By James Landry, Director of Planning
As we approach the end of the year, the window of opportunity for many tax-saving moves begins to close. It’s important to evaluate your tax situation now, while there’s still time to affect your bottom line for the 2019 tax year.
Income tax concerns for higher-income individuals
• The top Federal marginal tax rate (37%) applies if your taxable income exceeds $510,300 in 2019 ($612,350 if married filing jointly, $306,175 if married filing separately).
• Your long-term capital gains and qualifying dividends could be taxed at a maximum 20% tax rate if your taxable income exceeds $434,550 in 2019 ($488,850 if married filing jointly, $244,425 if married filing separately, $461,700 if head of household).
• Additionally, a 3.8% net investment income tax (unearned income Medicare contribution tax) may apply to some or all of your net investment income if your modified AGI exceeds $200,000 ($250,000 if married filing jointly, $125,000 if married filing separately).
• High-income individuals are subject to an additional 0.9% Medicare (hospital insurance) payroll tax on wages exceeding $200,000 ($250,000 if married filing jointly or $125,000 if married filing separately).
Income tax law changes to note
Modified Provision: Recent legislation has modified many provisions, generally for 2018 to 2025.
• Personal exemptions were eliminated.
• Standard deductions have been substantially increased to $12,200 in 2019 ($24,400 if married filing jointly, $18,350 if head of household).
• The overall limitation on itemized deductions based on the amount of adjusted gross income (AGI) was eliminated.
• The AGI threshold for deducting unreimbursed medical expenses has returned to 10% in 2019, it was reduced from 10% to 7.5% for 2017 and 2018.
• The deduction for state and local taxes has been limited to $10,000 ($5,000 if married filing separately).
• Individuals can deduct mortgage interest on no more than $750,000 ($375,000 for married filing separately) of qualifying mortgage debt. For mortgage debt incurred before December 16, 2017, the prior $1,000,000 ($500,000 for married filing separately) limit will continue to apply. A deduction is no longer allowed for interest on home equity indebtedness. Home equity used to substantially improve your home is not treated as home equity indebtedness and can still qualify for the interest deduction.
• The top percentage limit for deducting charitable contributions was increased from 50% of AGI to 60% of AGI for certain cash gifts.
• The deduction for personal casualty and theft losses was eliminated, except for casualty losses attributable to a federally declared disaster. Previously deductible miscellaneous expenses subject to the 2% floor, including tax preparation expenses and unreimbursed employee business expenses, are no longer deductible.
Expired provisions: Several provisions are extended periodically. The following provisions have expired and are not available for 2019 unless extended by Congress.
• Above-the-line deduction for qualified higher-education expenses
• Ability to deduct qualified mortgage insurance premiums as deductible interest on Schedule A of IRS Form 1040
• Ability to exclude from income amounts resulting from the forgiveness of debt on a qualified principal residence
• Nonbusiness energy property credit, which allowed individuals to offset some of the cost of energy-efficient qualified home improvements (subject to a $500 lifetime cap).
Timing is everything
Defer Income: Consider any opportunities you have to defer income to 2020. For example, you may be able to defer a year-end bonus, or delay the collection of business debts, rents, and payments for services. Doing so may allow you to postpone paying tax on the income until next year. If there’s a chance that you’ll be in a lower income tax bracket next year, deferring income could mean paying less tax on the income as well.
To delay income to the following year, you might be able to:
• Defer year-end bonuses.
• Defer the sale of capital gain property (or take installment payments rather than a lump-sum payment).
• Postpone receipt of distributions (other than required minimum distributions) from retirement accounts.
Accelerate Deductions: Similarly, consider ways to accelerate deductions into 2019. If you itemize deductions, you might accelerate some deductible expenses like medical expenses, qualifying interest, or state and local taxes by making payments before year-end. Or you might consider making next year’s charitable contribution this year instead.
To accelerate deductions into this year:
• Consider paying medical expenses in December rather than January, if doing so will allow you to qualify for the medical expense deduction.
• Prepay deductible interest.
• Make alimony payments early (If the divorce agreement was not entered into or modified after Dec 31, 2018).
• Make next year’s charitable contributions this year.
Reminder: Make sure you retain proper substantiation of your charitable contribution. In order to claim a charitable deduction for any contribution of cash, a check, or other monetary gift, you must maintain a record of such contributions through a bank record (such as a cancelled check, a bank or credit union statement, or a credit card statement) or a written communication (such as a receipt or letter) from the charity showing the name of the charity, the date of the contribution, and the amount of the contribution. If you claim a charitable deduction for any contribution of $250 or more, you must substantiate the contribution with a contemporaneous written acknowledgment of the contribution from the charity. If you make any noncash contributions, there are additional requirements.
Bunch Itemized Deductions: Recent legislation substantially increased the standard deduction amounts and made significant changes to itemized deductions (generally for 2018 to 2025). It may now be especially useful to bunch itemized deductions in certain years; for example, when they would exceed the standard deduction.
