The end of 2013 is in sight and an unpleasant task sits ahead of us. No, not the Robocop remake - although it will likely be bad. It is once again time to file taxes. This is the time of year to check in with your accountant and find ways to minimize your 2013 tax liability and position your finances in anticipation of 2014. This year comes with a bit of a twist, however, if you are in the upper income brackets in the United States. A combination of new taxes and expiring tax reductions and new surtaxes are conspiring to make your 2013 taxes – and your 2014 tax planning – a bit more interesting than usual.
The root of this year’s tax uncertainty is, of course, Washington. We are all waiting to see what kind of fiscal bargain will be struck during budget negotiations early next month. Many believe that taxes in the higher brackets are likely to increase. That means that upper-income Americans will be facing yet another year of increasing taxes in 2014, as 2013 also saw an increase. If that’s the case, traditional tax strategies of deferring year-end income until after the calendar flips over and accelerating deductions will be reversed.
"In years when taxes are expected to go down, it makes sense to defer income," says Jonathan Medows, a Certified Public Accountant and small business specialist. “But with all the 2014 tax rates currently set to change, a new Medicare surtax and the end of the Social Security tax reduction, we are likely facing increases next year. This means people in higher brackets may want to lock-in more income at 2013 rates."
Deferring and accelerating are the main tools available for tax purposes and they can be used on deductions and income. Working on the assumption that 2014 taxes will be higher, here are some last-minute tips to help you with your 2013 filing.
Sell Your Gainers
If you own stocks that have increased in value since you purchased them, you may want to consider unloading them before the end of 2013. “Essentially there are two tax components to think about here,” Medows says. “Capital gains tax and the new 3.8% Medicare tax. The Medicare tax is being imposed on the unearned income of individuals whose adjusted gross income (AGI) is upwards of $200,000 and married couples with $250,000 or more in AGI.” The tax will be taken on the excess income over those monetary thresholds, he explains. “Given this reality, taxpayers may want to sell their winning stocks and take gains now, to keep their AGI down in 2014 and minimize their share of this new Medicare tax.”
Before you click the sell button, remember to consider your holding period. The IRS treats short- and long-term gains differently. Selling a stock early to avoid a higher tax bill will end up costing you much more if it qualifies as a short-term gain.
Plan Capital Loss Carryovers
One way to cancel out short-term gains is to offset them with capital losses – assets in your portfolio that have depreciated since you purchased them. Capital losses can be used to offset capital gains and reduce ordinary income up to $3,000. This means your stock market losses can be used to offset $3,000 worth of salary, contract work and so on. “Make sure to utilize this strategy to offset your overall gain,” Medows advises. “If your prior-year carryovers can offset 2013 gains or you can realize more losses this year, that could help get your income below the new tax thresholds. Any excess losses that you don’t use in 2013 can be applied to your 2014 taxes.”
Accelerate Income if You Can
With higher taxes likely to hit high incomes, it makes sense to take in as much income as you can at today’s tax rate. “If you are working under a bonus structure, ask your employer if is possible to rework the payout to fall inside the calendar year. Similarly, if you contract, bill your clients early and ask clients who owe you money to pay up before the end of the year,” Medows advises.
The highest-earning Americans are also the most likely to have significant investments, including dividend paying stocks. Couples with household incomes above $450,000 will see their dividend tax rates increase by 5% to 20% in 2014.
"People shouldn't get too caught up in the tax side of their investments," Medows says. "The most important thing for an investor is to have a profitable and well-balanced portfolio. If you are earning a significant amount of income from that portfolio - say over 15% of your annual income - then it may make sense to go through it with the help of a tax professional."
With personal income tax rates likely to be increasing, however, investment income in the form of interest or dividends can bump up your tax liability and make you subject to the new Medicare tax. “An index fund that doesn’t generate dividends or interest may make a better investment from a tax perspective than a dividend stock,” Medows says.
With higher taxes on the way, higher-income Americans will want to defer some deductions to keep 2014’s tax bill down as well. “It is definitely worth looking at whether you should hold off on charitable donations until after Jan. 1. It makes sense if that deduction can help reduce a potentially higher tax liability in 2014 than you face in 2013. A donor-advised fund can be used to maximize your tax savings from charitable giving and it can be funded in the tax years where it will make the most impact,” Medows says.
Re-evaluate Business Ownership
People who earn more than $117,000 in 2014 will phase out of paying Social Security taxes, meaning the tax is not applicable beyond this threshold. Unfortunately for the self-employed - as they pay both the employee and the employer portion of the tax – the threshold continues to rise. But that’s not all. You may want to look at how you operate your business. “Members of LLCs [limited liability companies] should reconsider whether they are active or passive in the LLC or partnership,” Medows says. “Passive members are potentially subject to the new 3.8% Medicare taxes imposed by the Affordable Care Act, while active members are not. That’s because passive members are deemed to have an investment interest in the company.”
The Bottom Line
Whether you make $500,000 or $50,000, offsetting your capital gains with losses is an excellent strategy. Beyond that, many of these tips are aimed at the people in the $400,000 and up bracket who are likely going to see the changes outlined above, but that’s not a sure thing. Predicting the trends of taxation is an imperfect art at the best of times. With the current uncertainty in Washington, it is all but impossible.