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Year-end planning strategies for individuals

October 21, 2015 Article 11 min read
Michael Monaghan

Managing tax rates effectively

Our tax laws have become extremely complex. Our Internal Revenue Code (IRC) provides for regular taxes, alternative minimum taxes (AMT), and, in the last two years, surtaxes. In addition to these taxes, the law provides for lower maximum tax rates for capital gains and qualified dividends. Lastly, there are provisions for phasing out personal exemptions, itemized deductions, and even the tax-free character of Social Security payments at varying income levels.

All of these variations must be considered when determining which tax applies, what taxable income and allowable deductions apply, and what exemptions or deductions are being phased out. In the examples below we’ll discuss how tax rates, surtaxes, and phaseouts impact your tax situation; there’s nothing like a good projection to identify and isolate income and deduction items and how they impact your tax bill.

Regular taxes

The regular tax is the one to which the IRC gives the most attention and the one we normally think of when we think of taxes. It’s calculated based on your total income less adjustments, deductions, and exemptions. In 2014, the maximum tax bracket for regular tax was increased to 39.6 percent before surtaxes.

Alternative minimum tax

In 1969, when the tax environment was much different, Congress felt that many high-income taxpayers were escaping the payment of regular tax through the use of deductions and credits, so they created the AMT. The AMT acts like a flat tax in that it doesn’t allow certain deductions and places limitations on credits and exemptions. While it increases the tax base, it decreases the maximum rate. For 2015, the maximum AMT rate is 28 percent, while the maximum ordinary income tax rate is 39.6 percent. While the initial law focused on a very small number of taxpayers, the current AMT impacts a far greater number.

In the chart below, you’ll note that the AMT does not provide benefits for taxes, miscellaneous deductions, and certain home equity interest expenses. In addition, the AMT can impact large families as exemptions are limited.

Surtaxes & phaseouts

In 2013, Congress enacted two surtaxes that impact “high-income” taxpayers. These include a 3.8 percent surtax on net investment income and a separate 0.9 percent surtax on wages and self-employment income. Both surtaxes increase a taxpayer’s tax liability on income over designated “modified adjusted gross income” thresholds. In addition to the two surtaxes, “high-income” taxpayers are also subjected to phaseouts that reduce the benefit of itemized deductions and exemption deductions. The phaseout of itemized deductions (also know as the Pease limitation) is the lesser of 3 percent of the adjusted gross income (AGI)over the applicable threshold or 80 percent of certain itemized deductions. The Personal Exemption Phaseout (PEP) reduces all personal exemptions (including taxpayers and dependents) by 2 percent for each $2,500 that AGI exceeds the applicable threshold. See the table below for applicable thresholds.

When you compare the taxation of a taxpayer using regular tax, alternative minimum tax, and adjusting for the surtaxes and phaseouts, it becomes easier to see how these issues can add a significant amount to a taxpayer’s tax bill. In the grid below, the taxpayer starts with an effective tax rate of 23.8 percent ($119,199 / $500,000) that increases to 28.5 percent ($142,250 / $500,000) due to the effects of the alternative minimum tax and the impact of surtaxes.

Charitable contributions

Giving to charity is wonderful for two reasons: it may benefit a cause that’s worthy, and it lowers your tax liability. For tax planning purposes, a charitable contribution can be flexible in many ways. As the donor, you determine the form of donation (cash vs. non-cash), the timing, and the recipient to best meet your needs. But while the gifting is flexible, the required documentation is not.

All donations of $250 or more must be substantiated with written documentation from the charity stating the amount given and whether the donation was in the form of cash or a non-cash gift. There must also be a statement that “no goods or services were provided in consideration for the contribution.” When goods or services are provided, such as in the event of a dinner gala, the fair market value of the goods or services received in return for the contribution must be provided via a contemporaneous donor letter. When non-cash gifts in excess of $5,000 are contributed, a qualified appraisal is required.

In two recent cases, the IRS denied (and the Tax Court agreed) deductions for cash donations of $250 or more that weren’t supported by a contemporaneous donor letter and non-cash donations in excess of $5,000 made to a local charity. In both cases, the taxpayers were able to show donative intent and support the actual contribution but did not have the required documentation or appraisal at the time their tax return was filed.

