Year-end Planning

Key tips that can minimize the tax bite

Andrew Osterland, Special to
Troels Graugaard | E+ | Getty Images

Tax planning can be an expensive proposition when you're trying to handicap outcomes of a dysfunctional political system. Just ask the taxpayers who shelled out large sums last year to protect their wealth from expected changes in estate tax laws that never came to pass.

The estate tax exemption stayed at $5 million and remained portable between spouses, arguably making all those tax-planning efforts a waste of time and money.

"Everyone was scared about the potential changes to the estate-planning laws, and a lot of people engaged in expensive legal schemes to protect their wealth," said Ric Edelman, CEO of Edelman Financial Services. "It turned out to be all for naught."

As the recent government shutdown illustrates, Congress hasn't gotten its act together yet. But the resolution of the fiscal-cliff drama last year has at least provided some certainty for American taxpayers.

This year, the tax-planning picture is far simpler. There are changes that affect wealthier taxpayers, such as the rise in the top marginal tax rate to 39.6 percent and extra taxes to fund the Affordable Care Act. The potential tax liabilities for most Americans are now much clearer, however, and the strategies they can use to reduce taxes are more straightforward.

(Read more: Year-end tax planning)

"This is the first year in a very long time that we have permanent, not extended, tax rates," said Barry Glassman, president of Glassman Wealth Services. "I'll take tax planning based on a client's income versus planning around potential congressional decisions any day."

In the more transparent environment, advisors suggest that individuals consider five things to minimize the bite on April 15:

1. Plan early: Tax tips are generally useless outside the context of a specific financial situation. The most important factor in good tax planning is making an accurate assessment of your income for this year and next.

If there is likely to be a substantial difference, it can make sense to either defer or accelerate deductions or income and investment gains to reduce overall taxes.

The sooner taxpayers understand their likely income situations, the more effectively they can address their tax liabilities, according to financial advisors.

"People have to sit down and sort through the impacts of income thresholds," said Rick Kahler, president of Kahler Financial Group. "It's critical this year to pay attention to gains and losses."

(Read more: Questions taxpayers should ask)

2. Know your tax brackets: All things being equal, it's better to pay taxes tomorrow rather than today, if only to capture the time value of money.

The marginal tax rate for individuals an couples earning more than $200,000 and $250,000, respectively, rose to 39.6 percent this year from 35 percent. They will also be liable for additional surtaxes of 0.9 percent on regular income and 3.8 percent on investment income over those thresholds to fund the Affordable Care Act.

Deferring income distributions, whether flexible compensation or investment gains, may make sense if it would keep you in a lower tax bracket this year. That holds true for all the income-tax rate thresholds. If, on the other hand, deferring pushes you into a higher bracket next year without affecting your tax rate this year, you're better off paying this year.

A few notable strategies include deferring flexible compensation until next year, deducting an additional month of mortgage interest this year (13 months are allowed), making charitable contributions and investment-loss harvesting.

3. Harvest tax losses: One of the most common ways to offset income is to harvest losses in investment portfolios in taxable accounts.

The incentive is even greater for taxpayers earning more than $400,000 this year, as the capital-gains tax rate increases to 20 percent from 15 percent on gains over that threshold. With this year's strong equity markets, investors can expect significant capital-gain distributions from mutual funds at the end of 2013.

Given that capital losses offset gains on a one-to-one basis, investors may want to harvest losses on some investments to reduce taxable income. If you still like the investment, make sure to wait 31 days before repurchasing it to avoid "wash-sale" penalties.

Glassman suggests exercising restraint with such maneuvers, saying. "Taxes shouldn't be driving your portfolio rebalancing."

(Read more: Time to reposition the portfolio)

4. Understand special situations: One significant decision for taxpayers over age 70½ is whether to take the first required minimum distribution (RMD) from a 410(k) plan or individual retirement account (IRA), or to defer it for a year. Advisors say it may be worth it if delaying the distribution reduces an investor's tax rate this year. Keep in mind that individuals who do defer the first RMD will have to take twice the amount into taxable income the following year.

Kahler also recommends that clients in the highest tax bracket consider recharacterizing Roth IRA conversions they did last year—despite the fact that their marginal tax rate rose to 39.6 percent.

When a traditional IRA is converted to a Roth, the owner is liable for taxes on the entire amount at the marginal tax rate. Taxpayers can recharacterize the account as a traditional IRA within one year.

Given expectations that tax rates would increase in 2013, Roth IRA conversions were all the rage last year. While the top marginal rate in 2013 is higher, Kahler thinks the likely outcome of tax reform will be lower rates and fewer deductions, meaning conversions could be made at lower rates in the future.

"Our best guess is that there is strong sentiment to lower top rates and to close loopholes," he said.

(Read more: Year-end financial tips)

5. Don't wag the dog: Every good financial advisor conducts year-end tax-planning assessments for clients, but there is such a thing as too much tax planning. The most oft-repeated advice from advisors is to never let the "tax tail wag the investment dog."

If you're investing for tax reasons alone, you probably aren't investing well. The downside of that can be much greater than the tax benefits you anticipate.

"If we put off a good investment opportunity for tax reasons, more often than not we regret it," Kahler said.

—By Andrew Osterland Special to