Take action to get results from midyear tax planning
Happy midyear! Are you ready to review and revise your 2016 tax plan? With half the year over, you have a solid foundation for making decisions. You can start by assessing the types of income you have already received and what you expect to receive through the remainder of the year. As you know, under federal tax law, income is taxed in different ways, depending on the source. Here are tips to consider.
Interest, dividends, and capital gains are investment income, and the 3.8% net investment income tax generally applies to all three when your adjusted gross income exceeds certain levels. Under regular rules, each type of income can be taxed at varying rates, or in some cases, not at all. For example, you’ll typically pay tax at your ordinary income tax rate on interest income in the year you receive it. But you can usually exclude municipal bond interest from your taxable income as well as from the net investment tax calculation, although the alternative minimum tax may apply to interest earned from certain municipal bonds.
Planning tip: Decide if adding municipal bonds to your portfolio makes sense.
Dividends earned from your investments can be taxed at capital gain or ordinary income rates. The distinction matters because the maximum capital gain rate is 20%, while ordinary income can be taxed at rates up to 39.6%. For capital gain rates to apply, the dividends you receive have to meet certain requirements, one of which is a holding period for the underlying stock.
Planning tip: Review the dividend-paying stocks that you already own. As you rebalance your portfolio, you can determine whether including these investments in your taxable accounts or placing them in tax-deferred retirement accounts will provide more benefit.
The tax rate on the sale of investments you own for a year or less is based on your ordinary income. The more beneficial long-term capital gain rate applies to gain on most investments that you hold longer than a year. Tracking your holding period can result in a lower tax, but you may have to sell an investment before you can take advantage of the long-term rates. That’s when having an accurate measure of your basis can be even more valuable than usual.
Planning tip: Update your basis records for reinvested dividends, stock splits, and other investment activity, including prior and current year “wash sales.” If you inherited any of your investments, be aware of whether the new estate tax rules for basis consistency apply. In some cases, these rules require the executor of an estate to notify the IRS and the estate beneficiaries of the value of inherited property. When the rules apply, penalties can be assessed if you sell the property and use a different value as your basis.
The structure of your business determines how you report the income earned from operations, and influences how that income is taxed. As an example, S corporations are pass-through entities, meaning the business income “flows through” the corporation and is taxed on your personal income tax return. In addition, the pass-through income typically retains its character, so, for instance, interest earned by the corporation is taxed as interest on your personal return.
Planning tip: Revise and arrange your company’s chart of accounts to classify income into tax-specific categories. Making changes now can point out areas that will benefit from early planning, as well as streamline year-end tax preparation time and reduce misstatements. Having your chart of accounts set up properly can be especially important this year, since a recent law requires earlier due dates for certain 2016 tax and information returns.
Generally, all income from rental properties and business ventures in which you’re not actively involved is taxable. You may also have to pay net investment income tax on your passive income. In contrast, losses from your passive activities can only be deducted against other passive income. Losses that are unused in the current year are carried forward to offset future passive income or taxable gains from selling the underlying asset.
Planning tip: If you have multiple passive income sources, investigate whether you will benefit from treating them as a single activity for purposes of the passive loss rules. “Grouping” several activities can help you more easily meet the rules that will allow you to treat the income as nonpassive. Be aware that making the election to group assets means you may not be able to easily use prior-year losses if you dispose of one of the grouped assets.
Income you earn from your job or your business is taxed at ordinary rates on your federal income tax return. When your wages or self-employment income exceed $200,000 (if you’re single), $250,000 when you file jointly, or $125,000 when you file separately, you’ll also owe an additional Medicare tax of 0.9% on the amount over the threshold.
Planning tip: One way to reduce your tax liability when the bulk of your income is from employment is to maximize contributions to tax-deferred retirement plans, such as 401(k) plans and deductible IRAs. You get a double benefit from your contributions: tax deferral on asset growth inside the plan and a lower adjusted gross income in the current year that can increase other tax breaks. Similarly, you may also want to take full advantage of other employer-provided benefit programs, such as flexible spending accounts.
The most important fact to remember about tax planning is that you don’t have to have it all figured out to move forward. Action generates results. Contact us today to get started.
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