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2002
Year-End Tax Planning Strategies
by: James
Lange, CPA, JD and Glenn
Venturino, CPA
Last year President Bush
signed into law an enormous tax relief program called The Economic
Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).
The effective date for many provisions was January 1, 2002.
On March 9, 2002, the President signed into law the Job Creation
and Worker Assistance Act of 2002. That act has provisions
that are retroactive to September 2001. The new legislation invokes
significant income tax changes, but its broad sweep also has enormous
implications for IRAs, retirement plans, minimum distributions and
estate taxes. For more details on the changes, we recommend that
you read our articles: “The
Economic Growth and Tax Relief Reconciliation Act of 2001 Summary”
and “Finalized
Regulations for Retirement Plan Distributions”
This newsletter concentrates
on how to take advantage of the major income tax provisions that
we think will have an impact on our readers' taxes. Please
get paper and pen ready to make a list of your personal “action
points.”
Tax Loss Harvesting
Most investors lost money
in the stock market. Tax planning can't restore your losses,
but it can soften the blow. Using losses to reduce taxable gains
by means of tax-savvy realization of losses to match gains is referred
to as loss harvesting or tax-loss selling. For
many readers, tax loss harvesting is the single most important
area for reducing taxes now and in the future. Financial planners
and advisors who understand and apply these principles really do
offer “value added service.” Proper tax loss harvesting strategies
can save you taxes and help you diversify your portfolio in ways
you may not have considered. Now is the
time to start thinking about harvesting losses to offset unrealized
capital gains.
Example:
Assume you have a winner;
you bought it for $50, it is now worth $100 and there is no adjustment
to the basis.
Also, please assume, you
have a loser; you bought it for $100 and now it is worth $50.
What are your options?
Idea 1: Buy and
Hold
Do nothing, buy and hold.
No taxes on any transaction. Next year, if you sell the winner,
perhaps in a rebalancing or diversification attempt, and hold on
to the loser, you will have to pay $10 in capital gains tax ($50
x 20% tax = $10 tax).
Idea 2: Dump
the Loser
Assume your capital gains
rate is 20%. Sell the loser and deduct $50 in losses. This means
you will pay $10 less in taxes than you would have if you had done
nothing (Idea 1). Knowing that you will pay $10 less in taxes
(the 20% of your losses that you can deduct), you can afford to
reinvest $60 (the $50 sale price of the investment, plus the $10
tax savings; subject to limitations), which is 20% more than your
losing investment was worth ($60 is 20% more than $50). So, you
get an immediate $10 benefit. When you add state capital gains
taxes, the savings are greater.
If you later sell the
winner for $100 and have to pay capital gains tax of $10 ($50 X
20%) at least you enjoyed the time value of your $10 while you held
the stock. If you can use other losses to offset the winner,
you would be $10 ahead plus the growth on the $10 over time.
Idea 3: Dump
the Loser and Repurchase
Let's assume you like
the loser or it is a “core holding” of your portfolio or you think
the loser will come back. Sell the loser and then, subject
to the wash rules, buy it, or something similar to it, back.
Assume you made the correct decision to sell and repurchase. After
repurchasing the loser for $50, it goes back to $100. Except
for transactions fees, you would have the benefit of the $10 savings
you made by deducting the loss, and you have the growth. Furthermore,
you have maintained the integrity of your portfolio.
Idea 4: Use Your Losses
to Diversify Your Portfolio
Let's assume you have
a heavy position in a particular stock or mutual fund in a particular
sector (like a large cap fund) that has a low basis. You have
avoided selling it for years because you are too cheap to pay the
capital gains tax. (Let's be honest here.) Then, either
your advisor nags you or the fear of an Enron scenario makes you
want to diversify.
Let's assume that the
basis is $10,000, and the value is $100,000. You never sold
it because you didn't want to pay the $18,000 in taxes ($100,000
proceeds less $10,000 basis = $90,000 gain X 20% = $18,000).
