We are into the final quarter of the year. With that in mind, this may be a good opportunity to review some tax planning strategies that may help reduce your overall income tax burden.
While there has not been any major income tax reform this year, several tax-related legislations were enacted. Accordingly, a tax review may be advisable.
Year-end planning may take on increased importance for anyone who has had a change in circumstance during the past year. Changes could include a marriage or divorce, birth or death of a family member, acquisition or sale of a business, promotion or loss of a job, or any other major event.
As we have expressed to you in prior communications, tax planning is concerned with the timing and method of reporting income and deductions. The basic philosophy is to defer the payment of tax. Accelerating deductions and postponing recognition of income items typically accomplish this.
We offer you several ideas that are grouped by type of taxpayer. Remember that these items may not all be relevant to your specific situation. Therefore, it is a good idea to check with us before taking any significant steps.
Bonuses and Salaries – If your employer will defer the payment into January 2007, bonus and salary amounts will not be taxed on your return until next year. (The employer may still be able to claim a deduction on its 2006 tax return.)
Stock and Bond Sales – Gains and losses are determined on the trade date. For 2006, the last trading day is Dec. 29. You may want to consider not selling that stock with the gain until January to defer recognition. Likewise, sell those stocks with losses before the end of the year to reduce any other gains you may have. Don’t forget that, overall, only $3,000 of net losses from security transactions can be deducted currently. The balances of any loss will carry over to next year. You also need to be mindful of the length of time that you have held the investment – favorable long-term capital gain rates are applicable when you have held the property for more than one year. Don’t spoil that favorable long-term capital gain rate with a short-term capital loss. If you do sell some stocks at a loss, be careful not to repurchase the same security within 30 days of the sale date.
Deductible Expenses – Charge deductible expenditures on credit cards to get a current deduction even if payment of the charge will not be made until next year.
Charitable Donations – Make charitable donations with appreciated stock owned more than one year. The fair market value is used to measure the donation, and there is no tax on the difference between your cost and the fair market value. (If the fair market value is less than your cost, consider selling the item to recognize the loss and contribute the cash proceeds.) For tax years beginning after Aug. 17, 2006, charitable contributions must be substantiated with bank records or receipts – the “miscellaneous” cash contribution will no longer be allowed without a receipt. If you are over age 70½, consider distributing up to $100,000 of your IRA balance to qualified charities. For 2006 and 2007, you won’t recognize the distribution as income (or get the deduction), but it will count toward your required minimum distribution.
Retirement Contributions – Make the maximum contribution to retirement arrangements whether employer sponsored or an IRA (see chart below).
Medical Expenses – Medical expenses are deductible if they exceed a limitation based on adjusted gross income. You may want to schedule and pay for procedures this year to get the benefit of a 2006 medical deduction – or reschedule to next year for a 2007 deduction. (If you pay more than one-half of the support of a parent or child, regardless of their qualification as a dependent, and you pay their medical expenses, it is deductible on your tax return.) Also includible as medical expenses are transportation, medical insurance premiums, certain long-term care premiums, prescription drugs and certain medically prescribed programs such as weight-loss. You may also be in a position to set up a health savings account provided you have “high-deductible” health insurance.
Flexible Spending Accounts – For calendar year plans, flexible spending account balances may be used through March 15, 2007, instead of Dec. 31, 2006, without losing the account balance. (Make sure that your employer has amended its plan to allow this.)
Tax Basis – Review your tax basis in partnerships or S corporations that may have a current-year loss. If the tax basis is insufficient to claim the loss, you may need to make a contribution to the capital of the business.
Passive Activity – Dispose of a passive activity with suspended losses. When a passive activity has suspended losses, those losses become deductible in the year the activity is sold.
Installment Sales – Consider an installment sale of property rather than collecting all proceeds this year.
Tax Liability – Review your tax liability position and determine whether to reduce your payroll tax withholding or adjust any estimated tax payments. You don’t want to be in a position where you will be penalized for underpaying taxes, nor do you want to give the government an interest-free loan.