The Opposite Approach: Sometimes, however, it may make sense to take the opposite approach — accelerating income into 2019 and postponing deductible expenses to 2020. That might be the case, for example, if you can project that you’ll be in a higher tax bracket in 2020; paying taxes this year instead of next might be outweighed by the fact that the income would be taxed at a higher rate next year.
Factor in the AMT: Make sure that you factor in the alternative minimum tax (AMT). If you’re subject to the AMT, traditional year-end maneuvers, like deferring income and accelerating deductions, can have a negative effect. That’s because the AMT — essentially a separate, parallel income tax with its own rates and rules — effectively disallows several itemized deductions. For example, if you’re subject to the AMT in 2019, prepaying 2020 state and local taxes won’t help your 2019 tax situation and could hurt your 2020 bottom line.
Originally intended to prevent the very rich from using “loopholes” to avoid paying taxes, the alternative minimum tax (AMT) now reaches further into the ranks of middle-income taxpayers. The AMT is governed by a separate set of rules that exist in parallel to those for the regular income tax system. These rules disallow certain deductions in computing your regular income tax liability, and treat specific items, such as incentive stock options, differently. As a result, AMT liability may be triggered by such items as:
• The standard deduction
• Large deductions for state, local, personal property, and real estate taxes
• Exercising incentive stock options
So, when you sit down to project your taxes, calculate your regular income tax on Form 1040, and then consider your potential AMT liability using Form 6251. If it appears you’ll be subject to the AMT, you’ll need to take a very different planning approach during the last few months of the year. If you think AMT is going to be a factor, consider talking to a tax professional about your specific tax situation.
Incentive Stock Option Planning – Avoid the AMT: Have you exercised incentive stock options earlier this year? Check the price movement of your employer’s stock since you exercised the incentive stock options earlier in the year. If the stock has precipitously declined in value, it may make sense to sell the stock before year end (creating a “disqualifying disposition”) in order to avoid a potential alternative minimum tax (AMT) hit.
Check your withholding amounts
• If you project that you’ll owe a substantial amount when you file this year’s income tax return, ask your employer to increase your federal income tax withholding amounts. If you have both wage and consulting income and are making estimated tax payments, there’s an added benefit to doing this:
• Even though the additional withholding may need to come from your last few paychecks, it’s generally treated as having been withheld evenly throughout the year. This may help you avoid paying an estimated tax penalty due to under-withholding.
• Of course, if you’ve significantly overpaid your taxes and estimate you’ll be receiving a large refund, you can reduce your withholding accordingly, putting money back in your pocket this year instead of waiting for your refund check to come next year.
Donate to a charity
You can help someone in need and reap the benefits of a tax deduction for non-cash and monetary donations donated to a qualified charitable organization if you can itemize your tax deductions.
If you volunteer at a qualified charitable organization, don’t forget that you can also deduct your mileage (14 cents of every mile) driven for charitable service. Make these donations count on your taxes by donating by December 31st. Even if you make a donation by credit card, you do not have to pay it off in 2019 to receive the tax deduction.
Bunch Itemized Deductions by gifting to a Donor Advised Fund (DAF)
• A Donor Advised Fund (DAF) is a charitable investment account that provides simple, flexible, and efficient ways to manage charitable giving. The money that goes into a Donor Advised Fund becomes an irrevocable transfer to a public charity with the specific intent of funding charitable gifts. This public charity serves as the administrator of the DAF.
• A DAF can allow a Donor to accelerate tax deductible gifting that would otherwise be unavailable in retirement due to a lower Adjusted Gross Income level. This might also allow the Donor to preserve the value of a concentrated position for charity through diversification.
Qualified Charitable Distributions – avoid the income recognition altogether
• A popular way to transfer IRA assets to charity is via a tax provision which allows IRA owners who are 70 ½ or older to direct up to $100,000 of their IRA distributions to charity. These distributions are known as qualified charitable distributions, or QCDs. The money given to charity counts toward the donor’s required minimum distribution (RMD) but doesn’t increase the donor’s adjusted gross income (AGI) or generate a tax bill.
• Keeping the donation out of the donor’s AGI is important because doing so can (1) help the donor qualify for other tax breaks (2) reduce taxes on the donor’s Social Security benefits; and/or (3) help the donor avoid a high-income surcharge for Medicare Part B and Part D premiums (which kick in if AGI is over certain levels).
• Further, because charitable contributions will not yield a tax benefit for those taxpayers who will no longer itemize their deductions (and thanks to the 2017 Tax Cuts and Jobs Act, this will be the case for many taxpayers), those who are age 70 ½ or older and are receiving RMDs from IRAs, may gain a tax advantage by making annual charitable contributions by way of a QCD from an IRA. This charitable contribution will reduce RMDs by a commensurate amount, and the amount of the reduction will be tax-free.
Gift to non-charitable beneficiaries
• Now is also a good time to consider making noncharitable gifts. You may give up to $15,000 (in 2019) (twice that amount for a married couple) to as many individuals as you want without incurring any federal gift tax consequences. If you gift an appreciated asset, you won’t have to pay tax on the gain; any tax is deferred until the recipient of your gift disposes of the property.