Let's also assume you
have a loser or losers with a combined loss of $90,000. You
sell both, winner and loser, offset the gains and the losses and
pay no capital gains. Lo and behold, you just opened up your
window to diversification and getting out of that heavy concentration
in one stock or sector problem. You repurchase the winner
and the loser or whatever you like, and your basis will be your
purchase price.
The best losses are short-term
capital losses. This is because the IRS forces you to match
short-term gains against short-term losses and long-term gains against
long-term losses first. Then the net short-term results are
netted against the net long-term results. If the result is a gain,
it will be taxable as short-term, long-term, or a combination thereof.
If the losses incurred were short-term rather than long-term, there
will be a better chance that your gain will be long-term instead
of short-term and taxed at lower rates. The short-term
gains tax rate can be almost twice the long-term gains tax rate.
Therefore, if you own losing investments that you have owned for
less than a year, they are a better choice for tax-loss selling
than long-term investments.
The following example
is somewhat complicated but it demonstrates why it is critical to
think ahead and map out a strategy to capitalize on gains and losses.
Imagine you hold an investment
that qualifies for a short-term capital loss (i.e., a losing investment
held for less than a year) with an unrecognized loss of $20,000.
You also have a long-term winner with an unrecognized gain of $20,000.
You decide not to sell either prior to year-end. After all
you haven't really lost any money on paper. (Hint: this may be bad
logic.)
The following year you
decide it's time to sell the long-term winner and recognize a $20,000
long-term gain at a long-term tax rate of 20%. In this same
year, you also incur a short-term capital gain of $10,000 from the
sale of another stock. You now have $30,000 in taxable income to
recognize.
In the meantime, the loser
is still down $20,000. Fine you think, let's sell the $20,000
loser, offset it against the $20,000 gain, and pay tax on the $10,000
gain. (By the time you decide to sell the loser, it is no longer
a short-term transaction because you have held it for over a year.)
When you prepare your 2002 Schedule D, you report a long-term gain
and long-term loss that net to $0. You also report a short-term
gain of $10,000 taxed at your ordinary rate of 30% that costs you
$3,000 of federal income taxes.
What you could
have done was sell the loser while you could still realize the short-term
capital loss, and deduct a $3,000 loss at your ordinary tax rate
of 30%, or $900 ($3000 X 30% = $900) and recognize a $17,000 short-term
loss carryover. In the following year, using the netting rules,
the $10,000 short-term gain would be offset by the $17,000 short-term
loss carryover. The excess short-term loss of $7,000 would
then offset the long-term gain of $20,000 leaving you with a long-term
taxable gain of $13,000. This gain would result in tax of
$2,600 ($13,000 X 20%). The net tax over these two years is
only $1,700.
In summary, recognizing
the short-term loss when you had the chance would have saved you
$1,300 or 43% of the total taxes.
If your net capital losses
exceed your net capital gains, you can deduct up to $3,000 of the
losses (short or long-term) against ordinary income. That adds up
to a $900 tax savings for an individual who is in a 30% tax bracket.
Be careful to avoid a wash sale, i.e., buying the same security
back within 30 days before or after you sell the shares. Tax
rules will disallow the loss. Keep in mind, however, that with all
the stock and mutual fund choices, there is probably a similar investment
available for you to park your money in for 30 days. This may be
a better strategy than keeping funds in cash for 30 days waiting
to repurchase the same stock since the market or the sector may
move up significantly in 30 days.
Selling investments to
realize net losses in excess of $3,000 is a good idea too. The losses
will carry over to future years when future gains can be reduced.
Plus, up to another $3,000 per year can be deducted from ordinary
income. Even if investments you currently hold recover in
value, you would have been much better off by selling them at a
loss and reinvesting the proceeds in similar investments.
Using this strategy, you will hold investments of the same value,
but with a lower cost basis and have additional tax savings each
year. To the extent that the $3,000 net loss is deducted against
ordinary income every year, you save money at ordinary tax rates.
