence, such as putting in extra insulation or installing energy saving windows, or an energy efficient heater or air conditioner. You may qualify for a tax credit if the assets are installed in your home before 2014.
o Unless Congress extends it, the up-to-$4,000 above-the-line deduction for qualified higher education expenses will not be available after 2013. Thus, consider prepaying eligible expenses if doing so will increase your deduction for qualified higher education expenses. Generally, the deduction is allowed for qualified education expenses paid in 2013 in connection with enrollment at an institution of higher education during 2013 or for an academic period beginning in 2013 or in the first 3 months of 2014.
o You may want to pay contested taxes to be able to deduct them this year while continuing to contest them next year.
o You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.
o If you are age 70-1/2 or older, own IRAs and are thinking of making a charitable gift, consider arranging for the gift to be made directly by the IRA trustee to the charity. Such a transfer, if made before year-end, will not provide a charitable deduction, but the withdrawal will also not be included as taxable income. This could be important if you are looking to keep taxable income below a certain level.
o Take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70-1/2. Failure to take a required withdrawal can result in a penalty of 50% of the amount of the RMD not withdrawn. If you turned age 70-1/2 in 2013, you can delay the first required distribution to 2013, but if you do, you will have to take a double distribution in 2014 the amount required for 2013 plus the amount required for 2014. Think twice before delaying 2013 distributions to 2014; bunching income into 2014 might push you into a higher tax bracket or have a detrimental impact on various income tax deductions that are reduced at higher income levels. However, it could be beneficial to take both distributions in 2014 if you will be in a substantially lower bracket that year, for example, because you plan to retire late this year.
o Make gifts sheltered by the annual gift tax exclusion before the end of the year and thereby save gift and estate taxes. You can give $14,000 in 2013 to each of an unlimited number of individuals (the $14,000 per donor amount also applies to gifts made in 2014) without triggering the gift tax (bear in mind that it is the donor who pays any gift tax, not the donee). Extending this further, a married couple may each give $14,000 to an individual without gift tax consequences, for a combined gift of $28,000 for the year. Note that you cannot carry over unused exclusions from one year to the next. The transfers also may save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax.
Businesses – Year-End Tax Planning
o Businesses should consider making expenditures that qualify for the business property expensing option. For tax years beginning in 2013, the expensing limit is $500,000 and the investment ceiling limit is $2,000,000. Off-the-shelf-computer software is eligible for expensing and a limited amount of expensing may be claimed for qualified real property. However, unless Congress changes the rules, for tax years beginning in 2014, the dollar limit will drop to $25,000, the beginning-of-phaseout amount will drop to $200,000, and expensing won’t be available for off-the-shelf computer software and expensing won’t be available for qualified real property. The generous dollar ceilings that apply this year mean that many small and medium sized businesses that make timely purchases will be able to currently deduct most if not all their outlays for machinery and equipment. What’s more, the expensing deduction is not prorated for the time that the asset is in service during the year. This opens up significant year-end planning opportunities.
o Businesses also should consider making expenditures that qualify for 50% bonus first year depreciation if bought and placed in service this year. This bonus writeoff generally won’t be available next year unless Congress acts to extend it. Thus, enterprises planning to purchase new depreciable property this year or the next should try to accelerate their buying plans, if doing so makes sound business sense.
o Nail down a work opportunity tax credit (WOTC) by hiring qualifying workers (such as certain veterans) before the end of 2013. Under current law, the WOTC won’t be available for workers hired after this year.
o Make qualified research expenses before the end of 2013 to claim a research credit, which won’t be available for post-2013 expenditures unless Congress extends the credit.
o If you are self-employed and haven’t done so yet, set up a self-employed retirement plan.
o Depending on your particular situation, you may also want to consider deferring a debt-cancellation event until 2014, and disposing of a passive activity to allow you to deduct suspended losses.
o If you own an interest in a partnership or S corporation you may need to increase your basis in the entity so you can deduct a loss from it for this year.
We hope this information is helpful. If you would like more information on these and other topics, please check our website at www.bsd-cpa.com (click on Resources, then Client Bulletins for longer articles or News Room for shorter dispatches). If you are in need of year-end tax planning, please call our office to arrange an appointment.