Ask the Experts: Advice for Avoiding Tax Pitfalls
As the end of 2016 approaches, the time for making year-end tax adjustments is running out. To ensure maximum benefit of eligible deductions and to avoid potential tax pitfalls, a year-end tax projection is likely to prove a very useful tool. As a first step, gather and organize all of your documentation for income and deductions related to the 2016 tax year (It is important to remember that the IRS will not let you make ballpark estimates, you must document your activities). After collecting your documentation, compare the income and deductions known for the current year with amounts from previous years to focus on any discrepancies. Most tax planning opportunities, or tax deficiencies, that come to light will likely require action before the end of the year, so time is of the essence.
Year-end areas for consideration. Review your flexible spending accounts. While providing significant advantages throughout the year, the infamous “use it or lose it” rule applying to flex accounts may catch some taxpayers off guard. Also, review your policy for adoption of a grace period permitted by the IRS that allow employees to spend 2016 flex contributions as late as March 15, 2017.
With the stock markets reaching record levels, taxpayers with high capital gains may want to consider “loss harvesting” - selling investments such as stocks and mutual funds to realize losses - to offset capital gains. In general, capital losses can be used to offset capital gains, to the extent of the capital gain. If capital losses exceed capital gains, $3K of capital losses can be used to offset other income, including ordinary income. Loss harvesting may be a particularly attractive tool for taxpayer’s subject to the Net Investment Income tax (NII) – a 3.8% tax imposed on net investment income or MAGI above $250K for married individuals.
For those taxpayers with appreciated capital gains property planning to make charitable contributions, an alternative to the traditional cash contributions is giving the appreciated property. While annual limitations apply to various types of property given, as well as to charitable contributions overall, giving capital gain property allows for a charitable contribution deduction equal to the properties FMV on the date of the gift without recognizing the capital gain associated with the increase in value. For example, a taxpayer that owns stock they purchased for $20 with a FMV of $100 could sell the stock for $100 and give the proceeds to charity. The result is an $80 capital gain (100-20) and a $100 charitable contribution. If instead, the taxpayer giving the stock to the charity would result in a $100 charitable contribution deduction (FMV on date of gift) and no capital gains recognized. Taxpayers 70½ and over may exclude from income, distributions for charitable contributions made directly from their individual retirement account of up to $100k.
Taxpayers on the cusp of claiming itemized deductions may want to accelerate deductible expenses into 2016 (the standard deduction for 2016 is $12,600 for married couples). Common expenses taxpayers claim as itemized deductions include state and local income tax payments (sales tax may be substituted for states without income tax), ad valorem property taxes (property taxes on personal property), charitable contributions, and medical expenses. Taxpayers may claim as a deduction in 2016, those 2017 estimated tax payments made before the end of the 2016 tax year. For tax payers that are also home owners, paying multiple property tax bills in one year may generate a larger deduction. Consider making payment on future charitable pledges before the end of the year. Consider purchasing non-urgent medical expenditures before the end of the year to get total medical costs above 10% of AGI floor (7.5% for taxpayers 65 and older). Beginning in 2017, the 7.5% floor for taxpayers 65 and older will be phased out and medical expenses for all taxpayers will be subject to the same 10% floor.
While the above opportunities require action prior to the end of the 2016 tax year, remember deductible IRA contributions made up to April 15, 2017 may be claimed in 2016.
Lastly, a few general filing considerations.
Your federal income tax liability is due when you earn the income. If you do not timely remit payment of your federal tax liability, you may be assessed an underpayment penalty. To avoid assessment of an underpayment penalty, check your withholding to ensure that you have paid in a sufficient amount of income tax. As long as 90% of this year’s tax liability, or 100% of last year’s tax liability (110% for high income individuals), is paid in timely you will not be subject to the penalty. If you are in danger of an underpayment penalty, additional tax payments made through withholding your salary or bonuses may alleviate this penalty. Estimated tax payments relate the quarter in which the payment was made only, while a tax liability is generated throughout the year, with some exceptions. Accordingly, a large estimated tax payment in the final quarter will not cover taxes due in previous quarters and exposes the taxpayer to tax penalties assessed against prior quarters. However, federal tax payments made through payroll withholding of wages are deemed to be timely no matter when made throughout the year.
While same sex couples have been required to file their federal tax returns according to their legal “marital status,” pursuant to the June 26, 2015, U. S. Supreme Court decision authorizing same-sex marriages, the Alabama Department of Revenue will accept “married filing jointly” income tax returns filed by same-sex couples. For tax years within the statute of limitations (those returns that are seeking a refund will likely have a limitation of three years), same-sex couples who filed “single” returns will be allowed to amend their tax returns to file as “married filing jointly.”
Given the recent natural phenomenon in the surrounding areas – consider a casualty loss and determine what year to claim it in. Natural disasters are eligible to create a casualty loss that can be carried back 3 years to generate immediate cash flows.
Contributed by Dr. Russ Hardin, Chair, and Dr. James Rich, Assistant Professor, Department of Accounting, MCOB