The loss carryover can also eliminate future short-term and long-term
capital gains and will free you from subsequently sticking with
investments only because of the holding period. If the remaining
investments are subsequently sold at a gain, it will be taxed at
lower long-term gain rates, and the overall result will be less
tax than holding the original investment. If the investment
with a lower basis remains to become part of your final estate,
the heirs will get a step-up in basis and avoid the tax altogether.
Harvesting your investment
losses can reduce your capital gain income to zero and give you
a bonus of a $3,000 ordinary income reduction each year. It's
a great way to increase the after-tax rate of return on your portfolio
without the risks of active trading. In combination with a
good asset allocation and reallocation strategy, you can add value
to your investment portfolio without increasing your investment
risk.
If you find all of this
too overwhelming, and yet you see the inherent value of the advice,
perhaps you would be well advised to consult with your financial
advisor and your tax advisor.
ALERT-Special Allowance
Depreciation
If you filed your 2001
tax return prior to June 1, 2002, and did not claim the new special
depreciation allowance for new cars and qualifying property (for
example—new items such as equipment, computers, furniture, etc.)
resulting from the Job Creation and Worker Assistance Act of
2002, you should consider filing an amended return to get a
2001 refund. The amended 1040X return must be filed by April
15, 2003. See IRS publication 3991 for specific details of
qualifying depreciable property and details on how to compute the
additional depreciation.
Alternative Minimum
Tax
With the four top income
tax rates falling by another half-point in 2002, the popular recommended
strategy of accelerating deductions this year and deferring income
into next year can be advantageous. In recent years, many individuals
have used this strategy to defer taxes and take advantage of the
time value of money concept. Add to the equation real tax savings
because of lower tax rates, and this strategy makes even better
sense. Before you jump headfirst into this strategy,
please be aware that Alternative Minimum Tax (AMT) rules can totally
offset the benefits. Top factors leading to AMT liability
are an increased number of personal exemptions, limited medical
expenses, disallowed items such as miscellaneous itemized deductions
and certain home equity interest. Unfortunately, if you have
an excessive amount of these deductions, you are a very good candidate
for the AMT. Because the IRS has failed to index the AMT exemption
in 2002, more taxpayers will be subject to the AMT.
In general, you compute your tax liability using both regular tax
rates and the AMT tax rates and pay the higher of the two. If you
determine that you may fall prey to AMT in 2002, holding off paying
certain deductible expenses such as state and local taxes, real
estate taxes, etc. until next year may prove to be advantageous.
There was some positive
movement in this area due to changes introduced in the Job Creation
and Worker Assistance Act of 2002. Education credits,
dependent care credit and other credits that were allowed to reduce
both regular tax and AMT were due to expire at the end of 2001.
This provision has been extended and will be in effect for 2002
and 2003.
Qualifying Taxpayers
Should Plan to Convert a Portion of their Traditional IRA to a Roth
IRA
The benefits of converting
a traditional IRA to a Roth IRA are discussed at length in our peer-reviewed
article, Roth IRAs: Accumulating Tax Free
Wealth. The conversion must be completed before year-end
and many brokerage houses recommend getting the Roth IRA conversion
form to their offices well before year-end to qualify for a year
2002 conversion.
Current law dictates that
tax rates will be lower in the upcoming years. But waiting to convert
to a Roth IRA until rates are lower is risky. Yes, the converted
amounts would be taxed at a lower rate but considering the current
market conditions, your IRA account value may be at its lowest point.
A 3% recovery in your account value between now and 2005 would offset
the 2% tax rate reduction savings that is in effect for tax years
2004-2005.
Consider Recharacterizing
your Roth IRA
A complete discussion
of Roth IRA converting and unconverting is found in a separate article
on our web site, Finessing
Market Uncertainties: Roth
IRA Conversion Strategies.
Transfer Appreciated
Stock to Children 14 Years Old or Older
Consider transferring
stock to your child. For example, assume you are in a 27% tax bracket
and are planning to sell some appreciated long-term held stock (at
least five years) to pay for your child's education. Your child
is in a 10% tax bracket. Consider making a gift and transferring
the stock to your child who subsequently sells the stock. You have
effectively shifted long-term capital gains from a 20% taxation
rate to your child's long-term capital gains tax rate of eight percent.
