Smart timing of income and expenses can reduce an individual’s tax liability, and poor timing can unnecessarily increase it. When one does not expect to be subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year may be a good idea. Why? Because it will defer tax, which usually is beneficial.
However, when one expects to be in a higher tax bracket next year — or one believes tax rates may rise — the opposite approach may be beneficial, i.e., accelerating income will allow more income to be taxed the current year’s lower rate and deferring expenses will make the deductions more valuable because deductions save more tax when an individual is subject to a higher tax rate.
The good news is sometimes individuals can time income and expenses; for example, here are some items of income that one may be able to have some control over and beneficially time when recognized:
- Consider in a year when one changes jobs, one could try and time the bonus income from the previous employer and income from the new employer to avoid bunching of income that could put him or her in a higher tax bracket.
- Self-employment income. Self-employed individuals have more control over their income than employees do. They can choose when to invoice clients and when to receive payments. This can be helpful for timing income to avoid bunching.
- U.S. Treasury bill income, and,
- Retirement plan distributions, to the extent they won’t be subject to early-withdrawal penalties and aren’t required. Individuals could consider doing a Roth conversion in a year when he or she knows they will be subject to a lower tax rate.
Some expenses with potentially controllable timing are investment interest, mortgage interest, and charitable contributions.
However, the Tax Cuts and Jobs Act (TCJA) changes continue to impact previous tax planning ideas with expenses. For example, property tax used to be a popular expense to time. Yet, with the TCJA’s infamous state and local tax deduction “SALT” limit, property tax timing will likely provide little, if any, benefit for higher-income taxpayers. Through 2025, the entire itemized deduction for SALT — including property tax and the greater of income or sales tax — is limited to $10,000 ($5,000 if married filing separately).
Another area the TCJA impacted is the ability to control miscellaneous itemized deductions. This deduction for expenses such as certain professional fees, investment expenses and unreimbursed employee business expenses is suspended through 2025.
Bunching expenses is a tax strategy that involves grouping as many tax-deductible expenses as possible into a single tax year. This can make it possible to itemize deductions in that year, even if one’s itemized deductions would not normally exceed the standard deduction. This strategy is of particular importance right now as the TCJA nearly doubled the standard deduction.
Bunching expenses can be a particularly effective strategy for taxpayers who have large, irregularly occurring expenses, such as medical expenses, charitable contributions, or investment expenses. For example, if an individual has a major medical procedure one year, he or she may be able to bunch his or her medical expenses into that year to itemize deductions. Or, if one is planning to make a large donation to charity, he or she may be able to bunch his or her charitable contributions into a single year to itemize deductions.
To bunch expenses, one needs to plan ahead. For example, if one is planning to make a large charitable contribution, he or she may want to consider making the donation in December of one year and January of the next year. This will allow one to bunch the donation into a single tax year.
One popular tool to effectively bunch charitable contributions is to utilize donor-advised funds (DAFs). A DAF is a type of charitable giving account that allows donors to make tax-deductible contributions and then recommend grants to qualified charities over time. This allows the donor to take a current year charitable contribution deduction while bunching charitable donations in a single year and allows the DAF to spread those funds out over time to use the funds more effectively. In “non-bunching” years this strategy allows donors to take advantage of the currently high standard deduction.
As the year end approaches, Topel Forman wants to emphasize the importance of controlling the timing of income and expenses so that one can maximize his or her potential tax benefits. It is important to reach out to your Topel Forman advisor if you have any questions about any of these concepts or would like more information about this strategy.