With the end of the year approaching, it’s time to make some moves to lower your 2013 tax bill. This is the second installment of our two-part series on that subject (also see: Tax moves to make before Christmas).
Strategy: Prepay Deductible Expenditures
If you itemize deductions, accelerating some deductible expenditures into this year to produce higher 2013 write-offs makes sense if you expect to be in the same or lower tax bracket next year. (See the tables at the end of this column for the 2013 and 2014 federal income tax brackets.)
January House Payment: Accelerating the house payment that’s due in January will give you 13 months’ worth of deductible interest in 2013 (unless you’ve already been following the prepayment drill). You can use the same strategy with a vacation home.
State and Local Taxes: Prepaying state and local income and property taxes that are due early next year can reduce your 2013 federal income tax bill, because your total itemized deductions will be that much higher.
Charitable Donations: Prepaying charitable donations that you would otherwise make next year can reduce your 2013 federal income tax bill, because your total itemized deductions will be that much higher. Donations charged to credit cards before year-end will count as 2013 contributions.
Medical Expenses and Miscellaneous Deduction Items: Consider prepaying expenses that are subject to deduction limits based on your AGI. The two prime candidates are medical expenses and miscellaneous itemized deductions. As explained earlier, medical costs are deductible only to the extent they exceed 10% of AGI for most people. However, if you or your spouse will be 65 or older as of year-end, the deduction threshold is a more-manageable 7.5% of AGI. 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 fighting chance of clearing the 2%-of-AGI hurdle and getting some tax savings.
Warning: Prepaying Is Not a No-Brainer: The prepayment strategy can backfire if you will owe the alternative minimum tax (AMT) for this year. That’s because write-offs for state and local income and property taxes are completely disallowed under the AMT rules and so are miscellaneous itemized deductions. So prepaying these expenses may do little or no tax-saving good for AMT victims. Solution: ask your tax adviser if you’re in the AMT mode before prepaying taxes or miscellaneous deduction items.
Strategy: Make Major Year-end Purchases and Deduct Sales Taxes
If you live in a state with low or no personal income taxes, consider making the choice to deduct state and local general sales taxes instead of state and local income taxes on your 2013 return. Most people who choose the sales tax option will use an IRS-provided table to calculate their allowable sales tax deduction. However, if you’ve hoarded receipts from your 2013 purchases, you can use your actual sales tax amounts if that results in a bigger write-off.
Even if you’re stuck with using the IRS table, you can still deduct actual sales taxes on a major purchase such as a motor vehicle (car, truck, SUV, van, motorcycle, off-road vehicle, motor home, or recreational vehicle), a boat, an aircraft, a home (including a mobile prefabricated home), or a substantial addition to or major renovation of a home. You can also include state and local general sales taxes paid for a leased motor vehicle. So making a major purchase (or motor vehicle lease) between now and year-end could give you a bigger sales tax deduction and cut this year’s federal income tax bill.
Remember: the sales tax write-off only helps if you itemize. And if you’re hit with the AMT, you’ll lose some or all of the tax-saving benefit.
Strategy: Prepay College Tuition
If your 2013 AGI allows you to qualify for the American Opportunity college credit (maximum of $2,500) or the Lifetime Learning higher education credit (maximum of $2,000), consider prepaying college tuition bills that are not due until early 2014 if that would result in a bigger credit on this year’s Form 1040. Specifically, you can claim a 2013 credit based on prepaying tuition for academic periods that begin in January through March of next year.
- The American Opportunity credit is phased out (reduced or completely eliminated) if your modified adjusted gross income (MAGI) is too high. The phase-out range for unmarried individuals is between MAGI of $80,000 and $90,000. The range for married joint filers is between MAGI of $160,000 and $180,000. MAGI means “regular” AGI, from the last line on page 1 of your Form 1040, increased by certain tax-exempt income from outside the U.S. which you probably don’t have.
- Like the American Opportunity credit, the Lifetime Learning credit is also phased out if your MAGI is too high. However, the Lifetime Learning credit phase-out ranges are much lower, which means they are much more likely to affect you. The 2013 phase-out range for unmarried individuals is between MAGI of $53,000 and $63,000. The 2013 range for married joint filers is between MAGI of $107,000 and $127,000.
If your MAGI is too high to be eligible for the Lifetime Learning credit, you might still qualify to deduct up to $2,000 or $4,000 of college tuition costs. If so, consider prepaying tuition bills that are not due until early 2014 if that would result in a bigger deduction on this year’s Form 1040. As with the credits, your 2013 deduction can be based on prepaying tuition for academic periods that begin in the first three months of 2014.
Strategy: Give to Charity
If you have charitable instincts, here are two suggestions.
Donate Appreciated Stock; Sell Losers and Donate Cash: If you have appreciated stock or mutual fund shares (currently worth more than you paid for them) that you’ve held in a taxable brokerage firm account for over a year, consider donating them, instead of cash, to IRS-approved charities. You can generally claim an itemized charitable deduction for the full market value at the time of the donation and avoid any capital gains tax hit. On the other hand, don’t donate loser stocks. Sell them, book the resulting capital loss, and donate the cash sales proceeds. That way, you can generally deduct the full amount of the cash donation while keeping the tax-saving capital loss for yourself.
Remember: you must itemize deductions to gain any tax-saving benefit from charitable donations, except for donations out of an IRA, as explained immediately below.
If You’ve Reached Age 70 1/2: Donate from Your IRA: You can make up to $100,000 in cash donations to IRS-approved charities directly out of your IRA, if you’ll be 70 1/2 or older by year-end. Such direct-from-your-IRA donations are called qualified charitable distributions, or QCDs. Because they are tax-free, and no deductions are allowed for them, QCDs don’t directly affect your tax bill However, they count as withdrawals for purposes of meeting the required minimum distribution (RMD) rules that apply to your traditional IRAs after age 70 1/2. So you can avoid taxes by arranging for tax-free QCDs in place of taxable RMDs. Note that the QCD privilege will expire at the end of this year unless Congress extends it.
Don’t Overlook Estate Planning
For 2013, the unified federal gift and estate tax exemption is a relatively generous $5.25 million, and the federal estate tax rate is a historically reasonable 40%. Even if you already have an estate plan, it may need updating to reflect the current estate and gift tax rules. You may also have state estate tax issues that need to be addressed. Finally, you may need to make some changes for reasons that have nothing to do with taxes (births, deaths, and so forth). Contact your estate planning pro if you think your plan might need a tune-up. Year-end is a good time to do it.
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