TAX SAVING STRATEGIES
This may be a good time
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 affecting individual taxation this
year, there are a few relatively new and basic twists to
include in a year-en d
review. Let us discuss some
new legislations
and the related year-end income tax strategies.
Year-end Individual Income tax Strategies
In our
last month’s Strategies page we discussed some new tax
legislations giving short-term relief on simmering issues
like, Alternative Minimum Tax, a two-year extension to
2010 on the 15% top tax rate on capital gains and
qualified dividend income, Kiddies tax, hybrid Vehicle
credit, Roth Conversions, Charitable Donations and
Charitable Gifts from IRAs and the related year-end tax
planning tools. In this newsletter we will discuss some
proven strategies
that may help you reduce your taxes once again this year.
The
most basic form of year-end planning involves pushing tax
bills into the future by deferring income into the next
year, accelerating deductions into the current year and
shifting Income.
The steps that individuals take now can reduce their 2006
federal tax bills and put them in better position to pay
less in 2007 and beyond.
Let us
look at some common individual situations and relevant tax
strategies.
1)
Cash Method of Accounting:
Opportunities to manage taxes are greater for taxpayers on
a cash basis of accounting. If you are self-employed and
use the cash method of accounting for income-tax purposes,
time late 2006 customer billings so that payment won't be
received until 2007.
2)
Bonuses:
You
can delay receipt of anticipated bonuses or incentive
compensation coming to you to defer taxation until a
future year so that these amounts will not be taxed on
your return in 2006.
Ask your employer to defer paying your 2006 year-end bonus
until early 2007. (The employer may still be able to claim
a deduction on its 2006 tax return.)
3)
Capital Gains and losses:
You
can use capital gains or losses within your accounts to
offset each other so you don’t have to pay tax on realized
gains in the current year. So, if
you have a few loser stocks that you wouldn't mind
unloading, now is the time. You can sell them to wipe out
all your realized capital gains for the year, plus another
$3,000 ($1,500 for married filing separately) in regular
income. The balance of any loss will carry over to next
year. Be careful to avoid a wash sale — i.e. buying the
same security within 30 days before or after you dump
shares. Tax rules disallow the loss if such practice is
adopted.
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 the favorable
long-term capital gain rate with a short-term capital
loss.
4)
Convert non-deductible interest to Deductible interest:
Interest expense on personal auto loans, credit cards, and
most student loans offers no tax deduction. However,
interest on home equity loans and investment loans is tax
deductible within certain limits. For example, if you have
$35000 ready in the bank and you are planning to buy a car
and some stock, make sure you use the money to buy the car
and get a loan to buy the stock. This will maximize your
interest expense deduction and avoid the borrowings on
which interest is not tax deductible.
5)
Deductible Interest & Real state Taxes:
Consider making your January 2007 mortgage payment (which
includes December's interest) in late December 2006, so
that the mortgage interest will be deductible on your 2006
return (applicable only if you itemize deductions on your
income-tax return). You can prepay in December real estate
taxes due in January or February.
6)
Medical and Miscellaneous Itemized Deductions:
Your deductions are limited to the amounts that exceed
7.5% of adjusted gross income for medical expenses and 2%
of adjusted gross income for miscellaneous expenses.
Bunching two years of your or your family's unreimbursed
medical or miscellaneous itemized expenses (such as
certain job-related expenses and investment expenses) into
one year may allow you to surpass the deduction floors and
help you gain an itemized deduction for part of your
expenses.
7)
Retirement Contributions :
Maximize 2006 contributions to any tax-deferred retirement
savings plan in which you participate, such as a 401(k)
plan or a 403(b) tax-sheltered annuity. If you are age 50
or older, you may be able to make additional "catch up"
contributions to your plan.
8)
Charitable Contributions:
If you are planning to make a charitable donation in early
2007, consider a 2006 year-end donation instead.
Contributions charged on your credit card in 2006 count as
2006 deductions, even if you don't receive or pay the
credit card bill until 2007.
