Individual Taxation: Tax-Minimization Strategies

As the year 2013 winds down, our thoughts, once again, turn to gathering the applicable documents necessary for the preparation of our federal income-tax return. While many provisions in the tax law remain the same for 2013, as usual, there are also many changes.

It behooves taxpayers to have a rudimentary knowledge of individual taxation in order to understand and implement efficient tax-minimization and planning strategies. Related: Corporate Taxation Services.

These strategies frequently center on the timing of transactions and an awareness of the tax advantages available to one’s individual financial circumstance. A taxpayer so equipped is well-set to pose relevant questions to his or her certified public accountant.

tax-form-1040Above-the-Line Deductions

These deductions are reported on the first page of Form 1040 and are subtracted from gross income giving the all-important “adjusted gross income,” AGI, figure. The reason these deductions are so helpful is that many tax deductions and credits are calculated based on the extent to which they exceed a percentage of AGI. Also, some tax benefits phase-out at specified levels of AGI. Therefore, taxpayers will want to take full advantage of every above-the-line deduction available to them. Included among these deductions are moving expenses, penalty on early withdrawal of savings, and deductions for retirement contributions, student loan interest, educator expenses and tuition.

Contributions to Retirement Plans

When possible, taxpayers should fund qualified retirement plans up to the contribution limit.

  • By funding retirement instruments, taxpayers have the benefits of preparing for retirement, deferring tax on the fund’s income and lowering AGI if the contributions are deductible.

Normally, a taxpayer has had an event or circumstance that gave rise to an above-the-line deduction. For example, he or she may have moved or withdrawn funds from a certificate of deposit prior to maturity. However, deductions related to the funding of retirement accounts are within the control of working taxpayers.

Additionally investments in mutual funds where the fund manager makes decisions without regard to tax implications are best held in a tax-deferred retirement account such as a 401(k) or an Individual Retirement Arrangement, IRA. Finally, some lower-income taxpayers may be eligible for a retirement contribution credit that will reduce their tax bill.

Other Tax-Planning Strategies

Taxpayers still have many strategies available to them to minimize taxes. Here are several that may apply to your tax planning.

Rather than selling an appreciated asset, consider donating the property and deducting its fair market value as a charitable contribution. By doing so, you can avoid paying tax on the capital gain that would result from a sale. This strategy is particularly beneficial for high-income taxpayers. These individuals may avoid the new higher tax rates on capital gains as well as the new Medicare surtax on an asset’s investment income.

Another tax-minimization strategy is to hold municipal bonds that yield interest exempt from federal taxation. If the percentage yield is greater than what you would earn on a taxable investment multiplied by one minus your effective tax rate, then investment in municipals may be a good choice. Consult your tax adviser prior to investing to determine if the alternative minimum tax enters into your investment decision.

If you plan to sell securities that will generate a loss, execute the sales in a year when you anticipate long-term capital gains from other items. Long-term capital gains are those resulting from the sale of capital assets that have been held longer than one year. You can apply $3,000 of a loss to reduce your capital gain and, therefore, reduce your AGI. Any capital loss not used can be carried forward to subsequent tax years and applied to offset capital gains in those years.

If you hold a security for 1 year or less, be aware of a wash-sale. This is when you sell a security at a loss and then buy identical, or similar, securities within a 30-day period before or after the sale. The loss will be disallowed at the time of the sale. The amount of the disallowed loss will be added to the cost of the second purchase and, reduce the gain or increase any loss on the sale of the repurchased securities. A wash sale can be a beneficial strategy when you defer the loss to another year.

Cash-basis taxpayers with a sole-proprietor business can often time the payment of expenses or the receipt of income. Pay expenses prior to year-end and delay billing customers or clients until the following year.

Tax-Planning-AdvicePhase-out of Some Benefits Based on AGI

For 2013, be aware that some tax benefits have been reduced for taxpayers with high AGIs. The personal exemption will be reduced by two percent for every $2,500, or fraction thereof, of AGI exceeding $250,000 for single filers and $300,000 for married taxpayers.

Also, some itemized deductions will be subject to a maximum eighty percent reduction for high-income taxpayers. The applicable deductions will be reduced three percent for AGIs above $250,000 for single taxpayers and $300,000 for married couples.

Medical expenses, casualty and theft losses, and some other deductions are exempt from these reductions. In order to deduct medical costs, these expenses must now exceed 10 percent of AGI for most taxpayers.

Finally, tax planning is a year-round activity. As simple as it sounds, maintaining organized records is an effective tax strategy. Organization enables a taxpayer to efficiently present tax documents and financial changes to his or her tax accountant and, therefore, reduce the likelihood of having to later amend a return due to an omission.

Reviewed by: Brian Winter, CPA