Making Sure this Year’s Tax Strategies Work

Tax planning is harder than ever, especially for many in their 50s and older. That’s because Congress continues to tinker with the tax code. Over the years, many provisions that I call Stealth Taxes were created. The Stealth Taxes include the 3.8% Medicare surtax on net investment income, the Medicare premium surtax, the inclusion of some Social Security benefits in gross income, the phaseout of personal and dependent exemptions, the reduction in itemized expenses, the Alternative Minimum Tax, and more.

Of course, these provisions make it harder to complete an income tax return. That’s why professionals prepare more than half of individual income tax returns. More importantly, the Stealth Taxes make tax planning more difficult. The diabolical nature of the Stealth Taxes is that a strategy that reduces one person’s income taxes can increase the taxes for another person. Also, I call them Stealth Taxes, because their effects often aren’t intuitive or obvious; you should complete hypothetical returns assuming different scenarios to discover the best strategy. Following generic tax advice instead of working through your own situation can increase your tax bill.

Let’s look at examples of some traps and pitfalls you need to avoid. Study them now and consider your strategies for the rest of the year. When it comes time for year-end tax planning, you won’t be among the many Americans who inadvertently trigger higher tax bills.

• A standard year-end tax strategy is to prepay some deductible expenses by Dec. 31 instead of waiting until their final deadlines in January. The strategy is commonly recommended for local taxes, such as real estate, income and personal property taxes. For many people, it is good advice.

For some people, however, increasing those deductions in one year pushes the taxpayers into the Alternative Minimum Tax (AMT). Under the AMT, the benefits of these and other tax breaks are reduced or eliminated. The AMT originally was directed at millionaires who paid no income taxes, at a time when a million dollars was a heck of a lot of money. Now, the AMT is imposed on many middle and upper-middle income taxpayers, and it disproportionately affects retirees.

It’s important to determine if one or more strategies will trigger the AMT.

• Selling assets with long-term capital gains can be fraught with hidden perils. Long-term capital gains in general receive favorable tax treatment. But long-term gains can have undesIRAble secondary effects, such as triggering or increasing Stealth Taxes.

Another widely-used strategy is to sell enough appreciated assets that the longterm capital gains push you to the top of your current tax bracket without pushing you into the next higher tax bracket. This can be an especially smart strategy for taxpayers in the 15% income tax bracket, because the long-term gains rate in that bracket is 0%. It is a good idea to take those gains in a year when you’re confident they won’t be taxed instead of waiting until a future year when you might be in a higher bracket.

Yet, you have to be careful. While those additional gains won’t be taxed, they increase your adjusted gross income. That means they could trigger income taxes on Social Security benefits or increase the amount of your benefits subject to income taxes.

Taking more gains also can reduce deductions for medical expenses. Your medical expenses are deductible as itemized expenses, but only to the extent they exceed a percentage of your AGI. For taxpayers under age 65, only medical expenses that exceed 10% of AGI are deductible (and only if you itemized expense). For taxpayers 65 and older, medical expenses exceeding 7.5% of AGI are deductible, and that will rise to 10% of AGI after 2016.

Even higher income taxpayers have to be careful about taking too many of those tax-favored capital gains. The additional gains could trigger the AMT or the Medicare premium surtax. You might not feel the full effect for two years, because your 2016 income taxes determine your 2018 Medicare premium surtax. The 3.8% Medicare surtax on net investment income also could be triggered or increased by higher capital gains, because that surtax is triggered at higher levels of AGI.

The lesson is to know the trigger points for the Stealth Taxes and when some additional income, even tax-favored income such as long-term gains, might backfire by triggering or increasing those taxes. This situation is especially important for higher-income taxpayers but also is important for taxpayers with lower incomes who might lose medical expense deductions or have Social Security benefits taxed.

• There also are traps in computing capital gains taxes. Suppose you recognized some short-term capital gains early in the year. These are taxed at the same rate as ordinary income. You decide to sell an investment that has losses to offset the short-term gain and avoid taxes on it. The loss assets you sell are long-term. Often it doesn’t matter that the gains are shortterm (assets held one year or less) while the losses are long-term. They offset each other.

But sometimes it does matter. When mutual funds distribute their gains for the year, those gains always are long-term gains to shareholders. Long-term gains and losses offset each other first. That means if one or more of your funds distributed a lot of gains late in the year, your tax planning could be for naught. The long-term losses you recognized would offset the tax-favored long-term gains distributions from the mutual funds. Only any of the losses that exceed the fund distributions would be available to offset the short-term gains.

The lesson is that it is best to offset short-term gains with short-term losses, if you have them in your portfolio. The other lesson is that mutual funds can make surprising distributions near year-end that upset some of your tax planning.

Whether you do income tax planning on your own or with the help of a professional advisor, be sure that your full tax position is analyzed before a strategy is executed. Look for the hidden and unintended effects of a strategy. Could it trigger one or more of the stealth taxes? Are you at risk of falling into the AMT? Don’t settle for rules of thumb or back-of-the-envelope estimates.