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2003
Year-End Tax Planning Strategies
by: James
Lange, CPA, JD and Glenn
Venturino, CPA
Last
year President Bush signed the Jobs and
Growth Tax Relief Reconciliation Act of 2003 (JGTRRA).
JGTRRA accelerated the tax cuts scheduled to take effect in future
years into tax year 2003. This means, everything else being equal,
you should pay less tax this year than last year.
A few
year-end tax-planning action points could help reduce income taxes
even further and add positive returns.
Reduced
Tax Rates on “Qualifying Dividends”
Effective for
tax years beginning after 2002 and before 2009, qualifying dividends
are generally taxed at a maximum federal rate of 15%. The tax rates
on interest bearing investments are at the higher ordinary tax rates.
Reduced
Tax Rates on Individual Long-Term Capital Gains (Assets Held More
Than One Year)
JGTRRA reduces
the top adjusted net capital gain rate from 20% to 15% for long
term capital gains taken after May 5, 2003 and before January 1,
2009. This rate applies to both regular and alternative minimum
tax. The capital gains rate for lower income taxpayers is reduced
from 15% to 5%. Make sure that you know how long you have held an
appreciated security that you plan to sell. The difference of 35%
for short-term gains versus 15% for long-term gains is substantial.
For taxpayers heavily invested in highly appreciated securities
now may be the time to realize these gains at the lower capital
gains rates in order to better diversify your portfolio. Please
be AWARE of the Alternative Minimum Tax (AMT) trap.
Capital gains are a tax preference add-back in the AMT calculation.
Run the numbers before you leap. You may discover that spreading
a gain over two years may save you from a severe case of AMT indigestion!
When planning
your investments, you may consider a reallocation based on taxes.
The combination of the lowered income tax rate for qualifying dividends
and capital gains creates an incentive to make changes. Please assume
you have both taxable (after tax) and IRAs or other retirement plan
funds. There is greater tax incentive now to invest more of your
interest bearing investments into your IRAs and retirement plans.
There is also an incentive to invest the individual securities that
enjoy the preferential capital gains rate and dividend rate in your
taxable accounts. Even maintaining the same overall asset allocation
mix, you could significantly reduce your taxes. The tax advantage
of having your income securities in your IRA and qualifying stocks
outside your IRA must be weighed against the traditional advice
of keeping your income assets in the after tax accounts and your
individual securities in the IRA. The reasoning behind the traditional
advice is that many investors count on the interest income to meet
their short term expenses and want to make sure that money is there
when they need it.
Maximize your
savings by using the incremental changes in the tax rate schedules.
If your income ordinarily fluctuates, or better yet, you have some
control over the timing of income recognition, take full advantage
of this situation. Please see our Tax
Reference Card.
This discussion
of capital gains is limited in scope. In actuality, this year it
is possible for a taxpayer to have capital gains (both long and
short term) taxed at one of the following rates- 5%, 7.5%, 8%, 10%,
14%, 15%, 20%, 25%, 28%, 33%, or 35%.
Retirement
Savings and Pension Contributions
Retirement savings
incentives and pension plan reform did not undergo any sweeping
changes in 2003. The 2003 limits for elective deferrals to 401(k)s,
403(b)s, and Section 457 retirement plans increases to $12,000 ($14,000
for individuals age 50 and over). 2003 contribution limits to the
popular Simplified Employee Pension Retirement plan (SEP) remains
at the lesser of 25% of an eligible employee’s compensation
(maximum $200,000) or $40,000.
Now is your
last chance to review with your plan administrator options for additional
deductions from your December pay to maximize your tax deferred
contributions for 2003. If your 2003 tax return refund is bigger
than usual due to the changes from the JGTRRA of 2003, consider
lowering your federal withholdings from your paycheck in 2004 and
increasing your contributions to your retirement plan. This move
will create a new deduction for yourself while saving a little extra
for your retirement.
Keep in mind
that contributions to elective deferral retirement plans and self-employed
retirement plans will reduce your “adjusted gross income.”
