Planning Year-End Taxes

You finally can do serious year-end tax planning in 2011. Year-end planning was difficult the last few years, because so much of the tax code was up in the air. But the December 2010 deal made the tax code fairly certain for 2011 and 2012. That’s important, because tax planning requires looking at two years or more together. Year-end planning often involves moving items between different years and minimizing total taxes over the period.

Begin year-end planning by estimating your tax bill for this year and next, assuming no changes are made the rest of the year. Then, consider changes you can make, such as those we discuss here, and recomputed the taxes.

The key factor for many people is whether they are able to itemize deductions on Schedule A or must use the standard deduction. Use Schedule A when your itemized deductions exceed the standard deduction. As a general rule, people with mortgages itemize deductions but people without mortgages don’t have enough deductions to exceed the standard deduction. But there are exceptions. In areas with high real estate or personal property taxes, taxpayers might have enough itemized deductions without mortgage interest. Also, people with high charitable contributions might be able to itemize based only on those deductions.

When you itemize deductions, you might be able to move them around to minimize overall taxes. When your income is volatile, you want to move deductions to the year with the highest income and therefore the highest tax rate when possible. When income is stable, it’s usually better to take a deduction now instead of later. When your itemized deductions modestly exceed the standard deduction each year, you might benefit by trying to bunch itemized deductions in one year and take the standard deduction the next.

You bunch itemize deductions by accelerating some of them into 2011.

When you have a mortgage, you can pay January’s interest in December. That gives you 13 months of interest deductions this year. (You’ll have only 11 months of interest deductions in 2012 unless you do this again next year.) You also can prepay state and local income and property taxes. You can prepay only expenses that are due early next year. When you prepay too early, if the IRS audits you they’ll disallow some of the deductions because they were paid before owed. A good rule of thumb is to pay in December expenses due in January.

When you live in a state without an income tax, you might benefit from taking the option of deducting sales taxes instead of income taxes in 2011. If so, you can deduct either standard sales taxes as listed in the table provided by the IRS, or you can deduct actual sales taxes. You also can use the IRS table and add sales taxes from major purchases such as boats and vehicles. You bunch the sales tax deduction by being sure to make in December any large purchases you’re planning to make anyway in coming months.

Charitable contributions are easy to bunch in one year. When you have the cash available you can take the extreme step of making contributions in one year that you normally would spread over two years. You also might be able to donate property, such as appreciated investments, instead of cash. In that case, you deduct the fair market value on the date of the contribution.

Medical expenses are deductible only to the extent they exceed 7.5% of adjusted gross income, and miscellaneous deductions are deductible to the extent they exceed 2% of AGI. You might be able to bunch these in one year, because many of them are flexible.

For example, you have some control over the timing of many medical treatments and procedures. These include routine and periodic exams, elective surgery, and procedures the doctor or dentist has been encouraging you to undergo that you’ve been delaying. You also might be able to prepay some medical insurance premiums such as long-term care insurance premiums. A number of people buy new eyeglasses and visit the dentist in December to bunch their medical expenses.

When trying to accelerate deductions, remember the credit card rule. A deductible expense is deducted in the year it is charged against your credit card regardless of the year in which you pay the credit card bill. So, you can charge an expense in 2011, deduct it on your 2011 return, and not pay for it until 2012.

When you’re working and haven’t maximized contributions to 401(k)s and deductible IRAs (if you’re eligible), consider putting more money into them by Dec. 31.

Some people might not want to move deductions into this year. Suppose you anticipate having more taxable income next year or know some of this year’s deductions won’t be available next year. You might want to defer deductions into next year. Do that simply by delaying payment until after Dec. 31.

You also can move income around. You probably want to maximize income in a year when you’re bunching deductions, so the deductions offset the most income and at the highest tax bracket. Some people will want to take the opposite tack and defer income simply to defer the taxes.

There’s usually flexibility possible timing the recognition of some income, especially investment income. You can accelerate income into this year by taking actions early. You can sell by December 31 assets with gains you plan to sell soon anyway. You also can take earlier distributions from IRAs, annuities, and other accounts.

In a year when you want to minimize income (because you have few deductions or already have a lot of income), reverse those steps. You also can search your taxable accounts for assets with paper losses. Sell those assets, and the losses first will offset any capital gains for the year. Any excess loss will offset up to $3,000 of other income. When there’s still a loss exceeding that, it can be carried forward to future years to be used the same way.

Don’t forget that a recent tax law change takes effect for your 2011 stock gains and losses. The broker or other custodian of your account (such as a mutual fund) computes the basis of stock purchased and sold in 2011 and reports the basis on your Form 1099 for the year in January 2012. Next year the same thing is done for mutual fund shares.

You probably know there are several ways to compute the basis of shares you sold when you didn’t purchase and sell the entire holding of an asset at one time. You can use an average method; specific identification of shares; first-in, first-out; and last-in, first-out. The firms set a default method and will use that unless you select another method. You should have received a notice from your broker in Fall 2011 informing you of the options. More details are in our December 2010 visit.

When you’re working, you might negotiate the payment date of bonuses and pay raises so the additional amount is recognized in the year that is best for you.

Before making a move, be sure to compute not only your regular income tax but also the alternative minimum tax. Some tax breaks, especially state and local taxes and miscellaneous itemized deductions, are not allowed under the AMT. Medical expenses also are harder to deduct.

RW December 2011