A
popular retirement savings alternative for individuals who
are self-employed is SEP IRA. Contributions to the plan
are tax deductible within certain limits, it is relatively
easy to establish, and there are no annual compliance
burdens to maintain. Therefore, self-employed individuals
who do not already have a tax-deferred retirement plan
should consider starting one before year-end.
9) 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.
10)
Installment Sales :
Consider an installment sale of property rather than
collecting all proceeds this year.
11)
Tax Liability:
Finally as it comes upon year-end, be sure you have had
enough withholdings, or paid in enough estimated tax. 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.
Income
deferral and expense acceleration strategies are
especially effective if you expect to be in the same or a
lower tax bracket in the year in which you will be
reporting the income on your tax return. However, if you
are a high earner facing a limitation on your itemized
deductions or if you expect to be in a much higher tax
bracket in 2007, deferring income and accelerating
payments into 2006 may not be your best course of action.
In addition, if you claim high deductions in 2006, you may
be subject to the alternative minimum tax.
Two
important factors should be kept in mind for application
of above-mentioned planning tools: -
• Most
strategies must be completed before Dec. 31 to affect 2006
tax levels.
• Only a number of tax-saving opportunities are
highlighted here. There are many other tax planning
strategies to consider with the assistance of a tax
adviser taking into account your individual tax
situations.
OUR STRATEGIES FOR NOVEMBER
1) Alternative
Minimum Tax
Tax Increase Prevention
and Reconciliation Act (TIPRA) has increased and extended
the AMT exemption amount to $62,550 for joint filers and
$42,500 for single filers through the end of 2006. It now
permits certain new credits, such as the dependent care
credit, credit for the elderly and disabled, energy –saving
credits, tuition credits and certain homeowner credits also
for AMT purposes. Previously, credits were allowed to the
extent that the taxpayer had regular income-tax liability in
excess of the tentative minimum tax, disallowing them for
AMT purposes but now they can be used to set off entire
regular tax and AMT liability through the end of 2006.
A strategy that is
beneficial for regular tax purposes can backfire for AMT
purposes because of differences in how the IRS handles
certain deductions and income exclusions. For example, AMT
is a flat tax rate of 28%. Therefore, for most of the
taxpayers in 35% tax bracket, it may be beneficial to
accelerate income instead of reducing into 2006 so that it
is taxed at the favorable 28% rate.
Time value of money must
be considered whenever you accelerate income that would not
be taxed until a later time. Also, it may be wise to delay
instead of accelerating deductions until a later year when
you will not be in the AMT so those deductions can be used
when they produce a 35% tax benefit.
If you project that you
will be in AMT for 2006, but will not be in AMT for 2007,
consider deferring paying real estate taxes, state taxes,
year end contributions, investment fees and other
miscellaneous itemized deductions until January of 2007.
2) Kiddie Tax
The tax law requires
children who have more than a small amount of unearned
income ($1,700 in 2006) to pay tax on that excess income at
their parents' marginal tax rate.
Beginning in 2006, the
kiddie tax applies to children under age 18 (formerly, age
14). Due to this change, higher-income parents should
consider investing any assets put aside for their
under-age-18 children in investments that generate little or
no current taxable income (such as U.S. savings bonds,
municipal bonds, or growth stock index funds). Also, parents
can explore the strategy of shifting income to children,
grandchildren or other individuals over age 18 in a lower
income bracket. However, such strategy must also be
coordinated with a family’s overall wealth transfer
strategy, bearing in mind the gift tax exemptions and
exclusions.
3) Reduced tax rate
on capital gains and qualified dividend income
TIPRA has extended the
top tax rate of 15% (or 5% for lower-income taxpayers) on
capital gains and qualified dividend income, which was set
to expire at the end of 2008 through 2010. In 2011, the
rates will revert back to the former income tax rates.
Individuals who are business owners of closely held
corporations should give thought to taking advantage of the
lower tax rates on dividend income.
4)
Roth Conversions
Earlier this year, TIPRA
removed the income limit for high earners who want to
convert their traditional Individual Retirement Account to a
Roth IRA.