Without adequate documentation, the IRS is quick to challenge these deductions, and the burden of proof falls on the taxpayer.

Invest in children

If you have children or grandchildren, investing in their futures can provide significant tax benefits. Depending on your combined tax situations, you can invest in them through tax-advantaged education plans, IRAs or Roth IRAs, or gifts through UGMA (Uniform Gifts to Minors Act) accounts.

Education vehicles

There are a number of ways to fund your child or grandchild’s education. The most popular plans are “529 plans,” named after the IRC section that created them. 529 plans provide both gift tax and income tax benefits. They can sometimes provide state income tax benefits, too.

A 529 plan works, in many ways, like a 401(k) plan, except that it’s used for educational purposes rather than retirement. Gifts to 529 plans are qualified gifts that are generally excluded from gift taxation, and any income earned by the 529 plan is exempt from income tax if used for qualified purposes. A donor can frontload $70,000 of contributions (five years of gifts) to these plans. The complexity in 529 plans comes from the fact that there are so many available; each state has its own version. However, it may be beneficial to invest in one in your home state to qualify for state tax benefits that are often available.

Michigan offers a 529 plan: the Michigan Education Savings Plan (MESP). The MESP is a savings plan used as a way to save for tuition, room and board, required books, and other mandatory fees. Michigan also has the Michigan Education Trust (MET), which is a prepaid plan that guarantees tuition and mandatory fees at Michigan public colleges. Both offer a deduction for state purposes of up to $10,000 ($5,000 for individuals filing single).

Ohio offers two 529 plans: the direct-sold Ohio CollegeAdvantage 529 savings plan and the BlackRock CollegeAdvantage plan. Illinois has three 529 college savings plans available. You can choose from the Bright Start College Savings Program or the Bright Directions College Savings Program. You also could invest in the College Illinois! 529 Prepaid Tuition plan.

IRAs and Roth IRAs

If your child or grandchild has a job, you may consider giving them a gift that can be used to set up an IRA, or, better yet, a Roth IRA. Since your child will generally be in a low tax bracket, there will be little benefit from the tax deduction that a traditional IRA provides. By contributing to a Roth IRA, your child or grandchild will start building a fund that will be tax free when they retire many years in the future. The earnings will continue to compound tax free until withdrawn.

UGMA/UTMA accounts

Lastly, an easy way to provide a straight gift to your child or grandchild is through a UGMA or UTMA (Uniform Transfer to Minors Act) account. These are opened at your local bank or financial institution. The account name is required to read, “[Adult], trustee for [Child] Under UGMA or UTMA.” The account would be opened in the social security number of the child and would be taxable to him/her. The child cannot request a withdrawal from a UGMA account until his 18th birthday or from a UTMA account until his 21st birthday. The adult can request withdrawals but only for non-basic needs of the child (no room and/or board).

Same-sex marriage

In 2013, the U.S. Supreme Court ruled that same-sex marriages would be recognized for federal tax purposes, allowing same-sex married couples to file as married-filing-jointly on their federal 1040s. On June 26, 2015, the Court ruled that the Constitution guarantees the right for same-sex couples to marry in all 50 states. This means that all same-sex married couples are now required to file as married-filing-jointly or married-filing-separately on their state tax returns as well.

This applies to any same-sex couples who are filing their 2014 returns after the ruling date and can greatly simplify the filing process. Prior to the ruling, same-sex couples living in a state that had a ban on same-sex marriage could have filed up to five returns — a joint federal return, two separate state returns, and two mock federal married-filing-separate returns. It’s important to note that the ruling only applies to legally married same-sex couples, not registered domestic partnerships, civil unions, or similar relationships.

Identity theft

Tax-related identity theft occurs when someone uses another taxpayer’s Social Security number to file an unauthorized return with the intent of claiming a refund. Most unsuspecting victims find out that their identities have been stolen when they attempt to file their legitimate returns and the IRS notifies them that another return was already filed using their Social Security numbers. The IRS is devoting significant resources to combat tax-related identity theft through a strategy that includes prevention, detection, and victim assistance. A number of states are also announcing new steps and safeguards to fight identify theft. Please see the article on page 16 devoted to preventing identity theft.

