By Sheryl Rowling
Q: How can I lower my tax bill if my 2016 taxable income will be higher than in 2017?
A: Because your tax bracket will probably be higher in 2016 than in 2017, you may benefit by deferring income into 2017. Deferring income will help you out as long as it will not bump 2017 into a higher bracket.
Q: How can I defer income?
A: Some ways to defer income are:
• Delay Billing: If you are self-employed, you can delay billing clients so that payments won’t be received until 2017.
• Defer Compensation: If you will get a year-end bonus, you might ask your boss to delay the bonus until after the end of the year.
Q: I have the opposite problem. My income will be much higher in 2017 than in 2016. What should I do?
A: If your 2016 tax bracket is lower than in 2017, you may benefit by accelerating income into 2016. Remember, accelerating income will help you out as long as it will not bump 2016 into a higher tax bracket.
Q: I don’t understand why I would ever choose to pay taxes sooner rather than later. Can you give me an example?
A: Sure. Let’s say that your 2016 tax bracket is 15% and your 2017 tax bracket will be 28%. Your boss has told you that your $10,000 bonus can be paid to you in December or January. If it’s paid to you in December, you’ll pay taxes of $1,500. If the bonus is paid to you in January, the tax cost will be $2,800. Even if you have to pay the tax a full year earlier, unless you can earn over 86% on your investments, you’re better off paying less tax earlier (rather than more tax later).
Q: How can I accelerate income into 2016?
A: Here are some ways to accelerate income:
• Accelerate Collection of Accounts Receivable: If you are self-employed (and report on the cash basis), send your invoices early and collect before the end of 2016.
• Accelerate Compensation: If your employer generally pays bonuses after year-end, ask to get it before the end of 2016. A cash-basis employer might not mind – by paying you before the end of the year, the company gets a tax deduction early!
• Accelerate IRA Distributions: If you are over age 59-1/2, consider taking withdrawals from your IRA. You might also consider converting part or all of your IRA to a Roth IRA.
Q: What about tax deductions – when do I get to claim deductions?
A: In general, individuals report income and deductions on the cash method. This means that income is taxable when received and deductions are deductible when paid. Here are the basic rules:
• An expense is only deductible in the year it is actually paid.
• A payment by check is deductible only if dated and mailed before year-end.
• Payment with money borrowed from a third party is deductible. So, if you take out a loan or pay by credit card in 2016, you can take the deduction even though you don’t pay the credit card bill (or make loan payments) until 2017.
• A promise to pay or providing a note does give you a deduction. For example, you can’t deduct charges on a store credit card (because it’s not a third party).
Q: What is the itemized deduction phase-out?
A: The itemized deduction phase-out is really an “additional income tax.” Here’s how it works: For 2016, itemized deductions are reduced by 3% of Adjusted Gross Income (AGI) over $259,400 if single and over $311,300 if married. So, let’s say that brothers Abraham and Isaac both have AGI of $359,400. Abraham has itemized deductions of $10,000 and Isaac has itemized deductions of $20,000. Abraham’s and Isaac’s “itemized deduction phase-out” will both be $3,000 [3% times $100,000 (the difference between $359,400 and $259,400)]. In other words, both of them will have their taxable income increased by $3,000. The amount of their itemized deductions has no impact. (For those of you who love details, there is a slight exception: The “phase-out” cannot exceed 80% of itemized deductions.)
Q: What are the percentage limitations and how can I plan for them?
A: Certain deductions are allowed only if they exceed a percentage of AGI. For example, medical expenses are deductible only to the extent that they exceed 10% of AGI (or 7.5% of AGI if over age 65) and miscellaneous itemized deductions are deductible only to the extent that they exceed 2% of AGI. To make the most of these deductions, consider “bunching” medical expenses and miscellaneous expenses.
Q: Can you give me an example of “bunching?”
A: Of course! Let’s say that you need dental work that will cost $7,000. The dentist will let you make payments over 2 years. Normally, your other medical expenses are $4,000 per year and your AGI is $100,000 a year. Since your medical expenses are only deductible to the extent they exceed $10,000, you typically can’t deduct medical expenses (because $4,000 is less than $10,000). If you pay the dentist $3,500 per year for 2 years, your medical expenses will be $7,500 in each year and you will not get any tax deduction! Instead, let’s say you pay the entire bill this year. Your medical expenses will now be $11,000 and your deduction will be $1,000 ($11,000 minus $10,000). You won’t get any deduction next year, but at least you were able to get some deduction this year!
Q: Are there any other ways to increase my deductions?
A: Sure. If you’ll owe state taxes for 2016, consider making the payment before the end of 2016 (if you are not subject to Alternative Minimum Tax). This will generate a Federal tax deduction in 2016. Also, consider increasing your charitable contributions before the end of the year. Remember, you can claim the deduction even if you use a credit card to charge donations in 2016 and pay the bill in 2017.
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Rowling is a certified public accountant, personal finance specialist, and principal of Rowling & Associates. She may be contacted via sheryl.rowling@sdjewishworld.com