It’s that time of year again—yes, the holiday season, but also an important time for clients to take stock of 2015 finances to ensure they don’t miss out on any last minute year-end tax planning moves (most tax moves must be made by December 31).
Intelligent year-end tax planning can generate welcome tax savings for clients—not just on 2015 returns, but in future years as well. This article will highlight some of the tax planning strategies that clients may be overlooking as the year draws to a close. In-depth coverage of these issues (and more) can be found in the four-volume Tax Facts series, which provides a comprehensive guide to advising clients on tax and financial issues—now available in both online and print formats.
Step 1: Maximizing Value for Health Expenses
Taxpayers who have incurred significant medical expenses in 2015 should compare these expenses to adjusted gross income (AGI) in order to determine whether they are deductible—generally, medical expenses that exceed 10% of a taxpayer’s AGI are deductible. The threshold for 2015 is 7.5% if the taxpayer is 65 or older. If a taxpayer is close to the threshold, he or she may wish to consider accelerating medical expenses into 2015 that normally would be incurred early in 2016 to take advantage of the deduction.
Further, taxpayers should take a close look at the terms of any tax-preferred health flexible spending accounts (FSAs) to which he or she contributed in 2015. Health FSAs may be subject to the use-it-or-lose-it rule, which means that all 2015 contributions must be used by the end of the plan year unless the FSA offers either of the carryover or grace period options. The carryover provision allows a taxpayer to carry up to $500 in unused funds into 2016, while the grace period option gives taxpayers an extra 2 1/2 months to use the funds. FSAs may contain one of these provisions, but not both.
Step 2: Minding the Investment Income Tax
Beginning in 2013, new taxes—including the 3.8% net investment income tax (NIIT) and the 0.9% additional Medicare surcharge—were introduced in order to increase the tax liability of certain high-income taxpayers. The taxes impact taxpayers with AGI that exceeds $200,000 for single filers or $250,000 for married couples filing jointly. The NIIT applies to the lesser of AGI or net investment income, but only if the taxpayer’s AGI exceeds the threshold. Clients who determine that their AGI is only slightly above the threshold limits can take proactive steps before year-end to avoid the tax.
These clients should ensure that they are taking all steps possible to reduce AGI—such as maxing out pre-tax contributions to retirement accounts, health savings vehicles and dependent care programs. It’s also important that clients examine their portfolios carefully to determine whether they can offset any capital gains with capital losses. Taxpayers are also able to offset up to $3,000 worth of ordinary income with capital losses, and can carry any unused losses into future years (see Mike Patton).
Step 3: Making Roth Conversions
Taxpayers who have reason to believe that their taxable income will increase in future years may wish to take advantage of Roth conversions before the end of 2015, while they are in lower tax brackets. This can reduce eventual required minimum distributions from traditional accounts in order to lower AGI in future years and potentially avoid the NIIT and additional Medicare taxes in 2016 and beyond. Lowering AGI in future years can also reduce the taxes that apply to Social Security income, and can allow clients to avoid the income-based surcharges on Medicare premiums.
Clients whose IRA holdings suffered during 2015 may be especially attracted to making a Roth conversion before year-end. When a client converts to a Roth, he or she pays ordinary income tax on the entire amount converted—if the value has declined, the conversion will generate a lower tax liability.
If the asset values rebound, the growth in the Roth assets will be tax-free—and if the values continue to decline, the client can always reverse the transaction and recharacterize the Roth (or a portion of the Roth) before October 15, 2016.
Step 4: Maximizing Tax-Free Giving
In 2015, taxpayers can make gifts of up to the $14,000 ($28,00 per married couple) annual gift tax exclusion amount per donee without incurring gift tax liability. Once the calendar turns to 2016, however, the clock resets and taxpayers cannot retroactively use their 2015 exclusion amounts to transfer wealth.
For wealthy clients who are worried about leaving valuable gross estates that are worth more than the estate tax exemption ($5.43 million in 2015 and $5.45 million in 2016), making small gifts each year can reduce the eventual estate tax burden. Taxpayers who live in states with estate or inheritance taxes should also consider lifetime giving, as exemption levels for state death taxes can be lower than the federal amount.
Clients can give cash, but they can also give shares of stock or other assets, and the donee will receive the giver’s original tax basis in the gifted assets.
Funding a Section 529 college savings plan for a friend or relative may also appeal to many clients. Generally, clients are permitted to give up to the $14,000 annual limit without generating gift tax liability, but in the case of 529 plans only, a taxpayer is eligible to make a large gift to the 529 plan and elect to treat that gift as though it was spread over a five-year period for gift tax purposes.
Therefore, in 2015, a taxpayer could contribute $70,000 ($140,000 for a married couple) without gift tax liability to a beneficiary’s 529 plan if he or she files a gift tax return and makes the election on that return. If the annual exclusion amount increases during the five-year period, the taxpayer can make additional contributions.
Step 5: Using Tax-Free Charitable IRA Rollovers
The provision that allows taxpayers aged 70 ½ and older to make tax-free charitable donations directly from IRA accounts technically expired at the end of 2014—but Congress has a lengthy history of retroactively extending this particular provision. For many taxpayers, this move can allow them to take annual RMDs from retirement accounts without the corresponding increase in taxable income.
The tax-free treatment of charitable donations from IRA accounts lets these taxpayers directly transfer an RMD of up to $100,000 per year ($200,000 per couple if each spouse has a separate IRA) to a qualified charity without increasing their tax burden (qualified charities include organizations such as churches and hospitals—most private foundations and donor-advised funds are excluded).
Assuming the provision is retroactively instated, taking advantage of the tax-free IRA charitable rollover can prevent a taxpayer from exceeding the annual income thresholds for higher tax rates and limitations on deductions and exemptions in 2015. A tax-free rollover can also help clients avoid higher Medicare premiums and any taxes that may be imposed on Social Security payments based on income levels.
The donation cannot also be treated as an itemized deduction if tax-free rollover treatment is elected. However, because the value of a client’s itemized deductions will be phased out if income exceeds the annual threshold level, electing tax-free treatment may now be more beneficial than ever, allowing clients to reduce taxable income to enjoy the full benefit of their other itemized deductions.
While the tax repercussions of any given financial move should be considered year-round, the end of the year presents an opportunity for clients to take stock and evaluate—both to take advantage of potential year-end moves and to avoid mistakes in the future.