As we are a little over half-way through the year, individuals will start thinking about year-end tax planning strategies for 2016.
Taking into account the official inflation-indexed figures for 2016, this letter puts together a list of typical questions that you, as clients, may have about this year’s inflation adjustments to the tax brackets and other items, and provides answers to them. We hope this information will be helpful as you continue to plan for 2016.
Question: Do the tax rates go down in 2016?
Answer: No. The tax rates for individuals stay at 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% in 2016. There is some tax relief in 2016, however, in the form of inflation adjustments to the tax brackets and other items.
Question: How do the inflation adjustments work?
Answer: The point at which each of the top seven tax brackets begins is increased for inflation. This means that, in 2016, more income will be taxed at the 10%, 15%, 25%, 28%, 33%, and 35% rates than in 2015.
Question: Are other income tax items adjusted for inflation?
Answer: There are numerous other income tax items that are adjusted for inflation including, for example, the standard deduction and the personal exemption amount. In 2016, the personal exemption amount is $4,050 (up from $4,000 in 2015.) The standard deduction for those who are married filing separately and single taxpayers will remain the same as 2015 ($6,300), while the standard deduction for Heads of Household will increase to $9,300 (up from $9,250 in 2015). The basic standard deduction for a married couple filing jointly is $12,600 in 2016 (same as 2015). Both the personal exemption and the standard deduction will begin phasing out at $311,300 of adjusted gross income for joint returns/surviving spouses, $285,350 for heads of household, $259,400 for single individuals, and $155,650 for those who are married filing separately. Note that as a result of the inflation adjustments to the tax brackets, exemption amount, and standard deduction amounts, many taxpayers can receive a modest increase in income in 2016 without being pushed into a higher tax bracket.
Question: Do all of the items that qualify for adjustments get at least some increase?
Answer: No, because the way in which adjustments are made varies for different items. For example, different items have different rounding mechanisms. Many adjustments are rounded down, which could result in no increase for a particular year.
Question: What kind of tax savings will be realized in 2016 from the adjustments?
Answer: Let’s look at a two-wage-earner couple with two children. For 2015, they have gross income of $120,800, $30,000 of itemized deductions, and taxable income of $74,800, after taking into account their four $4,000 (for 2015) personal exemptions. Their tax (before any allowable credits) for 2015 comes to $10,298. If their income stays at exactly the same level for 2016, their taxable income will drop to $74,600 (taking into account the four $4,050 personal exemptions), but their tax will go down to $10,263, for a savings of $35.
Question: Do any taxpayers not benefit from inflation adjustments?
Answer: The AMT can rob individuals of the benefit of inflation adjustments because the AMT is not adjusted for inflation.
Question: What is the AMT?
Answer: We actually have two income tax systems – the regular tax and the alternative minimum tax or AMT, which prevents taxpayers from paying too little tax by disallowing or reducing certain deductions and treating as income certain items that are exempt from regular tax. If an individual’s AMT exceeds his regular tax, he pays the difference plus his regular tax. So let’s say for 2015 an individual’s regular tax was $30,000 and his AMT also was $30,000. He pays $30,000 in regular tax. Now, for 2016, inflation adjustments push his regular tax down. His AMT is still $30,000, because it’s not adjusted for inflation, so he ends up still having to pay $30,000. In other words, the AMT robs him of the benefit from the inflation adjustment. Note that the family of four with gross income of $120,800 from the example above showing the benefit from the inflation adjustments could actually be subject to AMT, depending on the make-up of their itemized deductions and other factors.
Question: Are the monthly amounts that an employee can exclude from income for transit passes and parking under a company program increased?
Answer: The 2015 monthly $130 limit for transit passes and commuter transportation will remain the same for 2016. The parking limit ($250 per month in 2015) is increased to $255 for 2016. Employees of companies who offer these benefits can save income tax. In addition, social security taxes can be saved by employees whose wages are not over the social security wage base ($118,500 for 2016) and by employers with respect to such employees.
Question: What other key adjustments are there?
Answer: There are some other important adjustments that affect individuals with incomes at higher levels. Many tax breaks are reduced or eliminated as income exceeds certain thresholds including, for example, certain education tax breaks. These thresholds generally are increased for inflation.
Question: What can be done to avoid losing tax breaks when income starts approaching the thresholds at which tax breaks are reduced or eliminated?
Answer: Individuals whose income is close to the threshold amount for a particular item may be able to take some steps to keep income below the threshold. A couple may know they are going to be over next year but may be able to keep below the threshold this year by taking certain steps. For example, it may be possible to reduce this year’s income by pushing a bonus into next year, moving money from taxable interest bearing accounts to tax-exempt accounts, increasing 401(k) and IRA contributions, and selling stock at a loss. An individual who would be over the limit this year but who might not be next year, should consider the opposite type of planning moves, i.e., accelerating income into this year and deferring above-the-line deductions until next year.
Question: What do the adjustments all mean for individuals?
Answer: The inflation increases are low and thus the tax savings from the adjusted figures are low. Individuals can’t figure on a whole lot of savings next year from the inflation adjustments. However, as a result of recent tax law changes, there are several steps that individuals can take to reduce their tax bill this year and next year, including the following:
- Shift investments that produce ordinary income into stock or mutual funds because capital gains and qualified dividends are taxed at a maximum rate of 20%.
- Place up to $2,000 in a Coverdell education savings account (formerly education IRA) for a child or grandchild.
- Make an up to $5,500 annual contribution to an IRA (an additional $1,000 can be contributed by qualifying individuals age 50 and over).
- Make the maximum contribution that you can afford to a company 401(k) plan. The limit is $18,000 for 2016. Employers can allow those 50 or over to contribute an additional $6,000.
- Take advantage of the maximum lifetime learning credit, which is $2,000.
- If you are a self-employed individual, you can deduct 100% of the amount you pay for medical care insurance for yourself, your spouse, your dependents, and your children who are under age 27.
As always, please don’t hesitate to contact us with your tax planning questions.