To save or defer tax, think about timing
When it comes to tax planning, nothing is simple. For example, first you need to consider your marginal tax rate -- this is the regular rate you'll pay on your next dollar of "ordinary income" (salary, business income, interest and more).
Then there’s the alternative minimum tax (AMT), which was designed to ensure wealthy taxpayers with “excessive” deductions would pay some income tax. The top AMT rate is lower than the top regular income tax rate on ordinary income. (See the Charts “2016 individual income tax rate schedules.” and “2015 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.
You also need to consider the various tax deductions and credits that could save you taxes. On the other hand, income-based phaseouts and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate.
That’s why, no matter what your situation, 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 — and keeping an eye out for additional tax law changes. Only then can you time income and expenses to your advantage.
Before taking action to time income or expenses, you should 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. (See the AMT Alert under “Income investments.”)
Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability.
With proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. (See the Charts “2016 individual income tax rate schedules.” and “2015 individual income tax rate schedules.”)
To determine the right timing strategies for your situation, work with your tax advisor to assess 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.
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.
Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase it.
When you don’t expect to be subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year typically is a good idea. Why? Because it will defer tax, which is usually beneficial.
But when you expect to be in a higher tax bracket next year — or you expect tax rates to go up — the opposite approach may be beneficial: Accelerating income will allow more income to be taxed at your current year’s lower rate. And deferring expenses will make the deductions more valuable, because deductions save more tax when you’re subject to a higher tax rate.
Also, don't forget to take into account the income-based itemized deduction reduction when considering timing strategies.
Whatever the reason behind your desire to time income and expenses, here are some income items whose timing you may be able to control:
- Consulting or other self-employment income,
- U.S. Treasury bill income, and
- Retirement plan distributions, to the extent they won’t be subject to early-withdrawal penalties (see “Early withdrawals”) and aren’t required (see “Required minimum distributions”).
And here are some potentially controllable expenses:
- State and local income taxes,
- Property 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 December 31) property 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 property taxes that relate to next year and deduct the payment on this year’s return.
Many 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.”
As the year progresses, record your potential deductions to date. If they’re close to — or they already exceed — the 2% floor, consider paying accrued expenses and incurring and paying additional expenses by December 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.
Medical expenses are another deduction you may be able to bunch. If your medical expenses exceed 10% of your AGI, you can deduct the excess amount. Eligible expenses may include:
- Health insurance premiums,
- Long-term care insurance premiums (limits apply),
- Medical and dental services,
- Prescription drugs, and
- Mileage (19 cents per mile driven for health care purposes
in 2016, down from 23 cents in 2015).
Consider bunching nonurgent medical procedures (and any other services and purchases whose timing you can control without negatively affecting your or your family’s health) into one year to exceed the 10% floor. (See the Case Study "Bunching medical expenses to save taxes.) Taxpayers age 65 and older enjoy a 7.5% floor through 2016 for regular tax purposes but are subject to the 10% floor now for AMT purposes. These taxpayers may want to bunch medical expenses into 2015 to potentially be able to take advantage of the 7.5% floor.
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.
Expenses that are reimbursable by insurance or paid through a tax-advantaged account such as the following aren’t deductible:
HSA. If you’re covered by qualified high-deductible health insurance, you can contribute pretax income to an employer-sponsored Health Savings Account — or make deductible contributions to an HSA you set up yourself — up to $3,350 for self-only coverage for 2016 (and 2015) and $6,750 for family coverage for 2016 (up from $6,650 for 2015). Moreover, for 2016 (and 2015), you may contribute an additional $1,000 if you're age 55 or older.
HSAs can bear interest or be invested, growing 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 (not to exceed $2,550 for plan years beginning in 2015). The plan pays or reimburses you for qualified medical expenses. With limited exceptions, you have to make your election before the start of the plan year. What you don’t use by the end of the plan year, you generally lose — though your plan might allow you to roll over up to $500 to the next year. Or it might give you a 2 ½-month grace period to incur expenses to use up the previous year’s contribution. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Congress has made permanent the break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes — the break had expired December 31, 2014. The deduction can be valuable to taxpayers residing in states with no or low income tax or who purchase a major item, such as a car or boat.
If your AGI exceeds the applicable threshold, your personal exemptions will be phased out and your itemized deductions reduced. For 2016, the thresholds are $259,400 (single), $285,350 (head of household), $311,300 (joint filer) and $155,650 (married filing separately). These are up from the 2015 thresholds, which are $258,250 (single), $284,050 (head of household), $309,900 (joint filer) and $154,950 (married filing separately).
