Great year-end tax tips
It's not too late to make changes that can improve your tax situation for 2011. A little planning goes a long way. Here are 12 steps you can take before Dec. 31 to take advantage of tax breaks and maximize your return.
• Pay less tax by reducing your adjusted gross income (AGI). You can reduce your AGI by maximizing "above-the-line" deductions such as Individual Retirement Account contributions, Health Savings Account contributions, moving expenses, job-hunting expenses and alimony payments. ("Above-the-line" deductions are those deductions that the IRS allows a taxpayer to subtract from his or her gross income.)
• Avoid penalties for estimated tax shortfalls by increasing your withholding. If you are in danger of being penalized for not paying enough tax throughout the year, make up the shortfall through increased withholding on your salary or bonuses. Remember, however, that making up the shortfall in your last quarterly estimated tax payment can still leave you exposed to penalties for underpayments in previous quarters.
• Bunch itemized deductions into a single year. Many IRS deductions require you meet minimum thresholds before you are eligible to deduct them, so beat the IRS at its own game by bunching them into a single year. Miscellaneous expenses that you may be able to accelerate and pay now include investment expenses (advisory fees, custodial fees, safe-deposit box rentals, accounting or legal fees), professional fees (tax planning and preparation), unreimbursed employee business expenses (travel, meals, entertainment, vehicle mileage, publications) and medical expenses (health insurance premiums, prescription drugs, medical or dental fees).
• Accelerate income to "zero out" the Alternative Minimum Tax (AMT). Originally targeted at high-wealth individuals who used clever accounting to avoid taxes, the AMT has become a concern for more and more non-high-wealth individuals. Typically, you have to pay the AMT when it results in more tax than your regular income tax calculation, largely because the AMT takes away key deductions. The silver lining is that the top AMT tax rate is only 28 percent. So you can "zero out" the AMT by accelerating income into the AMT year until the tax you calculate for regular tax and AMT are the same. Although you will have paid the tax sooner, you will have paid it at an effective tax rate of only 26 to 28 percent on the accelerated income, which is less than the top rate of 35 percent that is paid in a year when you are not subject to the AMT.
• Avoid the "wash sale rule" with a bond swap. The IRS established the "wash sale rule" to prevent taxpayers from creating a quick capital-loss tax deduction by selling a stock at a loss and then repurchasing the same (or similar stock) to maintain the asset. However, bond swaps are a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality from a different issuer. You'll avoid the "wash sale rule" because the bonds are not considered substantially identical.
• Use zero capital gains rate to benefit children. Taxpayers in the bottom two tax brackets pay no taxes on long-term capital gains and qualifying dividends. (If income from these items would have been in the 10 or 15 percent bracket based on income, then the tax rate is zero.) If you have adult children in these tax brackets, consider giving them dividend-producing stock or long-term appreciated stock. They can sell the stock for gains or dividends without owing any taxes.
• Defer investment interest for a bigger deduction. Unused investment interest expense can be carried forward indefinitely and may be used in later years. Many taxpayers elect to treat qualified dividends and long-term capital gains as investment income in order to deduct unused investment expenses. However, it could make sense instead to carry forward your unused investment interest until after 2013 when tax rates are scheduled to go up and the 15 percent rate on long-term capital gains and dividends is scheduled to disappear.
• Consider an 83(b) election on your restricted stock. With an 83(b) election, you immediately recognize the value of the restricted stock as ordinary income when the stock is granted. In exchange, you don't recognize any income when the stock actually vests. You only recognize the gain when the stock is sold, and it is taxed at the lower capital gain level.
• Give directly from an IRA if you are 70½ or older. These taxpayers are eligible to make tax-free charitable distributions from an individual retirement account (IRA). You will not get to take a charitable deduction for the gift, but making a tax-free IRA distribution could save you more in taxes.
• Give appreciated property to enhance savings. Consider donating appreciated property to a qualified charity because you avoid paying tax on the long-term capital gain you would have incurred if you sold the property. So, donating property that has appreciated considerably can lighten your tax bill. Note that you should not donate depreciated property. Instead, sell it first and give the proceeds to charity so you can take both the capital loss and the charitable deduction.
• Pass money to your kids or grandkids by making payments directly to educational institutions. If you have children or grandchildren in private school or in college, consider making direct payments of tuition to their educational institutions. Your payments will be gift tax-free and they will not count against the annual exclusion amount of $13,000 or your lifetime gift tax exemption.
• Roll over to a Roth IRA. There is little doubt that taxes will increase in the future, so the elimination of the $100,000 AGI limit on rolling over a traditional IRA into a Roth IRA couldn't have come at a better time. To roll over, you must pay tax on the investments in your traditional account immediately in exchange for no taxes at withdrawal. Tax rates today are almost certainly lower than they will be in the future, so the move makes sense for many people.
Regardless of age, income or work status, there are strategies for minimizing your tax burden. Do yourself a favor and spend a little time before the end of the year to take more control over your tax situation.