With the end of the year approaching, now is the time to look for opportunities to save on income taxes. Here are some items you should look for:
In Charleston and Myrtle Beach, clients and potential clients often assume the Affordable Care Act (ACA) only helps low earning individuals and families. This is far from the case. When using proper financial planning strategies, some families can make up to $239,000 and still qualify for the healthcare subsidy.
Over 10 million Americans utilized Affordable Care Act (ACA) healthcare insurance in 2018, 87% of which received some sort of subsidy to help them pay for that insurance. Many receiving that subsidy don’t understand the how and why of the program; and many who aren’t receiving the subsidy don’t realize just how close they may be to pocketing thousands in tax relief via the Premium Tax Credit. We’re going to walk you through a broad overview, without getting into too much detail, so you may determine if you can qualify for the Premium Tax Credit and what strategies you can implement to help you qualify.
Who qualifies for tax relief from the Affordable Care Act in 2020?
How do you determine your Modified Gros Income (MAGI)?
Start with Gross Income which, for simplicity, is any income you receive throughout the year.
Next, you’ll need to determine your Adjusted Gross Income (AGI). You’ll do this by subtracting:
Finally, to determine your MAGI, add-back to your AGI:
We see that for most people, the only way to lower your MAGI number is to increase the deductions that calculate your AGI, such as 401k (or any qualified employer plan), IRA (SEP, SIMPLE, Traditional) and HSA contributions—therefore we use these deductions in our general example below. Theoretically, the following gross compensations can be earned with corresponding contributions reducing overall MAGI:
Often families cannot afford to, or choose not to, dedicate the maximum amounts to these accounts. We recommend establishing a strategy each year for qualifying for the Premium Tax Credit that matches your personal and financial goals.
Keep in mind, this is a general overview. There are many other rules that can change these calculations, such as non-working Spousal IRA contributions which phase out at certain income levels and the catch-up provisions afforded to anyone over the age of 50 for IRAs and 55 for HSAs; The goal of this article is to give a broad overview so you may pinpoint exactly where your family sits in reference to the Premium Tax Credit eligibility.
If you’d like a CERTIFIED FINANCIAL PLANNER™ to help create and manage a tax strategy that will aims to qualify your family for the Premium Tax Credit click here.
Okay-- you just completed your income tax return for last year. You want to file it away and not worry about taxes until next year, but before you do-- take a look at your completed return to identify ways you can save tax dollars next year.
Income tax planning can add to your future net worth and your future income streams. Here is a line by line view of some of the things that good income tax planning can do to improve your financial life.
Line 10 on your new 1040 return shows your taxable income after all deductions. Knowing your marginal income tax rate is the first step to efficient income tax planning. Lowering your income taxes in the current tax year is not always the best long-term strategy, lowering your lifetime income tax liability is often much more important.
For 2019, the federal income tax brackets for individuals are:
Your marginal income tax rate is the amount you would pay on your last dollar. For example, a single person with taxable income of $84,201 would pay a 24% rate on only one dollar of income, not their total taxable income. They would in fact pay 10% on their first $9,700 of taxable income, then 12% on the next $29,775, then 22% on the next $44,725, and finally 24% on the last dollar of taxable income.
It is important to remember that the current income tax rates for individuals are scheduled to revert to the pre Tax Cuts and Jobs Act rates in 2025. Barring tax changes passed by Congress in the interim, you have six years to utilize the current brackets to your benefit.
Managing Your Income Tax Bracket
Depending on your income level, managing the income tax bracket you fall in may mean realizing extra income to take advantage of a favorable rate; or you may want to lower your taxable income to qualify for a lower tax bracket or other income tax benefits (such as Obamacare).
In my opinion the 12% bracket is extremely valuable. Married couples can have up to $78,950 of taxable income and pay no more than 12% in federal income taxes. Less than 25% of American households have taxable income above this level and I believe the odds of their marginal income tax rate falling is quite small.
If you are among the many that fall into the 12% rate, you should look for ways to pay taxes on as much income as you can without moving into the 22% bracket. Some of the things you should consider are:
Contribute to a Roth IRA or Roth 401k rather than a Traditional IRA or standard 401k account
Convert existing Traditional IRA funds to a Roth IRA
Higher marginal income tax payers will want to take the opposite approach. They’ll want to defer more income unless they anticipate being in an even higher bracket in future years. High bracket individuals will want to:
The absolute worst taxable income numbers are $200,000 for single filers and $250,000 for joint filers; along with $157,500 for single filers and $315,000 for joint filers who own their own business.
The first range, $200,000 single and $250,000 joint subjects a taxpayer to the 3.8% net investment income tax.
