As we near the end of 2014, year-end tax planning again takes center stage. In this article we summarize a number of strategies that may produce substantial tax savings with just some year-end tax planning.
Making Trust Distributions
The tax brackets for trusts are much more compressed compared to the brackets for individuals. This suggests, if the governing instrument allows it, that trustees should consider making discretionary distributions of income to beneficiaries at the end of 2014 to reduce tax rates.
Harvesting Ordinary Income
Harvesting ordinary income is another part of an overall successful year-end plan. Harvesting ordinary income should, at a minimum, be considered to make the following two statements true:
- Ordinary income at least equals itemized deductions plus exemptions; and
- Tax liability at least equals tax credits available.
Furthermore, harvesting ordinary income may be considered in order to “fill-up” your marginal tax bracket. This is especially true today with the advent of seven different ordinary income tax brackets.
Harvesting Capital Gains
A taxpayer with a lower long-term capital gain bracket in 2014 than he or she expects to have in later years might consider selling appreciated assets that he or she planned to sell in 2015, or a later year, to take advantage of the lower tax rate.
Harvesting Capital Losses
If a taxpayer recognized capital gains earlier this year, or anticipates recognizing any gains before the end of this year, it might make sense to harvest capital losses to help offset the gains recognized.
Choice of Filing Status
Married taxpayers can file jointly or separately. Moreover, filing status can make a significant difference in the amount of NIIT owed. Recall that for individuals the NIIT applies to the lesser of (1) NII or (2) MAGI minus the applicable threshold amount (ATA) for the taxpayer’s filing status. The ATAs are $250,000 for married taxpayers filing jointly, $200,000 for single taxpayers and $125,000 for married taxpayers filing separately.
A taxpayer might have a 2014 spike in income pushing them into a higher tax bracket than they expect to have in the future. Consider a single taxpayer, ordinarily in the 35% tax bracket, who recognizes a large capital gain increasing their 2014 income to $435,000, of which $250,000 is NII. The 39.6% bracket applies to the last $28,250 of income. $235,000 is also subject to the 3.8% NIIT (NIIT applies to the lesser of (1) NII ($250,000) or (2) MAGI exceeding the ATA ($435,000 – $200,000 = $235,000)).
One way to reduce the tax is to make a $28,250 contribution to charity. The charitable deduction eliminates the income in the 39.6% tax bracket (assuming we do not consider any phase-outs), but it does not eliminate or reduce the NII. Because the charitable deduction is a below the line deduction, AGI remains equal to $435,000 and the NIIT still applies to $235,000.
Charitable Remainder Trusts for Large Sales
Taxpayers who plan to make large sales at the end of the year should consider creating a CRAT or CRUT to smooth income. The mechanics of the transaction are simple. The taxpayer transfers an appreciated asset to a CRT, which sells it. Because the trust is a tax-exempt entity, no gain is recognized. Gain on the annuity or unitrust payments are subject to tax only as annual distributions are received by the donor, thereby spreading the income out over a period of time. This prevents a spike in income and may help avoid the higher tax brackets and reduce or eliminate NIIT.
Charitable Lead Trusts
Taxpayers with charitable intent should consider creating a charitable lead trust (CLT) at the end of the year. During the term of a CLT, payments are made to the charitable beneficiary. At the end of the term, any assets remaining in the trust pass to non-charitable remaindermen; generally with very favorable gift tax results. The remaining assets transfer as a tax-free gift to the remaindermen if the return on trust assets exceeds the Section 7520 rate, which is currently very low (a CLT produces interest rate arbitrage like a GRAT). Assuming the CLT assets produce a return in excess of the Section 7520 rate, it is a more efficient gifting strategy than an outright gift to charity because it benefits charity to the same extent while providing a bonus for family members.
Roth IRA Conversions
Whether a Roth IRA conversion is favorable for a particular taxpayer is fact dependent. A detailed quantitative analysis is necessary to determine whether a conversion provides an overall economic benefit. Some of the many factors that might favor a Roth IRA conversion include:
- The taxpayer’s marginal income tax rate at the time of the conversion and the taxpayer’s expected marginal income tax rate when distributions will be received (i.e., if it is lower at the time of the conversion than when distributions will be received, converting provides an economic benefit);
- Whether the taxpayer has available funds outside of the IRA that can be used to pay the conversion tax (i.e., it, in effect, packs more value into the IRA);
- Whether the taxpayer has special favorable tax attributes that may help offset the taxable conversion amount;
- Whether the taxpayer needs the required minimum distributions (RMDs) at age 70 ½ (i.e., a Roth IRA suspends RMDs); and
- Roth IRA distributions are not included in net investment income or MAGI, whereas, IRA distributions are included in MAGI.