Section 529 Plan – Consider using a Section 529 plan for college funding. Many taxpayers set up “Uniform Gift to Minor Act” accounts for their children to help pay for college. The income on these accounts is taxed to the children; however, unearned income over $1,700 is taxable at the parents’ higher tax rate (until the child is over age 18). Convert these accounts to 529 plans and avoid the tax on the earnings – so long as the amounts are used for education.
Hybrid Vehicle – If you purchase and take possession of a qualified hybrid motor vehicle in 2006, you may get a tax credit.
For cash-basis method businesses, send out invoices late in December so that collections will not be made until January.
Establish a retirement plan before the end of the year. The deduction is allowed on the current-year return even if funded just before you file the return next year. (See retirement plan limit chart.) Only a SEP plan can be established and funded after the end of the year.
Establish a medical insurance plan or convert to or establish a high-deductible health plan.
Employ your minor children to perform administrative tasks and avoid Social Security taxes on the wages – this shifts income to a lower bracket. (The children may establish Roth IRAs to gain significant benefits for the future.)
Review your meal and entertainment expenditures to make sure you have proper substantiation.
Consider your eligibility for home office expenses.
Acquire and place equipment into service before the end of the year to take advantage of the immediate deduction of up to $108,000. Limitations may apply if total expenditures exceed $430,000.
Look at adopting the LIFO inventory method.
Evaluate the new deduction for domestic production activities.
Establish a retirement plan before the end of the year. The deduction is allowed on the current year return even if funded just before you file the return next year. (See retirement plan limit chart.) Only a SEP plan can be established and funded after the end of the year.
Offer additional benefits such as a Roth option to existing 401(k) plans.
Trade in fully depreciated business assets instead of selling at a gain. If a trade-in value is less than net book value, sell instead of trade to get the benefit of the loss.
Consider the status of any final estimated tax payment requirements. A penalty for underpayment of taxes can be costly.
The maximum compensation to be taken into account for plan limits is $220,000 for 2006.
|
Type of Plan |
Contribution Limit |
Additional Catch-Up Contribution Over Age 50 |
|
IRA |
$4,000 |
$1,000 |
|
SIMPLE |
$10,000 |
$2,500 |
|
401(k) |
$15,000 |
$5,000 |
|
SEP IRA |
$44,000 |
-- |
We have seen more clients become subject to the alternative minimum tax (AMT) in recent years.
Once considered a tax on the wealthy, by virtue of its construction, the AMT is catching more and more individuals. Those who happen to have significant deductions – those living in a state with a relatively high personal income tax rate and high real estate taxes – are vulnerable. The AMT makes year-end planning difficult and potentially dangerous if done in a vacuum.
Reducing regular tax liability through deductions, deferral and overall rate reductions has increased the AMT liability exposure. All planning must consider multiple years to be truly effective. While a credit for prior-year AMT may be available against regular income tax in a subsequent year, there is no guarantee that the AMT will ever be recovered.
If your estate is large enough to be subject to the estate tax, the rates are higher than the income tax rates. The top estate tax rate is 46 percent.
It makes sense to minimize any estate tax and ensure that the largest possible amount ends up with your heirs and not with the federal or state government.
The federal annual exclusion for gifts is $12,000 to any individual. If you are married and your spouse consents, the effective annual exclusion can be $24,000. This provides a good opportunity to transfer income-producing assets to heirs who may also be in a lower income tax bracket.
In addition to the annual exclusion per person, up to $1 million may be transferred without additional tax.
If you are making gifts to limit or reduce future estate tax and you have reached the annual exclusion, be aware that payments of tuition and medical expense for an individual are not subject to gift tax. There is an unlimited exclusion of amounts paid directly to educational organizations for tuition (not books, fees, etc.) and healthcare providers for medical expenses.
The technical information here is necessarily brief. No final conclusion on these topics should be drawn without further review and consultation. Please be advised that, based on current IRS rules and standards, the advice contained herein is not intended to be used, nor can it be used, for the avoidance of any tax penalty assessed by the IRS.
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