Year-End Tax Planning for Individuals in Light of Changes Made by ATRA and Expiring Provisions (Parker Tax Publishing: October 25, 2013)

As year-end approaches, it's time for practitioners to pursue with their clients any last minute strategies that might lessen the impact of 2013 taxes. Last year, there was a lot of uncertainty over whether or not the Bush-era tax cuts would be extended. A last-minute deal was struck and, under the American Taxpayer Relief Act of 2012 (ATRA), the more favorable tax rates for lower income taxpayers were made permanent, while rates on the highest-earning taxpayers were increased to 39.6 percent. The Act also temporarily extended some of the more popular deductions.

Practice Aid: See our Sample Client Letter dealing with 2013 year-end planning issues for individuals.

The following are some of the major areas that practitioners should be thinking about when addressing year-end planning issues with their clients.

Increase in Top Tax Rate

As noted above, beginning in 2013, a new top tax rate of 39.6 percent takes effect. This rate applies to taxable income in excess of $450,000 (joint returns and surviving spouses), $425,000 (heads of household), $400,000 (unmarried other than head of household and surviving spouse), and $225,000 (married filing separately).

New Taxes Take Effect in 2013

There are two new high-profile taxes that take effect in 2013: the 3.8 percent tax on net investment income above a threshold amount and the .9 percent additional Medicare tax on wages and self-employment income above a threshold amount. The threshold amount is $200,000 ($250,000 if married filing jointly, or $125,000 for married filing separately). Income taken into consideration in calculating net investment income includes most rental income and net gain attributable to the disposition of property other than property held in a trade or business. Thus, this generally covers sales of interests in a partnership or S corporation.

Increased Tax Rate on Certain Capital Gains and Dividends

While the favorable tax rates in effect before 2013 for capital gains and dividend income were generally made permanent by the American Taxpayer Relief Act of 2012, a new 20-percent rate applies to amounts which would otherwise be taxed at the 39.6-percent rate. Thus, tax rates of 0, 15, and 20 percent apply to capital gain and dividend income, depending on the taxpayer's tax bracket. These rates apply for alternative minimum tax purposes also.

Reduction in Personal Exemptions and Itemized Deductions for High-Income Taxpayers

For 2013 and later years, ATRA resurrected the reduction in personal exemptions and itemized deductions for taxpayers with adjusted gross income over $250,000 (unmarried other than head of household and surviving spouse), $300,000 (joint returns), $275,000 (head of household), and $150,000 (married filing separately), which will have the effect of increasing taxes on those taxpayers. Year-end planning should consider the effect of these additional taxes on determining whether a client has paid a sufficient amount of tax so as to avoid any underpayment of estimated tax penalty.

Same-Sex Couples Filing Status

Also new for 2013, same-sex couples who are legally married can no longer file returns using the single filing status. They can either file a joint return or file as married filing separately. This could significantly increase the tax burden on some of these couples.

OBSERVATION: For purposes of computing the underpayment of estimated tax penalty for a taxpayer who files a joint return for 2013 but who filed a separate return for 2012, the tax shown on the 2012 return for the preceding tax year, for purposes of determining the applicability of the exception to the estimated tax penalty based on 100 percent of the tax shown on the individual's tax return for the preceding tax year, is the sum of both the tax shown on the 2012 return of the taxpayer and the tax shown on the 2012 return of the taxpayer's spouse.

Increased Threshold for Deducting Medical and Dental Expenses

Medical and dental expenses are only deductible if they exceed a certain percentage of the taxpayer's adjusted gross income for the year. For years before 2013, that percentage was 7.5 percent. For 2013 and later years, the percentage is 10 percent. However, for any tax year ending before January 1, 2017, the floor is 7.5 percent if the taxpayer or the taxpayer's spouse has reached age 65 before the end of that year.

