As 2015 winds down, it’s a good idea to budget for your 2015 personal income tax bill, in the event that you’ll owe the IRS money. Taxpayers who review their situations before year end have many more tax-reduction strategies at their disposal than those who wait until after the start of the tax filing season. Here’s an overview of several ways to lower taxes that require you to act before December 31.
Pay Deductible Expenses Early
If you itemize deductions, consider accelerating some deductible expenses to produce higher 2015 write-offs. This generally makes sense if you expect to be in the same or lower tax bracket next year. You’ll reduce your income tax liability over the long run only if you’re in a lower bracket next year; if you’re in the same bracket, you’ll simply defer part of your liability until next year.
Perhaps the easiest deductible expense to prepay is your mortgage bill on your primary residence or vacation home due on January 1, 2016. Making that payment this year will give you 13 months’ worth of deductible interest in 2015 (if you didn’t implement this strategy last year). However, if you prepay this year, you’ll have to continue the policy for next year and beyond. Otherwise, you’ll have only 11 months’ worth of interest in the year you stop.
Also easy to prepay are state and local income and property taxes due early next year.
Expenses subject to deduction floors based on a percentage of your adjusted gross income (AGI, which is the number at the bottom of page 1 of your Form 1040) merit attention as well. You can deduct such expenses only to the extent that they exceed the applicable floor. If year-to-date you’ve exceeded the floor — or you’re close to exceeding it — consider accelerating additional expenses into 2015. But if you’re far away from the floor, to the extent possible, defer expenses until next year to help you potentially exceed the floor then.
The two prime candidates are medical costs (10% floor for most taxpayers) and miscellaneous deductions (2% floor), such as investment expenses, job-hunting expenses, unreimbursed employee business expenses and fees for tax preparation and advice.
Important note: Prepayment may be a bad idea if you owe the alternative minimum tax (AMT) in 2015. That’s because write-offs for state and local income and property taxes, as well as miscellaneous itemized deductions subject to the 2% floor, are disallowed under the AMT rules. Even if an expense is also deductible for AMT purposes, such as mortgage interest and medical costs, the deduction may be less valuable under the AMT because your AMT rate may be lower than your regular tax rate. Before prepaying expenses, ask your tax adviser if you are in danger of owing AMT in 2015.
Pay College Tuition Bills Early
If you qualify for the American Opportunity credit or the Lifetime Learning credit but haven’t incurred enough expenses to max out the credit for 2015, consider prepaying tuition bills due in early 2016. Specifically, you can claim a 2015 credit based on prepaying tuition for academic periods that begin in January through March of next year.
The maximum American Opportunity credit is $2,500 per student, but it’s phased out if your 2015 modified adjusted gross income (MAGI) is too high. The 2015 MAGI phaseout range for unmarried individuals is $80,000 to $90,000. The range for married joint filers is $160,000 to $180,000.
The maximum Lifetime Learning credit is $2,000 per tax return, but it’s also phased out if MAGI is too high. The 2015 MAGI phaseout range for unmarried individuals is $55,000 to $65,000. The range for married joint filers is MAGI of $110,000 to $130,000.
For both credits, if your MAGI is within the phaseout range, you can take a partial credit. If it exceeds the top of the range, your credit is completely phased out. Many other rules apply to these credits, so contact your tax adviser for details.
It may be worthwhile to defer some taxable income into next year if you expect to be in the same or lower tax bracket in 2016. For example, if you’re a self-employed, cash-basis taxpayer, you might postpone recognizing taxable income by waiting until late in the year to send out some client invoices. That way, you won’t receive these payments until early 2016. You can also defer taxable income by accelerating some deductible business expenses into this year. Both moves will postpone tax liability until next year, and could even save taxes permanently, depending on your tax bracket next year.
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 credit or higher-education tax credits. By deferring income every other year, you may be able to take more advantage of these breaks in alternating years.
Sell Underperforming Stocks Held in Taxable Accounts
Selling losing investments held in taxable brokerage firm accounts can lower your 2015 tax bill, because you can deduct the resulting capital losses against this year’s capital gains. If your losses exceed your gains, you will have a net capital loss.
You can deduct up to $3,000 of net capital loss (or $1,500 if you are married and file separately) against ordinary income, including your salary, self-employment income, alimony and interest income. Any excess net capital loss is carried forward to future years and puts you in position for tax savings in 2016 and beyond.
Gift Appreciated Assets to Family Members in Lower Tax Brackets
For 2015, the federal income tax rate on long-term capital gains and qualified dividends is still 0% for taxpayers in the 10% or 15% rate brackets. While your tax bracket may be too high to take advantage of the 0% rate, you probably have loved ones who are in the lower tax brackets. If so, consider giving them appreciated stock or mutual fund shares. They can sell the shares and pay 0% federal income tax on the resulting long-term gains.
Important note: Gains will be considered long-term if your ownership period plus the gift recipient’s ownership period equals at least a year and a day.
Giving qualified-dividend-paying stocks to family members eligible for the 0% rate is another tax-smart idea.
But before making a gift, consider the gift tax consequences. The annual gift tax exclusion is $14,000 in 2015 (the same as 2014). If you give assets worth more than $14,000 (or $28,000 for married couples) during 2015 to an individual, it will reduce your $5.43 million gift and estate tax exemption — or be subject to gift tax if you’ve already used up your lifetime exemption. Also keep in mind that, if your gift recipient is under age 24, the “kiddie tax” rules could potentially cause some of his or her capital gains and dividends to be taxed at the parents’ higher rates.
Donate to Charity
Charitable donations can be one of the most powerful tax-saving tools because you’re in complete control of when and how much you give. No floor applies, and annual deduction limits are high (20%, 30% or 50% of your AGI, depending on what you’re giving and whether a public charity or a private foundation is the recipient).
If you have appreciated stock or mutual fund shares that you’ve owned for more than a year, consider donating them instead of cash. You can generally claim a charitable deduction for the full market value at the time of the donation and avoid any capital gains tax hit.
If you own stocks that are worth less than you paid for them, don’t donate them to a charity. Instead, sell the stock and give the cash proceeds to a charity. That way, you can generally deduct the full amount of the cash donation while keeping the tax-saving capital loss for yourself.
Consult with your Tax Pro
As always, year-end tax planning must take into account each taxpayer’s particular situation and goals. Consult with your tax adviser before year end to devise a tax-saving plan that most effectively meets your needs and factors in the latest tax rules.
Extenders Create Uncertainty
Year-end tax planning for 2015 is particularly challenging because Congress has yet to act on a host of tax breaks that expired at the end of 2014. It’s uncertain at this time whether the “extender” provisions will be extended by Congress on a permanent or temporary basis (and whether any such extension would be made retroactive to January 1, 2015). For individuals, these tax breaks include:
1. The option to deduct state and local sales tax instead of state and local income taxes,
2. The above-the-line-deduction for qualified higher education expenses,
3. Tax-free IRA distributions for charitable purposes by those age 70-1/2 or older, and
4. The exclusion of up to $2 million of mortgage debt forgiveness on a principal residence.
Discuss the status of these extenders with your tax adviser before year end.
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