10 Year-End Tax Strategies

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by William Baldwin
Forbes Staff
November 1, 2013

You’ve got two months left for tax tricks. The objective is to either lower your taxable income or push it into lower brackets. One tax strategyitem on my list has to do with lowering estate taxes.

There are two ways to reduce your taxable income: increase your itemized deductions or reduce your adjusted gross income. A lowering of AGI is more powerful because the AGI is used to figure all kinds of benefits, like college tax credits and personal exemptions.

1. Kick up your 401(k) contribution. If withholding from your paycheck has been lower than it could be, talk to your plan administrator about making a one-time catch-up. Your annual maximum is $17,500, or, if you are at least 50, $23,000. These “elective deferrals” come on top of whatever the boss is putting in for you.

This powerful tax dodge lowers your AGI.

2. Contribute to a Health Savings Account. High-deductible insurance plans permit the employee to chip in; for family coverage, the maximum total contribution (employer plus employee) is $6,450 a year. If you are 55 or older, add $1,000.

By paying out-of-pocket medical expenses via the HSA, you accomplish two things. First, you get around the limits on medical deductions, which are so tight that most people can’t deduct medical costs at all. Second, you lower your AGI.

3. Sell stinker stocks.The game here is to sell losing investments to get the capital loss deduction, while letting winners ride. You can cry poor to the tax collector even though your overall portfolio is doing well.

Some people hesitate to sell because of the “wash sale” rule, which says you can’t claim a capital loss on stock X if you get back into X within 30 days. They are worried the stock will rebound while they’re on the sidelines.

Here’s a cure for those worries: Diversify your loss harvesting. If you have six losing positions, A through F, sell A, B and C, and use the proceeds to double up on D, E and F. After 31 days, sell the original (high-cost) lots of D, E and F and use that money to reestablish your positions in A, B and C.

Capital losses lower your AGI up to the point where they top capital gains by $3,000. That is the maximum net loss you can claim in any one year.

If you would otherwise have reported gains of $12,000 for 2013, but manage to harvest $14,000 of losses next week, then the harvest lowers your 2013 AGI by $14,000. If you previously had $12,000 of gains and now harvest $140,000 of losses, you’ll lower this year’s AGI by $15,000 (the gain/loss entry goes from +$12,000 to -$3,000) and you’ll have a $125,000 loss carryforward to use in future years.

4. Do a bond fund swap. If you had the misfortune to buy a long-term bond fund a year ago, it’s under water now. Grab a capital loss deduction. It’s easy to honor the 31-day wash sale without taking the risk of being whipsawed while you wait. You do that by switching into a similar (but not identical) fund. If you are down 10% on the Vanguard Long-Term Government Bond Index fund (VLGSX), you could switch to the Vanguard Long-Term Treasury fund (VUSUX).

If your intermediate-term tax-exempt fund is doing badly, you could switch temporarily, or permanently, into a blend of short-term and long-term muni funds.

Bond swaps work best with no-load funds, but they also can make sense for exchange traded funds. With the ETF, your transactions are not free, but they are pretty cheap: You’ll be out some $8 commissions and bid/ask spreads. The iShares ETF covering the bond market, ticker AGG, is similar but not identical to the Vanguard product, ticker BND. You can swap from one to the other without triggering the wash sale rule.

The great battle between investors and the IRS over which ETFs are “substantially identical” has yet to be fought. I think the IRS would win if someone swapped two S&P 500 funds and tried to claim a loss (SPY for VOO), because their positions match. Taxpayers will win if the AGG-BND swap is challenged. These portfolios are close to identical in economic effect (they are mostly Treasuries, with an average duration of five years) but the positions do not match.

Are you losing money on a gold position? You can probably take a loss on a bullion ETF and get right back in because the IRS views these ETFs as “collectibles,” not “securities,” and the wash sale rule applies only to “securities.” Good news for underwater GLD holders.

5. Make some gifts. That annual $14,000 exclusion from the gift/estate tax is a use-it-or-lose it benefit. If you know you will be leaving money to heirs, start leaving it now. You should be thinking about not just the federal estate tax, which for couples kicks in at $10.5 million, but state inheritance taxes, which can nail bequests of only $1 million.

6. Time your bonus. Do you have some sway over the timing of your year-end pay? Figure out which year is likely to leave you in a lower tax bracket.

If you started a high-paying job this year, you may be in a lower bracket in 2013, and that’s when to get supplemental pay. If you are retiring next year, though, 2014 would be the better timing for an extra paycheck.

Other things that can put an upward or downward jolt in your tax bracket: getting married, getting divorced, moving between a high-tax and a low-tax state and doing a Roth conversion. If you’ve got any of these things going on, talk to your accountant and then talk to your boss.

7. Think about Roth. Senator William Roth (1922-2003) came up with the idea that you might be willing to prepay income tax on your retirement account in return for a free pass when you take the money out. Is this a good deal for you? Often, yes. It’s particularly likely to be a winner if you can pay the tax from sources outside the account and if you expect to remain in a fairly high tax bracket during retirement.

If you work the numbers and they tell you to go Roth, waste no time. You are probably going to be better off doing a little in 2013 and a little in 2014 than doing a lot in 2014. Your target amount of Roth conversion in any one year should be no higher than whatever fills up your current tax bracket. If your marginal tax rate is 35%, for example, it would be foolish to Rothify so much money that you get pushed into the 39.6% bracket.

8. Pay state taxes early-maybe. You’ve got it in your calendar to make your fourth payment of estimated state income tax on Jan. 15. You might do yourself a favor by sending the money in a month early. That will raise your 2013 itemized deduction total on your federal return but lower your 2014 deduction. Why would you want to do that? It could help if your tax bracket is going down.

Accelerating state taxes would also help if you are not paying alternative minimum tax in 2013 but expect to be paying AMT in 2014. That’s because AMT payers lose the right to deduct state taxes on their federal returns.

9. Bunch your deductions. Two important deductions-for medicine and for “miscellaneous” items-have hurdles. You only can claim amounts above the hurdle. Strategy: concentrate payments into alternate years.

This year the medical floor for people younger than 65 is 10% of AGI (oldsters can use the former 7.5% floor until 2017). Say your AGI is $100,000 and your med costs are running $10,000 a year. Maybe in January you can pay a 2013 surgeon’s bill late and pay for three years of a kid’s braces early. That would kick some expenses into the deductible zone.

The miscellaneous category includes fees for investment advice and unreimbursed employment costs, with a 2%-of-AGI floor.

There are limits to your ability to deduct prepayments of monthly fees. But a bill due Jan. 1 can be legitimately paid in either December or January, and prepayments, as on braces contracts, are likely to pass muster if they get you a discount.

10. Prefund charitable gifts. Are you giving $10,000 a year to charities? It might make sense to put $50,000 right now into a donor-advised fund (of the sort offered by Schwab, Fidelity, Vanguard and others), then use that fund to make your annual contributions. This would be a winning move if your tax bracket is likely to be higher this year than in later years, or if you want to use this deduction to offset a $50,000 Roth conversion.

Here, there’s no arguing with the IRS about whether the deduction for a prepayment is legit. You are clearly entitled to the deduction as soon as you have irrevocably partly with the money. Another reason for liking those donor-advised funds is that they make it easy to pay for charity with appreciated securities. Do that and you get a deduction for their market value, yet the appreciation never gets taxed.

The changes that took effect this year are forcing many a taxpayer to take another look at financial planning.