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Year-end tax planning

As the end of the year approaches, it's time to consider strategies that can help you reduce your tax bill.

Review withholdings

If you project that you'll owe a substantial amount when you file this year's income tax return, ask your employer to increase your federal income tax withholding amounts. If you have both wage and consulting income and are making estimated tax payments, there's an added benefit to doing this: Even though the additional withholding may need to come from your last few paychecks, it's generally treated as having been withheld evenly throughout the year. This may help you avoid paying an estimated tax penalty due to under-withholding.

Of course, if you've significantly overpaid your taxes and estimate you'll be receiving a large refund, you can reduce your withholding accordingly, putting money back in your pocket this year instead of waiting for your refund check to come next year.

Impact of alternative minimum tax

Originally intended to prevent the very rich from using "loopholes" to avoid paying taxes, the alternative minimum tax (AMT) snags more and more middle-income taxpayers every year, since (unlike regular income tax) it doesn't keep pace with inflation. The AMT is governed by a separate set of rules that exist in parallel to those for the regular income tax system. These rules disallow certain deductions and personal exemptions that you are allowed to include in computing your regular income tax liability, and treat specific items, such as incentive stock options, differently. As a result, AMT liability may be triggered by such items as:

  • Large numbers of personal exemptions
  • Large deductible medical expenses
  • Large deductions for state, local, personal property, and real estate taxes
  • Home equity loan interest where the financing isn't used to buy, build, or improve your home
  • Exercising a large incentive stock option
  • Large amounts of miscellaneous itemized deductions such as unreimbursed employee business expenses

If it appears you'll be subject to the AMT, you'll need to take a very different planning approach during the last few months of the year. Even some of the most basic year-end tax planning strategies can have unintended consequences under AMT rules. For example, accelerating certain deductions into this year may prove counterproductive since AMT rules may require you to add them back into your income.

Accelerate or Delay Income or Deductions

The last few months of the year may be the time to consider delaying or accelerating income and deductions, taking into consideration the impact on both this year's taxes and next. If you expect to be in a different tax bracket next year, doing so may help you minimize your tax liability. For instance, if you expect to be in a lower tax bracket next year, you might want to postpone income from this year to next so that you will pay tax on it next year instead. At the same time, you may want to accelerate your deductions in order to pay less tax this year.

To delay income to the following year, you might be able to:

  • Defer compensation
  • Defer year-end bonuses
  • Defer the sale of capital gain property (or take installment payments rather than a lump-sum payment)
  • Postpone receipt of distributions (other than required minimum distributions) from retirement accounts

To accelerate deductions into this year:

  • Consider paying medical expenses in December rather than January, if doing so will allow you to qualify for the medical expense deduction
  • Prepay deductible interest
  • Make alimony payments early
  • Make next year's charitable contributions this year

Charitable Donations and Gifts

If you itemize your deductions, consider donating money or property to charity before the end of the current tax year in order to increase the amount you can deduct on your taxes. As an aside, now is also a good time to consider making non-charitable gifts. In 2009, you may give up to $13,000 ($26,000 for a married couple) to as many individuals as you want without incurring any federal gift tax consequences. If you gift an appreciated asset, you won't have to pay tax on the gain; any tax is deferred until the recipient of your gift disposes of the property.