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Year Round Tax Strategies and Opportunities


Most people do not think of tax planning until the end of the year, right before the big tax bill hits, and by then it is sometimes too late to take action.


Tax planning is a year round exercise, so now is the perfect time to start thinking about how you can reduce your 2017 income tax liability. The following are various tax planning strategies you should consider throughout the year in order to minimize your tax bill and increase tax savings.

Education Savings Vehicles

As the cost of education continues to rise, it is important for taxpayers to consider effective tax planning strategies to help cover some of the increasing costs. Since college aid is not always available to higher-income families, it is important to identify options that are available to any and all taxpayers, regardless of income. The following are a few ideas to consider when planning for future educational expenses.

529 Plans
A 529 plan, also referred to as a Qualified Tuition Plan, is a tax-advantaged savings plan used to encourage savings for future college expenses. There are two types of 529 plans: savings and prepaid plans. Savings plans are similar to investment accounts in which your contributions are invested in mutual funds or similar investments.

The entire balance in this account is available to be used at any accredited public, nonprofit or private college or university. Prepaid plans allow you to pre-pay all or part of future college costs. In effect, you are purchasing future college tuition at today’s prices.

While these state programs are set up to cover in-state tuition, some states have provisions that allow the savings to be used for tuition at a private or out-of-state school.

There is no guarantee, however, that the tuition purchased will cover the same credits at another school.

Although contributions are not deductible for federal tax purposes under either type of plan, earnings in a 529 plan grow tax-free as long as the money is ultimately used to pay for qualified higher-education expenses. Many states, however, do offer state tax benefits by offering a deduction or a credit for a contribution to the plan.

If earnings are withdrawn from the plan and used for non-educational purposes, the income is subject to income tax as well as a 10% penalty. If the funds are no longer needed for the beneficiary’s education, most 529 plans are flexible in that they provide the ability to change the beneficiary of the account to another qualifying family member.

While your investment options for a 529 plan are directed by the state plan, you can change your investments twice a year. Furthermore, if you decide you don’t like the 529 plan originally selected, you can rollover your funds into another 529 plan allowed once every 12 months.

A 529 plan is a savings vehicle that anyone can take advantage of. There are no income limits, age limits and the contribution limits, while varying by state, are generally high. It is important to keep in mind, that the deposits made to the plan are considered gifts and, therefore, could be subject to gift tax.

Contributions up to $14,000 per individual 
per year, or $28,000 for married couples filing jointly, will qualify for the annual gift tax exclusion. For those interested in contributing more than the annual gift tax exclusion in a given year, a 529 plan does offer an estate planning technique whereby a contribution to a 529 plan in one year can be treated as if it were made over a five-year period. This allows a taxpayer the ability to contribute $70,000 in one year ($140,000 for couples) without generating a taxable gift to the beneficiary.

Coverdell Education Savings Accounts (ESA)
A Coverdell ESA is an investment account created merely for the purpose of covering a beneficiary’s elementary, secondary and/or college expenses. Similar to a 529 plan, earnings grow tax-free and are ultimately not taxable as long as the account is used to pay for qualified education expenses of the beneficiary. If distributions are made from the account in excess of qualified education expenses, the earnings' portion of the distribution is taxable and subject to a 10% penalty.

Contributions to a Coverdell ESA are not deductible and are limited to $2,000 a year. Furthermore, the maximum annual contribution is phased out for single taxpayers with an adjusted gross income between $95,000 – $110,000, and married filing joint taxpayers with adjusted gross income between $190,000 – $220,000. In such a case, a parent may consider giving the money to the child and letting the child open his/her own Coverdell ESA.

Unlike a 529 plan, contributions to a Coverdell ESA must be made before the beneficiary reaches 18. In addition, whereas control of an account for a 529 plan remains with the contributor, a Coverdell ESA is controlled by the beneficiary when he or she becomes “of age” (18 in most states).

