Many investors wait until they file their income tax returns to ask what it is they can do to improve their income tax position. In many cases, it is unfortunately too late to wait until that time to make changes that will impact current year returns. The time to make changes is prior to the end of the calendar year. Although the following ideas are not an all-inclusive list, they are a start to keeping more of what you earn.
Investment losses: Income tax decisions should not be the sole motivation for making an investment decision. They should however never be overlooked. Near the end of each year every investor should thoroughly review their portfolio for investments that have lagged the market in general and, in the case of a mutual fund, have lagged the performance of other similar funds. A strategic favorite of mine is to look at any funds that are below their original purchase price and replace them with another strong fund with similar underlying holdings. The change does not change the overall composition of the portfolio but a tax loss is generated. The created tax loss can be used to offset investment gains that would otherwise result in the need to pay income tax. The transaction effectively allows for an investor to not pay income tax on gains in the current year and, possibly, for many years in the future, depending on the magnitude of the loss created.
Stock options: Exercising stock options will be considered a "preference item" in calculating your Alternative Minimum Tax to the extent that the market value exceeded the strike price. Many investors exercise stock options and do not realize that this can significantly impact the amount of tax that they will owe when they file their tax return the following year.
Another stock option issue that is worth noting is that an investor should consider the benefits of waiting two years from the time granted and one year from the time exercised before selling the related stock. Waiting these time periods will ensure that the investor pays more favorable capital gains tax rates rather than the higher ordinary income tax rates.
Giving: Charitable gifts need to be made prior to December 31st in order for them to offset current year income. There are limitations on the amount of charitable gifts (generally 50% of adjusted gross income) that can be deducted as detailed in Internal Revenue Service Publication 526.
Gifts to family members, although not deductible, can take advantage of the annual gifting rule which allows them to make gifts that are free of the federal gift tax. Each person can give away $12,000 per person per year meaning that a husband and wife can give away $24,000 to any given person. These gifts can also be used to fund 529 college savings plans. A 529 plan can also be front-loaded with an individual gifting five years of allowable gifts ($60,000), or a couple gifting $120,000. Front-loading a 529 Plan will require that they not make another contribution to that particular 529 Plan for at least five years.
Company benefit plans: Employees should review their elections in existing company benefit plans. These elections include their level of participation in flexible spending accounts, insurance coverage, and tax-deferred retirement savings plans. Participation in these plans will directly impact the income tax liability every year.
The time is now to alter the amount of income tax that you will owe the tax man next April 15th and every April 15th in years to come. Remember, it is not what you earn, but rather what you keep that matters. If you have specific questions about how you can change the amount that you will owe and in the process improve the performance of your investment portfolio, please feel free to contact me.