2011 Year-End Strategies

• Posted on October 23, 2009

With the economy still in the doldrums, this year has not been the greatest year for most individuals.  Unemployment is still high, incomes are lower, retirement savings have declined and many taxpayers are struggling to make ends meet.  The government has provided a variety of tax incentives to help weather the economic storm, and you are urged to take advantage of these special tax benefits as well as other strategies to keep your tax bite as low as possible. 

• State Estimated Tax Payments – Although the deadline to make the current year 4th quarter state estimated tax payment is January 15 of the next year for most states, the payment will count as a tax deduction on the federal Schedule A for the current year if that payment is made before the end of December.

• Property Taxes – Generally, your property taxes are billed in installments, and that’s how most people pay them. However, the tax can be paid all at once, if it provides a greater tax benefit for the current year. 
Caution: The preceding two strategies do not benefit taxpayers who are subject to the alternative minimum tax (AMT), since taxes are not deductible to the extent a taxpayer is subject to the AMT. Taxpayers subject to the AMT might, instead, consider deferring deductible tax payments to the subsequent year.

• Bunch Deductions - If your tax deductions normally fall short of itemizing your deductions, or even if you are able to itemize but only marginally, you may benefit from using the “bunching” strategy.  For more on this technique, read the article “Bunching Your Deductions Can Provide Big Tax Benefits”.  

• Required Minimum Distributions (RMDs) from Retirement Plans – If you are in a low or zero tax bracket this year, it may be to your benefit to take a withdrawal more than the minimum.  RMDs generally apply to individuals age 70 ½ and older, but even younger retirees who are not yet required to take a distribution may find this strategy beneficial. If you receive Social Security benefits, IRA distributions can sometimes be planned to minimize the taxability of the Social Security income.

• Tax Credit for First Four Years of College - The American Opportunity Credit (AOC) takes the place of the Hope education credit and provides a credit for tuition and certain other expenses of the first four years of college (Hope only applied to the first two years).  So even if you used the Hope credit in prior years you may still qualify for the AOC.  The credit is 100% of the first $2,000 of qualified expenses and 25% of the next $2,000.  40% of the credit is refundable which means that taxpayers with little or no tax liability can still benefit from the credit.  This credit does begin to phase-out for single taxpayers with AGI above $80,000 ($160,000 for joint filers) and no credit is allowed for taxpayers filing married separate.

Important: The AOC is only applicable to tax years 2009 through 2012.  Without Congressional action, 2012 is the final year for this more lucrative education credit.

• Energy-Efficient Home Improvements – Homeowners who have or will make certain energy-efficient improvements to their existing homes may qualify for energy credits up to 10% of the cost (credit limited to a lifetime maximum of $500 taking into account credit claimed in prior years).  This credit applies to the following qualified energy efficient improvements:  exterior windows and skylights, exterior doors, metal and asphalt roofs, heating systems, air-conditioning systems and insulation.  With many contractors without work this could be an opportune time to negotiate reasonable prices and make those home modifications, but the work must be completed before year-end if you want the credit. Without Congressional action, this credit expires at the end of 2011. 

• Roth IRA Conversions – If your taxable income is low or a negative amount for the year, it may be appropriate to convert some or all of your taxable traditional IRA to a Roth IRA for little or no tax cost. Taxpayers are able to convert funds in regular IRAs (as well as qualified retirement plans) to Roth IRAs regardless of their income level.

• Review Estimated Tax Payments and Withholding – Ensure they are sufficient to meet the “safe-harbor” payment amounts so as to avoid underpayment penalties.

• IRA and Self-Employed Retirement Plan Contributions – The primary purpose of these plans is to provide for your future retirement and whenever you are eligible and financially able, you should always contribute as much as possible.  Contributions also provide a tax deduction when they are made to Self-employed plans and to most traditional IRAs.  The benefit derived from this tax deduction is based upon your tax bracket.  (Some contributions to traditional IRAs may not be deductible if you also participate in another retirement plan, depending on your income level.)  Those individuals who simply prefer the Roth option, but are barred from making Roth contributions because their income exceeds the AGI phase out limitations, might consider making a non-deductible traditional IRA contribution and then converting it to a Roth IRA since as of 2010 there are no income limitations on conversions.

• Establish a Retirement Plan – If you do not already have a retirement plan and you are considering one, there are several options.  Some, such as Keogh or 401(k) plans, must be set up before the year’s end.   If you are an owner-only business, you should review the article “Owner-Only Businesses Should Consider a Solo 401(k) Plan,” which provides great benefits for business owners with no employees other than their spouse. 

