Most of you recently completed your 2011 income tax returns or soon will. Don’t file your copies of the returns away just yet. The federal income tax return is one of the best financial planning documents available. Many financial planners insist on seeing the latest returns very early in the relationships with a potential client. Since the government made you incur the time and expense to prepare it, you should take some extra time to benefit from it by seeing what the return says about your finances.
Scanning your tax return with an educated eye reveals much about your finances and provides some tips to how your net worth can be increased.
First, determine your two tax rates. The first rate is your average tax rate. Divide the total income taxes you paid by the total gross income for the year. That’s the percentage of your income that goes to federal income taxes (but not to all those other taxes you pay). When that’s higher than you’d like or think it should be, study your return closely for opportunities to reduce it.
The other tax rate is your marginal tax rate, or the rate on your last dollar of income. You generally find this in the tax tables by seeing which tax bracket you’re in. The tax tables also indicate whether you are in danger of rising to the next higher bracket by earning a little more income or could fall to a lower tax bracket by reducing taxable income a bit. When you’re near either edge of your bracket, sharpen your tax planning. A few timely moves could keep you from moving into the next higher bracket or push you into the lower bracket.
Higher-income taxpayers sometimes pay a higher marginal tax rate than indicated in the tables, because some tax breaks are phased out as income rises. Several of the key benefit phase outs (the reductions in itemized deductions and in personal exemptions) are suspended for 2011 but could return for 2012. Computing the marginal rate is too complicated for these taxpayers, but you should know your marginal rate is higher than the tax rate table says.
Next, were you subject to the alternative minimum tax (AMT) in 2011? If so, you probably lost the benefit of some tax deductions and other breaks. There are two ways you can respond to the AMT.
You could study your return for ways to avoid the AMT in 2012. This might mean reducing long-term capital gains or other tax breaks that triggered the AMT. Or you could accept that you’ll be subject to the AMT and plan accordingly. When you accept the AMT, your planning might involve avoiding expenses that are deductible or creditable under the regular income tax but not under the AMT, because you won’t benefit from them. You also might accelerate some ordinary income, because you know the AMT’s flat rate will be the highest rate imposed on that income.
People with some flexibility over the timing of their income and deductions decide to arrange income and deductions so they’re subject to the AMT one year but not the next. Whichever route you take, when you’re potentially subject to the AMT, your tax planning should be different than for other taxpayers.
A review of the personal information on the return is next. Major changes here mean your estate plan needs an update. Were there changes in your residence, marital status, or number of children (or grandchildren)? If so, arrange to meet with your planner.
Next, review your income. Most people focus on deductions in their tax planning, but you receive more benefit these days from income planning. Not everyone can change income flows, but when you can the tax benefits can be significant.
One factor to consider is whether you have too much income. This is especially likely for retirees. When your gross income or taxable income greatly exceeds your spending needs for the year, see if there are ways to reduce the income you recognize each year.
There could be distributions from IRAs, annuities, or other retirement-oriented assets that you didn’t need and didn’t have to take. Changing the distributions could help you avoid paying taxes you don’t have to.
To avoid future excess income, consider converting a traditional IRA to a Roth IRA. The required minimum distributions from traditional IRAs rise as you age, and many people find the RMDs force them to distribute far more taxable income than they need. Converting to a Roth IRA could save you and your heirs far more taxes in the long run. Another reason to consider converting is you could be subject to higher tax rates after 2012. If so, it makes sense to pay taxes now instead of later. If your tax bracket is expected to be lower than usual this year because of reduced income or higher deductions, it might be a good time to convert your IRA.
When you’re earning a salary, it’s taxable at the highest rate and also subject to payroll taxes. When you can, opt for non-taxable benefits or deferred salary instead of cash salary. Caution: Don’t defer salary when you expect to be in a higher bracket in the future.
Examine your interest income. It probably isn’t much because of the Fed’s zero interest rate policy. But consider the options. Would tax-exempt bonds be a better deal in your tax bracket? When you don’t need the interest to meet expenses, can the money generating the interest be shifted into a deferred annuity, IRA, or other deferred vehicle?
These days qualified dividends can be better than interest. They’re taxable at only a 15% rate at least through the end of 2012. You have to be careful, because earning dividends means buying stocks, and stocks introduce a lot more volatility and risk into your portfolio. They aren’t the place for safe cash.
Long-term capital gains are another preferred source of income. You want to minimize short-term capital gains and ordinary income when you can. That means minimizing holdings of mutual funds that make large distributions of short-term gains each year. Instead, focus on funds that minimize their distributions or make primarily long-term capital gains distributions. You also want to avoid sales of mutual funds and other assets that you’ve held for less than one year, because those are taxed as ordinary income. Hold your positions for more than one year to ensure receiving the long-term capital gains treatment. The difference between capital gains and ordinary income is substantial, so anything you can do to turn short-term gains into long-term gains will pay off.
One word of caution is that a high level of long-term capital gains and qualified dividends can trigger the AMT. These types of income won’t be subject to the AMT; they retain the 15% top tax rate. But they could cost you deductions and other tax benefits by triggering the AMT.
Capital gain assets also let you determine the timing of the income. You decide when to sell assets and recognize the gains. In addition, you can sell assets with losses and deduct those losses against gains for the year. When the losses exceed your gains, up to $3,000 of capital losses can be deducted against other income.
While considering your income, review your sources of income to see if they cause more trouble than they’re worth. Some people hold small positions in assets such as master limited partnerships. These can trigger several different tax forms and returns in different states. While there are benefits to these assets, consider the full picture. The tax preparation expense of small positions in such investments might more than offset the benefits.
Too much income also can be a sign that your estate plan needs a review. Perhaps you should be giving to your loved ones some of those assets that are generating more income than you need. Get them out of your estate, move the income to the tax returns of relatives, and let your loved ones benefit from the assets now instead of waiting to inherit them.
Now, shift your attention to the deductions on your return.
You probably aren’t itemizing expenses on Schedule A unless you have a mortgage or live in an area with high real estate or income taxes. When you are itemizing, consider these issues.
Should you pay off a mortgage or perhaps refinance it? It can make sense to pay off your mortgage when the after-tax yield earned on your money is less than the after-tax rate on your mortgage. You get a bigger pay off from using that cash to eliminate your mortgage interest expense than you do from the way it’s invested. Of course, you want to retain enough cash to cover your expected spending for a period of time, what I call the safety fund. But when you have a lot of money sitting around in low-earning accounts, consider using it to eliminate your mortgage.
Don’t be swayed by the traditional argument that you always should have a mortgage because that saves taxes. That made some sense when the top tax rate was 50% or higher. In those days, the IRS paid most of your mortgage interest. Now, with a top tax rate of 35%, you’re picking up most of the interest expense.
When your mortgage rate is higher than current mortgage rates, consider refinancing. There probably will be closing costs and fees. The rule of thumb is to first estimate how long you’ll stay in the current home. If it’s fewer than two years, don’t bother refinancing. Otherwise, be sure the savings from the lower mortgage rate over two to three years will at least equal the costs of refinancing. Then, it usually might make sense to refinance.
You probably aren’t deducting medical expenses. Most people don’t. If you aren’t, review the rules. Most people don’t realize how broad the deduction is and might be able to receive some tax benefits by keeping track of all their medical expenses. For details, review our January 2012 visit available on the Tax Watch section of the Archive on the members’ web site.
You also should review your charitable giving strategies. Are you giving in the most efficient way, getting the most bang for the buck? If not, reconsider your giving strategies. I’ll review this in detail next month.
RW April 2012.
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