TCP CPA Practice Questions Explained: The Timing of Income and Expenses for Tax Planning

In this video, we walk through 5 TCP practice questions teaching about the timing of income and expenses for tax planning purposes, including the effects of changing tax rates and legislation. These questions are from TCP content area 1 on the AICPA CPA exam blueprints: Tax Compliance and Planning for Individuals and Personal Financial Planning.

The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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The Timing of Income and Expenses for Tax Planning

When considering the effect of changing tax rates and legislation on the timing of income and expense items for tax planning purposes, it’s important to adopt a strategic approach that takes into account both current tax laws and anticipated changes.

1. Understand Current and Anticipated Tax Rates and Laws

• Stay Informed: Regularly review the current tax laws and stay updated on any legislative changes that may impact tax rates and deductions.
• Anticipate Changes: Pay attention to potential tax reforms discussed in the media or legislative bodies that could affect future tax periods. This includes changes in tax rates, adjustments to deduction limits, or alterations to tax credits.

2. Evaluate Your Income and Expenses

• Assess Taxable Income: Consider your current taxable income and any expected changes in the coming years due to fluctuations in earnings, investments, or changes in employment.
• Identify Deductible Expenses: List out potential deductions such as mortgage interest, medical expenses, state taxes, and charitable contributions. Determine whether these are subject to any caps or phased adjustments based on income levels.

3. Timing of Income

• Defer Income: If higher tax rates are expected in the future, consider deferring income to a later year when tax rates may be lower. This could involve deferring bonuses, delaying business income, or postponing large financial transactions.
• Accelerate Income: Conversely, if tax rates are expected to rise, it may be beneficial to accelerate income into the current tax year to take advantage of lower rates.

Examples of Pushing Income to a Different Year

1. Deferring Year-End Bonuses:
   • Scenario: If you anticipate a higher tax rate this year due to an unusually high income and expect a lower rate next year, you might request your employer to defer your year-end bonus to January of the next year.
   • Benefit: This allows you to receive the bonus in a year with a lower tax rate, reducing the overall tax liability on that income.
2. Delaying Business Invoices:
   • Scenario: If you’re a freelancer or run a small business and you’re nearing the end of the tax year, consider delaying sending invoices for services performed late in December to January of the next year.
   • Benefit: This defers the recognition of income to the next tax year, which can be beneficial if you expect to be in a lower tax bracket.
3. Using Retirement Contributions:
   • Scenario: Making contributions to a traditional IRA or a 401(k) plan can defer taxes on income until withdrawal in retirement.
   • Benefit: Contributions reduce your taxable income in the year they are made, pushing the tax liability to future years where you might be in a lower tax bracket.

Examples of Accelerating Income

1. Accelerating Business Income:
   • Scenario: If tax rates are expected to increase next year, a business owner might choose to accelerate income by completing projects or making sales before the year-end, rather than delaying them.
   • Benefit: This strategy brings more income into the current year to take advantage of the current lower tax rates.
2. Selling Investments:
   • Scenario: If you have investments that have appreciated and you are considering selling, doing so in a year where your overall income is lower can be advantageous if you expect to be in a higher tax bracket in the future.
   • Benefit: Capital gains may be taxed at a lower rate if your total taxable income is lower in the current year.

4. Timing of Deductions

• Accelerate Deductions: If tax rates are decreasing in the future, it may be advantageous to accelerate deductions into the current tax year. This means making prepayments on deductible expenses like state taxes and mortgage interest or advancing charitable donations.
• Defer Deductions: If tax rates are expected to increase, consider deferring deductible expenses so that they can be claimed in a year with higher tax rates, thereby providing greater tax relief.

Examples of Shifting Deductions

1. Prepaying Expenses:
   • Scenario: If you itemize deductions and anticipate that next year’s tax rates will be higher, you might consider prepaying deductible expenses such as property taxes or January’s mortgage payment in December.
   • Benefit: This increases your deductions in the current year, reducing your taxable income in a year where it might be more advantageous.
2. Bunching Charitable Donations:
   • Scenario: Instead of spreading charitable donations over several years, you might choose to “group” or “bunch” several years’ worth of donations into one year.
   • Benefit: This can push your deductions over the standard deduction threshold, maximizing your tax benefit in a single year.
3. Medical Expenses:
   • Scenario: If you have significant medical expenses that aren’t covered by insurance, scheduling additional medical procedures in a year when you have already incurred substantial medical costs can help surpass the AGI threshold for deducting medical expenses.
   • Benefit: Accelerating medical expenses to exceed the threshold in one year can maximize deductions, particularly if the following year is expected to have lower medical expenses.

5. Use of Tax Credits and Losses

• Optimize Tax Credits: Some tax credits may be more beneficial in years with higher taxable income. Align the use of tax credits such as education credits or for energy-efficient home improvements with years of higher income.
• Harvest Tax Losses: If anticipating higher tax rates, consider harvesting losses in years when those losses can offset higher-taxed gains, reducing the overall taxable income.