Year End Tax Strategies Part 1 of 2

It has been said that there are three kinds of taxpayers....

There are those who wait until it’s time to prepare their tax return before they think about finding ways to minimize their taxes. Then they frantically engage in what can be called the “River dredging method of tax planning.” That means they “dredge the river” of their finances for the previous year, hoping they may encounter some nuggets of overlooked deductions.

The second type of taxpayer is always oblivious to taxes. This may be someone who has so much money that they can simply hire others to worry about such mundane matters. It may be those who do not have enough taxable income to ever owe any taxes. Then there are some people who just do not want to take the time to even think about taxes, regardless of the cost.

The third type of taxpayer consists of those that actively seek legal ways to avoid taxes, by arranging their financial affairs to secure the minimum tax consistent with their other financial goals. That is called “tax planning.” Ideally, tax planning occurs all year long, but the fact is that most of us put off thinking about taxes until near the end of the year, even if we are concerned about minimizing our taxes.

The purpose of this text is to focus on tax planning near the end of the year. It should not be too difficult to make a reasonably close estimate of what you will owe for the year and how much will be withheld, or paid through quarterly installments of estimated taxes.

If you can still make a decision later, when it is time to prepare your tax return, then year-end planning is not necessary. You can wait until you prepare your return to make decisions about the method of depreciation to use on business equipment, whether you can deduct your various expenses, or whether to put money into an IRA.

However, if the timing of a transaction will affect your taxes for this year, then it will be too late to look for tax savings when this year’s return is being prepared next year. Examples include the purchase of business equipment late this year instead of early next year, matching your capital gains and losses to end up with a net $3,000 long term loss, being sure that a deduction for worthless securities can be proven, and making a decision about whether to give a church or charity some cash or some appreciated securities.

Before you begin to consider year-end strategies, it would help to review the likely changes in the law. Every year, changes in the tax law have become commonplace. Since Congress is always considering tax legislation that will affect the entire year, you may need to make some decisions based on a guess as to the outcome of pending legislation.

If you underpay your taxes, the IRS will charge you interest at a rate that is slightly more than the rate of interest paid on short-term government bonds. (If you underpay by more than a certain amount, the IRS may also assess a penalty that is essentially equal to the interest.) By minimizing your taxes for the current year, you can also reduce your minimum required payments for next year. This article will review some of the planning strategies you can use to minimize the interest and penalty on underpaying your taxes.

Year-end tax planning usually takes the form of looking for ways to postpone some income or to bunch some deductions. A section of this material will discuss most of the ways that investors and individuals can defer taxes from one year to another.

Sometimes you can save taxes by shifting part of the tax obligation to dependents that are in a lower tax bracket. A few ideas for income shifting at the end of the year are also reviewed. This text concludes with a recap of other tax strategies for investors at the end of the year and with some comments on how to get more tax saving ideas from your tax preparer.

NEW AND PENDING TAX BILLS COMPLICATE PLANNING

The big question for most investors is what will happen with new tax law changes. Each year, significant changes in tax law are introduced and eventually some of the changes are passed into law. Individuals need to consult their financial advisor when making substantial investment decisions. Past investment decisions will also need to be re-evaluated by your financial advisor as new tax laws are passed.

Starting in 1981, the government began to change the tax law in stages, over a number of years. The 1981 law introduced lower tax rates, with a top rate of 50%, but the new rates were not fully implemented until 1984. Indexing was introduced in 1981, to be effective after 1984. The 10% two-earner deduction was phased in over three years. More tax changes have been introduced each year, all of them expanding on the concept of introducing tax changes in stages.

This trend continued with the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The changes of this tax act were to be phased in between 2001 and 2010. The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 accelerated some of the changes. In 2004 we had the Working Families Tax Relief Act (WFTRA), the Pension Funding Equity Act (PFEA) and the American Jobs Creation Act (AJCA). The disastrous natural events of 2005 resulted in the Katrina Emergency Tax Relief Act (KETRA 2005). The coming year promises to be no less eventful.

WHAT’S NEW FOR INDIVIDUALS AND INVESTORS

Marriage penalty” relief sections of EGTRRA 2001 increased the basic standard deduction for a married couple filing a joint return, providing for a phase-in of the increase until the basic standard deduction for a married couple filing jointly equaled twice the basic standard deduction for an unmarried individual filing a single return by 2009. However, JGTRRA 2003 accelerated the phase-in, providing that the basic standard deduction for a married couple filing a joint return equaled twice the standard deduction for an unmarried individual filing a single return for 2003 and 2004, then reverting to the lower, gradually increasing standard deduction amounts provided for under EGTRRA for 2005 through 2009.

This was then changed by WFTRA in 2004 and the standard deduction for married individuals filing jointly will remain twice the amount of the standard deduction for unmarried individuals filing single for 2005 and through 2009.



The larger standard deduction for married individuals filing jointly will “sunset” (expire) for taxable years beginning after December 31, 2010, at which time the standard deduction in effect prior to the enactment of EGTRRA 2001 will become effective (i.e., the standard deduction for married individuals filing jointly will, once again, be 167% of the standard deduction for single individuals). Unless, of course, Congress once again changes the law. The personal exemptions of certain upper income taxpayers are phased out over defined income levels. The dollar amount of personal and dependency exemptions of taxpayers with adjusted gross income above certain levels is reduced by two percentage points for every $2,500 (or fraction thereof; $1,250 in the case of a married individual filing separately) by which the taxpayer’s adjusted gross income exceeds the following threshold amounts in 2007: Married filing jointly (and surviving spouses): $234,600; Head of household: $195,500; Single: $156,400; Married filing separately: $117,300. For taxable years beginning after 2007, the phase-out will be gradually reduced each year until it is completely repealed in 2010. Tax rates for individuals: While the tax rates have been moving downward, the tax brackets have been increased about 3 to 4% annually. Thus, if your income increased by 4% for a cost of living adjustment, you were not pushed into a higher bracket merely because of inflation.