While elimination of the $100,000 income limit to convert
traditional IRAs to Roth IRAs under TIPRA doesn't start
until 2010, maximizing that opportunity can begin in 2006
with maximizing contributions in 2006 and each year
thereafter to a nondeductible IRA that can then be converted
into a Roth in 2010.
5) Hybrid Vehicles
The tax credit for hybrid vehicles applies to those
purchased on or after January 1,2006 and could be as much as
$3,400 for those who purchase the most–fuel-efficient
vehicles. Starting in 2006, this tax credit replaces the tax
deduction of $2000, previously allowed for taxpayers who
purchased a new hybrid vehicle before December 31,2005 for
the clean-burning fuel deduction. The tax credit requires a
different certification. Many currently available hybrid
vehicles may qualify for this new tax credit, but the
specific amount of the credit varies from model to model of
eligible vehicle. If you purchase and take possession of a
qualified hybrid motor vehicle in 2006, don’t overlook the
hybrid tax credit.
6)
Charitable Gifts from IRAs
The Pension Protection Act of 2006 allows IRA holders who
are 70-1/2 and older to make charitable contributions of up
to $100,000 for 2006 and again in 2007 only from their IRAs
without realizing income. So, those who are charitably
inclined and wish to maximize this temporary benefit, the
transfer from IRA to charity must be completed in 2006 for
this year's $100,000 benefit cap to apply; the benefit is
not cumulative and cannot be carried over to make $200,000
income-tax-free in 2007.
7) Charitable Donations
Taxpayers wishing to deduct charitable
donations of cash, clothing, household items and other items
must conform to stricter rules. Charitable donations of
cash, check, or other monetary gifts are allowed only if the
donor can provide a bank record or written communication
from the charity indicating the contribution amount, the
date the contribution was made, and the name of the charity.
New rules apply to
contributions of clothing and household items made after
August 17, 2006. In general, the items must be in "good"
condition. However, you can still deduct the value of an
item that isn't in good if the value of the donation is more
than $500 and you include a qualified appraisal with your
tax return.
In our last
month’s Strategies we discussed “who must pay estimated
tax and the related planning tools”. We take up from there
to discuss the ways to assess estimated tax, ways of
making payment and penalty for underpayment.
Estimating Your Tax
Form
1040-ES, used to pay estimated tax, comes with a worksheet
one can use to estimate how much tax one will owe for the
current year. Most people don't prefer to use it as it
takes them through more detail than may be necessary and
is still unable to eliminate uncertainty about the tax
liability. The usual way to estimate taxes is
comparatively simple:
●
We look at each number on the prior year's tax return and
ask whether this year's number is likely to be
significantly different and disregard differences in wages
because there will be a corresponding difference in
withholding.
●
Now we
add up all the differences to see how much more or less
our taxable income will be for the current year.
●
And
then apply the tax rates to see how much difference this
will make in our income tax. (If the difference results
from a capital gain, we apply the capital gain tax rates.)
We can round the number up or tack on an added amount to
increase our comfort level about avoiding a penalty.
Many people
using this method don't consider changes in tax rates,
standard deduction and personal exemptions that result
from inflation adjustments. These changes will decrease
your tax slightly, so that's one way of providing a
cushion of extra payments. Example: Suppose you estimated
your 2006 taxable income exactly right, but used the 2005
tax rate schedules to estimate the tax. You would get a
refund, because the inflation adjustments for 2006 will
result in a lower tax.
Making the Payment
After
determining how much you need to pay, you should consider
whether to use estimated tax payments or an
increase in withholding to pay this amount.
1)
Estimated Tax Payments –There are
two ways to figure each payment.
a) Regular Installment Method
One of the
easiest ways to make quarterly payments is to estimate
your total tax liability for the year and divide by four.
For nearly all taxpayers, the due date for the first
estimated tax payment of each year is April 15 — the same
day the return is due for the previous year.
Subsequent payments are due June 15, September 15, and
January 15 of the following year. Although they're
considered quarterly payments, they're not all three
months apart.
Note
that if you itemize deductions,
it may be to your advantage to make your fourth quarter
estimated tax payment in December, not January, so you can
deduct it a year earlier.
