Steve Landsman, of local accounting firm Squar Milner, shares important tips on how you can plan for the upcoming tax season.

Your taxes are likely to increase in 2014 due to the increase in 2013 tax rates and the new Medicare tax on investment income. If you live in California, the maximum combined federal and California tax rates could be as high as 51.4%. These changes make tax planning more important than ever!

Will You Be in the Maximum Tax Bracket in Either 2013 or 2014, But Not Both Years?

The maximum federal tax bracket for both 2013 and 2014 is 39.6%, up from 35% in 2012. This bracket is reached when taxable income exceeds $400,000 ($450,000 if married filing joint). In addition, capital gains are taxed at 20%, instead of 15%, once this threshold is reached.

California tax brackets go all the way up to 13.3% if your taxable income exceeds $1,000,000. At taxable income of $400,000, the marginal California tax rate is 11.3% (9.3% if married filing joint). There is no reduced California tax rate for capital gains. Fortunately, state taxes are deductible from federal purposes, unless you are in AMT (Alternative Minimum Tax).

Focusing on federal taxes, it is generally better to defer 2013 taxable income until 2014, unless the deferral puts you into a higher tax bracket in 2014. Conversely, if you know your taxable income will be higher in 2014, you may want to consider accelerating the income into 2013 if it puts you in a lower tax bracket. Income can be accelerated by accelerating receipt of year-end bonuses, accelerating customer collections, and deferring deductions until 2014. Income can be delayed through setting up deferred compensation arrangements, postponing year-end bonuses, maximizing deductible retirement contributions, and delaying year-end customer collections (if cash basis).

New 3.8% Medicare Surtax on Investment Income

The 3.8% Medicare surtax on net investment income only applies if your modified adjusted gross income(“MAGI”) exceeds $200,000 ($250,000 if married filing joint). Keeping MAGI below $200,000 ($250,000) can eliminate this surtax. The tax only applies to net investment income. Thus, if your threshold is $250,000 and your MAGI is $300,000, the maximum net investment income subject to the surtax is $50,000. If your net investment income is $80,000, only $50,000 will be subject to the 3.8% surtax.

Net investment income (“NII”) is a new term. It includes interest, dividends, capital gains from investments, income from passive activities, such as real estate or rentals and other passive business activities, annuities, and royalties. It does not include gain on a sale of an active interest in a business or retirement plan distributions. Investment expenses that reduce investment income include investment interest expense, allocable state taxes, and certain miscellaneous itemized deductions related to the investments. Planning techniques to avoid the Medicare surtax on NII include: invest in tax exempt bonds, annuities on life insurance products, materially participate in businesses or become a real estate professional, maximize use of retirement plans, avoid or postpone capital gains via tax free exchanges, installment sales or charitable remainder trusts, or change timing of income or expenses in order to keep MAGI below the $200,000/$250,000 threshold.

Since passive activity income from a trade or business is considered investment income, it is advisable to materially participate if at all possible so as to avoid the passive activity treatment. However, once treated as active, you may find yourself subject to self-employment tax unless you operate as an S corporation. LLCs in particular have this risk. Fortunately, it is possible for an LLC to elect to be treated as an S corporation.

Phase out of Personal Exemptions and Itemized Deductions

If your MAGI exceeds $250,000 ($300,000 if married filing joint), your personal exemptions of $3,900 per person in your household will begin to phase out. This same threshold triggers a reduction in your itemized deductions equal to 3% of MAGI in excess of the threshold. These limitations are new in 2013 and increase your effective tax rate.

Alternative Minimum Tax (“AMT”)

The stealth tax, AMT, is alive and well. This alternative tax could kick-in when you have large state tax deductions (including property taxes) and/or large capital gains. It also could occur if you have large miscellaneous itemized deductions or when you exercise incentive stock options. If you expect to be subject to AMT in 2013, but not 2014, you may want to accelerate income into 2013, because the AMT tax rate is only 28%, or defer state taxes to 2014. In some cases, state taxes related to a business, asset sale, real estate operations or S corporation can be deducted for AMT purposes. Thus, it is important to have your tax professional analyze your current year’s income data to determine the AMT impact. Another area where you should obtain professional advice is on the exercise or possible exercise of Incentive Stock Options (“ISOs”), which may trigger substantial AMT consequences. In order to accurately predict AMT, it is generally necessary to project both your 2013 and 2014 income taxes using tax software. Your tax professional can assist you with this calculation.

Harvest Capital Losses

If you have large capital gains in 2013, it may be advisable to accelerate capital losses by selling securities with unrealized losses before year-end. If you want to continue to invest in theses sold securities, make sure you wait 30 days before repurchasing the securities in order to avoid the wash sale rules. Harvesting capital losses is more important if you are in the 20% tax bracket for capital gains. This rate applies once your MAGI exceeds $400,000 ($450,000 if married filing joint). The old 15% tax bracket for capital gains continues to apply if your MAGI is less than this threshold. The opportunity to have capital gains taxed at zero percent still applies if you are in the 10% or 15% tax bracket for ordinary income (check the tax tables in the linked Squar Milner Year-End Tax Planning Guide to find your applicable tax bracket). Clearly, if you are eligible for the 0% tax on capital gains, you should not accelerate capital losses.