Account funds must be used by the time the beneficiary turns 30. If there are remaining funds at that time, the remaining balance can be rolled over into a Coverdell ESA for a qualified relative tax free.

Similar to contributions to a 529 plan, contributions to a Coverdell ESA are considered gifts to the beneficiary. As a result, they qualify for the annual gift tax exclusion and should be considered in a taxpayer’s annual gifting.

Know Your Marginal Rate

While it is interesting to note what your total tax bill is in relation to your income, for investment and tax planning purposes, it is more important to know your marginal rate. Your marginal rate is simply the increase or decrease in tax for a given change in income.

For example, to decide whether it makes sense to invest in taxable bonds at a higher interest rate and pay income tax or to invest in tax-free municipal bonds, you will want to know the tax that would be paid on that amount of taxable bond interest. It is more complicated than just looking up the bracket shown on tax tables.

The actual tax rate can be a combination of factors such as whether you are subject to alternative minimum tax, net investment income tax, to what extent phase outs are eliminating deductions as your income increases, whether your capital gains tax rate is increasing due to the increase in other taxable income and more.

Roth IRAs

Roth IRAs are a great way to earn not just tax deferred, but tax-free, income. With a Roth IRA, you don’t receive a tax deduction when you contribute, but any investment appreciation and income is not subject to tax when withdrawn.

To qualify for the tax-free treatment, the distribution must be made after age 59½ and the account must have been open for at least five years. In many cases, distributions of the amounts contributed (or converted) can be withdrawn tax free before age 59½.

Contributions to Roth IRAs can be made 
by individual taxpayers until income reaches $133,000 and married filing joint taxpayers up to $194,000 of income.

The annual contribution limit is $5,500 with an extra $1,000 allowed for taxpayers age 50 and over.

The annual contribution is also limited to earned income such as a salary or self-employment income.

Taxpayers (even those with higher incomes) also have the ability to convert existing IRA balances to Roth IRAs. The amount converted must be included in income currently, but then future income and appreciation can be excluded from income.

This strategy can be useful if your current marginal tax rate is lower than the expected marginal rate in retirement. This might occur if you have current year tax losses, you expect your income to increase in retirement or you expect tax rates to increase.

You may also consider this strategy if the account value decreases significantly due to investment performance, which provides an opportunity to pay tax on a lower amount of conversion income.

An additional opportunity for higher income taxpayers to move money to a Roth IRA is nicknamed a “backdoor Roth IRA” contribution. Any taxpayer under age 70½ with earned income can contribute to a traditional IRA. Higher income taxpayers that participate in a company retirement plan can’t take a tax deduction for the contribution. This results in after-tax money trapped in the IRA until distributed, when a pro rata portion of each distribution is not taxable.

If the taxpayer does not have other IRA balances, then a conversion from the traditional IRA to a Roth IRA will avoid tax, other than any increase in traditional IRA account value prior to conversion. This two-step process results in a contribution to a Roth IRA which would not otherwise be available.

Tax Credits

There are many tax credits in the tax code available to low and middle-income taxpayers such as the earned income tax credit, the savers tax credit and the various tuition tax credits. The following are some of the credits often missed that are available to all taxpayers regardless of income.

The Alternative Minimum Tax (AMT) Credit is available for taxpayers who paid AMT in prior years due to certain timing items such as accelerated depreciation or employee incentive stock options. The AMT paid allocable to these items is computed and tracked on Form 8801.

Often, when the income item reverses, for example the stock acquired by options is sold or the accelerated depreciation in early years results in lower depreciation in later years, the credit can be claimed to reduce the tax. Form 8801 has to be completed each year until the credit is claimed or eliminated, even if there were no AMT items during the year.

The Foreign Tax Credit is available when income subject to tax in the U.S. has already been subject to tax in a foreign country. Often, taxes are paid to a foreign country for stocks of foreign companies and mutual funds investing globally. Foreign taxes paid up to $300 on an individual return and $600 on a joint return can be claimed directly on the Form 1040.