Tax-related identity theft is on the rise. If you’re a victim, the IRS has outlined actions you should take quickly to begin fixing the problem. These include:

  • File a report with local police and the Federal Trade Commission at
  • Contact one of the three major credit bureaus (Experian, Equifax, and Transunion) to place a fraud alert on your credit record, and close any accounts opened fraudulently.
  • Call the contact number on any IRS Notice received by the taxpayer, and complete IRS Form 14039 (Identity Theft Affidavit) to flag the account for further questionable activity.
  • Continue to file returns and pay taxes due in paper form until your account is corrected.
  • Contact the Identity Protection Specialized Unit at 1.800.908.4490 to follow up on IRS activity on your account or to report further unauthorized access to your tax returns.

Other helpful information from the IRS can be found on the Taxpayer Guide to Identity Theft page at

New FBAR penalty limits

U.S. citizens are required to report the income from foreign bank accounts, mutual funds, and other investments. U.S. citizens and residents must also report the names and addresses of foreign institutions, bank account number information, and year-end or maximum balances in the account(s) when they’re above certain thresholds. These balances are reported on FinCEN Report 114 (Report of Foreign Bank and Financial Accounts) and Form 8938 (Statement of Specified Foreign Assets).

While it may seem unbelievable, the law, as it’s currently written, would allow for penalties of up to $600,000 on a $20,000 bank account. The annual penalty for willful non-filing of the FBAR report is 50 percent of the balance or $100,000, whichever is greater. The penalty is capped at a maximum of six years.

In order to encourage taxpayers to come forward voluntarily, the IRS has introduced a series of voluntary disclosure programs, streamlined filing processes, and relaxed penalty guidelines. For eligible taxpayers, reduced penalties ranging from 0 percent to 50 percent, applied only to a single year, may be available. Filing periods range from 3 to 8 years.

Estimated payments and withholding

Taxpayers with significant non-wage income (and even those with wages with a significant bonus element) must generally make quarterly estimated payments to ratably pay their tax bills throughout the year to avoid penalties connected with underpayments. States also have similar estimated tax rules, and many have high penalties for noncompliance.

There are several methods available for taxpayers to calculate their estimated taxes. Two of the methods — prior-year exception and annualized income — are safe harbors. The crystal ball calculation, however, becomes a bit hazier.

Prior-year exception

As the name implies, the prior-year exception method relies on the prior-year income and taxes paid. In general, the prior-year exception rule provides that you won’t receive a penalty in the current year if your withholding and estimated taxes paid are at least equal to 100 percent of last year’s total tax. If your prior year’s AGI was more than $150,000 ($75,000 if you’re married filing separately), the percentage increases to 110 percent.

Annualized income

For taxpayers with more complex tax situations, the annualized income installment method should be used. This method requires taxpayers to do a “mini-tax return” quarterly and annualize taxable income for each quarter to arrive at taxable income for a full year. The calculated tax on the full year is allocated over each quarter (with 25 percent due at April 15, 50 percent cumulative due on June 15, 75 percent cumulative on September 15, and 100 percent due on January 15). While this method is more complex, it’s often more beneficial when income is lower compared to the prior year or when income will be earned later in the year.

Crystal ball calculation

When one of the two previous safe harbors may not apply, you may rely upon your final actual income to calculate your tax liability. This method is beneficial if you’re aware that income late in the year will be lower than early in the year. As long as you pay in at least 90 percent of the total current year tax liability spread evenly over four quarters, penalties do not apply.

Mix and match

This allows a taxpayer to mix prior-year exception, annualized income, and crystal ball methods in different quarters depending on which method provides the lowest safe harbor amount. This can be beneficial if extraordinary income occurs early in the year or if you can accurately predict your ultimate annual income.

This is just one article within our 2015 Year-End tax Guide. For more great insights, plan to attend our individual or business year-end planning webinars.

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