Consider applicable rates and limits
to better time income and expenses
The top alternative minimum tax (AMT) rate is lower than the top regular income tax rate on ordinary income (salary, business income, interest and more). (See the Charts “2011 individual income tax rate schedules” and “2012 individual income tax rate schedules.”) But the AMT rate typically applies to a higher taxable income base.
So if you plan only for regular income taxes, it can result in unwelcome tax surprises. Also, income-based phaseouts and other limits can increase your marginal rate for regular-tax or AMT purposes.
That’s why it’s important to review your income, expenses and potential tax liability throughout the year, keeping in mind the many rates and limits that can affect income tax liability. Only then can you time income and expenses to your advantage.
AMT triggers
Before you take action to time income or expenses, determine whether you’re already likely to be subject to the AMT — or whether the actions you’re considering might trigger it. Many deductions used to calculate regular tax aren’t allowed under the AMT (see the Chart “Regular tax vs. AMT: What’s deductible?”) and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:
- Long-term capital gains and dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,
- Accelerated depreciation adjustments and related gain or loss differences when assets are sold, and
- Tax-exempt interest on certain private-activity municipal bonds.
Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability.
Avoiding or reducing AMT
With proper planning, you may be able to avoid the AMT, or at least reduce its impact — or perhaps take advantage of its lower maximum rate. But, planning for the AMT will be a challenge until Congress passes long-term relief.
Unlike the regular tax system, the AMT system isn’t regularly adjusted for inflation. Instead, Congress must legislate any adjustments. Typically, it has done so in the form of a “patch” — an increase in the AMT exemption. Currently such a patch is in effect for 2011, but not for 2012.
So it’s critical to work with your tax advisor to determine whether:
You could be subject to the AMT this year. Consider accelerating income and short-term capital gains into this year, which may allow you to benefit from the lower maximum AMT rate. Also consider deferring expenses you can’t deduct for AMT purposes until next year — you may be able to preserve those deductions.
Additionally, if you defer expenses you can deduct for AMT purposes to next year, the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax consequences of exercising ISOs.
You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because you’ll likely pay a relatively lower AMT rate. And prepay expenses that will be deductible this year but that won’t help you next year because they’re not deductible for AMT purposes. Also, before year end consider selling any private activity municipal bonds whose interest could be subject to the AMT.
The AMT credit
If you pay AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year.
In effect, this takes into account timing differences that reverse in later years. But the credit might provide only partial relief or take years before it can be fully used. Fortunately, the credit’s refundable feature can reduce the time it takes to recoup AMT paid.
Timing income and expenses
Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase it.
If you don’t expect to be subject to the AMT this year or next, consider deferring income to next year and accelerating deductible expenses into this year. This will defer tax, which is usually beneficial. But if you expect to be in a higher tax bracket next year, the opposite approach may be beneficial. Warning: Tax rates are scheduled to increase in 2013, although Congress may extend current rates or take other action. Check back for updates.
Also keep in mind that the otherwise applicable adjusted gross income (AGI) limits reducing itemized deductions were eliminated for 2010, and this elimination has been extended through 2012. If you’re normally subject to the limit, your deductions may provide you more tax savings this year — as long as they don’t trigger the AMT.
Whatever the reason you’d like to time income and expenses, here are some income items whose timing you may be able to control:
- Bonuses,
- Consulting or other self-employment income,
- U.S. Treasury bill income,
- Real estate or other nonpublicly traded property sales, and
- Retirement plan distributions, if not required.
And here are some potentially controllable expenses:
- State and local income taxes,
- Real estate taxes,
- Mortgage interest,
- Margin interest, and
- Charitable contributions.
Warning: Prepaid expenses can be deducted only in the year to which they apply. For example, you can prepay (by Dec. 31) real estate taxes that relate to this year but that are due next year, and deduct the payment on this year’s return. But you generally can’t prepay real estate taxes that relate to next year and deduct the payment on this year’s return.
Miscellaneous itemized deductions
Expenses that may qualify as miscellaneous itemized deductions are deductible for regular tax purposes only to the extent they exceed, in aggregate, 2% of your AGI. Bunching these expenses into a single year may allow you to exceed this “floor.”
Carefully record your potential deductions throughout the year. If as the year progresses they get close to or start to exceed the 2% floor — and you don’t expect to be subject to the AMT this year — consider paying accrued expenses and incurring and paying additional expenses by Dec. 31, such as:
- Deductible investment expenses, including advisory fees, custodial fees and publications,
- Professional fees, such as tax planning and preparation, accounting, and certain legal fees, and
- Unreimbursed employee business expenses, including travel, meals, entertainment and vehicle costs.