Financing an Education
for Your Children and Grandchildren
Let's start with my favorite
way to finance the education of your family.
Section
529 Qualified State Tuition Plans
The
529 Plans, which are distinct from the prepaid tuition plans, provide
an excellent way to save for college. The 529 Plans now allow tax-free
withdrawals for all “qualifying educational expenses.”
529
plans also have significant estate tax advantages. Ideally, they
can be considered a gift to children or grandchildren who will eventually
go to college. However, if you decide for whatever reason you want
to take the money back and use it for yourself, you may do so¾a
little like a gift with a string attached that you can yank back
if and whenever you want.
If
you currently have UTMA/UGMA accounts for your children or grandchildren
holding their “college funds,” now may be the ideal time to liquidate
those accounts and establish a 529 Plan account. There is
a very good chance that minimal or no income taxes would be incurred
due to depressed market prices. Any future market appreciation
would escape from income taxes if used for “qualifying educational
expenses.” Due to increased competition between state programs,
setup and maintenance costs are lower than ever.
A
disadvantage of the 529 Plan is that your investment options are
limited. Also, 529 Plans may be inappropriate if you can afford
to pay tuition directly and make a personal gift.
For
example:
You
have a potential federal estate tax and are trying to reduce your
estate with gifts to children or grandchildren. Your grandchild
is 18 and you want to take care of his tuition and give him an additional
$11,000. If you put $11,000 in a 529 Plan account, that is deemed
a gift to him; however, if you pay his tuition directly, that is
not deemed a gift and you can give him an additional $11,000 without
eating into your once-in-a-lifetime exclusion. Under these circumstances,
you would be better off not establishing a 529 Plan account.
Some
financial planners feel that because of the shift from the need-based
scholarships to the merit-based scholarships, parents are well advised
to concentrate their effort on qualifying for aid rather than saving
for college in a tax efficient manor. I disagree because I
assume most of my clients' children and grandchildren will not qualify
for aid and prefer the certainty of the tax savings.
A
more detailed discussion of 529 Plans is found in the article
"Saving
for College with a Qualified State Tuition Program (QSTP)."
Tax Planning for
Education Tax Credits
You can help yourself
to a lower tax bill if you follow some of the steps below. Be sure
to maximize any available education credits that you qualify for.
Knowing when and when not to prepay tuition expenses could save
otherwise reduced or lost college tax credits. You might want to
contact your tax advisor for assistance in this area.
New in 2002:
Deduction for Qualified Higher Education Expenses. Beginning
in 2002, these expenses are now eligible for an above-the-line deduction.
Taxpayers may claim this deduction whether or not they itemize their
deductions. Taxpayers with an adjusted gross income not exceeding
$65,000 ($130,000 in the case of married couples filing joint returns)
are entitled to a maximum deduction of $3,000 per year. These gross
income limits are higher than the levels necessary for qualifying
for the Hope and Lifetime Learning education credits.
Maximize Student Loan
Interest. More college grads will be eligible to deduct
student loan interest in 2002. Deductions will no longer be
limited to the first 60 months that payments are required on the
loan. More importantly, the income eligibility limits will rise
to $65,000 for singles and $130,000 for couples.
Let your Child Claim
the Hope or Lifetime Learning Credits. If you're tired
of losing education tax credits because of your income bracket,
all is not lost. If you are eligible to claim your student child
as a dependent, but choose not to, your child may be able to claim
a Hope Scholarship or Lifetime Learning Credit for the qualified
tuition and related expenses that you paid. This move can be a family
tax saver if your income level is above the phase out range for
claiming the tax credit. Of course your child must have a taxable
income to claim the credit. Note that the child cannot claim the
forfeited dependency exemption on his own return. This is really
good when your child's dependency exemption is partially or fully
phased out on the parent's return.