When you
make estimated tax payments you need to enclose Form
1040-ES. It asks for your name, address, social security
number and the amount you're paying. You don't have to
justify your estimated tax payments. All you're saying is
"here's a payment on account. Estimated tax payments don’t
go to the same address as your return. So, check the
instructions for Form 1040-ES for the proper address.
b) Annualized Income Installment Method
If your
year’s income starts off low and ends up high (say because
you have huge fourth-quarter capital gains), you should
probably use the “annualized method”. This is an exception
to the general rule that your four estimated tax payments
should be equal. Under the annualized method, estimated
payments correspond to your cash flow, so you won’t owe
big installments on the earlier due dates before you have
the money to pay them. Under this method calculation is
very complicated, but it sometimes reduces the penalty by
a substantial amount. If you use the annualized income
installment method to figure your estimated tax payments,
you must file Form 2210. But if you don't want to fill out
the form, you don't have to do anything until the IRS does
the math and sends you a bill.
2) Increasing Your Withholding
In order to
increase the amount of federal income tax withheld from
your paycheck, you need to file a new Form W-4 with your
employer. This form contains several worksheets, and the
instructions tell you to "complete all worksheets that
apply." You can fill out the worksheets if you want, but
there's no particular need if the only thing you're doing
is increasing your withholding to cover tax on investment
income.
There are
two ways to increase your withholding on this form. One is
to
reduce
the number of allowances you claim
on the form. This can be a little complicated, because you
don't necessarily know how much your withholding will
change when you change your allowances. The amount depends
on your income level.
Another way
is to
request an "additional amount" to be withheld from your
paycheck. This makes it fairly
easy to determine the amount of the increase when you file
Form W-4. Keep an eye on your paycheck stubs to confirm
that the change was properly made and had the effect you
anticipated.
There’s a
special benefit to this approach: extra withholding that
comes late in the year is treated the same as if it was
spread evenly over the year. You can use this approach to
avoid late payment penalties.
Example:
Suppose you realize in May that you need to pay $10,000
estimated tax for the year, and you've already blown the
first $2,500 payment that was due April 15. You can avoid
the penalty altogether by increasing your withholding for
the rest of the year by $10,000. This back-loaded
withholding can be used retroactively to abate the
penalty. This is a real penalty-saving opportunity just
for W-2 wage earners.
Penalty for
Underpayment
The penalty
for underpayment of estimated tax is figured the same as
interest. You determine the amount of the underpayment for
each period of time and the number of days in that period,
and then apply an appropriate interest factor. The
interest rate is adjusted from time to time based on
market interest rates.
Example:
Suppose you make estimated tax payments of $5,000 per
quarter, thinking that $20,000 would be enough to cover
90% of your tax liability in a year when the prior year
safe harbor wasn't available.
It turns out
that $25,000 was required to cover 90% of your tax
liability, so you should have paid an additional $1250 per
quarter. The amount of your underpayment is $1250 for the
period from April 15 to June 15, $2500 from June 15 to
September 15, $3750 until January 15, and $5,000 until
April 15, 2007 when you file your return with your
payment. Assuming that the recently announced rate for
underpayments (third quarter of 2006) is 7%, the
underpayment penalty would be roughly $234.
The penalty
is not deductible, even if it arises because of investment
or business income. If you underpay only a small amount,
or you correct the underpayment quickly, the penalty will
be small.
So you see,
even if the estimated–tax rules apply to you, there are
easy ways to lessen the pain.
IRS
CIRCULAR 230 DISCLOSURE:
To ensure
compliance with requirements imposed by the IRS, we inform
you that any U.S. tax advice contained in this
communication is not intended or written to be used, and
cannot be used, for the purpose of (i) avoiding tax
related penalties under the internal Revenue Code, or (ii)
promoting, marketing or recommending to another party any
tax related matters addressed herein.
Important note: Many exceptions, definitions, and
special rules in the law have been paraphrased, simplified,
and/or omitted. Readers should not take specific action
based on this summary without first consulting the statute
and regulations or seeking advice from a qualified
professional.
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