Health care breaks
Medical expenses are another deduction you may be able to bunch. If your medical expenses exceed 7.5% of your AGI, you can deduct the excess amount. Eligible expenses include:
- Health insurance premiums,
- Long-term care insurance premiums (limits apply),
- Medical and dental services, and
- Prescription drugs.
Consider bunching nonurgent medical procedures and other controllable expenses into one year to exceed the 7.5% floor. (See the Case Study “Bunching deductions can save tax when income is low, medical expenses are high.”) Bunching such expenses into 2012 may be especially beneficial because in 2013 the floor is scheduled to increase to 10% under the Patient Protection and Affordable Care Act of 2010. If one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly.
Also remember that expenses that are reimbursed (or reimbursable) by insurance or paid through one of the following accounts aren’t deductible:
HSA. If you’re covered by qualified high-deductible health insurance, a Health Savings Account allows 2012 contributions of pretax income (or deductible after-tax contributions) up to $3,100 (up from $3,050 for 2011) for self-only coverage and $6,250 (up from $6,150 for 2011) for family coverage. Moreover, account holders age 55 and older can contribute an additional $1,000.
HSAs bear interest or are invested and can grow tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit. The plan pays or reimburses you for medical expenses not covered by insurance. (If you have an HSA, your FSA is limited to funding certain “permitted” expenses.) What you don’t use by the end of the plan year, you generally lose.
Warning: Since 2011, you no longer can use HSA or FSA funds to pay for over-the-counter drugs unless they’re prescribed.
Sales tax deduction
The break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes is available on your 2011 tax return but hasn’t been extended for 2012. (Check back here for updates.) It can be valuable to taxpayers residing in states with no or low income tax rates or who purchase major items, such as a car or boat.
Employment taxes
In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and bonuses. For 2011 and 2012, the employee portion of the Social Security tax on earned income has been reduced from 6.2% to 4.2%. The maximum taxable wage base for Social Security taxes for 2011 is $106,800; for 2012, it's $110,100. So the maximum tax savings from this break is $2,136 for 2011 and $2,202 for 2012.
Warning: All earned income is subject to the 2.9% Medicare tax (split equally between the employee and the employer).
Self-employment taxes
If you’re self-employed, your employment tax liability doubles, because you also must pay the employer portion of these taxes. As a result, self-employment income can be taxed at an effective federal rate as high as 48% compared to about 43% for income from wages. Why isn’t the difference greater? Because you receive a deduction for 50% of the self-employment tax you pay.
However, for 2011 and 2012, the self-employed’s rate for the Social Security portion is also reduced by two percentage points, from 12.4% to 10.4%. This doesn’t reduce a self-employed individual’s deduction for the employer’s share of these taxes — you can still deduct the full 6.2% employer portion of Social Security tax, along with one-half of the Medicare tax, for a full 7.65% deduction.
Employment taxes for owner-employees
There are special considerations if you’re a business owner who also works in the business, depending on its structure:
Partnerships and limited liability companies. Generally, all trade or business income that flows through to you for income tax purposes is subject to self-employment taxes — even if the income isn’t actually distributed to you. But such income isn’t subject to self-employment taxes if you’re a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest.
S corporations. Only income you receive as salary is subject to employment taxes. So to reduce these taxes, you may want to keep your salary relatively low and increase your distributions of company income (which generally isn’t taxed at the corporate level).
But to avoid potential back taxes and penalties, you must take a “reasonable” salary. What’s considered reasonable is determined by the specific facts and circumstances, but it’s generally what would be paid to an outside individual performing the same services for your company.
C corporations. Only income you receive as salary is subject to employment taxes. You may prefer to take more income as salary (which is deductible at the corporate level) because the overall tax paid by both the corporation and you may be less.
Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully.
Estimated payments and withholding
You can be subject to penalties if you don’t pay enough tax during the year through estimated tax payments or withholding. To avoid such penalties, make sure your estimated payments or withholding equals at least 90% of your tax liability for this year or 110% of your tax last year (100% if your AGI last year was $150,000 or less or, if married filing separately, $75,000 or less).
Here are some more strategies that can help you avoid underpayment penalties:
Use the annualized income installment method. This method often benefits taxpayers who have large variability in income by month due to bonuses, investment gains and losses, or seasonal income (especially if it’s skewed toward the end of the year). Annualizing computes the tax due based on income, gains, losses and deductions through each estimated tax period.
Estimate your tax liability and increase withholding. If as year end approaches you determine you’ve underpaid, consider having the tax shortfall withheld from your salary or year end bonus by Dec. 31. Because withholding is considered to have been paid ratably throughout the year, this is often a better strategy than making up the difference with an increased quarterly tax payment, which may still leave you exposed to penalties for earlier quarters. •
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