Additional Tax Planning Considerations
The key to any year-end planning strategy is to minimize taxes. This is generally done by either reducing the amount of income received or increasing the amount of deductions.
In recent years, the possibility of increased rates on higher incomes due to proposed legislation or changes in qualification for various stimulus proposals made the decision of deferral or acceleration highly dependent upon individual circumstances. However, as the end of 2023 approaches, these factors are no longer in play.
The impact of inflation makes deferral of income a likely winner for almost all individuals. While the increase is much lower from 2023 to 2024 (approximately 5%) than from 2022 to 2023 (approximately 8%) due to easing inflation, it is still much higher than in many years prior to 2023.
Individuals may not necessarily see increases in earnings that keep up with that level of inflation, meaning that if deferral of income from 2023 into 2024 is possible, it would mean that more income would fall into a lower tax bracket. In the long run, that would mean a lower aggregate tax burden.
Delaying and Reducing Gains
Like taxes on ordinary income, taxes on capital gains also apply at different rates depending upon the amount of taxable income. For 2023, rates have adjusted significantly due to inflation.
For taxpayers whose income tends to fluctuate from year to year, it would be wise to examine the impact of sales of investment items. For taxpayers who think they may have lower income in 2024, it would be smart to hold off on the sale of a capital item if their income is at or near a threshold for a higher capital gains bracket.
Long-term capital gains (and qualified dividends) are subject to a lower tax rate than other types of income.
Investors should consider the following when planning for capital gains:
- Holding capital assets for more than a year (more than three years for assets attributable to carried interests) so that the gain upon disposition qualifies for the lower long-term capital gains rate.
- Considering long-term deferral strategies for capital gains, such as reinvesting capital gains into designated qualified opportunity zones.
- Investing in and holding “qualified small business stock” for at least five years.
- Donating appreciated property to a qualified charity to avoid long-term capital gains tax
Net Investment Income Tax
This type of consideration should not be limited to capital gain taxes but also the net investment income (NII) tax.
The 3.8% NII tax kicks in at $200,000 of modified adjusted gross income for single and head-of-household filers, $250,000 for joint filers, and $125,000 for married taxpayers filing separately.
- An additional 3.8% net investment income tax (NIIT) applies to net investment income above certain thresholds. Net investment income does not apply to income derived in the ordinary course of a trade or business in which the taxpayer materially participates. Similarly, gain on the disposition of trade or business assets attributable to an activity in which the taxpayer materially participates is not subject to the NIIT.
- In conjunction with other tax planning strategies that are being implemented to reduce income tax or capital gains tax, impacted taxpayers may want to consider deferring net investment income for the year.
Social Security Tax
The Old-Age, Survivors, and Disability Insurance (OASDI) program is funded by contributions from employees and employers through FICA tax. The FICA tax rate for both employees and employers is 6.2% of the employee’s gross pay, but only on wages up to $160,200 for 2023 and $168,600 for 2024. Self-employed persons pay a similar tax, called SECA (or self-employment tax), based on 12.4% of the net income of their businesses.
Employers, employees, and self-employed persons also pay a tax for Medicare/Medicaid hospitalization insurance (HI), which is part of the FICA tax but is not capped by the OASDI wage base. The HI payroll tax is 2.9%, which applies to earned income only. Self-employed persons pay the full amount, while employers and employees each pay 1.45%. An extra 0.9% Medicare (HI) payroll tax must be paid by individual taxpayers on earned income that is above certain adjusted gross income (AGI) thresholds, i.e., $200,000 for individuals, $250,000 for married couples filing jointly, and $125,000 for married couples filing separately. However, employers do not pay this extra tax.
For 2023, the inflation-adjusted standard deduction amounts are $27,700 for joint filers, $20,800 for heads of households, and $13,850 for all other filers. High standard deduction amounts coupled with the $10,000 limitation on the deduction of state and local taxes, means it is difficult for many taxpayers to claim enough deductions to make itemizing deductions beneficial. Thus, maximizing deductions may not be beneficial for all taxpayers.
One of the best ways to maximize the amount of deductions is to develop a bunching strategy. This involves accumulating charitable contributions, or even medical expenses, from two or more years into one year.
For example, a taxpayer may have not made any of his or her normal charitable contributions in 2022, and then made double the normal amount in 2023 in order to help surpass the standard deduction amount.
Again, the impact of inflation must be considered here, as the standard deductions are higher for 2024 as compared with 2023. Even with bunching, achieving itemized deductions high enough in 2024 to surpass the standard deduction may be difficult.
The same strategy can be employed for deductible medical expenses where the timing is somewhat flexible, such as for elective procedures (remember that purely cosmetic procedures are not deductible).