Because certain limitations on deductions and tax credits are based
on your “adjusted gross income,” you have the chance
to trim 2003 income taxes by hundreds or thousands of dollars.
One-Person
401(k) Plan or a SIMPLE
Small business
owners have been waiting for a plan that would allow them to set
more money aside for retirement, with tax-favored treatment. The
biggest potential benefit is realized by one-person businesses earning
between $50,000 and $160,000. An unincorporated business owner earning
$50,000 could shelter roughly $21,200 in 2003 or 42% of earnings!
This plan must be established no later than December 31, 2003 in
order to make a contribution based on 2003 earnings.
Individuals already participating in 401(k) or 403(b) elective deferral
plans at work while earning additional income from a side business
are not the best suited to take advantage of this type of plan because
of limitations on the combined retirement contributions.
Sole proprietors
earning less money may consider a SIMPLE in you could deduct up
to $8,000 for 2003 (or $9,000 if 50 or older) even though your income
was only $8,000.
Tax
Loss Harvesting
We will shortly
send out a more detailed discussion of tax loss harvesting. Many
readers will have capital loss carry-forwards to use in 2003 and
possibly beyond. Using losses to reduce taxable gains by offsetting
the losses against the gains is referred to as “tax-loss harvesting
or tax-loss selling.” Now is the time to review your investment
portfolio and make some decisions that will generate tax savings.
The best losses
to have 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. Only then can you use your
excess short-term losses to offset long-term gains. If all your
losses are long-term losses, and you have no short-term losses to
soak up your short-term capital gains, you will be taxed on your
short-term capital gains at ordinary income rates. This rate might
be twice as high as you pay on your long-term capital gains.
Many investors
fail to maximize the benefits by specific lot selling. Keeping track
of your stock purchases at lot levels (instead of the First-In,
First-Out default method) allows for greater control when instructing
your broker to sell shares.
If your losses
exceed your profits, you can deduct up to $3,000 of losses against
ordinary income. That adds up to $840 tax savings for an individual
who is in a 28% tax bracket. Be careful to avoid a wash sale, i.e.,
buying the same security within 30 days of the time you sell the
shares-the tax rules will disallow the loss.
Harvesting your
investment losses can reduce your capital gain income to zero. 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.
ALERT-Special
Allowance Depreciation and Increased Section 179 Expense Limits
The Jobs and
Growth Tax Relief Reconciliation Act of 2003 provides for an additional
first-year depreciation deduction equal to 50% of the adjusted basis
of the qualified property placed into service after May 5, 2003.
The Job Creation and Worker Assistance Act of 2002, introduced the
30% additional depreciation allowance. Taxpayers can make an election
to use the percentage that allows for the maximum tax savings.
JGTRRA increase
the maximum dollar amount that may be deducted under Section 179
to $100,000. This allows taxpayers to reduce income taxes by fully
expensing qualifying assets in the year of purchase. Again, it is
very important to look forward before deciding how much to expense
immediately. Deferring some of the deduction for a year or two down
the road when you project your marginal tax rate to be higher than
your current tax rate will undoubtedly save tax dollars in excess
of the time value of money lost due to accelerating income taxes.
More
Bonus Depreciation for Business Autos
If you use a
car for business purposes, you are no doubt aware of the incredibly
unfavorable depreciation rules. Until now, the maximum first-year
depreciation write-off for a new (not used) vehicle placed in service
this year was a paltry $7,660. Thanks to the new 50% bonus depreciation
break, you can deduct up to $10,710 worth of first-year depreciation
for new (not used) vehicles acquired after May 5th of this year.
For new autos acquired this year but before May 6th, the maximum
first-year depreciation deduction is still only $7,660 (under the
30% bonus depreciation rule). For used vehicles placed in service
at any time this year, the maximum first-year depreciation deduction
remains at only $3,060.
