Now is an excellent time to consider steps you might take to reduce your taxes for the current year. You can use the lessons learned from your 2005 tax filings to develop ways to reduce your 2006 tax liability.
Below are some mid-year tax planning ideas. Keep in mind that we cannot possibly address every specific situation. Therefore, please review your situation with your tax adviser before taking any action.
Plan ahead. At a minimum, project what your taxable income will be for 2006 and 2007. Multiple year projections are essential to proper planning. The projections will help you consider ways to reduce your combined 2006 and 2007 liability.
Avoid underpaying or overpaying your tax. Review your tax position to determine if you need to adjust your payroll tax withholding or estimated tax payments. Underpayment of your tax may cause you to pay penalties to the IRS. Overpaying your tax provides the IRS an interest-free loan.
Keep good records. Prepare now for April 15 of next year. Many deductions are lost because a taxpayer did not keep adequate records. An example would be to start a log of your business, medical and charitable miles.
Take time for investment planning. Keep tax consequences in mind when making investment decisions. If you have net capital losses, you can deduct only $3,000 of capital losses from ordinary income for the year, and you must carry over the excess loss. If you are selling less than your entire holding of a specific stock or fund, and you purchased shares on different dates, you could minimize your capital gain by selling shares that have a higher cost basis. To sell shares other than those purchased first, you must tell your broker the specific shares you want to sell.
The current favorable tax rates for long-term capital gains apply only when you hold an investment for more than one year. Don't combine a favorable long-term capital gain with short-term capital loss. In this situation, try to take long-term gains in one year and short-term losses in the next to take full advantage of the long-term capital gain rates.
If you hold mutual funds, you also need to consider the fund manager's buy-sell decisions. Many funds will post estimates of tax consequences on their Web sites.
When investing new money, consider high-yield dividend-paying stocks taxed at favorable capital gains rates over interest income generating investments, which are taxed at ordinary rates.
Review passive losses. Many individuals have suspended passive activity losses. Most investments in limited partnerships and rental activities are considered passive. If losses exceed gains, the loss is generally suspended and carried forward until passive income is recognized. As is often the case, there are exceptions to the passive-loss rules. Now is an excellent time to review your situation to determine if you can make any changes to meet one of the exceptions or generate passive income to offset the suspended passive losses.
Plan retirement account minimum distributions. Under the minimum required distribution rules, distributions from qualified retirement plans, IRAs and tax-sheltered accounts generally must begin by April 1 of the year following the year you turn age 70½. The minimum distribution for the second and later years must be made by Dec. 31 of each year. As a result, the first and second distributions could occur in the same tax year. For example, an individual who turns 70½ in 2006 is required to take a first distribution by April 1, 2007. Under the IRS rules, the second distribution must be taken by Dec. 31, 2007. You should determine if it would be more beneficial to start your distributions in 2006 and include the first distribution in 2006 income rather than taking two distributions in 2007.
Remember that Roth IRAs are generally not subject to these rules unless the Roth was inherited.
Consider setting up a health savings account (HSA). HSAs allow you to pay medical expenses on a pretax basis for beneficiaries who are covered under a high-deductible health plan. If you don't use the funds by age 65, you can withdraw the funds for nonmedical reasons and pay only income tax. If you currently have a medical savings account (MSA), you should consider rolling it over to an HSA because the HSA is generally more beneficial.
Review charitable contributions. If you own appreciated stock held for more than one year, consider donating it to a charitable organization. The fair market value of the stock is your charitable contribution (subject to adjusted gross income limitations), and you avoid paying income taxes on the gain. If you hold multiple lots of the stock, consider gifting the specific lot with the lowest basis. If you own depreciated stock, consider selling the stock and contributing the cash.
If you want to keep the appreciated stock but need to make a large charitable contribution, consider giving the stock and using the cash to replace it. You end up in the same position, but you have eliminated the unrealized gain on that security.
Remember that record keeping and filing requirements for charitable contributions vary based on whether the contribution is made in cash or property and the amount of the contribution. Now would be a good time to review your contributions and determine if you have adequate documentation to support a deduction.
Be aware of "kiddie tax" changes. The kiddie tax rules require a child's net unearned income (interest, dividend, capital gains) to be taxed at the parent's tax rate. Prior to 2006, the kiddie tax applied to children who were under age 14, had net unearned income greater than $1,600 and were claimed by their parents as dependents. For 2006, the net income amount has changed to $1,700, and the age limit has been changed to under age 18.
