Year End Tax Planning for Individuals 

 

  

INTRODUCTION.  Each year we work with clients to maximize tax savings through year-end planning.  Traditionally, we have recommended that you make sure your income is taxed at the lowest possible rate, and that you postpone your taxes by deferring taxable income and accelerating deductions.  These tax planning techniques have become even more important in recent years as Congress targets more of its tax breaks to middle income taxpayers.  Unfortunately, many of these benefits are  phased out if your income exceeds certain levels.  With proper year-end planning, however, accelerating certain year 2001 deductions into 2000, or deferring income  into year 2001, may help you meet these income thresholds.  The income levels that apply to these tax benefits are highlighted in this letter.

 

Please, keep in mind that tax changes over the past several years have made year-end tax planning much more complex.  For example, certain transactions reduce your personal exemptions and itemized deductions, or may subject you to alternative minimum tax (AMT).  You should not adopt any tax planning proposal contained in this letter without first computing the impact on your marginal tax rates and your alternative minimum tax for 2000 and 2001.  

 

WILL CONGRESS PASS A LAST-MINUTE TAX BILL?  As we go to press with this letter, Congress is still considering passage of the “Taxpayer Relief Act of 2000.”  If passed, this tax bill would increase significantly the amount you could contribute to IRAs, 401(k) plans, and most employer-sponsored retirement plans.  Most of these changes would be phased in beginning in 2001.  This bill also contains tax relief for businesses, including: increased deductions for equipment, and health insurance premiums; relief for installment sales by accrual method taxpayers and small businesses using the accrual method of accounting; and many other miscellaneous pro-taxpayer provisions.  If you think any of these proposals could impact your year-end tax planning – please call our office and we will be glad to give you a status report.

 

NOTE!  This letter contains ideas for Federal Income Tax Planning only, state income tax issues are not addressed.  We suggest that you call our firm before implementing any tax planning technique discussed in this letter or if you need more information.


 

 

 

 

 

 

PLANNING FOR AN ARRAY OF TARGETED TAX BENEFITS

 

As you begin your 2000 year-end tax planning, don’t forget that – over the past three years – Congress has passed a laundry list of tax breaks targeted for middle-income taxpayers.  Let’s review how these new tax benefits work!

 

The Roth IRA -- A Valuable Retirement Savings Option.  The “Roth IRA” has proven to be one of the most popular retirement savings devices to come along in many years.  If you have “earned income” at least equal to the contribution, you may make a  nondeductible contribution of up to $2,000 to a “Roth IRA.”  Individuals can generally make a contribution for year 2000 anytime on or before April 16, 2001.  If you are married, you can contribute up to $2,000 for yourself, and an additional $2,000 for your spouse, provided your combined earnings are at least equal to the contributed amount.  However, the $2,000 contribution limits are phased out if your adjusted gross income is $160,000 or more on a joint return ($110,000 if single).  Also, the $2,000 amount you may contribute to a Roth IRA is reduced by any contributions you make to a regular IRA for the same tax year.  

Setting Up A Roth IRA For A Minor.  Recently published IRS regulations confirm that you can set up a Roth IRA for your minor child.  Planning Alert!  The minor must have "earned income" at least equal to the Roth IRA contribution (the maximum contribution is $2,000).  Tax Tip!  Your child's earned income can include money from baby sitting or mowing lawns.   

 

Converting Regular IRA To Roth IRA.  If your adjusted gross income for 2000 is $100,000 or less, you may convert your regular IRA to a Roth.  However, the taxable portion of the regular IRA is taxed entirely in the  year you convert.

 

Should You Convert From A Regular IRA To A Roth?   This is a much debated question.  For most people, there is no clear cut answer.  However, one point is clear -- you should never convert your regular IRA to a Roth without first preparing projections comparing the Roth with the regular IRA.  We will gladly assist you with the calculations.  At a minimum, you should consider the following before converting:

 

·         Changing Your Mind.  If you convert in 2000 and later decide it was a bad idea, you can undo the conversion by a “trustee-to-trustee” transfer of the Roth assets (plus earnings) back into a regular IRA.  You must “undo” the Roth, however, no later than the due date (including extensions) of your 2000 tax return.  Planning Alert!  You cannot reconvert the regular IRA back into a Roth until the later of: (i) the beginning of the tax year following the tax year you converted, or (ii) 30 days after the day you recharacterized your Roth as a regular IRA.  For example, assume you converted your regular IRA to a Roth on February 1, 2000, and recharacterized that Roth back to a regular IRA on June 1, 2000. You cannot reconvert that regular IRA back to a Roth until January 1, 2001.

