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Time Your Income and Deductions
- Accelerate income in light of the elimination of the Adjusted Gross Income phase-out of itemized deductions.
- Consider recognizing long-term capital gains to take advantage of the current maximum 15% tax rate.
- Consider recognizing capital losses to offset any realized capital gains.
- If you have lent money to someone and may not collect it, take the necessary steps to ensure a bad debt deduction before year-end.
Alternative Minimum Tax Planning
- Estimate your exposure to the Alternative Minimum Tax and, if appropriate, accelerate income, such as business income, and/or defer deductions, such as state tax and real estate tax payments.
Bunch Your Expenses
- Use any remaining balance in your flexible spending account. Also, estimate your expenses and take advantage of your company’s flexible spending account for next year.
- If you are funding education expenses eligible for either a credit or deduction, consider if you get a better advantage by paying the spring tuition in December or waiting until January.
Business Tax Moves
- If you have a C corporation, consider paying dividends before year-end to take advantage of the current maximum 15% individual tax rate while at the same time helping eliminate potential issues with the accumulated earn-ings tax.
- If you invested in a small business and have suffered a loss, consider disposing of the stock to secure a section 1244 ordinary loss deduction.
Take What the Law Gives You
- Consider converting a regular IRA to a Roth in light of depressed market.
- If you have a business, consider purchasing needed equipment to take advantage of up to $139,000 immediate deduction for such purchases of new or used equipment (as long as the total equipment purchases are less than $560,000 and the business has taxable income) and the temporary 50% bonus depreciation for new equipment.
- Purchase a new automobile to use in your business to take advantage of the special extra first-year depreciation of up to $8,000. Purchase a qualifying SUV for your business to take advantage of up to $25,000 of first-year immediate deduction, possibly 50% bonus depreciation for new automobiles, and depreciation on the remainder.
- If you are a surviving spouse and immediately before the death of your spouse you both would have met the tests, remember that a recent provision allows you to exclude up to $500,000 of the gain on the sale of your principal residence if you sell it within two years of your spouse’s death.
- Make IRA and retirement plan contributions early, especially if the market is down, to take advantage of future appreciation inside the tax-deferred or tax-free account.
Shift Income to Taxpayers with Lower Marginal Rates
- Reduce your future tax by making gifts to others and shift the future appreciation to the donee. Consider gifts of both the annual exclusion, presently at $13,000 per person, and the lifetime exemption of $5,120,000.
- Consider using Independent 529 plans for college savings for children or grandchildren. Generally, these plans are protected from tuition inflation, provide a guaranteed discount rate, and offer a state tax deduction.
- Take advantage of the 0% capital gains tax rate if you are in the 10% or 15% tax rate bracket, or by gifting appreciated stock to someone else in the 10% or 15% tax rate bracket. This may not work for children subject to the kiddie tax who are taxed at the parents’ tax rate, but it can be advantageous for older children and elderly relatives.
- Pay tuition and medical expenses of family members with no income or gift tax consequences.
Keep Organized Tax Records
- If you estimate you will owe tax for the year, consider increasing your withholding before year-end to minimize or eliminate any potential penalties for not paying in enough taxes.
- Remember the rules for obtaining and retaining documentation for charitable contributions. Generally if the donation is $250+, you must obtain a written receipt from the organization. If the donation is made with cash, you must obtain a written receipt from the organization, regardless of the amount. If the donation is a car that the charity sells, generally your deduction is based on the sales price the charity obtains.
- If the donation is non-cash and the value of all similar items donated during the year exceeds $5,000, generally you must obtain an appraisal of the property to secure a tax deduction.
Look to the Future
- If you believe your tax rates will increase in the subsequent year, consider deferring deductions, such as state income taxes and charitable contributions, until that subsequent year.
- Prior to engaging in any transactions, consult with competent tax counsel to determine the tax implications of the proposed transactions. This advice isn’t intended or written to be used for the purpose of avoiding penalties and cannot be used for that purpose.
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 9th edition.
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- Written by: Julie Welch
The costs of higher education may be offset with two credits: the American Opportunity tax credit and the Lifetime Learning credit.
The American Opportunity tax credit (previously known as the HOPE Scholarship credit, which was more limited than this new credit) is available for a student’s first four years of postsecondary education. Either the student or the parents may claim the credit. The maximum credit allowed for any year is 100% of the first $2,000 of qualified expenses plus 25% of the second $2,000 of qualified expenses. In other words, the maximum annual credit is $2,500 per student, and the maximum overall credit is $10,000 per student. The credit may be adjusted annually for inflation.