Don't forget alternative minimum tax planning. Unfortunately, by reducing your regular tax liability, you have increased the chances that you will be subject to the alternative minimum tax (AMT). No amount of tax planning is complete without considering the AMT implications. The AMT was created almost 40 years ago to force the wealthy to pay income tax. The AMT requires you to calculate your tax liability using the regular method and the AMT method and then pay whichever is higher. In calculating your income under AMT rules, certain adjustments are made from the regular tax calculation. You are likely to be subject to AMT if:
Planning to minimize AMT exposure usually involves multiple years' worth of projections and postponing deductions to later years or accelerating income into the current year.
Maximize the production deduction. For 2006, businesses can deduct (for both regular and alternative minimum tax) 3 percent of their qualified production activities income. The deduction percentage increases to 6 percent in 2007 and to 9 percent beginning in 2010. The production deduction is available for income from:
To qualify for the deduction, the activities must be performed in whole or significant part within the United States. Businesses should review their operation to determine if they qualify for this deduction. If you don't qualify, can anything be changed to make you qualify? If a business is eligible, the deduction can be maximized by reviewing pricing, increasing internal employment rather than outsourcing or merely reviewing your accounting process to make sure costs are allocated properly.
Evaluate your asset acquisition plan. Does your business have an asset acquisition plan that will maximize your expense deduction under Internal Revenue Code Section 179? The maximum amount a taxpayer may expense (immediate deduction) is $100,000 reduced by the amount by which the cost of qualifying property exceeds $400,000. Both amounts are increased for inflation for tax years beginning in 2003 and before 2010. For 2006, the amounts are $108,000 and $430,000 respectively. However, no Section 179 deduction is allowed in 2006 if acquisitions exceed $538,000.
If a taxpayer owns an interest in a pass-through entity, the Section 179 deduction is passed through to the owner. Careful planning needs to be done to maximize the deduction if an individual owns multiple entities that could potentially pass through the Section 179 deduction.
Consider a cost segregation study. If you have constructed, purchased, expanded or remodeled real estate since 1987, consider a cost segregation study to increase cash flow by accelerating depreciation deductions and deferring or recouping federal and state income taxes.
The purpose of a cost segregation study is to identify assets that can be depreciated over 5, 7, and 15 years rather than the usual 27½ or 39-year life for buildings.
Think about adding a Roth contribution. Starting in 2006, participants covered by a 401(k) or 403(b) plan whose employer has adopted the Roth feature will be able to designate some or all of their salary deferred contributions as after-tax contributions.
This can be a significant benefit for higher income individuals who are not eligible to make a Roth IRA contribution. You do not get a deduction for Roth contributions (deferral is from after-tax dollars), but the earnings are tax free if held in the plan until a qualifying event. Employers should consider amending their eligible plans to accept Roth contributions.
See if you qualify for the research and development credit. The research and development credit is not just for high-tech companies. If you have developed a new process or product or improved an existing process or product, you could qualify. The rules for taking and qualifying for these credits are constantly changing. Recent rules have made it much easier to qualify. In addition, you may be able to file amended returns and receive refunds.
Save estate taxes through gifting/annual exclusion. If you have accumulated substantial wealth, the estate tax is as much or more of a consideration than the income tax.
One method of reducing your estate is to make gifts to your potential heirs. The federal annual exclusion for gifts increased to $12,000 in 2006 (from $11,000). If you are married, you and your spouse can each give $12,000, for a total of $24,000 per donee. If your gifts exceed the annual exclusion, they are counted against your $1 million exemption amount before any gift tax is paid.
Often-overlooked items to the gift tax rules are the education and medical exceptions. Amounts paid directly to the organization providing the medical service for medical expenses are excluded from the gift tax. Similarly, transfers to qualifying educational institutions for tuition are excluded from the gift tax.
The gifting of income-producing assets to children who also may be in a lower income bracket has lost some of the benefits as a result of recent changes to the kiddie tax rules by the Tax Increase Prevention and Reconciliation Act of 2005 (see "Be aware of 'kiddie tax'" under Individual Income Tax Considerations).
Consider gifting/529 plans. Consider setting up a 529 plan to put money aside to fund the cost of college for a selected beneficiary. Earnings and distributions are tax free if used for qualified college education expenses. Since the contribution is not made directly to the educational institution, it does not qualify for the gift tax tuition exclusion but does qualify for the annual exclusion. There is an election available to spread the contribution over a five-year period, allowing the annual exclusion in future years to avoid taxable gifts. Therefore, an individual could contribute $60,000 in 2006 per beneficiary without paying gift tax on the contribution.
With early tax planning, you are more likely to be prepared for April 15 next year. Call us today to review some tax planning strategies. We may be able to help you lower this year's tax bill before it is too late.