Once the credit exceeds this amount, the allowable credit is calculated on Form 1116, Foreign Tax Credit. The amount allowable each year is generally the amount of U.S. tax paid on the foreign income. So the credit may be limited if the foreign country has a higher tax rate than the U.S.

Residential energy credits can help reduce your tax liability. The Non-Business Energy Credit is a relatively modest credit with a lifetime maximum of $500.

This credit is for the cost of certain new energy efficient appliances, windows, doors, insulation, etc.

The Residential Energy Efficient Property Credit is for investment in certain alternative energy property in your home such as solar electric property or solar water heating, wind energy property and geothermal heat pumps (through 2016). This credit is equal to 30% of eligible costs and is not limited. For example, a $100,000 investment could result in a $30,000 tax credit.

Federal Insurance Contributions Act (FICA) tax of 6.2% is paid on the first $118,500 of wages during the year in 2016. If a taxpayer changed jobs during the year and paid FICA tax on more than $118,500, then the excess can be reclaimed as a credit on the taxpayer’s individual tax return.

Education tax credits such as the American Opportunity Credit and the Lifetime Learning Credit are phased out once income reaches $180,000 and $131,000, respectively, on jointly filed returns, preventing many parents from claiming the credits.

However, if a dependent student has a tax liability, then the credit can be shifted to the dependent to help offset his or her tax liability. If a dependency exemption for the student is not claimed on the parent’s tax return, then the student will be deemed to have paid the education expenses and can claim the credit.

The benefit of the credit on the student’s return has to be compared to the cost of losing the dependency exemption. However, the exemption is subject to an income phase out which may reduce or eliminate any benefit of the exemption to the parent.

Charitable Giving

For the charitably inclined, donating to a cause can also result in tax savings for taxpayers who itemize their deductions. A few strategies to keep in mind when considering your contributions include:

Donate Stock to a Charity Versus Cash
Cash is often used because it is the simplest and most straightforward way to make a donation. However, cash may not be the most tax efficient. Gifting appreciated shares of a publicly traded security can be a 
win-win for you and the charity. 

Donations of publicly traded securities held for more than one year yield an income tax deduction equal to the fair market value of the security on the day you make the contribution. Furthermore, you avoid paying income tax on the capital gain.

To illustrate, let’s assume John and Betty purchased 500 shares of a publicly traded security in 2000 for $10,000. Today, the stock is worth $30,000 and they want to use this asset to make a contribution to a public charity.

Assume their marginal tax rate is 39.6% making them subject to a 20% capital gains rate and the 3.8% net investment income tax. If they sell the security and donate the after-tax proceeds to the organization, John and Betty will first pay a capital gains and Medicare surtax of $4,760 on the built-in appreciation of $20,000. This leaves $25,240 for the charity and John and Betty with a tax savings from the charitable contribution of $9,995.

Alternatively, if John and Betty donate the long-term appreciated securities worth $30,000, they receive a charitable contribution deduction equal to the fair market value and a tax savings of $11,880.

As a result of using this strategy, John and Betty avoid the tax on the capital gain, receive a greater tax savings while the charity receives a large donation.

When donating long-term appreciated securities, it is important to keep in mind that, your deduction is generally limited to 30% of your adjusted gross income. If you are limited in a given year, you may carry over the excess contribution deduction for the next 5 years. If it is not used by such time, the carryover will expire.

Donating shares of a publicly traded security is a great idea when your stock has appreciated, but not so if the shares have declined in value. Since you are only allowed a deduction for the fair market value of the shares, it is more advantageous, in this case, to sell the shares.

If you sell the stock, you can recognize the capital loss for tax purposes and offset any capital gain income for the year. If you donate the proceeds from the sale, you can deduct that amount as a contribution.

Qualified Charitable Distribution from an IRA
For taxpayers at least 70½ taking distributions from an IRA, a qualified charitable distribution may be appealing. This technique can be attractive because it can satisfy the required minimum distribution (RMD) requirement and fulfill your charitable contribution desire without resulting in any tax consequences.