• Capital Loss Carryovers – If you have carryover capital losses remember you can only claim a maximum $3,000 net capital loss on your return and the remainder carries over to the subsequent year.  However, you may have some gains you can take to offset the carryover.  (If you sell at a gain but wish to repurchase stock in the same company, note that the wash sale rules don’t apply—they only apply to losses— so you will not need to wait 30 days to make the repurchase.) For long-term planning, it is important to keep in mind that the current lower capital gains rates of 0% and 15% are only available through 2012.  After that, without Congressional intervention, the rates return to the pre-2003 levels of 10% and 20%.  For more details on this strategy, read the “Fine-Tuning Capital Gains and Losses” article.   

• Non-Cash Charitable Donations – If you itemize your deductions and your garage and closets contain never-used items, you might consider donating those items to charity before year-end to increase your deductions. To claim a deduction for donated clothing and household goods, they must be in good condition or better, and the donations must be substantiated by a written receipt that includes the name of the charity, dates and location of the donation and a reasonably detailed description of the property donated.   A receipt is not required where the value is less than $250 and it is impractical to obtain one (for example, when items are left at an unattended drop site). If, instead, you decide to sell some of the property, the income is generally tax free provided you sell each item for less than your cost or basis in the property.

• Deduct IRA Losses – If a traditional IRA account that includes non-deductible contributions declines in value and the value of all of your IRA accounts combined is less than the sum of your non-deductible contributions, you can take a loss by withdrawing from (closing) all your IRA accounts.  However, this loss is beneficial only if you itemize your deductions and the loss, along with your other miscellaneous deductions, exceeds 2% of your income (AGI) for the year.

The foregoing are frequently encountered tax strategies that can be employed by most, but by no means all, taxpayers.  Please call this office if have questions regarding these issue or others or would like to engage in some year-end tax planning.  If you have a substantial increase or decrease in income this year it may be wise to schedule an appointment before the holidays to strategize.

Bunching Your Deductions Can Provide Big Tax Benefits

• Posted on October 23, 2009

If your tax deductions normally fall short of itemizing your deductions or even if you are able to itemize, but only marginally, you may benefit from using the ‘bunching” strategy.

The tax code allows taxpayers to utilize the standard deduction or itemize their deductions if that provides to be a greater benefit.  As a rule, most taxpayers just wait until tax time to add everything up and then use the higher of the standard deduction or their itemized deductions. 

If you want to be more proactive, you can time the payments of tax-deductible items to maximize your itemized deductions in one year and take the standard deduction in the next.  

For the most part, itemized deductions include medical expenses, property taxes, state and local income (or sales) taxes, home mortgage and investment interest, charitable deductions, unreimbursed job-related expenses and casualty losses.  The “bunching strategy” is more commonly associated with medical expenses, tax payments and charitable deductions; although, there are circumstances where the other deductions might be come into play.   There are many opportunities to bunch deductions, and the following are examples of the most commonly used with the “bunching” strategy:

• Medical Expenses – You contract with a dentist for your child’s braces. He may offer you an up-front lump sum payment or a payment plan.  By making the lump sum payment, the entire cost is credited in the year paid, thereby dramatically increasing your medical expenses for that year.  If you do not have the cash available for the up-front payment, then you can pay by credit card, which is treated as a lump-sum payment for tax purposes.  If you use a credit card, you must realize that the credit card interest is not deductible and you need to determine if incurring the interest is worth the increased tax deduction.  Another important issue with medical deductions is that only the amount of the total medical expenses that exceeds 7.5% of your income is actually deductible.  If you are caught by the Alternative Minimum Tax (AMT), then only the amount that exceeds 10% of your AGI is actually deductible.  So, there is no tax benefit of bunching medical deductions if the total is less than 7.5% (10% if taxed by the AMT).

If the current year is an abnormally high-income year, you may, where possible, wish to put off making medical expense payments until the subsequent year when the 7.5% (10%) threshold is less.

• Taxes – Property taxes are generally billed annually at mid-year and most locales allow the tax bill to be paid in semi-annual or quarterly installments.  Thus, you have the option of paying it all at once or paying in installments.  This provides the opportunity to bunch the tax payments by paying one semi-annual (or 2 quarterly) installment and a full year’s tax liability in one year and only paying one semi-annual (or 2 quarterly) in the other year.  In doing so, you are able to deduct 1-½ year’s taxes in one year and ½ a year’s taxes in the other. If you are thinking of being late on the property tax payments as means of bunching, you should be cautious.  The late payment penalty will probably wipe out any potential tax savings.

