Executives, management, partners, shareholders and other business owners all have one thing in common: Their income eventually gets taxed at the individual level. That’s where your tax planning should start.
Different types of income are taxed in different ways. The biggest chunk of your income is likely ordinary income. It includes items like salary and bonuses, self-employment and business income, and retirement plan distributions. Even most types of investment income like rents, royalties and interest are taxed as ordinary income. Two kinds of investment income are subject to special lower rates: qualifying dividends and long-term capital gains from assets held at least one year.
The top rate on ordinary income is 39.6%, while the top rate on long-term capital gains and qualifying dividends is 20%. These figures don’t include employment tax and net investment income (NII) tax, which are discussed in the next chapter. We’ve included tables with the full tax brackets for investment and ordinary income, plus the 2015 figures for many important tax rules and benefits.
Q: What’s a marginal tax rate?
Your income is subject to different rates as you climb up the tax brackets. Your marginal tax rate is typically the top rate that applies to you. It’s what you would pay on your next dollar of income.
Q: Is all income taxed the same way?
No, income is divided into many different categories and subject to different tax rules. Ordinary income is generally taxed at higher rates, while long-term capital gains and dividends enjoy special lower rates. Earned income is subject to employment taxes, while certain kinds of investment income are subject to NII tax.
Q: What’s the difference between an above-the-line deduction and an itemized deduction?
An above-the-line deduction is taken on the first page of your tax return to reduce adjusted gross income (AGI). It helps with AGI-based phaseouts and is taken whether or not you itemize deductions. Most deductions are itemized and do not reduce AGI, only taxable income. You typically itemize deductions only if they exceed the standard deduction, and many itemized deductions have limits, phaseouts or AGI floors.
Individual ordinary income tax rates in 2015
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Individual capital gains and dividends tax rates
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Looking beyond the tax brackets
Unfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may differ significantly from the nominal rate of your tax bracket. Hidden taxes like the alternative minimum tax (AMT) (see Chapter 4
) and penalties on early retirement plan withdrawals can drive your tax rates higher. Many tax credits and deductions also phase out as your AGI increases — meaning an extra dollar of income actually increases your tax more than the nominal tax rate. Two of the most costly phaseouts apply to your personal exemptions and itemized deductions.
Personal exemption phaseout
Under the personal exemption phaseout (PEP), you will lose 2% of your total personal exemptions ($4,000 for yourself, a spouse and any dependents) for every $2,500 that your AGI (or portion thereof) exceeds $258,250 (single), $284,050 (head of household) or $309,900 (joint). That means that by the time your AGI reaches $380,751 (single) or $432,401 (joint), you will lose 100% of your personal exemptions.
The “Pease” phaseout for itemized deductions operates a little differently. Some deductions — such as medical expenses, investment interest, casualty losses and certain contributions to disaster relief — aren’t included in the phaseout. But many of the most popular and valuable itemized deductions — such as mortgage interest, charitable contributions and employee business expenses — are affected. In 2015, the affected deductions are reduced by 3% of the total amount of AGI exceeding $258,250 (single), $284,050 (head of household) or $309,900 (joint), up to a maximum reduction of 80%. For instance, the itemized deductions of a single taxpayer with $358,250 in AGI would be reduced by 3% of $100,000 ($3,000), assuming $3,000 is less than 80% of the taxpayer’s total itemized deductions.
Tax benefit thresholds
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When you can’t reduce, defer
Sometimes you can’t control whether you pay tax, but you can control when. Deferring tax can be almost as good as escaping it. With the time value of money, postponing a tax bill into the future can help you generate a return that almost pays for the tax itself. The idea is to delay recognizing income while accelerating deductions. There are many items for which you may be able to control timing:
– Consulting income
– Self-employment income
– Real estate sales
– Gain on stock sales
– Other property sales
– Retirement plan distributions
– State and local income taxes
– Losses on stock sales
– Real estate taxes
– Mortgage interest
– Margin interest
– Charitable contributions
But be careful. As we’ll discuss later, certain circumstances may affect your strategy. You may want to delay an itemized deduction to bunch it with future expenses, or your tax planning may be affected by the AMT. You will likely benefit from multiyear tax planning. Contact your local Grant Thornton professional for more information.
You should also remember that prepaid expenses can be deducted only in the year they apply. So you can prepay 2015 state income taxes and take a deduction now even though they aren’t due until 2016. But you can’t prepay state taxes on 2016 income and deduct it on your 2015 return.
Planning tip: Bunch itemized deductions
Timing significantly affects your itemized deductions, because many of those deductions have AGI floors. For instance, miscellaneous expenses are deductible only to the extent they exceed 2% of your AGI, and medical expenses are deductible only to the extent they exceed 10% of your AGI (7.5% for taxpayers 65 and older). Bunching these deductions into a single year may allow you to exceed these floors and save. Miscellaneous expenses you may be able to accelerate and pay now include the following:
Deductible investment expenses such as investment advisory fees, custodial fees, safe deposit box rentals and investment publications
Professional fees such as tax planning and preparation, accounting and certain legal fees
Unreimbursed employee business expenses such as travel, meals, entertainment, vehicle costs and publications — all exclusive of personal use
Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your nonurgent medical procedures and other controllable expenses in one year to take advantage of the deductions. Deductible medical expenses include:
Health insurance premiums
Medical and dental costs and services, including elective surgical procedures that are not purely cosmetic
Planning tip: Manage capital gains with installments sales and like-kind exchanges
Capital gains and losses present excellent opportunities for deferral because you have nearly complete control over when you sell them. First, you need to understand two fundamental rules:
You must hold an asset for at least a year to enjoy the reduced rate on long-term capital gains, and some assets, like collectibles, are subject to a higher rate.
You generally cannot use a capital loss against other kinds of income, so consider the tax consequences before selling an asset that will generate a large loss.
When selling securities, two additional rules can affect your gain or loss:
If you bought the same security at different times and prices, you should identify in writing which shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or increase your loss.
For tax purposes, the trade date, not the settlement date, of publicly traded securities determines the year in which you recognize the gain or loss.
Once you understand the basics, consider more-sophisticated opportunities for deferring gain:
Installment sale: If you don’t need the money immediately, structuring a transaction as an installment sale allows you to defer capital gains on most assets other than publicly traded securities by spreading gain over several years as you receive the proceeds.
Like-kind exchange: (click for definition) Most types of business and investment property qualify, and the planning technique can be very powerful in real estate deals.
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