Harvest capital losses in your taxable investment accounts
Chances are you have a few investments in your portfolio that have gone down in value, but did you know you can recognize your losses and use them to offset investment winners?
• Consider timing the sale of assets to have offsetting capital losses and gains. Capital losses may be fully deducted against capital gains and may offset up to $3,000 of ordinary income ($1,500 for married filing separately).
• In general, when losses are taken, long-term losses are first matched against your long-term gains, and short-term losses against short-term gains. If there are any remaining losses, they may be used to offset any remaining long-term or short-term gains, or up to $3,000 (or $1,500) of ordinary income.
• You can also avoid paying taxes on stock appreciation by gifting stock to charity, your parents, and your children who are not subject to the kiddie tax.
IRAs and retirement plans
• Take full advantage of tax-advantaged retirement savings vehicles. Traditional IRAs and employer-sponsored retirement plans such as 401(k) plans allow you to contribute funds on a deductible (if you qualify) or pre-tax basis, reducing your 2019 taxable income. Contributions to a Roth IRA (assuming you meet the income requirements) or a Roth 401(k) aren’t deductible or made with pre-tax dollars, so there’s no tax benefit for 2019, but qualified Roth distributions are completely free from federal income tax, which can make these retirement savings vehicles appealing.
• For 2019, you can contribute up to $19,000 to a 401(k) plan ($25,000 if you’re age 50 or older) and up to $6,000 to a traditional IRA or Roth IRA ($7,000 if you’re age 50 or older).
• The window to make 2019 contributions to an employer plan typically closes at the end of the year, while you generally have until the April tax return filing deadline to make 2019 IRA contributions.
• If you are self-employed and contribute to a SEP IRA, you can contribute up to 25% of your net self-employment income up to $56,000 for 2019.
Required minimum distributions
• Once you reach age 70½, you’re generally required to start taking required minimum distributions (RMDs) from traditional IRAs and employer-sponsored retirement plans (special rules apply if you’re still working and participating in your employer’s retirement plan).
• You must make the withdrawals by the date required — the end of the year for most individuals. The penalty for failing to do so is substantial: 50% of the amount that wasn’t distributed on time.
• Year-end is a good time to evaluate whether it makes sense to convert a tax-deferred savings vehicle like a traditional IRA or a 401(k) account to a Roth account. When you convert a traditional IRA to a Roth IRA, or a traditional 401(k) account to a Roth 401(k) account, the converted funds are generally subject to federal income tax in the year that you make the conversion (except to the extent that the funds represent nondeductible after-tax contributions). If a Roth conversion does make sense, you’ll want to give some thought to the timing of the conversion. For example, if you believe that you’ll be in a better tax situation this year than next (e.g., you would pay tax on the converted funds at a lower rate this year), you might think about acting now rather than waiting. (Whether a Roth conversion is appropriate for you depends on many factors, including your current and projected future income tax rates.)
• Previously, if you converted a traditional IRA to a Roth IRA and it turned out to be the wrong decision, you could recharacterize (i.e., “undo”) the conversion. Recent legislation has eliminated the option to recharacterize a Roth IRA conversion.
Qualified opportunity zone tax benefits – year end 2019 tax benefit
• IRC Code Sec. 1400Z-1 allows for the designation of certain low-income community population census tracts as Qualified Opportunity Zones (QOZs). QOZs are eligible for several favorable tax rules aimed at encouraging economic growth and investment in businesses within the zone. These investments can be made into “Qualified Opportunity Funds” (QOF).
• Code Sec. 1400Z-2 provides, at the election of the taxpayer (“deferral election”), temporary deferral of inclusion in gross income for capital gains reinvested in a QOF and the permanent exclusion of capital gains from the sale or exchange of an investment in the QOF.
• Once invested in an Opportunity Fund, Section 1400Z-2 offers investors the following three primary tax benefits:
• Capital gains reinvested into a QOF are deferred until the fund is sold or until 12/31/2026, whichever occurs first.
• Investors receive a periodic step-up in basis for the capital gains that are reinvested into a QOF. If the investment is held for five years, the amount of the originally invested capital gains exposed to tax is reduced by 10%, and if it is held for seven years, that reduction is increased by another 5%. In order to achieve the maximum 15% exclusion, gains must be reinvested in an Opportunity Fund before the end of 2019.
• If the fund is held for longer than ten years, the gains earned by the QOF are exempt from capital gains tax.
• Deferral of the capital gain is not automatic. To benefit from the program, investors have to elect to defer the gain using Form 8949, and investors need to file this form along with the investor’s annual tax return for the year the capital gains tax is due.
Talk to a professional
Tax planning can be complicated. Consider seeking the assistance of a tax professional to determine what year-end tax planning moves, if any, are right for your individual circumstances.
In concert with your CPA, the financial planning team at Pallas Capital Advisors can help you with year-end tax planning or any other aspect of your financial planning objectives.