Last Year for State and Local Sales Tax Deduction

One provision scheduled to expire at the end of 2013 is the election to deduct state and local sales taxes in lieu of state and local income taxes. Thus, if a taxpayer is thinking of purchasing a large ticket item that will generate a larger deduction than the state and local income tax deduction, purchasing the item in 2013 may be beneficial.

Deduction for Eligible Teacher Expenses

Another provision that expires this year is the deduction for eligible teacher expenses. For tax years beginning before 2014, eligible educators (i.e., teachers) can deduct from gross income up to $250 of qualified expenses they paid during the year. If spouses are filing jointly and both were eligible educators, the maximum deduction on the joint return is $500. However, neither spouse can deduct more than $250 of his or her qualified expenses.

Limited Reimbursements under Flexible Spending Arrangements

Beginning in 2013, for a health FSA to be a qualified benefit under a cafeteria plan, the maximum amount available for reimbursement of incurred medical expenses of an employee, the employee's dependents, and any other eligible beneficiaries with respect to the employee, under the health FSA for a plan year (or other 12-month coverage period) cannot exceed $2,500. Thus, when an employee is given the option under a cafeteria plan maintained by an employer to reduce his or her current cash compensation and instead have the amount of the salary reduction be made available for use in reimbursing the employee for his or her medical expenses under a health FSA, the amount of the reduction in cash compensation pursuant to a salary reduction election must be limited to $2,500 for a plan year. The $2,500 limit is subject to indexing for years beginning after December 31, 2013

Qualified Principal Residence Debt Exclusion

Under a special rule that expires at the end of 2013, no income is recognized from the discharge of qualified principal residence debt (i.e., a mortgage on the taxpayer's home). The discharge of such debt is generally excludable from gross income for discharges through 2013. Qualified principal residence debt is debt that is incurred to buy, build, or substantially improve a principal residence and that is secured by that residence. It also includes debt secured by a principal residence that is used to refinance qualified principal residence debt, but not in excess of the outstanding principal amount of the debt that is refinanced.

Charitable Donations Using IRA Distributions

There is a special rule, not available after 2013, allowing taxpayers age 70-1/2 and older to make a qualified charitable distribution of up to $100,000 from the individual's IRA to a charity. The distribution is taken into account for purposes of determining if the taxpayer has met the minimum distribution requirements but is not included in the taxpayer's income. While no charitable deduction is allowed for any amount that was contributed to the IRA tax free, this can be a much more tax efficient way of donating for certain types of taxpayers. For example, donating this way reduces a taxpayer's adjusted gross income. This, in turn, potentially reduces the percentage of social security income that is taxed from 85 percent to 50 percent and increases certain deduction by reducing the effects of the limitations on personal exemptions, itemized deductions, and charitable contributions that are tied to higher adjusted gross income amounts.

Expiring Tax Credits

Obviously, generating additional tax credits will help reduce taxes and there are two expiring tax credits that environmentally conscious taxpayers may want to take advantage of.

One such credit is the residential energy credit, which is available only through the end of 2013. Taxpayers contemplating energy improvements to their home may want to accelerate the improvements into 2013. The credit is 10 percent of the amounts paid or incurred for qualified energy efficiency improvements installed during the tax year and the amount of residential energy property expenditures paid or incurred during the tax year, up to a maximum credit of $500.

The other green credit due to expire at the end of the year is the credit for qualified two- or three-wheeled plug-in electric vehicles. The credit is equal to the lesser of 10 percent of the cost of such vehicle or $2,500.

Accelerating Income into 2013

It may be prudent to accelerate income into 2013 where the taxpayer will have more income in 2014, with the potential of being in a higher tax bracket and/or being subject to one or more of the additional taxes mentioned above. One common strategy is harvesting gains from the taxpayer's investment portfolio. However, in doing so, practitioners must take into account whether such acceleration will cause the taxpayer to be subject to the 3.8 percent net investment income tax.

