FINANCE: Year-end Tax Planning: 9 Simple Steps to Cut Taxes, Avoid Pain
Column by Stephen Wiggs
With the end of the year fast approaching, you're probably wondering what you can do to cut your taxes. Remember: if you wait until April to start thinking about this, it's just too late. Here are some ideas to get you moving in the right direction now.
1. Pay state income taxes before Dec. 31. Many people wait until April 15 to pay their state income taxes, since that's when they file their state tax returns. However, if you pay your state income taxes in 2012, you can't claim the deduction for those taxes until you file your 2012 income tax return. That doesn't happen until April 2013. Thus, you have to wait an entire year before getting the tax benefit of the expense.
By paying your state taxes now, you get a deduction for those taxes in 2011. That means you get the benefit of the expense more than one year sooner than you'd otherwise realize.
For 2011, you have the option to claim a deduction for either the state income tax or you may claim the general sales tax deduction, whichever is higher. For those who live in a state with no income tax, you should claim the general sales tax deduction.
2. Review your wage withholding or estimated payments. Eighty-five percent of all taxpayers get a tax refund when they file their tax returns. The average refund is now more than $2,600. If you get a tax refund, it doesn't mean the government got religion and decided to give you free money. It means you paid more taxes than you owe. If you got a refund in 2011 for your 2010 taxes, you need to examine your withholding situation going into 2012 to make sure you don't overpay.
3. Count your money now. Each year, millions of people are blindsided come April 15 with surprise tax liabilities they don't have the capacity to pay. Don't wait until March or April to start figuring your tax, especially if 2011 was an unusual year somehow.
It is important for you sit down now and examine your 2011 financial situation. If there were substantial changes to your economic condition in 2011, they may have the impact of increasing your tax burden. If you don't have the money to cover the tax, you could wind up as one of the millions of taxpayers facing enforced tax collection action.
Unusual circumstances that might lead to a surprise tax liability include the following:
- A distribution from an IRA or 401(k).
- The receipt of unemployment compensation for which there was no withholding.
- The sale of appreciated business or investment property.
- The foreclosure on a home or other asset.
- Settling a lawsuit.
- The forgiveness of credit card or other debt.
- Sales of securities not included in a qualified retirement plan.
- The receipt of year-end bonuses for which there was no withholding.
- The receipt of alimony due to a divorce during 2011.
This list is not exhaustive. There is a litany of factors that bear on whether you might end up with a tax debt beyond what you expected. The only way to know for sure is to carefully review your situation and the process, get advice from an experienced tax pro. That way, you'll have a good handle on what you're going to owe.
If you figure it out now, you have four and a half months to put together a plan to pay the tax. If you don't, you could be hit over the head in April. In my experience, it's that kind of shock that causes people to start making critical mistakes in how they handle their tax burdens. Often, it leads to years of hassle and harassment from the IRS.
4. Review your financial portfolio. One of the biggest problems with our tax system is the unfair treatment it affords to investment gains and losses. If you win with your investment, the IRS stands next to you with its hand out to get "its share" of your success. If you lose, you are, for the most part, on your own.
The reason is that capital gains are subject to tax in their entirety in the year they are realized. However, capital losses are subject to a $3,000 cap in a given year. That means if you lose $15,000 in an investment, you can only deduct $3,000 at time. This means it takes you five years to fully write off your loss.
This is true unless you have both capital gains and capital losses in the same year. If that's that case, you offset your gains against your losses, plus you can take an extra $3,000 of loss. Suppose you have $10,000 of capital gains and $12,000 of losses. In that case, the $10,000 of gains are offset against the first $10,000 of losses, and thus not taxed. Then, you get the additional $2,000 of losses as a deduction that can offset other income.
To best use this rule, you might consider selling investments that are down in 2011 so that you can offset that loss against any investments that made money during 2011. This allows you to effectively increase the allowable capital loss deduction, thereby recovering your losses much faster than you otherwise would.
5. Consider making equipment purchases. If you own a small business, now is the time to consider purchasing any equipment you might need for your business. A special tax code section creates an advantage for acting now.
Code section 179 allows you to claim a full deduction for the cost of business tools and equipment that is placed in service in the year in question. Ordinarily, the cost of such equipment must be depreciated over the useful life of the equipment. For example, if you purchase a copier for $5,000, you would normally have to depreciate that copier over three years. In that case, you get a deduction of $1,667 for each of three years.
But under section 179, you can fully expense up to $500,000 of equipment placed in service in 2011. This allows you to get the full benefit of the deduction in the year of the purchase, rather than having to spread the recovery over several years.
The bad news is that this benefit is reduced to just $139,000 for tax year 2012. And it gets worse. For years after 2012, the amount you can expense drops to just $25,000 per year, the level it was at prior to the Bush tax reform measures. This is just one of the "tax breaks for the rich" that the president has pledged to eliminate.
Now is the time to take advantage of this deduction, especially if your income was unusually high during 2011. The best way to offset that income for tax purposes but still get the benefit of the money is buy equipment you need to more effectively operate your business.
6. Fund a Medical Savings or Health Savings Account (MSA or HSA). One of the best-kept secrets in tax planning remains the Medical Savings or Health Savings Account. These accounts allow you to set aside money that is earmarked to pay medical expenses not covered by insurance (other than the insurance policy itself). By placing the money in a specially designated savings account, the contribution to the account is tax deductible, up to certain limits.
It works much like an IRA or 401(k), except that you don't have to pay taxes on the money when it's distributed, provided you use it for medical expenses that are not covered by insurance. You can fund this account right up to December 31, 2011, and get a deduction for the money you put in, even if it's not used for medical expenses in 2011. What's more, any amounts left in the account at the end of the year carryover to 2012 and remain in your account, under your control. You don't lose the money. It's always available to pay medical bills not covered by insurance.
If you don't have an MSA or HSA, you need to look into getting one. They are available for anybody who has a high-deductible health plan and is not covered by another health plan, such as an employer provided plan.
7. Fund a retirement account. An IRA, 401(k) or other retirement account can be funded anytime during 2011, and you'll get a deduction for the contribution (within limits) in 2011. In fact, for most retirement accounts, you have up to April 15 of the following year to contribute. You can get a deduction for the prior year simply by designating the contribution to apply to the prior year. That means a contribution made in 2012 can still apply to and be deductible in 2011.
8. Consider restructuring your business. There are millions of people operating small businesses in the form of sole proprietorships. And while this is probably the best way to start a new business, it may not be the best way to continue an existing business into the future.
Various forms of business entities are available, including a small business corporation or partnership. Depending upon the nature of your business and your non-tax considerations, one or more of the available entities might be a better idea than continuing as a sole proprietorship.
Jan. 1 is generally the most convenient time to change the structure of an existing business but you should get help with this process. Talk to an experienced tax pro (like us of course!) who can point out the advantages and disadvantages of each business structure.
9. Catch up on your charitable contributions. If you make it a practice to give generously, make another contribution before Dec. 31. This gives you further opportunity to cut taxable income and help those in need around you at the same time.
When making significant charitable contributions, note that you must have a contemporaneous acknowledgement from the donee organization if your contribution is for $250 or more. This applies to one-time contributions, not a total of contributions to a given organization over the span of one year. If you don't have the proper acknowledgement in hand by the time you file your tax return, the deduction is not allowed, even if you have your canceled check and even you get the statement later. That's why they call it a "contemporaneous acknowledgement."
Happy New Year and the best to you in 2012.