For example:
The parent(s) give appreciated
stock to the child as a gift. The child, in turn sells the stock
to pay for qualifying tuition expenses. The capital gain is reported
and taxable on the child's return at a much lower tax rate. The
tax savings could be as much as 12% on the long-term gain. The tax
liability is now offset by the education tax credit claimed on your
child's return. If you are applying for financial aid, keep in mind
that the student's assets are a much bigger factor in the financial
aid formula than the parents' assets. However, if you are incorporating
this strategy, you probably don't qualify for financial aid assistance.
Contribute to a Coverdell
Education Savings Account (formerly called Education IRAs). There
are two significant changes in education savings accounts beginning
in 2002. First, the contribution limit has increased from $500 to
$2000 per designated beneficiary per year. Second, these tax-free
accounts can be used to pay for elementary and high school expenses.
Now parents and grandparents have a tax-free savings vehicle to
meet education costs from kindergarten to graduate school.
Beginning in 2002, taxpayers are allowed to make contributions until
April 15 of the following year. In addition, contributions
may be made to both an Education Savings Account and a 529 Plan
for the same designated beneficiary.
There are income limitations
on the Coverdell Education Savings Account. One way to avoid the
income limitations is to give your children or grandchildren money
and have them purchase their own Education Savings Account.
New in 2002
Eligible educators- kindergarten
through grade 12 teachers, instructors, counselors, etc., can deduct
up to $250 in qualified expenses (basically classroom supplies and
computer expenses) as an adjustment to gross income. As usual,
there are a few requirements that must be met in order to qualify.
Oldies, But Goodies
Make or Increase
Retirement Plan Contributions: Business owners
can reduce AGI by increasing contributions to pre-existing retirement
plans or establishing a new plan such as 401(k) plans, SIMPLE pension
plans, SEPs, Keogh plans, or regular (deductible) IRAs. Most self-employed
retirement plans allow for deductions in tax year 2002, although
payment can be postponed until the extended due date for filing
the return. In other words, payment of 2002 deductible retirement
plan contributions can be postponed until October 15, 2003 in certain
cases.
Maximize Loss Situations:
If you are experiencing an unusual tax year where you may be
in a much lower tax bracket than usual or even in jeopardy of wasting
itemized deductions and personal exemptions, careful tax planning
can be more crucial than ever. Make sure you project your
taxable income before the year-end has passed and examine all your
alternatives.
Enroll in a Cafeteria
or Flexible Spending Plan: If you have not yet done so,
please enroll in your employer's Cafeteria or Flexible Spending
Plan for the year 2003. This strategy allows you to pay for medical,
child-care and other qualified expenses with pre-tax dollars. Medical
expenses are rarely fully deductible on Schedule A due to the 7.5%
of AGI limitation. Medical costs paid for through your company's
cafeteria plan, however, will allow you to fully deduct your medical
expenses from your W-2 wages that include social security taxes.
Make a good estimate of
your projected qualified expenses for the year. If you set aside
more pre-tax dollars than you will be able to claim, the unused
portion is forfeited. Don't let the forfeiture risk deter you from
participating, just be a little more conservative in your estimate.
If you are currently enrolled in a program, review your outstanding
balance, and if necessary, schedule a dentist, doctor, optometrist,
chiropractor, etc. appointment before December 31st.
Calculate Medical
Expenses: If this year's out-of-pocket medical expenses
are larger than usual and your company doesn't offer a flexible
spending account, it makes sense to compute if you're eligible to
write-off your medical expenses. The total medical expenses must
exceed 7.5% of your adjusted gross income to qualify. Because very
few people normally beat the 7.5% test, be sure to pay as much as
you can before the year-end in a year that you qualify for medical
itemized deduction.
Take Advantage of
Pre-Tax Parking Breaks: If your employer offers pre-tax
dollars to be used for parking, mass transit or van pools, take
advantage of the tax savings. Many individuals are not afforded
the luxury of being able to deduct personal parking costs.