The personal exemption phaseout reduces exemptions by 2% for each $2,500 (or portion thereof) by which a taxpayer’s AGI exceeds the applicable threshold (2% for each $1,250 for married taxpayers filing separately).
The itemized deduction limitation reduces otherwise allowable deductions by 3% of the amount by which a taxpayer’s AGI exceeds the applicable threshold (not to exceed 80% of otherwise allowable deductions). It doesn’t apply, however, to deductions for medical expenses, investment interest, or casualty, theft or wagering losses.
If your AGI is close to the threshold, AGI-reduction strategies (such as making retirement plan and HSA contributions) may allow you to stay under it. If that’s not possible, consider the reduced tax benefit of the affected deductions before implementing strategies to accelerate or defer deductible expenses.
In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and bonuses. The 12.4% Social Security tax applies to earned income up to the Social Security wage base of $118,500 for 2016 (unchanged from 2015). All earned income is subject to the 2.9% Medicare tax. Both taxes are split equally between the employee and the employer.
If you’re self-employed, your employment tax liability typically doubles, because you also must pay the employer portion of these taxes. The employer portion of self-employment taxes paid (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above the line.
As a self-employed taxpayer, you may benefit from other above-the-line deductions as well. You can deduct 100% of health insurance costs for yourself, your spouse and your dependents, up to your net self-employment income. You also can deduct contributions to a retirement plan and, if you’re eligible, an HSA for yourself. Above-the-line deductions are particularly valuable because they reduce your AGI and modified AGI (MAGI), which are the triggers for certain additional taxes and the phaseouts of many tax breaks.
Another employment tax that higher-income taxpayers must be aware of is the additional 0.9% Medicare tax. Under the Affordable Care Act, taxpayers have to pay this tax on FICA wages and self-employment income exceeding $200,000 per year ($250,000 for married filing jointly and $125,000 for married filing separately).
Note that there’s no employer portion of this tax. So unlike the Social Security tax and the regular Medicare tax, the additional Medicare tax doesn’t double for the self-employed. But this also means that no portion of the tax is deductible above the line against self-employment income.
If your wages or self-employment income varies significantly from year to year or you’re close to the threshold for triggering the additional Medicare tax, income timing strategies may help you avoid or minimize it. For example, if you’re an employee, perhaps you can time when you receive a bonus, or you can defer or accelerate the exercise of stock options. If you’re self-employed, you may have flexibility on when you purchase new equipment or invoice customers. If you’re a shareholder-employee of an S corporation, you might save tax by adjusting how much you receive as salary vs. distributions. (See “Employment taxes for owner-employees.”)
Also consider the withholding rules. Employers are obligated to withhold the additional tax beginning in the pay period when wages exceed $200,000 for the calendar year — without regard to an employee’s filing status or income from other sources. So your employer might withhold the tax even if you aren’t liable for it — or it might not withhold the tax even though you are liable for it.
If you don’t owe the tax but your employer is withholding it, you can claim a credit on your income tax return for the year the tax was withheld. If you do owe the tax but your employer isn’t withholding it, consider filing a W-4 form to request additional income tax withholding, which can be used to cover the shortfall and avoid interest and penalties. Or you can make estimated tax payments.
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 may not be subject to self-employment taxes if you’re a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest. Whether the additional 0.9% Medicare tax on earned income or the 3.8% net investment income tax (NIIT — see the Case Study “Avoiding or reducing a 3.8% NIIT hit”) will apply also is complex to determine. So, check with your tax advisor.
S corporations. Only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. To reduce these taxes, you may want to keep your salary relatively — but not unreasonably — low and increase your distributions of company income (which generally isn’t taxed at the corporate level or subject to the 0.9% Medicare tax or 3.8% NIIT).
C corporations. Only income you receive as salary is subject to employment taxes, and, if applicable, the 0.9% Medicare tax. Nevertheless, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level, are taxed at the shareholder level and could be subject to the 3.8% NIIT) if the overall tax paid by both the corporation and you would be less.
Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully.
You can be subject to penalties if you don’t pay enough tax during the year through estimated tax payments and withholding. Here are some strategies to help avoid underpayment penalties:
Know the minimum payment rules. For you to avoid penalties, your estimated payments and withholding must equal at least 90% of your tax liability for the year or 110% of your tax for the previous year (100% if your AGI for the previous year was $150,000 or less or, if married filing separately, $75,000 or less).
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 December 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.
Warning: You also could incur interest and penalties if you’re subject to the additional 0.9% Medicare tax and it isn’t withheld from your pay and you don’t make sufficient estimated tax payments.