Year end is rapidly approaching. It's now time to consider making some moves that will lower your 2016 tax bill and get you into position for tax savings in future years. This article offers some year-end planning tips for individuals — while keeping the results of the recent election in mind.
Tax Reform Plans for Individuals
Both proposals set forth by President-elect Trump and the House Ways and Means Committee would reduce the number of tax brackets and lower top rates. In particular, the President-elect's proposal calls for the following federal income tax rates for married-joint filers:
The bracket thresholds for unmarried individuals would be half these amounts, and the head of household filing status would be eliminated. The tax rates on long-term capital gains would be kept at the current 0%, 15% and 20%.
Under the President-elect's plan, the alternative minimum tax (AMT) would be eliminated for individual taxpayers. And he has proposed capping itemized deductions at $200,000 for married joint-filing couples ($100,000 for unmarried individuals).
In addition, the standard deduction for joint filers would be increased to $30,000 (up from $12,700 for 2017 under current law). For unmarried individuals, the standard deduction would be increased to $15,000 (up from $6,350). But personal and dependent exemption deductions would be eliminated.
There's no way to tell what will happen in 2017. These proposed changes are significant and controversial to some, so it's uncertain what will actually change — or when. The President-elect's proposal differs somewhat from the House's Tax Reform Blueprint, and some concessions may eventually be made to appease congressional Democrats.
Current Federal Tax Scene
The 2016 federal income tax rate picture for individuals is the same as last year, except the rate brackets have been adjusted slightly for inflation. Specifically, the tax rates remain 10%, 15%, 25%, 28%, 33% and 35%. The highest-income individuals face a top rate of 39.6%, but that rate only affects singles with 2016 taxable income above $415,050, married joint-filing couples with income above $466,950, and heads of households with income above $441,000.
For most individuals, the 2016 federal income tax rate on long-term capital gains and dividends will be either 0% or 15%. The 0% rate applies to gains and dividends that would otherwise fall within the 10% or 15% brackets. However, the maximum rate on long-term capital gains and dividends rises to 20% for singles with taxable income above $415,050, married joint-filing couples with income above $466,950, and heads of households with income above $441,000. (These are the same thresholds as for the 39.6% maximum rate on ordinary income.)
Note: President-elect Donald Trump's current tax plan is similar to the proposal published by the House Ways and Means Committee earlier this year. Both call for reducing the number of brackets, lowering the top individual and business tax rates, eliminating the estate tax and making various other changes. (See "Tax Reform Plans for Individuals" at right.)
It's unknown when (or if) these tax reform proposals will be enacted. With the Republicans in control of Congress and the White House, it wouldn't be unreasonable to expect some of the proposals to pass and go into effect next year, however.
Under current tax law, high-income individuals may be subject to an additional 0.9% Medicare tax on wages and self-employment (SE) income. The 0.9% tax is charged on salary and/or net SE income above $200,000 for an unmarried individual and salary and/or net SE income above $250,000 for a married joint-filing couple.
Net investment income, including long-term capital gains and dividends, may also be hit with the 3.8% Medicare surtax, also known as the net investment income tax (NIIT). However, the NIIT doesn't apply unless your modified adjusted gross income (MAGI) exceeds $200,000 if you are unmarried or $250,000 if you are married and file jointly with your spouse. The NIIT applies to the lesser of your net investment income or the amount by which your MAGI exceeds the applicable threshold.
Note: The President-elect's proposed 100-day plan would repeal the Affordable Care Act (ACA). If his plan succeeds, the ACA-related surtaxes may be repealed in 2017.
Itemized Deduction Phaseouts
Under the phaseout rule for itemized deductions, you can potentially lose up to 80% of your write-offs for mortgage interest, state and local taxes, charitable donations and miscellaneous itemized deductions. However, the phaseout rule applies only if your adjusted gross income (AGI) exceeds the applicable threshold.
For 2016, the AGI thresholds for the itemized deduction phaseout are $259,400 for singles, $311,300 for married joint-filing couples and $285,350 for heads of households. The total amount of your affected itemized deductions is reduced by 3% of the amount by which your AGI exceeds the applicable threshold. However, the reduction can't exceed 80% of the affected deductions that you started off with.