40% of the American Opportunity tax credit may be refundable. This means that if the nonrefundable part of your credit is more than your tax, you can get the excess back as a refund. However, if you are under age 24, see IRS Publication 970 to determine if you can take advantage of the refundable portion of the credit.
To qualify for the American Opportunity tax credit, the student must be carrying at least one-half of the normal workload for the student’s course of study. Individuals convicted of a Federal or state felony offense related to a controlled substance cannot claim the American Opportunity tax credit.
The American Opportunity tax credit:
- Only applies to qualified expenses, including tuition and fees necessary for the enrollment or attendance of you, your spouse, or any of your dependents at a higher education institution. For the American Opportunity tax credit, expenses include books and course materials. However, books and course materials are not included for the Lifetime Learning credit. Expenses do not include sports fees (unless they are part of the degree program), activity fees, insurance expenses, transportation costs, or room and board. You must reduce your qualified expenses by scholarships, grants, and other tax-free educational benefits, but you do not need to reduce your qualified expenses by gifts, bequests, or inheritances. Higher education institutions include accredited postsecondary educational institutions that offer degree programs and are eligible to participate in student financial aid programs, i.e., colleges, community colleges, and many vocational schools.
- Is phased out if you are single with adjusted gross income (AGI) between $80,000 and $90,000 or married filing jointly with AGI between $160,000 and $180,000. Note that phase-out levels for the Lifetime Learning credit are lower, with AGI between $52,000 and $62,000 for 2012 if you are single or AGI between $104,000 and $124,000 for 2012 if you are married filing jointly. These amounts may be adjusted annually for inflation.
- Cannot be claimed if you are married filing separately.
Furthermore, you may elect either the American Opportunity tax credit or the Lifetime Learning credit with respect to one student. In other words, you cannot claim the American Opportunity tax credit if you use the Lifetime Learning credit to offset the expenses for the student’s education expenses. However, if you have more than one student at the same time, you can use the Lifetime Learning credit to offset the expenses for one student and the American Opportunity tax credit to offset the expenses of the other student.
You may claim the American Opportunity tax credit or the Lifetime Learning credit for some educational expenses and use tax-free Coverdell Education Savings Account earnings for educational expenses for which no credit is taken.
You and your wife have AGI of $70,000 and pay the expenses of your two children in college. Your son is ending his first year and starting his second year. Your daughter is starting graduate school in the fall. The tuition for your son for the year is $3,000. Your daughter’s graduate school tuition will be $2,500.
You may claim an American Opportunity tax credit for your son of $2,250 (100% of the first $2,000 plus 25% of the remaining $1,000). You may claim a Lifetime Learning credit of $500 ($2,500 x 20%) for your daughter’s first semester of graduate school. In other words, you can reduce your taxes by $2,750 of the $5,500 you pay in higher education expenses for the year.
If you and your husband/wife have AGI of $120,000, your American Opportunity Tax credit would not be reduced because of the phase-outs, but your Lifetime Learning credit would be reduced to $100 ($500 x ($124,000 - 120,000/$20,000)).
The planning strategies for the American Opportunity tax credit and the Lifetime Learning credit focus on timing your tuition payments so you receive the $10,000 maximum American Opportunity tax credit during your child’s first four years of school. Because most college students start in the fall following graduation from high school, the American Opportunity tax credit is usually available for four of the first five years following graduation. Generally, it is better to claim the American Opportunity tax credit first because the credit is larger ($2,500 compared to $2,000 for the Lifetime Learning credit) and the phase-out levels are higher. However, if tuition payments in the first semester are not at least $4,000, leading to a $2,500 credit, it may be advisable to claim the Lifetime Learning credit for the first semester and claim the American Opportunity tax credit for the second and third years.
For both the American Opportunity tax credit and the Lifetime Learning credit, it may make sense to pay spring semester tuition in the December before the semester begins. For the American Opportunity tax credit, this could bunch two semesters into the high school graduation year.
In the example above, you could claim a $500 Lifetime Learning credit for paying your daughter’s fall graduate school tuition. You could increase the Lifetime Learning credit to $1,000 ($5,000 x 20%) if you pay her spring tuition in December rather than in January.
NOTE: If available, you can use scholarships, Schedule C business education deductions, or Schedule A employee business expenses for amounts over $2,400.