There are several ways to reduce the cost and risk associated with a conversion. The cost can be reduced by staging it over several years to hold down the marginal tax rate applied to the conversion amount. While the ability to re-characterize a Roth IRA back to a traditional IRA if the assets drop in value eliminates much of its risk. The ability to re-characterize can further reduce risk if the taxpayer creates separate Roth IRAs for each asset class so if certain asset classes drop in value, only those that declined in value will be re-characterized.
State Income Tax and the NIIT
Reg. § 1.1411-4(f)(3)(iii) provides that “[t]axes imposed on income described in § 164(a)(3) that are allocable to net investment income…” are a properly allocable deduction. State income taxes are included in § 164(a)(3) and thus deductible against NII, if attributable to such NII. The Final Regulations provide that if the state income tax is allocable to both NII and non-NII, the portion of the deduction that is properly allocable to NII may be determined by taxpayers using any reasonable method.
If a taxpayer waits until 2015 to pay the state taxes on NII, the taxpayer may not have any NII in 2015 to take advantage of the state income tax deduction and will lose it. However, if the state income tax allocable to NII is paid in 2014 it can reduce federal NIIT liability.
Avoiding Estimated Tax Penalties
Favorable stock market returns and higher tax brackets may have caused underpayments of estimated tax for many taxpayers. Penalties can be avoided on the shortfall by having employers increase withholding.
With the end of 2014 fast approaching, now is the time to find out if one or more of these strategies might help your clients save on their income tax this year.
RELATED EDUCATIONAL PROGRAM
For more information about this topic, please join us and speaker, Robert Keebler, for a special and timely educational program on Wednesday, November 5th, 2014 at 9am Pacific Time entitled, “Special Year-End Tax Planning Opportunities for 2014”. >>REGISTER NOW
By the way, if you are unavailable or miss this program, you can still purchase the handout materials and the audio recording.
ABOUT THE AUTHOR
Robert S. Keebler, CPA/PFS, MST, AEP (Distinguished), CGMA is a partner with Keebler & Associates, LLP and is a 2007 recipient of the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels. He has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States and one of the Top 40 Tax Advisors to Know During a Recession. Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. His practice includes family wealth transfer and preservation planning, charitable giving, retirement distribution planning, and estate administration. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and in estate, gift and income tax examinations and appeals.
In the past 20 years, he has received over 150 favorable private letter rulings including several key rulings of “first impression.” Mr. Keebler is nationally recognized as an expert in estate and retirement planning and works collaboratively with other experts on academic reviews and papers, and client matters. Mr. Keebler is the author of over 75 articles and columns and editor, author, or co-author of many books and treatises on wealth transfer and taxation, including the Warren, Gorham & Lamont of RIA treatise Esperti, Peterson and Keebler/Irrevocable Trusts: Analysis with Forms.
He is a frequent speaker for legal, accounting, insurance and financial planning groups throughout the United States at seminars and conferences on advanced IRA distribution strategies, estate planning and trust administration topics including the AICPA’s Advanced Estate Planning, Personal Financial Planning Conference and Tax Strategies for the High Income Individual Conference.
To contact Mr. Keebler, call his office at 920-593-1701 or by e-mail at robert. [email protected].
OTHER ARTICLES IN THIS ISSUE
- MARKETING: “The Top 10 Marketing Must-Do’s for Estate Planners” by Jennifer Goddard, CEO & James Campbell, Vice President of Integrity Marketing Solutions
- SUPPORT STAFF: “8 Steps to Hiring a Great Executive Assistant” by Kristina Schneider, Executive Assistant
- PRACTICE-BUILDING: “Clearing the Bubble – – Transition to a Fixed Fees” by Philip J. Kavesh, J.D., LL.M. (Taxation), CFP®, ChFC, California State Bar Certified Specialist in Estate Planning, Trust & Probate Law
- ADVANCED-LEVEL ESTATE PLANNING: “Family Business Succession Planning” by Brandon E. Crooks, Principal at Counsel Trust Group
- FREE RESOURCE: 3rd Annual Dynasty Trust State Rankings Chart by Steven J. Oshins, J.D., AEP (Distinguished)
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