The minimum standard deduction is also indexed for inflation. The increases have also averaged about 4%.

No personal interest expense is deductible. This includes any interest you have to pay the IRS, but it does not apply to investment interest expenses, to interest on a personal residence or second home or to interest on funds borrowed for a trade or business.

Loans from single premium life insurance policies will be taxed as distributions. Unless you have older policies (prior to June 1988), do not borrow against any single premium policies unless you are prepared to pay income taxes on the money.

Parents can elect to just include the income of a minor child on their own tax return to avoid having to file a return for the child. The election is available if (1) the gross income of the child is solely from interest and dividends, (2) is more than $850 and less than $8,500, and (3) the child is not subject to backup withholding. (i.e. withholding on interest and dividends.)

The maximum employee deduction for 401(k) cash or deferred pay plans is $15,500 for 2007.

For 2005 through 2010, the child tax credit is $1,000. (Under prior law, after December 31, 2004, the child tax credit was scheduled to revert to the levels provided under EGTRRA 2001 (i.e., $700 in 2005 through 2008, $800 in 2009, reaching $1,000 once again in 2010).) The increased child tax credit will “sunset” (expire) for tax years beginning after December 31, 2010. At that time and barring further action in Washington, the child tax credit will return to its pre-EGTRRA level of $500.

The child tax credit is gradually phased out for joint filers with AGI of more than $110,000 ($75,000 for single filers and heads of households). However, low-income families may use the credit to offset their income tax as well as Social Security taxes paid for the year.

The childcare credit is now available for the care of a dependent only under the age of 13 rather than age 15.

The wage base for FICA taxes has increased every year from $7,800 in 1971 to $94,200 in 2006. In 2007, this was increased to $97,500 for a maximum of $7,459 for the employer and $7,459 for the employee.

The FICA tax rate is 7.65%; the current self-employment rate is 15.3%, compared to only 13.02% in 1989. However, half of the self-employment tax may be claimed as a business expense deduction by self-employed individuals.

AVOIDING ESTIMATED TAX PENALTIES

The government has become impatient to get its share of our income. Over the years, the laws have been changed to require faster and faster prepayments of taxes. Strong penalties have been enacted to discourage taxpayers from underpaying their estimated taxes. However, there are two significant exceptions to the penalties for an under payment of estimated taxes.

One exception is to pay in 100% as much as the previous year’s total tax (110% in the case of some high income tax payers). Thus, if your tax bill for the prior year was $15,000 and you expect to owe $50,000 in the current year, the under payment penalty will not apply if your current year tax withholding and payments total at least $15,000.

The second exception is to pay in at least 90% of the current year’s tax through withholding and/or quarterly estimated tax payments. Thus, if your prior year’s tax bill was $50,000 and you only expect to owe $15,000 for the current year, you can avoid penalties by paying in at least $13,500 for the current year via withholding or estimated payments.

For planning purposes, if you can reduce your current year tax bill, you will also reduce the minimum estimated payments that must be made in the following year by an equal amount. For example, if your current year tax bill would have been $10,000 and you can shift some income to next year so that your revised bill would be $9,000, then your minimum estimated payments in the coming year will also be $9,000.

TAX DEFERRAL IDEAS FOR INVESTORS

When the idea of shifting income from one year to the next is mentioned, many taxpayers will ask, “How can I shift income from this year to next year?” Not everyone is able to shift significant income from one year to another, but here are a few ways to postpone income and to speed up deductions.

• Defer the sale of appreciated assets to next year

If you can get the same price for an asset early next year as you could get late this year, then it might be better to wait. On the other hand, you can enter an agreement to sell at a predetermined price, effective in 30 or 60 days, as required. If you are trying to sell a listed security, that is clearly not practical.

• Use a short sale “against the box"

This would secure a set price on a listed security without having a sale recorded this year. The short sale is not treated as being final until the delivery date, which would be next year. By selling short on a security that you already own, you will simply deliver your own security to cover the future short sale.

• Sell Call Options

Another way to defer the gain and the tax on the sale of securities is to sell call options on the securities. That will secure a current price with a deferral of the capital gain until next year.

• Consider a Like-Kind Exchange

If you own appreciated real estate, ask your tax advisor to explain the rules for tax-free exchange on real estate. Also, look for a commercial real estate broker who is familiar with this technique and ask the broker to explain how it works. It could save you many thousands of dollars in taxes for many years.

• Defer taxes on some types of installment sales

However, the rules have been changing and have become complicated. Generally, if your property is worth less than $150,000, the installment sale is worth looking into. If the property is worth more than that, it is still worth trying to find some “loopholes” to qualify for the installment sale treatment. However, do not make an installment sale without qualified tax advice.

• Realize capital losses by cleaning your portfolio

This is one case where good investment strategy is consistent with good tax strategy. Sell your losers and hold your winners.

You are entitled to a full deduction of $3,000 of capital losses each year, which are deductible from all other forms of income. If you fail to take the deduction in any one-year, it is gone forever. Do not waste it. Also, remember carryovers from prior years.

• Watch out for the “wash sale” rule

If you buy back securities that you sold at a loss, the IRS can disallow the loss deduction if the purchase of substantially identical securities was made within 30 days before or after the date of the sale of the loss securities.

• Accumulate income and cash in tax paid assets

Most of us have been taught to preserve the principal of our assets and to only spend the income. Maybe the IRS started that advice to encourage more people to pay more taxes every year. Why not cash in some previously taxed assets to obtain the cash you need, while investing more of your assets in tax-deferred investments.

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