The second range for self employed filers of $157,500 for single and $315,000 for joint are the cutoff for the pass-through business income deduction.
Taxpayers at those levels should take aggressive steps to lower their taxable income.
Moving back up your return, line 2 and line 3 deal with investment income.
Note that these lines have been subdivided into an A and B column. The column on the left is better than the column on the right for income tax purposes.
On the left you have tax-exempt interest, which is income generated from municipal and state government entities. Municipal bond interest is generally income-tax free, although there are some taxable municipal bonds, and some municipal bond interest is subject to the Alternative Minimum Tax.
Tax-exempt interest is also added to your Adjusted Gross Income (AGI) for purposes of calculating how much of your Social Security benefits are taxed. The higher your marginal income-tax rate, the more valuable tax-exempt interest is. To determine the taxable equivalent yield of a tax-exempt security, you divide the tax-exempt yield by 1 less your marginal income tax rate.
For an investor in the 12% marginal income tax bracket, a municipal bond yielding 2.5% gives them the same after-tax return as a taxable security that yields 2.8% (.025/ (1-.12)). For an investor in the 32% tax bracket the same 2.5% yield from a municipal bond equates to a 3.6% taxable yield.
Again, the column on the left is more valuable than the column on the right. A qualified dividend is a dividend from a company that: a) trades publicly on a US exchange and b) is incorporated in a US possession or c) is eligible for the benefits of a comprehensive income-tax treaty with the US. The advantage to generating qualified dividend income is that these payments are taxed at your capital gains rate, which is generally much lower than the rate on your ordinary income
Dividends from REITs, MLPs, employee stock options, tax-exempt organizations, money market accounts, and shares used for hedging are not eligible for qualified dividend status.
Make sure to also consider the treatment of preferred stock dividends. Although ranked below bondholders in the event of financial difficulty, preferred stock pay yields that are similar to long-term bonds. All taxpayers should consider these securities against table bond holdings for the tax advantages alone.
IRAs, Pensions, and Annuities
Income received from pensions and some annuities are absolute, in that you receive the income and you pay the taxes; however, income from an IRA and certain types of annuities are somewhat discretionary. You can plan the timing and the amount you withdraw to achieve the best income-tax outcome for your personal needs. If you are over 70 ½, you are required to take some distributions from your traditional IRA accounts (required minimum distributions/RMDs), but even then you can take advantage of the Qualified Charitable Distribution rules to lower the amount that is reported to the IRS.
Income derived from variable annuities can be problematic for some. All income from variable annuities is considered ordinary income until you have spent down those assets to your cost basis. At that point, the withdrawals are deemed to be return of principal and are no longer subject to income taxes.
Although we prefer to use IRA to Roth IRA conversions to manage income tax brackets for those in the 12% marginal tax bracket, you can certainly use variable annuities in a similar fashion. If you are in a higher marginal tax bracket, you can also consider exchanging your variable annuity for an immediate annuity. Doing this will change the deemed ordinary income rule to a pro-rata distribution rule, where some of your distribution is considered ordinary income and some of it is considered a return of principal.
You probably will pay taxes on some of your Social Security benefits. If your total income is more than $25,000 but less than $34,000 for individuals; or $32,000 but less than $44,000 for joint filers, you will pay income tax on 50% of your Social Security benefit. If you are above those ranges, you’ll pay income tax on 85% of your Social Security benefit.
Sadly, I have to say I have seen cases where an individual is less than 70 years old, in a 30%+ marginal income-tax bracket, saving money, and still insists on claiming their Social Security benefit. It would be a simple fix to suspend Social Security benefits, reduce their taxable income, and accrue delayed filing credits to their future social security income. Yet some will still continue those benefits because they feel they have paid in all their life and want to see some return on their money. Yes, you could die, but throwing away money paying needless taxes is hard to understand.
Additional Income and Adjustments
In trying to make the form 1040 look simpler, the IRS added this line. It refers to a Schedule 1 and is attached to your 1040.
Under the old tax rules, alimony was deductible to the payer and taxable to the payee. No more--Congress has managed to shift the income tax burden for alimony payments to what is likely the higher earner with the higher marginal income tax rate. If you are divorcing it is important that the income tax liability of alimony payments be considered in developing an equitable settlement.
This has become a much more important item than in years past, as owners of any business that uses a pass-through entity can receive a 20% reduction to taxable income generated through that business. Assuring you maximize this important benefit is essential. See our previous post ‘Big Savings for Self-Employed and Business Owners’.
