As the end of 2013 approaches, it’s time to think about year end tax planning. Here are five often overlooked strategies you should entertain:
1. Use credit cards. If you’re in a temporary cash crunch, consider using credit cards to pay business expenses, medical expenses, property taxes and other deductible items. Expenses that are paid by credit card are deductible this year even if you don’t pay the bill until next year. Of course, weigh the tax benefit against the risk of not paying the credit card bill when due.
2. “Borrow” from your IRA. Technically, you can’t borrow money from your IRA. But you can withdraw funds and use them for deductible expenses or other short-term cash needs. So long as you return an identical amount to the IRA, or to another traditional IRA, within 60 days, there are no tax or early withdrawal penalties. However, beware that, when you withdraw funds from an IRA, the custodian is required to withhold federal income taxes at a 10% rate — unless you elect otherwise.
3. Sell securities and then buy them back. An effective year end strategy is to “harvest” capital losses by selling stocks and other securities that have declined in value. If you’re not ready to give up on an investment, it may be possible to sell securities to generate a tax loss and then reinvest in the same securities — if you comply with the “wash sale” rule. The wash sale rules are complex, and have many nuances, so be sure to consult your tax advisor.
4. Boost your withholding. Many taxpayers pay quarterly estimated taxes in addition to taxes withheld from their wages. This might be the case if one spouse is self-employed and the other receives wages, or if one person has both wages and consulting or other self-employment income. If you’re behind on your quarterly estimated tax payments, consider increasing withholding on your remaining wages this year to avoid underpayment penalties.
Why not simply make a larger fourth-quarter estimated tax payment? Because a year end catch-up payment won’t relieve you of underpayment penalties. Increased withholdings, on the other hand, are treated as if they were spread evenly throughout the year, thus helping you avoid penalties.
5. Avoid year end mutual fund investments. Most mutual funds pay out accumulated dividends and capital gains in December to investors who own shares on the “record date.” There’s a misconception that buying into a fund just before that date produces a windfall — an entire year’s worth of income even for new investors. In reality, this strategy merely buys you an unnecessary tax liability (unless the fund is held in a tax-deferred retirement account).
Why? Because when a mutual fund pays out dividends and capital gains, the share price immediately falls by the same amount (barring any adjustments for market fluctuations).
Suppose that you buy 10,000 shares of a fund at $10 per share (for a total investment of $100,000) just before the record date. The fund pays a dividend of $1 per share, reducing the price to $9 per share and essentially refunding a portion of your purchase price. You’re left with a $90,000 investment and a tax liability on $10,000 in dividends. If you had purchased the shares after the dividend payout, you’d still have a $90,000 investment but would avoid the tax liability.
These are just a few examples of the many year end strategies available for reducing your 2013 tax bill. Your tax advisor can help you identify strategies that are right for you.