Make a Roth IRA
Contribution: If you qualify, making an annual $3,000
Roth IRA contribution (up to $3,500 if over the age of 50 by the
end of 2002) both for you and your spouse will help you accumulate
tax-free wealth. You have until April 15, 2003 to fund a 2002
Roth IRA even though the deadline for converting a traditional IRA
to a Roth is December 31, 2002.
Recognizing Losses
on IRA Investments: If you
have a loss on your traditional or Roth IRAs, you can recognize
a loss on your income tax return, but only when all the amounts
in all your IRA accounts of that type (Roth or Traditional) have
been distributed and the total distributions are less than your
unrecovered basis, if any. You claim the loss as a miscellaneous
itemized deduction subject to 2% of adjusted gross income limits
on Schedule A. See IRS Publication
590 for details if you
think you may qualify. This is useful if your IRA was basically
wiped out and you are holding worthless paper. In that case,
at least enjoy the tax savings. If your IRA suffered but there
is still some value, then retaining the IRA will likely be more
valuable than the limited tax benefit of claiming the loss.
Make your Non-Cash
Charitable Deductions before December 31:
The IRS allows
a deduction for the lower of cost or fair market value for your
non-cash contributions. Please remember to ask for a receipt. You
must provide a schedule if your non-cash contributions exceed $500.
Donate Stock Instead
of Cash to your Favorite Charity: If you hold an appreciated
publicly traded stock for more than one-year, you can donate the
stock and get a charitable deduction for the full market value of
the stock and avoid paying any capital gains tax. You must
give the stock directly to the charity. The opposite is true for
stocks that have gone down in value. Never donate stocks that have
declined in value, but rather sell the stock at a loss and donate
the cash to charity.
Avoid Doubling Up
on First Year Minimum Distributions: It's possible
to receive two minimum distributions in the year after you reach
age 70 1/2. This may push you into a higher tax bracket, or even
worse, cause some of your social security benefits to become taxable.
Analyze your situation to see what strategy benefits you the most.
Please see details in our Minimum
Distribution Calculator, by entering 1930 or 1931 in the year
of birth column.
Self-Employed Individuals
Should Consider Employing their Child(ren): Employing
your child (age permitting) offers great tax-saving opportunities.
Assuming your child has no unearned income, the parent could pay
the child wages up to $4,700 in 2002, and the child would not have
to pay any federal income taxes. The next $6,000 would be subject
to a 10% tax rate. If the parents' marginal income tax bracket
were 27%, the $10,700 wage deduction would generate $2,289 in federal
income tax savings. Furthermore, when you employ a child under 18-years-old,
neither the employer nor the employee is subject to social security
tax on the child's wages. The wages your child earns will qualify
as earned income for the purpose of establishing a Roth IRA. A Roth
IRA will provide your child with an exceptional opportunity to accumulate
money with tax-free growth.
Self-Employed Individuals
with No Employees Should Consider Employing Their Spouse:
A self-employed individual may be able to deduct all of their
health insurance premiums and medical expenses by setting up a medical
reimbursement plan with his/her spouse as the only employee of his/her
business. Your spouse must become a bona fide employee of your business.
Theoretically, that means your spouse will be working under your
control. Good luck.
Last, But Not Least
High-income
taxpayers should consider investing in tax-exempt investments.
Middle-
or low-income taxpayers should consider selling tax-exempt investments
and aim for greater appreciation or income.
Be sure that you meet
the requirements for excluding gain on the sale of your principal
residence. The exclusion amounts are up to $250,000 for single
filers and $500,000 for married taxpayers filing jointly.
Conclusion
We hope this year-end
planning letter has been helpful. These strategies are aimed at
reducing both your short-term and long-term tax burden. Please take
a moment to review your personal game plan to be sure you are not
missing any opportunities.
If you are in need of
tax planning and/or income tax preparation, the CPA side of our
business stands prepared to help you. Client satisfaction was at
an all time high last tax season. This year, we happily report that
all five tax-preparers are returning, and we expect an even better
year.
We wish you and your family
a happy, healthy and profitable holiday season and New Year!
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