 

Child Tax Credit For Children Under Age 17.  You may qualify for a $500 tax credit for each of your dependent children under age 17. Your child tax credit will be reduced ($50 per $1,000 increment) once your modified adjusted gross income exceeds $110,000 on a joint return, or $75,000 on a single return.  You must have a “qualified child” to get the credit.  This includes your son or daughter (or their descendants), your stepson or stepdaughter, or your eligible foster child.  Tax Tip.  Your child must be your dependent to qualify you for the credit.  If you are divorced and have custody of the child, you generally will be entitled to the dependency exemption and thus the child tax credit.  Planning Alert!  If you are the custodial parent and waive the $2,800 dependency exemption by executing Form 8332, presumably you will also be giving up the $500 child credit.  Please contact us before signing this form.

 

“HOPE” Education Tax Credit.  If you incurred post high school education expenses for yourself, your spouse, or a dependent this year, you may be entitled to a tax credit of up to $1,500 per student. This credit only applies to qualifying expenses for two years of post secondary education in a degree or certificate program.  The credit  phases out ratably as your modified adjusted gross income increases from $80,000 to $100,000 on a joint return ($40,000 to $50,000 on a single return).  The HOPE  credit equals 100% of the first $1,000 (and 50% of the second $1,000) of tuition and fees required by the educational institution.  No credit is allowed for meals, lodging, transportation, or other personal living expenses.

 

 


 

The “Lifetime Learning” Credit.  In addition to the HOPE credit, we now have  a “Lifetime Learning” credit of up to $1,000 per return. This credit equals 20% of the first $5,000 of qualified tuition and fees per year, with the same income phase-out ranges as the HOPE credit discussed above.  There are several differences between the Lifetime Learning credit and the HOPE credit.  For example, unlike the HOPE credit, the Lifetime Learning credit is for an unlimited number of years, can be used for graduate or professional degrees (as well as undergraduate education), and the student can go to school less than half time.

 

You Can Take The Education Credits On An Amended Return.  1998 was the first year you could take the Hope  Credit, or the 20% Lifetime Learning Credit.  However, you may not have taken these credits because your income was too high. Good News!  The IRS recently released regulations allowing the student to claim the credits, provided you elect not to claim that child as a dependent on your tax return (even if the child otherwise qualifies as your dependent).  Of course, since the Hope Credit and Lifetime Learning Credits are non-refundable credits, your child must have an income tax liability to utilize the credits.  Tax Tip!  The IRS recently notified us that you (or your child) can claim either of these tax credits on an amended tax return.  If you failed to take the credit for your child's tuition in 1998 or 1999 because your income was too high, please call our office. We will help you determine whether you and your dependent child can save taxes overall by: (1) amending your return to remove your child's dependency exemption, and (2) amending your child's return to claim the Hope Credit or Lifetime Learning Credit.

 

Interest On Student Loans.  For interest due and paid in 2000, you may be able to deduct, whether or not you itemize deductions, up to $2,000 (up from $1,500 in 1999) of interest on qualifying student loans.  You can only deduct interest paid during the first 60 months that interest payments are required on the loan.  This interest deduction is phased out ratably as your modified adjusted gross income increases from  $60,000 to $75,000 on a joint return ($40,000 to $55,000 on a single return).  Planning Alert!  The interest deduction is not allowed if: 1) you are married and do not file a joint return  2) you are not legally obligated to pay the loan, 3) the loan is from certain related parties (e.g., family members or related businesses), or 4) the proceeds of the loan were not used “solely” for education expenses.

 

More IRA Benefits For Married Taxpayers.  Your $2,000 regular IRA deduction is phased out ratably if you are an active participant in your employer’s retirement plan as your adjusted gross income increases from $52,000 to $62,000 ($32,000 to $42,000 on a single return).  Tax Tip!  If you are married, otherwise qualify for a regular IRA contribution, and your adjusted gross income does not exceed $150,000, you may deduct a contribution to a regular IRA if you are not covered by an employer’s plan -- even if your spouse is covered.  Your IRA deduction, however, is phased out as the adjusted gross income on your joint return goes from $150,000 to $160,000. 

