Strategies to Prepare for Tax Increases

As lawmakers and administrations change in Washington, the direction of the federal government and its tax policies change with them. It takes time, however, for their destination to become clear. After the president and congressional leaders make a tax proposal, it’s still just that: a proposal. It can undergo many changes before it becomes law.

Even if you can’t be certain where it will end up, you can easily tell the direction far ahead of time and prepare accordingly.

So if increased taxes are on the map, in whatever form they take, what can you do to minimize the impact on your financial plan?

In general, the two main levers are income and deductions, and you can accelerate or defer these depending on when the increased taxes will be in effect. This chart illustrates this principle:

To prepare for an anticipated earned income tax increase in the near future, you’ll want to accelerate income into the current tax year as much as possible without pushing yourself into a higher tax bracket. Conversely, in a tax year when you’re paying a higher rate, you’d want to defer income to a future year.

For example, people who work on commission or receive bonuses can often choose which tax year they take the payment. Self-employed individuals can control the timing of invoices to increase or decrease their gross income depending on the timing of the anticipated tax increase.

Another example of this tactic is converting a traditional individual retirement account (IRA) to a Roth IRA to pay the taxes you’ll incur on that conversion before higher tax rates go into effect. Once the account is a Roth IRA, you won’t have required minimum distributions and you won’t pay tax on its earnings.

Deductions can be shifted in the same way. Swing the bulk of your available deductions into the tax year when you expect your earned income to be higher and to be taxed at a higher rate. You’ll be aiming for total itemized deductions that exceed the standard deduction.

For the self-employed, this can mean buying equipment, computers or software; paying bonuses to employees this year rather than after Jan. 1; or paying fourth quarter payroll taxes in December instead of January.

Charitable giving is one of the biggest levers all taxpayers have to reduce their adjusted gross income, dollar for dollar. To accelerate this type of deduction in any given year, you can contribute cash, securities or other assets to a donor-advised fund through a public foundation. You’ll get an immediate tax deduction, and funds can be invested for tax-free growth and timed disbursements to the charities of your choice.

When you donate cash, you can take an income tax deduction of up to 60 percent of your adjusted gross income. Donations of long-term appreciated securities directly to charity are eligible for an income tax deduction of the full fair-market value of the asset, up to 30 percent of your adjusted gross income. This also eliminates capital gains tax on long-term appreciated assets, as long as they’ve been held for more than a year.

Maximizing contributions to your retirement account is a must in any year you want to accelerate deductions. Qualified retirement and employee benefit accounts with pretax dollars can exempt some income from taxation and defer income taxes on other earnings.

Take advantage of a health savings account (HSA) if you are eligible and/or a flexible spending account (FSA) if your employer offers it. Contributions to these accounts are made pre-tax and reduce your taxable income, and you can use the funds to pay for eligible healthcare expenses. Mind the details: you keep HSA funds forever, but FSA funds must be spent by the plan deadline.

Talk to your financial advisor annually, especially if you anticipate a change in the capital gains tax rate. He or she can tell you if you might benefit from techniques such as tax-gain harvesting, which allows you to pay zero tax on capital gains in some years and pay fewer overall taxes in future years. You may also be able to use capital losses to offset gains.

Pat Walsh is a Certified Public Accountant and tax manager with Carr, Riggs & Ingram, LLC in High Point, NC. She can be reached at pwalsh@cricpa.com. Deanne Ebel is a trust and wealth advisor at Pinnacle Financial Partners. She is based at the firm’s North Main Street office in High Point, NC and can be reached by phone at 336-881-3603 or by email at Deanne.Ebel@pnfp.com.