Taxpayers using a qualified charitable distribution (QCD) can choose to donate up to $100,000 of the RMD to a qualified charitable organization. In such cases, the funds are withdrawn from the IRA and transferred directly to the charity. The QCD is not included in income, and the charitable deduction is not claimed as a deduction.

This can be especially helpful for taxpayers who do not itemize deductions (so would not receive a tax benefit for the charitable contribution) or taxpayers making contributions that exceed their adjusted gross income limitations (so do not receive an immediate tax benefit).

It should be noted that some charitable organizations are not qualified to receive QCDs (i.e. private foundations, donor-advised funds, etc.) so be sure to verify the organization is eligible before making the QCD.

In addition, if a taxpayer’s RMD in a given year is greater than $100,000, the taxpayer will have a taxable RMD for the amount not directed to a charity.

Donor-Advised Fund
For taxpayers who may want to donate publicly traded securities with value but aren’t sure which organization(s) to contribute to a donor-advised fund may be an option to consider.

This option allows taxpayers to receive an income tax deduction in the year the securities are donated to the fund; however, it provides the taxpayer time to decide which organizations to support.

Donor-advised funds are also great vehicles for taxpayers interested in leaving a legacy of charitable giving. Donor-advised funds can be set up in the name of the family so there is ongoing support of charitable causes in generations to follow.

Once the donation is made to the fund, the funds can be invested until it is decided how such dollars will be used. The taxpayer can make grants over time to support qualified charitable organizations. Donor-advised funds are generally low cost to start up and relatively low maintenance. Some donor-advised funds even allow contributions of complex, non-publicly traded appreciated assets such as shares of a privately held company or real estate.

Income Timing

Minimizing your tax bill takes planning. One way to do this is by timing income in a way that will result in less tax. No one wants to pay income taxes sooner than they have to, so generally, taxpayers often look for opportunities to defer income. This is even more important if you expect to be in a lower tax bracket in a future year.

Deferring income may include maximizing your 401(k) retirement plan contribution. This will lower your current year taxable income and allow the earnings in your 401(k) to grow tax free until a future date in time.

Instead of deferring income, there may be opportunities to offset the income you receive and therefore, reduce your taxable income. One way to do this is by offsetting gains and income with losses.

This strategy is referred to as tax-loss harvesting and when used, can reduce taxes. In its simplest form, tax-loss harvesting is selling a capital asset with a loss so it can be used to offset other gains or income.

Each taxpayer is allowed to offset capital gain income with capital losses and pursuant to the tax code, short and long-term capital losses must be first used to offset short and long-term capital gain income, respectively. To the extent the short or long-term losses exceed the gains of the same type, the excess losses can be used to offset the income of the other type.

The most effective tax loss harvesting will result when losses are used to offset 
short-term capital gain income since this income is taxed at your marginal rate on ordinary income.

Even if you do not have any capital gain income in a given year, generating a capital loss may still help reduce your taxes. Each taxpayer is allowed to deduct up to a $3,000 capital loss to offset ordinary income. If you have losses in excess of $3,000, the amount above and beyond $3,000 will carry over into future tax years until they are fully utilized.

After investments are liquidated to generate your losses, you will need to make decisions about what new investments to purchase. Keep in mind that the IRS will not let you sell an investment and reap the benefit of the loss, just to turn around and purchase a substantially identical security within 30 days before or after the date of the initial sale.

If such a security is purchased, the IRS will disallow the loss. You can still purchase assets targeting a similar industry in order to have exposure to the market; however, it is always best to contact your tax advisor prior to taking any action.

When reviewing your tax-loss harvesting strategy, you should also consider the income levels at which the net investment income tax applies.

This tax applies to taxpayers filing married, filing jointly and single filers with adjusted gross income levels in excess of $250,000 and $200,000, respectively. Planning around these income thresholds will help to minimize your tax bill.