As January 1, 2015 rapidly approaches, individuals and businesses are reviewing their gains and losses in 2014 in an effort to determine what can be done to improve in fiscal 2015. However, 2014 is not over yet and there is still time to take advantage of certain last minute tax and estate planning techniques and to ensure that certain tax elections have not “slipped through the cracks.” The following is a checklist of some year-end tax and estate planning tips to consider.
Income Tax Planning
- Income Tax Deferral- We are approaching the second anniversary of the enactment of the American Taxpayer Relief Act (“ATRA”) which increased the top individual income tax rate to 39.6% and the top capital gains rate to 20%. In addition to increasing the top income tax rates, ATRA also enacted the 3.8% tax created by the Affordable Health Care and Patient Protection Act (commonly known as “Obamacare”). As we approach the close of another year under ATRA, individuals should evaluate whether it makes “tax sense” to defer or postpone the recognition of income to next year. If an individual is contemplating whether to sell certain assets, he or she may have the ability to delay the sale so that the income is recognized in a future year. This strategy could be beneficial not only if the taxpayer expects to be in a lower tax bracket in future years, but allows deferral of the payment of the taxes on that gain by a year.
- Harvest Tax Losses- While the overall economy is in better shape now than it was a few years ago, many taxpayers continue to have capital losses from prior years that can be used to offset current capital gains. While capital losses in general can only be utilized to offset capital gains, if capital losses exceed capital gains, an individual can utilize the excess capital losses to offset $3,000 of ordinary income. Unused capital losses can be carried forward and used in future years.
- Accelerating Deductions- Another way for an individual to reduce their 2014 tax liability is to accelerate certain deductions so the deduction can be claimed in 2014. If a taxpayer had a high income tax year in 2014, the taxpayer may consider prepaying property taxes or state income taxes by December 31 in order to accelerate the deduction.
- 3.8% Obamacare Tax- Many high net worth individuals will be subject to the 3.8% healthcare surcharge on net investment income. The 3.8% tax applies to individual taxpayers whose modified adjusted gross income exceeds $200,000, or $250,000 for taxpayers who are married filing jointly. Net investment income includes, but is not limited to, certain capital gains, dividends, interest and royalties. In general, the 3.8% tax applies to certain passive activities in which the taxpayer does not materially participate. Deferring the recognition of certain income taxes and harvesting tax losses (both discussed above) are two ways of potentially reducing a taxpayer’s exposure to the 3.8% tax. Additionally, a taxpayer may consider gifting certain assets that would otherwise be subject to the 3.8% tax to family members in lower tax brackets, as only those taxpayers in the highest income tax brackets are subject to the 3.8% tax.The 3.8% tax also applies to trusts when the adjusted gross income of the trust exceeds $12,150. Therefore, trustees of irrevocable trusts should evaluate whether making distributions of trust income to beneficiaries (if the terms of the trust permit) who have income below the $200,000 or $250,000 threshold would remove the 3.8% tax liability.
- Charitable Planning – In addition to satisfying an individual’s philanthropic endeavors, year-end charitable planning may be able to provide significant income tax benefits. Many individuals make annual charitable gifts in cash without first considering whether or not there may be other tax-advantaged ways of giving to charity. For example, instead of giving cash to charity to obtain an immediate income tax deduction, an individual should consider gifting appreciated securities. By gifting appreciated securities, the individual would get an income tax deduction equal to the fair market value of the asset gifted and avoid the capital gains tax with respect to the appreciated asset. Gifting to charity may also assist taxpayers is avoiding the federal Alternative Minimum Tax (“AMT”) and the 3.8% Obamacare Tax discussed above. Although beyond the scope of this Tax Alert, there are many additional charitable planning techniques available to leverage an individual’s charitable intent as well as advance their estate plans, including the use of charitable lead trusts (for significant income tax deductions) and charitable remainder trusts (to defer significant capital gain).
Estate and Gift Tax Planning
- Estate and Gift Tax Exemption Gifts- In addition to introducing many income tax changes in early 2013, ATRA also provided a certain amount of stability to the federal estate and gift tax. ATRA increased the maximum estate, gift and generation skipping transfer (“GST”) tax rate from 35% to 40% and maintained the maximum exclusion amount for estate, gift and GST taxes at $5,000,000 per individual, indexed for inflation. Due to the inflation adjustments, the estate, gift and GST tax exclusion amount is $5,340,000 per individual for 2014 (and is scheduled to increase to $5,430,000 in 2015). Although ATRA was enacted less than two years ago, President Obama’s fiscal year 2014 and fiscal year 2015 budgets have included provisions to again reduce the estate, gift and GST tax exclusion amounts. Utilizing an individual’s exclusion amount allows an individual to remove the value of an asset, along with any appreciation on the asset, out of the individual’s estate for federal estate tax purposes. Those taxpayers who may be subject to the federal estate tax on death may still want to consider utilizing their full exemption amount during their lifetime.