NOTE: The American Opportunity Tax Credit expires on December 31, 2012, unless Congress enacts legislation to extend the credit to future years. The HOPE credit, which is more limited that the American Opportunity Tax Credit, would be available beginning January 1, 2013 in the event legislation is not enacted to extend the American Opportunity Tax Credit.
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- Written by: Julie Welch
Julie Welch (Runtz) is the Director of Tax Services for Meara, King & Co. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri-Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.
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Periodic Payments
Many retirement plans allow you to take annuity payments. For example, you can withdraw amounts regularly over a period of time, such as $1,000 a month until you die. If your employer fully funded the plan (you did not put any money into the plan) or if you put in some money but it was pre-tax dollars (such as a 401(k) plan), the full amount you receive is taxable. If you made nondeductible contributions, only a portion of the amount you receive is taxable. The rules for calculating the taxable amount vary based on when your payments began.
For annuities beginning before November 20, 1996, you could choose between the general rule and the old simplified general rule. For additional information on these methods, get IRS Publications 575 and 939 by calling 1-800-TAX-FORM.
For annuities with starting dates after November 19, 1996, you use the modified simplified general rule. Under all methods, you calculate the amount you receive tax-free. The remainder is taxable to you.
You use the following formula to calculate the amount you receive tax-free.
Nondeductible contributions you made
÷
Expected number of payments
Under the modified simplified general rule, you base your expected number of payments on your age when your distributions begin and one of the following charts.
Use this chart if your annuity starting date is after December 31, 1997, and your benefits are based on the life of more than one annuitant:
| Combined Ages | Expected Number of Payments |
| 110 and under | 410 |
| 111-120 | 360 |
| 121-130 | 310 |
| 131-140 | 260 |
| 141 and over | 210 |
Use this chart if your annuity is calculated on only your life:
|
Expected number of payments for annuities starting after |
Expected number of payments for annuities starting before |
|
| Age | November 18, 1996 | November 19, 1996 |
| 55 and under | 360 | 300 |
| 56 - 60 | 310 | 260 |
| 61 - 65 | 260 | 240 |
| 66 - 70 | 210 | 170 |
| 71 and over | 160 | 120 |
|
You are 62 and begin receiving $500 per month from your retirement plan based on your life expectancy. You made $26,000 of nondeductible contributions to the plan.
Using the modified simplified general rule, your monthly tax-free distribution is $100 ($26,000/260). Thus, you pay tax on only $400 ($500-100) per month.
If your distribution is based on your life and your spouse’s (age 60) life, your monthly tax-free distribution is $83.87 (26,000/310). Thus, you pay tax on only $416.13 ($500 - 83.87) per month. |
With the modified simplified general rule, you are spreading the income from your monthly payments, as well as the related income tax, over a period of time.
Lump-sum distributions if you were age 50 before 1986
When you receive a lump-sum distribution from a qualified pension or profit-sharing plan, you may be eligible for preferential income tax treatment. A lump-sum distribution is a payment of your full amount of benefits within one tax year. This amount represents one of the following:
- Distribution made because of your separation from service if you are an employee.
- Distribution made after you reach age 59½.
- Distribution made because of your death .
- Distribution made because of your disability if you are self-employed.
If you reached age 50 before 1986, you may be able to use the ten-year averaging treatment for your distribution. You can use this lump-sum method only once in your life. Alternatively, you can tax your distribution using your regular income tax rates. Compare your tax using the two available methods. Select the one that gives you the lowest result. You use Form 4972 to make these choices.
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You are age 69 and receive a lump-sum distribution of $100,000. You have not previously used your lump-sum distribution election. You are in the 35% tax rate bracket. Your tax on the distribution under the two alternatives (using 2011 tax rates) is: Ordinary income $35,000 Thus, if you do not anticipate a future lump-sum distribution, you could elect to use ten-year averaging to achieve the lowest tax on the distribution. |
Borrowing money from a qualified retirement plan
You may be able to borrow money from a qualified retirement plan. You must meet the plan requirements for repayment of the principal amount with interest. If you borrow the money to buy your house and you use the house to secure the loan, you can generally deduct the interest. Thus, you pay deductible interest to your retirement plan. The interest is tax-free in your retirement plan until you withdraw the money.
The maximum amounts you can borrow are:
| Your vested amount in the plan | Maximum borrowing |
| $20,000 or less | lesser of $10,000 or your vested balance |
| $20,000 - $100,000 | 50% of your vested balance |
| Over $100,000 | $50,000 |
Your plan may set lower amounts or not allow borrowing.