Bunching can be a very effective strategy, but it has to be effectively used and potentially planned out two or three years in advance to maximize the benefit while also taking into account shifts in tax policies as a result of political change.
Timing of Income & Deductions
Taxpayers should consider whether they can minimize their tax bills by shifting income or deductions between 2023 and 2024. Ideally, income should be received in the year with the lower marginal tax rate, and deductible expenses should be paid in the year with the higher marginal tax rate.
If the marginal tax rate is the same in both years, deferring income from 2023 to 2024 will produce a one-year tax deferral and accelerating deductions from 2024 to 2023 will lower the 2023 income tax liability.
Actions to consider that may result in a reduction or deferral of taxes include:
- Delaying closing capital gain transactions until after year-end or structuring 2023 transactions as installment sales so that gain is deferred past 2023.
- Considering whether to trigger capital losses before the end of 2023 to offset 2023 capital gains.
- Delaying interest or dividend payments from closely held corporations to individual business-owner taxpayers.
- Deferring commission income by closing sales in early 2024 instead of late 2023.
- Accelerating deductions for expenses such as mortgage interest and charitable donations (including donations of appreciated property) into 2023 (subject to AGI limitations).
- Evaluating whether non-business bad debts are worthless by the end of 2023 and should be recognized as a short-term capital loss.
- Shifting investments to municipal bonds or investments that do not pay dividends to reduce taxable income in future years.
On the other hand, taxpayers that will be in a higher tax bracket in 2024 may want to consider potential ways to move taxable income from 2024 into 2023, such that the taxable income is taxed at a lower tax rate.
Current year actions to consider that could reduce 2024 taxes include:
- Accelerating capital gains into 2023 or deferring capital losses until 2024.
- Electing out of the installment sale method for 2023 installment sales.
- Deferring deductions such as large charitable contributions to 2024.
Additional Considerations to Note
The Tax Cuts and Jobs Act capped the amount of the deduction for state and local taxes (SALT) at $10,000 ($5,000 for married individuals filing separately). As a result, many states have enacted legislation that permits certain pass-through entities (PTE) to elect to pay income tax at the entity level. By electing to be subject to income tax at the entity level, a PTE may reduce its owners’ federal income tax liability. Additionally, taxes paid by a PTE can be deducted by its owners and do not count towards the owner’s $10,000 limit of their SALT deduction.
Requirements vary from state to state, so taxpayers considering this new strategy should speak with their tax professionals.
Long-Term Care Insurance & Services
Premiums an individual pays on a qualified long-term care insurance policy are deductible as a medical expense. The maximum deduction amount is determined by an individual’s age.
Foreign Earned Income Exclusion
The foreign earned income exclusion is $120,000 in 2023 and increases to $126,500 in 2024.
Alternative Minimum Tax
A taxpayer must pay either the regular income tax or the alternative minimum tax (AMT), whichever is higher. The established AMT exemption amounts for 2023 are $81,300 for unmarried individuals and individuals claiming head-of-household status, $126,500 for married individuals filing jointly and surviving spouses, $63,250 for married individuals filing separately, and $28,400 for estates and trusts. The AMT exemption amounts for 2024 are $85,700 for unmarried individuals and individuals claiming head-of-household status, $133,300 for married individuals filing jointly and surviving spouses, $66,650 for married individuals filing separately, and $29,900 for estates and trusts.
The unearned income of a child is taxed at the parents’ tax rates if those rates are higher than the child’s tax rate.
Net Operating Losses & Excess Business Loss Limitation
Net operating losses (NOLs) generated in 2023 are limited to 80% of taxable income and are not permitted to be carried back. Any unused NOLs are carried forward subject to the 80% of taxable income limitation in carryforward years.
A non-corporate taxpayer may deduct net business losses of up to $289,000 ($578,000 for joint filers) in 2023. The limitation is $305,000 ($610,000 for joint filers) for 2024. A disallowed excess business loss (EBL) is treated as an NOL carryforward in the subsequent year, subject to the NOL rules. With the passage of the Inflation Reduction Act, the EBL limitation has been extended through the end of 2028.
Maximizing Education Credits
Individuals can claim a credit for tuition paid in 2023 even if the academic period begins in 2024, as long as the period begins by the end of March.
Increasing 401(k) Contributions
Adjusted gross income (AGI) can be reduced if individuals increase the amount of their 401(k) contributions.
Individuals eligible for deductions for IRA contributions can claim deductions and thus reduce AGI for amounts contributed generally through April 15, 2024.
Educators can claim a deduction for up to $300 of classroom expenses (like books, supplies, and computer equipment, as well as personal protective equipment, disinfectant, and other supplies used to prevent the spread of COVID-19) and should maximize those expenses by year-end.