Another option, which is new for 2013, is to have a taxpayer with a 401(k) plan that includes a qualified Roth contribution program to transfer an amount from his or her regular (preelective deferral account into a designated Roth account in the same plan. In 2012, this was allowed only for participants who were at least 59-1/2 years old. That age limitation does not apply in 2013 and, while the transfer is subject to regular income tax, no early distribution penalty applies.

Besides harvesting gains, other options to accelerate income into 2013 include:

1. if a taxpayer owns a traditional IRA or a SEP IRA, converting it into a Roth IRA and recognizing the conversion income this year;

2. taking IRA distributions this year rather than next year;

3. for self-employed individuals with receivables on hand, getting clients or customers to pay before year end, but being mindful of the .9 percent additional Medicare tax on self-employment income over $200,000 ($250,000 for joint returns); and

4. settling lawsuits or insurance claims that will generate income.

Deferring Income into 2014

For high-income taxpayers, especially those that may be subject to the 3.8 percent net investment income tax or the .9 percent Medicare tax, it may make sense to defer income into the 2014 tax year if the client expects a decrease in income in 2014 or to generally be in a more advantageous tax situation. Some options include:

1. if a client is due a year-end bonus, having the employer pay the bonus in January 2014;

2. if a client is considering selling assets that will generate a gain, postponing the sale until 2014;

3. delaying the exercise of any stock options;

4. considering an installment sale if property is being sold;

5.parking investments in deferred annuities;

6.. establishing an IRA, if the applicable income requirements are met; and

7.putting the maximum salary allowed into a 401(k) before year end.

Deferring Deductions into 2014

If a client expects to move into a higher tax bracket in 2014, or anticipates a substantial increase in taxable income or net investment income next year, deferring deductions into 2014 might be the right approach. Two alternatives to consider are:

1. postponing year-end charitable contributions, property tax payments, and medical and dental expense payments until next year; and

2. postponing the sale of any loss-generating property.

With respect to postponing the payment of medical and dental expenses, it's important to consider that, for tax years ending before January 1, 2017, the increase in the threshold for deducting such expenses (from 7.5 percent of AGI to 10 percent of AGI) does not apply if the taxpayer or the taxpayer's spouse has attained age 65 before the close of the tax year.

Accelerating Deductions into 2013

Where a client's income is expected to decrease in 2014, accelerating deductions into 2013 may be prudent. Some options for accelerating deductions into the current year include:

1. prepaying property taxes in December;

2. prepaying a January mortgage payment in December;

3. prepaying any state income taxes due, but only if the client doesn't owe AMT since there is no state tax deduction for AMT purposes, so the deduction would be wasted;

4. since medical expenses are deductible only to the extent they exceed 10 percent of AGI for 2013 for taxpayers under age 65, bunching large medical bills not covered by insurance into one year may help overcome this threshold;

5. making any large charitable deductions in 2013, rather than 2014;

6. gifting appreciated stock to avoid paying tax on the appreciation but obtaining a deduction for the full value of the stock;

7. selling loss stocks; and

8. if the client qualifies for a health savings account, setting one up and making the maximum contribution allowable.

Miscellaneous Items

Finally, some additional miscellaneous items practitioners should consider when doing year-end planning:

(1) Encourage clients that have a health flexible spending account with a balance to spend it before year end (unless their employer allows them to go until March 15, 2014, in which case they'll have until then).

(2) For taxpayers with a vacation home that was rented out during the year, determine the number of days it was used for business versus pleasure to see if there is anything that can be done to maximize tax savings with respect to that property. For example, if the client spent less than 14 days at the home, it may make sense to spend a couple more days and have the house qualify as a second residence, with the interest being deductible. As a rental home, rental expenses, including interest, are limited to rental income.

(3) Consider having taxpayers shift income to a child so that the tax on the income is paid at the child's rate.

(4) Impress upon clients the importance of disclosing any foreign asset holdings so that the proper tax forms can be prepared and the onerous penalties for not disclosing such assets avoided. (Parker Tax Publishing Staff Writers)

Don't miss: An In-Depth Look: Year-End 2013 Tax Planning for Businesses.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.