Contribute To Your Retirement Plan

Individuals with a traditional IRA or an employer sponsored retirement plan, such as a 401(k) plan, should consider making a contribution to the plan before year-end, if he or she has not already done so. Not all taxpayers will qualify for deductible IRA contributions.

For 2013, the IRA contribution limit is $5,500 for individuals under age 50 ($6,500 for individuals older than 50 years of age who qualify for the catch-up provisions). The maximum amount an employee can contribute to a 401(k) in 2013 is $17,500 ($23,000 for individuals older than 50 years of age who qualify for the catch-up provision).

Non-Cash Charity

Donating appreciated securities to charity creates a tax deduction for the value of the securities donated even though no taxes are paid on the built-in gain. Other property can be contributed to charity but an appraisal performed by a “qualified appraiser” will be needed if the fair market value is greater than $5,000. Gifting appreciated assets also avoids the 3.8% surtax on the gain that would otherwise be incurred on the sale of such assets.

Clothing and household items donated to charity must be in “good condition” in order to be deductible. Thus, taxpayers must be ready to prove both the value and the condition of the property contributed. In addition, taxpayers can no longer deduct charitable contributions made in cash (currency). Further, contributions made by check must be supported by bank record or receipt from the charity (contribution of more than $250 always must be supported by acknowledgement from the charity).

IRA Distributions Donated to Charity

Individuals over age 70 ½ are permitted to exclude from income up to $100,000 of their required minimum distribution (“RMD”) from retirement plans where the RMD is made payable to a qualified charity. Private foundations and donor advised funds are not included in the definition of eligible charity, however most public charities are considered qualified. This provision expires at the end of 2013.

Foreign Investments

Make sure you disclose all foreign bank accounts and investments to the IRS in order to avoid severe penalties.

Estate Planning

Transferring wealth to heirs reduces gift and estate taxes. At a minimum, be sure to take advantage of the annual $14,000 gift tax exclusion per recipient. Gift splitting with your spouse increases the limit to $28,000 per recipient. The combined lifetime gift/estate tax exemption is now $5.25 million per spouse. Consider transferring securities and real estate to trusts for the benefit of your heirs. Using trusts can reduce your estate tax by 30% to 50% or more. Certain trusts work especially well in a low interest rate environment. Consider grantor retained annuity trusts (“GRATs”), charitable lead annuity trusts (“CLATs”), and intra-family loans and installment sales that may or may not use trusts. The applicable interest rate on intra-family loans (e.g. down payment for a child’s home or for the sale of assets to a child financed with a loan) is incredibly low. A short term loan of less than three years can have an interest rate as low as 0.25% under current IRS tables. Mid-term loans (three to eight years) can be only 1.65%. Long-term loans (over eight years) can be only 3.32%. These rates change monthly.

Set Up Loved Ones to Pay 0 Percent on Investment Income

For 2013, the federal income tax rate on long-term capital gains and qualified dividends is still 0% for gains and dividends that fall within the 10 or 15% rate brackets. While your tax bracket may be too high to take advantage of the 0% rate, you probably have loved ones who are in the bottom two brackets.

Consider giving these individuals appreciated stock or mutual fund shares. They can sell the shares and pay no tax on the resulting long-term gains. Giving away dividend-paying stocks is another bright tax idea. As long as the dividends fall within the gift recipient’s 10 or 15% rate bracket, they will qualify for the 0% federal income tax rate.

Warning: If your gift recipient is under age 24, the ”Kiddie Tax” rules could potentially cause some of his or her capital gains and dividends to be taxed at the parent’s higher rates. That would defeat the purpose. Contact your tax adviser if you have questions about the Kiddie Tax.

Fund Education Through 529 Plans

Consider funding 529 plans by December 31 to apply 2013 annual gift tax exclusion treatment to the contributions. A 529 plan can be used to fund a child’s or grandchild’s college education. Income earned on the invested funds are exempt from income taxes. You can “front-load” 529 plans by making five years’ worth of annual exclusion gifts to a 529 plan. In 2013, you could transfer $70,000 ($140,000 for a married couple) to a 529 plan without generating gift tax or using up any of your gift tax exemption.

Concentrated Stock Positions

With increased capital gains rates and the new net investment income surtax, the tax cost of diversifying out of a position has increased. Investors with concentrated positions may also have concerns regarding liquidity, cash flow, volatility and more. Your tax professional can help you consider strategies to minimize your tax impact of diversification or to hedge against the downside of continued concentration. Consider whether systematic sales, equity collars, exchange funds, prepaid variable forwards or charitable remainder trusts make sense in your situation, and whether it would be helpful to implement any of these before year end.

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Click on our Squar Milner year-end tax planning guide to help you further investigate planning ideas. We are available to help you project your 2013 and 2014 taxes and evaluate planning opportunities. For assistance, please contact our office at (818) 981-2600.