- Annual Exclusion Gifts – Notwithstanding the $5,340,000 estate, gift and GST tax exclusion afforded to taxpayers, each individual is permitted to make a tax-free gift of $14,000 to an unlimited number of individuals every year. Each $14,000 “annual exclusion gift” does not reduce an individual’s overall $5,340,000 lifetime exclusion amount. However, annual exclusion gifts must be made by December 31 and any unused amount does not carry over to 2015. Utilizing an individual’s annual exclusion gifts is a simple way to transfer wealth to future generations. In addition, individuals are also permitted to make payments for another individual’s educational and medical needs without using the annual exclusion and without incurring gift tax or reducing the donor’s $5,340,000 exclusion amount if the payments are made directly to educational institutions or to healthcare providers.
- Funding 529 Plans- 529 plans have become popular vehicles for individuals who are looking to help family members save for college. In general, 529 plans are state-sponsored savings accounts that are exempt from federal income tax. Income accumulated in a 529 plan can grow income tax free provided that the account assets are used for the educational expenses of the beneficiary for whom the account was established. Contributions to a 529 plan are however subject to federal gift tax. Therefore, it is common for taxpayers to make gifts of their annual exclusion amounts (described above) to 529 plans in order to avoid any gift tax liability. An added benefit of a 529 plan is a special rule that permits the donor to contribute five years’ worth of annual exclusion gifts (or $70,000 in 2014) to the plan. If a donor chooses to “front-load” the plan using five years’ worth of annual exclusion gifts then the donor may not make any annual exclusion gifts to the plan beneficiary for the next four years. Contributions to a 529 plan must be deposited by December 31 in order to utilize the donor’s annual exclusion amount.
- IRA Distributions- Upon attaining the age of 70½, an individual must begin taking annual distributions (“required minimum distributions” or “RMDs”) from his/her retirement account. The amount required to be withdrawn is based on the age of the individual receiving the distribution. If an individual fails to withdraw the full amount or fails to take their RMDs by December 31, the amount not withdrawn will be subject to a 50% penalty tax. If the individual turned age 70½ in 2014, he/she can defer the first RMD to April 1, 2015. If an individual chooses to defer their first RMD until April 1, 2015, he/she will still be required to receive next year’s RMD by December 31, 2015.Note that at the end of 2013, a special rule expired that allowed taxpayers who had attained the age of 70½ to make direct contributions from an IRA to the charity of their choice in an amount not to exceed $100,000. The amount distributed to charity directly from the IRA was not required to be included in the taxpayer’s income for the year of the distribution. Congress has discussed re-enacting this rule. However, as of December 1, 2014 no action has been taken. Taxpayers and their advisors should be monitoring this and prepared to act quickly in the event Congress passes legislation prior to year end.
- Roth Conversion- Converting traditional IRAs to Roth IRAs has become a popular strategy for those whose annual income precludes them from making direct contributions to Roth IRAs. In fact, individuals can also convert other retirement plan accounts, such as a 401(k) to a Roth IRA. A Roth conversion triggers an income tax realization event for the taxpayer, as the taxpayer must pay tax on the amount converted. Therefore, conversion may make sense in a year where the taxpayer otherwise has a low amount of taxable income, but the means to pay any income tax generated by the conversion. Roth IRAs offer taxpayers significant benefits including tax-free distributions, tax-free growth of assets and no required minimum distributions. Please note, however, that different rules apply for inherited Roth IRAs. For those taxpayers looking to take advantage of a Roth conversion, the conversion must be completed by December 31.
Year-end is generally a good time to review your overall estate and financial plan. As described above, a number of tax-related decisions must be made by December 31 in order to take advantage of certain benefits. However, individuals are often inclined to procrastinate and postpone the discussion to the last minute. Estate planning and personal income tax planning are often intertwined, and now is a great time to not only take advantage of certain basic tax-related techniques but also to review your overall estate plan.