If you reside in a state that has state income tax, the state income tax paid or withheld during the year is deductible as a federal itemized deduction.  So, for instance, if you are making state quarterly estimates, the fourth quarter estimate is generally due in January of the subsequent year.  This gives you the opportunity to either make that payment before December 31st, and be able to deduct the payment on the current year’s return, or pay it in January before the January due date and use it as a deduction in the subsequent year.

For 2011, in lieu of deducting state income taxes on your federal return, you may choose to deduct state and local sales tax. If your state income tax that would be deductible is close to the amount you paid in sales tax for the year (or the amount of the sales tax allowed in the tables provided by the IRS), and you were planning to purchase a big-ticket item like a new car, boat or airplane in 2011 or early 2012, you may want to make the purchase in 2011 if the sales tax on the item will cause your total sales tax paid for the year to exceed the state income tax you paid. Not only will you have a higher state tax deduction on your 2011 return, but you could have less income to report in 2012. This is because when you deduct sales tax on your 2011 federal return and in 2012 you receive a refund of state income tax from your 2011 state tax return that you filed in 2012; you do not have to report the refund as taxable income on your federal return for 2012. If you deduct state income tax instead on your 2011 federal return, generally your state income tax refund received in 2012 will be taxable on your 2012 federal return.

A word of caution about the itemized deduction for taxes!  Taxes are only deductible for regular tax purposes.  So, to the extent you are taxed by the AMT, you derive no benefits from the itemized deduction for taxes.

• Charitable Contributions – Charitable contributions are a nice fit for “bunching” because they are entirely payable at the taxpayer’s discretion.  For example, if you normally tithe at your church, you could make your normal contributions during the year and then prepay the entire subsequent years’ tithing in a lump sum in December of the current year, thereby doubling up on the church contribution one year and having no deduction for charity in the other year.  Normally, charities are very active with their solicitations during the holiday season, giving you the opportunity to make the contributions at the end of the current year or simply wait a short time and make them after the end of the year.

If you think a “bunching” strategy might benefit you, please call this office to discuss the issue and set up an appointment for some in-depth strategizing.

Fine Tuning Capital Gains and Losses

• Posted on October 23, 2009

Year-end has historically been a good time to plan tax savings by carefully structuring capital gains and losses.  Conventional wisdom has always been to minimize gains by selling “losers” to offset gains from “winners,” and where possible, generate the maximum allowable $3,000 capital loss for the year.

Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. (“Long-term” means that the stock or property has been held over one year.) Keep in mind that taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income or AGI.  Individuals are subject to federal income tax at a rate as high as 35% on short-term capital gains and ordinary income. But long-term capital gains are generally taxed at a maximum rate of 15%. 

All of this means that having long-term capital losses offset long-term capital gains should be avoided where possible, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Avoiding this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains. However, this is not just a tax issue; investment factors also need to be considered. It would not be wise to defer recognizing gain until the following year if there is too much risk that the property’s value will decline before it can be sold. Similarly, one wouldn't want to risk increasing a loss on property that is expected to continue declining in value by deferring its sale until the following year.

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, a taxpayer should take steps to prevent those losses from offsetting those gains.

However, historical tax-planning logic may not apply when the tax rates are expected to be higher in the next year or two:

• Increasing Capital Gains Rates - The special long-term capital gains rates that have been in effect since 2003 sunset (end) at the end of 2012 and return to the pre-2003 levels of 10% and 20%! These federal rates are currently 0% for taxpayers in the 15% and lower tax brackets and 15% for those in higher tax brackets. Individuals with large long-term capital gains in their investment portfolios might consider selling those holdings in 2011 or 2012 to take their gains at the lower tax rates.  The good news here is that the wash sale rules do not apply to assets sold at a gain. So if you like a stock, you are free to buy it back right away. If your state doesn’t have a lower tax rate on capital gains, then the additional state tax you’d pay from selling profitable capital assets will need to be weighed against the federal tax you’d potentially save when deciding whether to make tax sales before year-end.