Personal and Dependent Exemption Phaseouts
Under the phaseout rule for personal and dependent exemptions, your write-offs can be reduced or even completely eliminated. However, the phaseout rule applies only if your AGI exceeds the applicable threshold. The thresholds are the same as for the itemized deduction phaseouts listed above.
Note: The President-elect's tax plan would eliminate personal and dependent exemptions.
Expiring Tax Breaks
These popular federal income tax breaks for individuals are scheduled to expire at the end of 2016, unless they're reinstated by Congress:
1. Higher education tuition deduction. This write-off can be as much as $4,000, or $2,000 for higher-income individuals.
2. Tax-free treatment for forgiven principal residence mortgage debt. Forgiven debts generally count as taxable cancellation of debt (COD) income. However, a temporary exception applies to COD income from canceled mortgage debt used to acquire a principal residence. Under the temporary rule, up to $2 million of COD income from principal residence acquisition debt that's canceled from 2007 to 2016 can be treated as a tax-free item.
3. $500 credit for energy-efficient home improvements. Homeowners can claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence. The $500 cap must be reduced by any credits claimed in earlier years.
Year-End Planning Tips
Now that we've covered the basics, here are eight tax-saving strategies to consider between now and year end:
1. Exceed the standard deduction allowance. If your total itemized deductions for 2016 would be close to the standard deduction amount, consider making enough additional expenditures for itemized deduction items to exceed this year's standard deduction. That will lower this year's tax bill.
For 2016, the standard deduction is $12,600 for married joint-filing couples, $6,300 for singles and $9,300 for heads of households. For 2017, the standard deduction amounts will be $12,700, $6,350 and $9,350 under current law.
Note: The standard deduction amounts for 2017 could be significantly higher if tax reform legislation is approved. If you expect an increase, plan to itemize this year, and then claim the more generous standard deduction next year. Your taxes will be lower in both years.
2. Consider prepaying deductible expenditures. If you itemize deductions, accelerating some deductible expenditures into this year to produce higher 2016 write-offs makes sense if you expect to be in the same or lower tax bracket next year. That's more likely with Republican tax reform proposals now on the table.
Perhaps the easiest deductible expense to prepay is included in the house payment due on January 1. Accelerating that payment into this year will give you 13 months of deductible home mortgage interest in 2016. You can use the same prepayment drill with a vacation home. However, if you prepay this year, you'll have to continue the policy in future years. Otherwise, you'll have only 11 months of interest in the first year you stop using this strategy.
Another option is to prepay state and local income and property taxes that are due early next year. Prepaying those bills before year end can decrease your 2016 federal income tax bill, because your itemized deductions will be that much higher.
In addition, you may prepay expenses that are subject to deduction limits based on your AGI, such as medical expenses and miscellaneous itemized deductions. Medical costs are deductible only to the extent they exceed 10% of AGI for most people. However, if you or your spouse will be age 65 or older as of year end, the deduction threshold for this year is a more-manageable 7.5% of AGI. (In 2017, this threshold will increase to 10% of AGI for people age 65 or older.)
Miscellaneous deductions — for investment expenses, job-hunting expenses, fees for tax preparation and advice, and unreimbursed employee business expenses — count only to the extent they exceed 2% of AGI. If you can bunch these kinds of expenditures into a single calendar year, you'll have a greater chance of clearing the 2%-of-AGI hurdle and receiving some tax savings.
Note: The prepayment drill can be a bad idea if you owe the alternative minimum tax (AMT). That's because write-offs for state and local income and property taxes, as well as for miscellaneous itemized deductions, are completely disallowed under the AMT rules. Therefore, prepaying these expenses may not save much tax for people who owe AMT.
3. Prepay tuition bills. If your 2016 AGI qualifies you for the American Opportunity credit (maximum of $2,500 per eligible student) or the Lifetime Learning credit (maximum of $2,000 per family), consider prepaying tuition bills that aren't due until early 2017 if it generates a bigger credit on this year's tax return. Specifically, you can claim a 2016 credit based on prepaying tuition for academic periods that begin in January through March of next year.
The American Opportunity credit can be reduced or completely eliminated if your MAGI is too high. Here are the current MAGI phaseout ranges:
$80,000 to $90,000 for unmarried individuals, and
$160,000 to $180,000 for married joint filers.