 

 

                                                        POSTPONING TAXABLE INCOME

 

If after factoring in the various income thresholds for the tax benefits discussed above, you believe that deferring taxable income until 2001 will save you taxes, consider the following strategies:

 

Self-Employed Business Income.  If you are self employed and use the cash method of accounting, consider delaying year-end billings to defer income until 2001.  Planning Alert!  If you have already received the check in 2000, deferring the deposit does not defer the income.  Also, you may not want to defer billing if you believe this will increase your risk of not getting paid.

 

Installment Sales.  If you plan to sell certain appreciated property in 2000, you might be able to defer the gain until later years by taking back a promissory note instead of cash.  If you qualify, the gain will be taxed to you prorata as you collect the principal payments on the note.  Planning Alert!  Although the sale of real estate and closely-held stock generally qualify for this deferral treatment, some sales do not.  For example, if you are an accrual method taxpayer and you sell property on or after December 17, 1999, you cannot use the installment method.  Furthermore, even if you are a cash method taxpayer, you cannot use this gain deferral technique if you sell publicly-traded stock or securities.  Also, you may not want to take back a promissory note in lieu of cash if you believe that your chances of getting paid are at risk.  Tax Tip.  If Congress reduces long term capital gains rates in the future, there is a good chance the new, lower rates would apply to gains from current installment sales that are reported after the new lower tax rate is effective.  As a result, a current installment sale could end up giving you a double tax benefit: deferring your capital gains and taxing them at lower rates.


Real Estate Swaps.  If you want to sell investment or business real estate but plan to use the proceeds to purchase other investment or business real estate, consider a like-kind exchange.  Have the purchaser of your property buy the property you want and trade it to you.  This way there should be no gain on the exchange.  Tax Tip.  The IRS has recently released guidelines that might allow you tax-free treatment for real estate you acquire before you transfer your existing realty.  This is commonly referred to as a “reverse like-kind exchange.”  Planning Alert!  Although like-kind exchanges (and the new “reverse like-kind exchange”) may appear simple, they are not.  It is very easy to accidentally convert what appears to be a tax-free exchange into a fully taxable transaction.  Tax-free exchanges present wonderful tax planning opportunities but please do not attempt one without calling us first. 

Deferred Compensation.  There are established ways to defer recognition of 2000 compensation until 2001.  These “deferred compensation” rules are extremely complex.  Please call us before participating in a nonqualified deferred compensation arrangement with your employer.  We will help explain the rules.

 

 

                             TAKING ADVANTAGE OF CAPITAL GAINS AND HOME SALE RULES

 

Although your regular income may be taxed at a rate up to 39.6%, your capital gains tax rate is generally capped at 20% (the rate can be higher if you sell depreciable real estate or collectibles).  Planning Alert!  If your adjusted gross income exceeds certain levels, the effective tax rates on your capital gains could actually be higher than the rates listed above.  This can happen because capital gains increase your income which can cause a portion of your itemized deductions, personal exemptions, and tax credits to be reduced.

 

Year-End Sales of Capital Assets.  Timing your year-end sales of stocks, bonds, or other securities may save you taxes.  After you have fully evaluated the economic factors, the following are several year-end planning ideas for sales of capital assets.  Caution!  Always consider the economics of a sale or exchange first!

 

·         Shifting Capital Gains To Lower Income Family Members.  If your capital gains will be taxed at 20%, you can give appreciated stock to your child (who is over 13) and let the child sell the stock and take advantage of their lower 10% capital gains rate (assuming that your child is in the 15% bracket).  Planning Alert!  Do not attempt this technique until your child has reached age 14, otherwise the “kiddie tax” provisions will tax the gain at your higher rates.  Caution!  The proceeds of the sale belong to the child.  Tax Tip.  This planning technique is particularly beneficial if by removing the gains from your income, you are also able to use more deductions, credits, etc.