• Raising Marginal Tax Rates – At least through 2012, we are assured of retaining the lower individual tax rates which are currently 10, 15, 25, 28, 33 and 35 percent. These rates apply to “ordinary” income. Without Congressional intervention, the rates are scheduled to return to their original levels of 15, 28, 31, 36 and 39.6 percent, beginning in 2013.

With record government deficits, taxes have to go up—campaign promises notwithstanding—and we can expect that to happen in the near future.  The only questions are when, how much, and for whom?  Conventional wisdom has always been to defer income, but with a potential for increased taxes it may be appropriate to consider accelerating income to take advantage of the current lower tax rates.

It may be in your best interest to review you current year tax strategy with an eye to the future to maximize your benefits from gains or losses associated with capital assets.  Please call this office for assistance.

Owner-Only Businesses Should Consider a Solo 401(k) Plan

• Posted on October 23, 2009

It goes by many names - Solo 401(k), Mini 401(k) and single-participant 401(k).  We will use Solo 401(k) in this article to describe probably the best type of pension plan for owner-only businesses.  It provides for larger contributions, including a Roth option for a portion of the contribution, and the ability to borrow funds from the plan at reasonable rates.  As a result, Solo 401(k) plans have become more attractive options than SEP-IRAs, Simple IRAs or profit-sharing or money purchase plans.  In addition, if the plan permits and most do, assets for other retirement plans can be rolled over into the Solo 401(k) plan.  

Generally, Solo 401(k) plans are a natural fit for two categories of businesses.  The first includes independent contractors, sole proprietors, and owner-only C or S corporations. The second is those who have dual incomes.  They are W-2 wage earners as employees of a company that offers a 401(k) plan who also have consulting income from corporate directorships or freelance work that requires them to file a Schedule C as a sole proprietor.  Since the 401(k) contribution limits apply to each individual for the year and not the individual plans, if the taxpayer has multiple 401(k) plans, he or she needs to make sure that not more than the annual limit is contributed to the combination of plans.

For 2011, the rules limit employer contribution (profit-sharing contribution) to 25% of compensation.  The employee can also make salary deferral contributions up to $16,500.  Together, these contributions cannot exceed the lesser of $49,000 or 100% of compensation.  In addition, if the employee is age 50 or over he or she can make an additional catch-up contribution of $5,500. 

Example – Susan Lewis, age 49, is the sole employee of an incorporated business. Her earned income is $100,000 in 2011. Under the law, Susan can contribute $25,000 to a SEP-IRA ($100,000 x .25), $14,500 ($11,500 plus 3% of $100,000) to a Simple IRA and $25,000 to a profit-sharing or money purchase plan.  However, she can contribute $41,500 to a Solo 401(k) plan ($25,000 employer contribution plus $16,500 employee deferral), still under the $49,000 maximum for the year. If Susan were age 50 or over, she could also make a catch-up contribution of $5,500, increasing her 401(k) contribution total to $47,000.  

In some cases, 401(k) plan contributions for an unincorporated business may be slightly lower than the above amounts.  For unincorporated businesses, compensation is net profit minus half of self-employment taxes minus employer contributions.

Although single-participant 401(k) plans are limited to the business owner and his or her spouse, business owners should note the added benefits of having his or her spouse as the business’s only other employee.  Having the spouse on the payroll gives the business owner the opportunity to shelter some or all of his or her income by having the spouse make an elective deferral to a 401(k) plan in addition to the business making a profit-sharing contribution.  Although the spouse and the business would be responsible for their respective share of employment taxes on the salary, combined employer and employee contributions can be up to the lesser of $49,000 (for 2011) or 100% of compensation. This limit applies separately to the business-owner and spouse, thus allowing a combined total of up to $98,000 (for 2011).  In addition, if age 50 or over, each individual could defer an additional $5,500 each year.

Potential downside - If a business grows and begins hiring employees, the single-participant 401(k) plan must become a full-blown 401(k) plan subject to other more stringent rules including discrimination testing that can serve to limit contributions by highly-paid executives.  Many providers recommend that businesses with immediate expansion plans not set up one of the Solo 401(k) arrangements.  Caution: If the business owner has other businesses or is part of a controlled group of corporations, partnerships, proprietorships or affiliated service groups, the employer aggregation rules may apply and the employees of those other businesses may have to be considered for purposes of meeting qualification and minimum coverage requirements for the Solo 401(k).

For additional information regarding Solo 401(k) plans and how it might fit into your tax strategy and retirement planning, please give this office a call.  If you are considering a Solo 401(k) plan, be aware that the plan must be set up before year’s end.