With only two weeks until the end of 2012, many of us have begun the annual ritual of analyzing our current year income tax situation to determine if there are any last-minute decisions that should be made to reduce our income tax. However, we find our President and our Congress spending their time and energy negotiating a tax policy, yet unable to reach a compromise, leaving us with great uncertainty of what income tax changes might become law and how this will affect us.
Our greatest risk is that the government will do nothing, letting the country fall off the “fiscal cliff”, and causing everybody’s income tax to increase. Although Potts & Company can’t see the future, we expect income tax rates and current deductions for individuals with less than $250,000 to be extended, while people with incomes in excess of $250,000 will suffer a tax increase. This is not a prophecy or prediction. It’s an educated guess.
Historically, the general rule at the end of each tax year is to accelerate deductions and to defer income. For 2012, that advice won’t hold true for everybody. If you expect your income in 2013 to be greater than $250,000, the reverse strategy might be your best choice. Then anybody with appreciated assets and potential long-term capital gains must consider whether to harvest their gains in 2012 rather than 2013.
The factors you must consider when deciding whether or not it is to your benefit to defer or accelerate your income is the taxable income expected for the current year as well as the next year and the related income tax brackets applied to your taxable income for each of these years. If you need help in deciding whether your situation calls for accelerating or deferring income into 2013, please call or make an appointment to discuss this matter with us.
How Do You Control the Timing of When Income and Deductions are Recognized?
Individuals recognize income and deductions using the cash basis of accounting except in infrequent cases. The cash basis of accounting requires income to be recognized when received and expenses and deductions to be claimed when paid. Businesses can be on a cash basis or an accrual basis of accounting. If your business is on the accrual basis of accounting, both income and expense is recognized when incurred.
Deferring Income Into 2013
If you’re on the cash basis of accounting and you determine that your best strategy is to defer income into 2013 and to accelerate deductions into 2012, here are some of your options:
- If you expect to receive a year-end bonus from your employer, ask your boss if he would be willing to wait and pay you the bonus in 2013.
- If you’re self-employed, delay billing your customers or clients so that their payments will not be received by you until 2013.
- If you’re planning to convert any of your investments to cash that would result in again, consider postponing the sale until next year.
Accelerating Income Into 2012
- If you’re on the cash basis of accounting and your best option is to accelerate income, you might want to:
- Ask your employer to accelerate any bonus you might have coming into 2012.
- If you’re self-employed, you might want to review your accounts receivable aging report in an attempt to accelerate collection so that payment is received in 2012.
- If you are over age 59 ½ and you participate in a retirement plan or have a traditional IRA, consider making taxable withdrawals before the end of the year.
Itemized Deduction Strategies
In calculating your taxable income, individuals deduct from adjusted gross income the greater of the standard deduction or their itemized deductions. The standard deduction is available to every taxpayer. For 2012, the standard deduction for married taxpayers filing jointly is $11,900; $5,950 for single taxpayers; and $8,700 for heads of household.
Taxpayers with itemized deductions that exceed the standard deduction will receive additional tax benefit. Itemized deductions include medical expenses, state income taxes, real and personal property taxes, mortgage interest expense, casualty losses, investment expenses, and employee business expenses.
In order for an itemized deduction to be allowed, you must have paid the expense in the year claimed. For example, you may have incurred a large medical expense in 2012 that will be paid in installment payments. Only the portion paid in 2012 is deductible in 2012. The IRS does count charges to your credit card the same as if you had written a check for payment as long as the charge date is in 2012. These rules apply to all expenses, not just medical expenses.
One strategy that taxpayers can use when considering determining whether they might benefit from itemized deductions is sometimes referred to as “bunching”. Bunching is where a taxpayer might time the payment of their deductions to achieve the highest possible deduction amount in a particular year.
Here is one example of a bunching strategy with medical expenses. If you have deductible medical expenses, you are allowed to deduct these expenses as an itemized deduction only when they exceed a certain floor. In 2012, the floor for medical deductions is equal to 7 ½% of adjusted gross income. In 2013, this floor will increase to 10% of adjusted gross income.
A taxpayer with adjusted gross income of $100,000 and medical expenses of $5,000 will receive no tax benefit because the medical expenses failed to exceed $7500. If this same taxpayer had an additional $5,000 of medical expenses that were unpaid, he could “bunch” the deductions into 2012 by paying the remaining medical bills so the total medical bills paid totaled $10,000, exceeding the $7500 floor by $2500 thereby creating a potential $2500 income tax deduction.
In 2013, the floor for medical deductions will increase from 7½% to 10%. Using the same scenario above in 2013, the taxpayer with $10,000 of medical expenses will not receive any income tax benefit for medical expenses paid because the amount of medical expenses did not exceed the 10% floor of $10,000. If you have significant unpaid medical expenses as we come to the close of 2012, consider if it might be to your advantage to pay them before December 31.
If you make estimated tax payments to any state, or if you expect to pay additional state income taxes in 2012, consider making the payment before December 31. However you need to be careful. A person has to consider the effect the payment of state income taxes might have on the Alternative Minimum Tax.
Cleaning your closet, or maybe a storage unit, can yield significant itemized deductions if you’re willing to donate them to a charitable organization. The amount deductible for the contribution is the fair market value of the donated items on the date of the contribution. The IRS requires the clothing and household items to be in good used condition or better to qualify for a deduction. So if your boxer shorts are worn thin and have holes in the material, you might want to keep them around the house for some alternative use.
In our experience, taxpayers tend to undervalue non-cash items donated to charities. We recommend that you use the Salvation Army Donation Guide
to help you determine the appropriate value of your non-cash gift of clothing and household items. You can use this guide whether you give to the Salvation Army or your church.
Another tax beneficial way to give is to give appreciated capital gain property to a charitable organization. Again, the amount of the deduction would equal its fair market value on the date of the gift. The advantage or the additional tax savings from donating appreciated property results from not having to pay tax on the gain that would have been recognized when the appreciated property was sold.