Alternative
Minimum Tax
Very few people
including the IRS understand the Alternative Minimum Tax. Unfortunately
more people, and not necessarily the wealthy, are falling victim
to its prey. The JGTRRA of 2003 provided some limited AMT relief
by increasing the exemption deduction. 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 be
a victim of the AMT in 2003, holding off paying certain deductible
expenses such as state and local taxes, medical expenses, real estate
taxes, etc. until next year may prove to be advantageous. Alternatively,
a 2004 AMT candidate may want to accelerate deductions before year-end
in order to avoid throwing away valuable tax deductions.
Education credits,
dependent care credit and other credits that could be used to reduce
both regular tax and AMT are set to expire at the end of 2003 unless
extended.
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 by December 15 to qualify
for a year 2003 conversion.
The JGTRRA of
2003 has accelerated the drop in tax rates that were to be phased
in over time from the Economic Growth and Tax Relief Reconciliation
Act of 2001 (EGTRRA). There hasn’t been a better time to consider
a Roth conversion.
Consider
Recharacterizing your Roth IRA
A complete discussion
of Roth IRA converting and unconverting is found in a separate article
on our web site, Roth IRA
Conversions: An Aggressive Strategy. The techniques discussed
in this article can help taxpayers get the most bang for their conversion
buck by jump starting the growth of the converted Roth IRA.
Transfer
Appreciated Stock to Children 14 Years Old or Older
Consider transferring
stock to your child. For example, assume you are in a 25% tax bracket
and are planning to sell some appreciated long-term stock 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 15% taxation rate to your child’s long-term
capital gains tax rate of 5%.
Revenue
Ruling 2003-12 Adds Over-the-Counter Drugs as Excludable in Flexible
Spending Accounts (FSA)
The IRS has
recently issued guidance regarding over-the-counter drugs such as
antacid, allergy medicine, pain reliever and cold medicine can be
paid for with pre-tax dollars through Flexible Spending Accounts
and other employer health plans. So be sure to include an estimated
amount for these annual costs in addition to the ones that you normally
include during the enrollment period for the upcoming year.
Consider
Married Filing Separate Status
The new tax
rate schedules under JGTRRA for married taxpayers filing jointly
are exactly twice the amount as married taxpayers filing separately.
This change may create new opportunities for married taxpayers who
choose to file separately. Some deductions are limited by a percent
of your AGI. For example, your medical deductions are allowed only
to the extent they exceed 7.5% of your AGI. Miscellaneous itemized
deductions must exceed 2% of your AGI before they're allowed. In
the right situation, one spouse may have substantial deductions
that are erased by the income of the other spouse.
S Corporations
with Prior C Corporation Retained Earnings
Former C Corporations
that converted to Subchapter S Corporations have an opportunity
and should consider making an election to distribute dividends from
prior C Corporations accumulated retained earnings. These qualifying
dividends will be taxed at 15% to the shareholder. This window is
set to close at the end of 2008.
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 2003, although
payment can be postponed until the extended due date for filing
the return. In other words, payment of 2003 deductible retirement
plan contributions can be postponed until October 15, 2004 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 if 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.
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 deductions.
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 2003) both for you and your spouse will help you accumulate tax-free
wealth. You have until April 15, 2004 to fund a 2003 Roth IRA.
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 Appreciated
Stock Instead of Cash to your Favorite Charity: If you hold
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 70½ . 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 on our web site 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 $4,750 in 2003, and the child would not have
to pay any federal income taxes. The next $7,000 would be subject
to a 10% tax rate. If the parents’ marginal income tax bracket
were 25%, the $11,750 wage deduction would generate $2,934 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
Always know
the tax consequences of separating or divorcing from your spouse.
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 eleven members of our tax staff 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!
P.S. On a different
note, we received glowing praise for our teleseminars given in November.
The seminar answered the most important questions readers have about
IRAs and retirement plans. We will be making tapes, CDs and transcripts
available after year end. If
you are interested in this material at the lowest possible price,
please send a blank email to admin@faculty-advisor.com
and write “best price” in the subject line. This doesn’t
commit you to anything, but will insure you will get a substantial
discount if you later decide to purchase.
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