Generally, you must repay a loan from your retirement plan within five years. However, if you borrow the money to buy your principal residence, the five-year limit does not apply.
Julie Welch (Runtz) is the Director of Tax Services for Meara, King & Co. She graduated from William Jewell College with a BS in Accounting and obtained a Masters in Taxation from the University of Missouri-Kansas City. She serves as a discussion leader for the AICPA National Tax Education Program. She is co-author of 101 Tax Saving Ideas.
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Although the deduction of most “passive” losses is limited, you can reduce your taxable income by deducting up to $25,000 of losses from rental real estate. In 1986, Congress stepped up its attack on tax shelters (investments that produce tax losses) with the enactment of the “passive loss rules.” Before 1986, many people invested money in tax shelters, such as real estate ventures, oil and gas operations, and farming businesses. The people did not get personally involved in the tax shelters, but they did use the losses from the tax shelters to reduce the tax on their salary and investment income.
The passive loss rules stop you from using losses from tax shelters to reduce your income from wages, interest, and dividends. If you have a loss from a passive investment (an investment that you spend less than 500 hours per year managing), you can only deduct the loss if you have income from another passive investment. Any losses you cannot deduct in the current year are suspended and carried over to the following year. The loss is deductible in a future year when you have passive income or sell the passive investment. In other words, the passive loss rules do not take away your loss; they just postpone the deduction to a future year.
With the rental real estate exception, you can deduct a loss equal to your passive income plus $25,000 every year. Naturally, there are several conditions you must meet before you can take this rental real estate deduction. First, you must own more than 10% of the real estate investment for the entire year. Thus, if you are a limited partner in a real estate partnership and you own 5% of the partnership, you cannot use the special $25,000 deduction.
Second, you must “actively participate” in the rental of the real estate. Active participation is not measured in hours. It is determined by the decisions you make. If you approve new tenants, decide rental terms, collect and deposit rent checks, and approve expenditures for repairs and improvements, you actively participate in the rental of the real estate.
Third, the $25,000 loss you can deduct is reduced by one-half of your adjusted gross income (AGI) over $100,000. In other words, if your AGI is less than $100,000, you can use the full $25,000 special deduction. If your AGI is between $100,000 and $150,000, the $25,000 loss you can deduct is reduced by 50% of your AGI over $100,000. Thus, if you have $130,000 of AGI, your loss deduction is limited to $10,000 ($25,000 - ((130,000 - 100,000) x 50%)). Finally, if your AGI is more than $150,000, you cannot use the $25,000 exception at all ($25,000 - ((150,000 - 100,000) x 50%) = $0). Any losses that you cannot deduct because of this AGI limitation are suspended and carried over for deduction in future years.
For Example:
You are single with $75,000 in AGI. You own a duplex that you rent to two tenants. You actively participate in the management of the rental property. Your income and deductions for the year are described below:
Rental income
$24,000 Deductions:
Interest (16,200)
Real estate tax (4,000)
Insurance (1,000)
Repairs and miscellaneous (2,000)
Depreciation (200,000 x 3.636%) (7,272)
Total deductions (30,472)
Loss from rental (6,472)
Tax rate (Federal and State) x 32%
Tax savings $2,071
Cash flow from the duplex:
Rental income $24,000
Tax savings 2,071
Less:
Principal (assumed) (1,200)
Interest (16,200)
Real estate taxes (4,000)
Insurance (1,000)
Repairs and miscellaneous (2,000)
Net cash flow $1,671
On paper, the rental of the duplex shows a loss of $6,472. However, the loss is the result of your depreciation deduction of $7,272. Depreciation is an expense you can deduct for the wear and tear on your rental property. You can depreciate a residential rental property over 27.5 years. The deduction has nothing to do with an actual change in the value of the property. Also, except for the initial purchase price of the property, depreciation does not require a cash outlay.
Your cash flow, after considering the tax savings from the loss you deduct on your tax return, is a positive $1,671. If you pick the right property,
• You have an investment that is giving you cash.
• Your tenants are paying the mortgage and other expenses for you.
• The value of the duplex is increasing.
If you are a real estate professional, such as a developer, and operate your rental properties as a business, you can deduct the full amount of your real estate losses. In other words, you avoid the $25,000 limitation discussed above. To qualify, both of the following must apply:
• You spend more than half of your time in real property trades or businesses.
• You spend more than 750 hours during the year in real property trades or businesses.
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