year-end

Accelerate deductions

Assuming your tax rates are the same or higher this year than they will be next year, then you should consider accelerating deductions into this year.

If you are on the cash basis, almost all individuals are, then you can prepay deductible items that are due next year. For example:

• Real estate taxes, in NC they are generally not late until after January 5th of next year but is it really worth waiting an entire year for the deduction to keep the money for five days?
• Personal property taxes.
• Charitable contributions.
• Final state and local estimated tax payments that are traditionally due in January of the next year.
• Pay outstanding medical bills if you will be able to itemize medical deductions (usually only amounts in excess of 10% of your adjusted gross income are deductible).
• Pay your January home mortgage payment early. Make sure the mortgage company gets it before the end of the year so they credit it to the year you paid.
• If you are in business, consider:
• • Buying assets subject to the Section 179 deduction. Currently, the limit is a maximum of $25,000 but Congress is considering changing the limit. Eligible assets are typically tangible personal property but the rules are complex. Check first to see if the asset is eligible as getting a refund from the seller may be difficult. There are other limits to keep in mind too that are not detailed here.
  • Pay year-end bonuses this year that are due in January of next year. Bonuses are still wages and subject to withholding taxes when paid to an employee.
  • Stock up on office supplies.
  • Prepay part of next year’s rent. Do not go overboard, only up to twelve months prepaid is deductible.
  • Complete repairs (not improvements) and pay for them this year.

Other options:

• Sell capital assets (e.g. stocks, mutual funds, and bonds) at a loss to offset capital gains and net a loss of $3,000 that can be deducted against other income. Watch out for the wash sale rule. This rule postpones losses if you buy the same or a similar asset (e.g. an option on the stock you sold) within 30 days before or after the loss sale date. For some people it is best to pretend it is 31 days as IRS does not forgive you for counting the days wrong.
• If you pay off your credit card balance every month, consider using your credit card to pay your deductions. There is no tax advantage in using a credit card versus paying in cash. The advantage comes from getting the deduction when the charge goes through versus when the payment is made to the credit card company next year. If you carry a balance on your credit card (i.e. you pay interest) then this option is much less attractive and may be cost more in interest than it saves in taxes.
• Businesses on the accrual method of accounting cannot generally accelerate deductions by paying them early. For example, an accrual business gets no benefit from paying this year for inventory to be received next year. The prepayment is treated as non-deductible deposit. Accrual businesses can take advantage of the Section 179 deduction and they have other options.

Keep in mind that if you claim the standard deduction instead of itemizing, accelerating deductions may not make much sense. Instead you should consider bunching itemized deductions into one year so that you can itemize and claiming the standard the next year (or vice versa – standard this year then bunch next year).

Finally, keep in mind that tax planning is a multiple year process. Saving tax this year at the cost of even more tax next year does not make sense. Also, be aware that if you owe Alternative Minimum Tax or are close to owing then accelerating some deductions, such as taxes, may not save any federal tax.

Most important

Do not allow the “tax tail to wag the dog.” In other words, the most important thing is how much you have after taxes. For example, a contractor should not buy a new generator just for the tax deduction when her old generator works just fine. The tax savings are less than the cost of the new generator.

Year-end tax planning part 1 is available here and pat 3 is here.

Income deferral

Deferring income into the next year is one of the most common year-end tax planning devices. The idea is to push the income into a future year when your tax rates will be lower. Even if your tax rates will not be lower next year, deferring income still makes sense as long as your rate next year will not be higher. As long as the tax rates are the same, paying in the future is usually better than paying today.

How do you defer income? Here are some possibilities:

1. Sell stocks, mutual funds, bonds, and other capital assets that have gains next year instead of this year.
2. Do not buy a mutual fund between now and the end of the year as mutual funds typically pay out any capital and ordinary gains in the last month of the year.
3. If you are self-employed and your business is on the cash basis, delay billing your customer(s) until closer to the end of the year or next year. Do not abuse this tactic. If your customer offers to pay you this year and you get them to hold the payment without a good business reason (i.e. a reason unrelated to taxes) then IRS will consider you to have received the income this year. IRS may also question delayed billings if you put it off too long. If you typically bill within 15 days of completing a job and decide to wait six months to defer the income, IRS can ignore the deferral. They will make the the argument that your customer would have paid before year-end if you billed them in a normal time frame. One way around this is to arrange the payment terms BEFORE you start the job (e.g. make it part of the contract terms).
4. Do not exercise non-qualified stock options until next year. Watch out, do not let an in the money option expire just to save some tax. Some after tax income is better than none.
5. Ask your employer about the possibility of a non-qualified deferred compensation plan. This is more for next year as the deferral has to be in place before the beginning of the year to which it applies. Be careful with this tactic as you can lose the deferred compensation if your employer goes bankrupt. The non-qualified part means the deferral is not subject to the normal protections provided to employer pension plans.
6. Defer as much as possible into your retirement plans – 401(k), 403(b), etc.

Unfortunately, Congress has made planning difficult because of the Alternative Minimum Tax and all the phasing out of deductions and credits. So postponing income into next year may cost you a tax credit, deduction or increase your Alternative Minimum Tax in the future. When you plan, always consider the effect to both this year and future years.

Most important

Do not allow the “tax tail to wag the dog.” In other words, the most important thing is how much you have after taxes. For example, if the stock you want to sell has a big gain now, consider the cost of waiting to sell next year when its price may have dropped significantly.

You can now read part 2 and part 3.