The Lifetime Learning credit is subject to lower phaseout ranges. The 2016 MAGI phaseout ranges for this credit are only:
$55,000 to $65,000 for unmarried individuals, and
$111,000 to $131,000 for married joint filers.
If your MAGI is too high to be eligible for these higher education credits, you might still qualify to deduct up to $2,000 or $4,000 of tuition costs. If so, consider prepaying tuition bills that aren't due until early 2017 if that would result in a bigger deduction this year. As with the credits, your 2016 deduction can be based on prepaying tuition for academic periods that begin in the first three months of 2017.
4. Defer income recognition. It may also be beneficial to defer some taxable income from this year into next year if you expect to be in the same or lower tax bracket in 2017 (which, again, is more likely with Republican tax reform proposals on the table). For example, if you're in business for yourself and a cash-method taxpayer, you can postpone taxable income by waiting until late in the year to send out some client invoices. That way, you won't receive payment for them until early 2017.
You can also defer taxable income by accelerating some deductible business expenditures into this year. Both moves will postpone taxable income from this year until next year, when it might be taxed at lower rates. Deferring income can also be helpful if you're affected by unfavorable phaseout rules that reduce or eliminate various tax breaks, such as the child tax credit or the higher education tax credits.
5. Sell loser underperforming stocks held in taxable accounts. By selling off loser investments (currently worth less than what you paid for them) held in taxable brokerage accounts, you may be able to lower your 2016 tax bill, because you can offset the resulting capital losses against capital gains from earlier in the year.
If losses exceed gains, you'll have a net capital loss for the year. You can deduct up to $3,000 of net capital loss (or $1,500 if you are married and file separately) on this year's return against ordinary income from salary, self-employment activities, alimony, interest, and other types of income. Any excess net capital loss is carried forward to future years and puts you in position for tax savings in 2017 and beyond.
6. Consider postponing Roth IRA conversions until next year. The best scenario for converting a traditional IRA into a Roth account is when you expect to be in the same or higher tax bracket during retirement. Even if the tax laws are reformed in 2017, you might eventually wind up in a higher tax bracket during retirement, so conversions can still be a smart tax-planning move.
But there's a current tax cost for converting, because the conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth account. If you don't convert until next year, the tax cost could be much lower if tax rates are cut by tax reform legislation.
After the conversion, qualified withdrawals (including income and gains that accumulate in the Roth account) will be federal-income-tax-free. In general, qualified withdrawals are those taken after:
You've had at least one Roth account open for more than five years, and
You've reached age 59-1/2 or become disabled or died.
With qualified withdrawals, you (or your heirs if you pass on) avoid having to pay higher tax rates that might otherwise apply in future years. While the current tax hit from a Roth conversion is unwelcome, it could be a relatively small price to pay for future tax savings.
7. Donate appreciated stock to charity. If you own appreciated stock or mutual fund shares that you've held for over a year, consider donating them to IRS-approved charities. If you itemize deductions, you can generally claim a deduction for the market value at the time of the donation and avoid any capital gains tax hit.
On the other hand, don't donate stocks or mutual fund shares that have decreased in value while you've owned them. Sell the underperforming investments, book the resulting capital losses and then donate the cash proceeds from the sales. That way, you can generally claim an itemized deduction for the cash donation while keeping the tax-saving capital loss for yourself.
8. Make charitable donations from IRAs. IRA owners and beneficiaries who have reached age 70-1/2 are permitted to make cash donations totaling up to $100,000 to IRS-approved public charities directly out of their IRAs. These so-called qualified charitable distributions (QCDs) are federal-income-tax-free, but you can't claim an itemized deduction for the charitable donation. That's okay, because the tax-free treatment of QCDs equates to an immediate 100% federal income tax deduction without having to worry about restrictions that can delay itemized charitable write-offs.
QCDs have other tax advantages, too. If you're interested in taking advantage of the QCD strategy for 2016, you'll need to arrange with your IRA trustee for money to be paid out to one or more qualifying charities before year end.
These are just some of the tax-planning strategies available to help individuals lower their taxes. Before implementing any of these strategies, consult your tax advisor to discuss the details and limitations, as well as other creative tax-saving alternatives. Your tax advisor is closely monitoring any tax law changes and will let you know when (and if) circumstances change.