Capital Gains and Losses
For all taxpayers, it is important to use tax-efficient strategies for taxable investment accounts. High yield stocks and bonds are more efficient being owned in tax advantaged accounts (401ks, IRAs, Roth IRAs etc), while investments that mostly appreciate in value are a better fit for taxable accounts. Still, capital gains rates are attractive relative to the tax rates on ordinary income.
You can use capital losses to offset any capital gains you receive, plus $3,000 of ordinary income. Capital losses are never a good thing, but at the end of each year you should review your investments to look for opportunities to offset gains.
Rental Real Estate, Royalties, Partnerships, S-Corps, trusts, etc.
If you own rental properties you know how helpful depreciation can be for your income tax liability. Yes, some of the depreciation will be needed to maintain the property, but some of it will also reduce your taxable income, and if you sell, will result in more income being taxed as capital gains at currently favorable rates. If you own a property that has been fully depreciated you might consider using a tax-free exchange to like property to increase your basis and start the depreciation process all over again.
Adjustments to Income
Health Savings Accounts
Many American’s are now covered by high-deductible health insurance plans either through their employer or purchased directly from insurers through the Affordable Care Act Marketplace. Contributing to an HSA will reduce your current income tax liability, and if the funds are used to pay for qualified medical expenses the distributions are tax-free as well. See our post on ‘Hacking Your Health Savings Account’.
Self Employed SEP, SIMPLE, and Qualified Plans
An easy way to reduce your current year income tax liability is to contribute to a retirement plan. IRA contributions are reported on line 32, but if you’re self-employed you can defer taxes on even more money. You can establish a SIMPLE retirement plan before October 31 of the current tax year and defer up to $13,000 ($16,000 if you are over age 50) annually.
A SEP retirement plan allows an even bigger tax deferred contribution of up to $56,000, plus a catch-up contribution of $6,000 if you are over age 50. Another useful benefit is you have until your income tax filing deadline, plus any extension, to establish and fund a SEP for the previous tax year. If you’re a business owner who still needs to reduce your previous years taxable income-- this is your chance!
Self Employed Health Insurance Deduction
If you’re self-employed, this is where you get to reduce some of your taxable income for health insurance expenses. If you’re not self-employed and are not covered by an employer health insurance plan, this is motivation for starting a side gig.
For example, the mechanic that works on cars after hours, or maybe the carpenter that does an occasional job on the side. Formalize your business to take advantage of this deduction.
While this is far from an exhaustive list of ways to reduce your income tax liability both now and in the future, you can see there are opportunities for almost everyone to benefit from income tax planning. Take some additional time to review the tax forms you just filed or see a financial planning professional-- there is a lot at stake.
The holidays may be on your mind now, but taking steps to reduce your income tax bill for 2017 could make for a merrier April. If you wait until the start of the New Year to think about income taxes, you will be too late. To help us understand the steps we should be considering, we enlisted the help of Myrtle Beach CPA Bart Buie.
With the proposed changes to deductibility of state and local income taxes it makes sense to accelerate the current year deduction. That means you should make your estimated tax payments In December of 2017 rather than waiting until January of 2018. You may even want to purposely over pay your state income taxes this month to get a bigger deduction when you file in 2018. Don’t worry if you overpay you will get that refunded to you in April of 2018.
Business owners should be doing a pro forma income tax calculation now to be sure they are minimizing their taxes. With rates purportedly going down in 2018, it makes sense to push as much income as possible into the new year. That means any billing should be delayed to the end of the month, if possible, so that the receipt will post to your books in 2018. Also, business owners should be looking to pay all the bills they have incurred in calendar year 2017 before December 31, even if they are not due until January of 2018. This will reduce 2017 taxable income by increasing expenses for the year.
Bart also talks about purchasing equipment needed for your business now. He offers an example of purchasing a work vehicle in December to qualify for a 2017 deduction, even though your payment may not begin until 2018.
December is also the last month to establish 401(k) and solo 401(k) plans to save on 2017 income taxes. Bart points out that an S-Corp with one employee can establish a plan before year end and the business owner can then make a salary deferral contribution in 2017; with the company match being made by their tax filing deadline in 2018. Because an S-Corp is a pass-through entity, the matching contribution will still lower your income tax bill for 2017.
Bart also encourages clients to accelerate charitable donations. If you have planned giving, you can go ahead and make the contribution to reduce your tax liability.
Don’t forget to look for chances to offset any realized capital gains with any capital losses available. You can use losses to offset 100% of any gains you claim plus $3,000 of other taxable income. There is talk of eliminating your ability to designate which lot of stock you sell in the future, so now would be a good time to review your accounts for places where the FIFO accounting method might be a negative for you. Be careful not to run afoul of the thirty-day wash sale rule as you implement this strategy.