 

·         Taking Capital Losses To The Extent Of Capital Gains Plus $3,000.  If you have already recognized capital gains in 2000, you should consider selling securities that have declined in value prior to January 1, 2001.  These losses will be deductible to the extent of your previously recognized capital gains plus $3,000.  Capital losses in excess of $3,000 are carried forward and offset capital gains for future years. These losses may have the added benefit of reducing your income to a level that will qualify you for several other tax breaks (like the child credit, HOPE credit, IRA contributions, etc., mentioned earlier in this letter).  Planning Alert!  If within 30 days before or after the sale of loss securities, you acquire the same securities, the loss will not be allowed currently because of the wash sale rules.  Tax Tip.  If in 2000 you have net 28% long-term capital gains from the sale of collectibles or 25% gains from the sale of depreciable realty and no 20% long-term gains, it may save you taxes if you sell your loss stocks held more than 1 year.  This way, these losses will offset your 28% or 25% gains in 2000.  Otherwise, these losses will offset 20% gains if sold in a year for which  you have only 20% gains.

 

·         Using A Market Downturn To Your Tax Advantage.  Remember, if your sales to date have created a net capital loss exceeding $3,000, consider selling enough appreciated securities before year end to decrease the capital loss to $3,000.  Stocks that you think have reached their peak would be good candidates.  All else being equal, you should sell the short term (held 12 months or less) securities first.  This will allow your short term capital gain to absorb your net capital loss (in excess of $3,000), while preserving your favorable long-term capital gains treatment for later years.

 

 

 


 

Taking Advantage Of Gain Exclusion On Home Sales.  As you probably know, in 1997 Congress replaced the 2-year rollover rules and the $125,000 exclusion for taxpayers over age 55 with a new rule.  This rule allows you to exclude up to $250,000 (up to $500,000 on a qualifying joint return) of the gain from taxable income.  Subject to limited exceptions, you must have owned and occupied your home as your principal residence for at least two of the five years preceding the sale.  Tax Tip!  Your mobile home, motor home, houseboat, or condominium could qualify for this exclusion if it constitutes your “principal residence.”

 

 

                                          TAKING ADVANTAGE OF “ITEMIZED DEDUCTIONS”

 

Accelerating Deductions Into 2000.  If you are a cash method taxpayer, you can generally accelerate a 2001 deduction into 2000 by “paying” it in 2000, unless the expenditure creates an asset lasting substantially beyond the 2000 tax year.  Accelerating an “above-the-line” deduction into 2000 may allow you to reduce your “adjusted gross income” below the thresholds needed to qualify for many tax benefits discussed earlier in this letter.  Remember, however, that itemized deductions do not reduce your “adjusted gross income” and, therefore, will not affect your 2000 phase-outs.  Itemized deductions include: charitable contributions, state and local taxes, medical expenses, unreimbursed employee travel expenses, and home mortgage interest.  Tax Tip.  “Payment” typically occurs in 2000 if a check is delivered to the post office, or an item is charged on a credit card in 2000.

 

Be Sure To “Pay” Your Charitable Contribution In 2000.  Remember, a 2000 charitable contribution is allowed if the check is mailed on or before December 31, 2000, or the contribution is made by a credit card charge in 2000.  However, if you give a note or a pledge to a charity, no deduction is allowed until you pay off the note or pledge. 

Maximizing Home Mortgage Interest Deduction.  If you are looking to maximize your 2000 deductions, you can increase your home mortgage interest deduction by paying your January, 2001 payment on or before December 31, 2000.  Typically, the January mortgage payment represents interest that was accrued in December and, therefore, is deductible if paid in December.

 

Time Your Payment Of State And Local Taxes.  Consider paying all property taxes, state income taxes (fourth quarter estimate and balance due for 2000), etc. for 2000 prior to January 1, 2001 if your tax rate for 2000 will be higher than or the same as your 2001 rate.  This will allow a deduction for 2000 (a year early) and possibly against income taxed at a higher rate.  Planning Alert!  You should not employ this tactic without carefully analyzing the alternative minimum tax.  Also, “overpayment” of your 2000 state income taxes is generally not advisable since a refund in 2001 from a 2000 overpayment may be taxed at a higher rate than the 2000 deduction rate.  Please consult us before you overpay state income taxes!

 

 

FINAL COMMENTS

 

Please call us if you are interested in a tax topic that we did not discuss. Tax law constantly changes due to new legislation, cases, regulations, and IRS rulings.  Our firm closely monitors these changes and will be glad to discuss any current tax developments and planning ideas with you.  Please call us before implementing any planning idea discussed in this letter or if you need more information.