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. Although these strategies are still generally beneficial for 2001, this year we have several new year-end strategies as a result of the "Economic Growth And Tax Relief Act of 2001 " - - the most sweeping tax cut legislation in 20 years. For example, in some situations you may be able to reduce taxes by postponing certain expenditures until 2002 when the majority of the 2001 Tax Act provisions becomes effective.
Please keep in mind that moving income from one tax year to another may reduce your personal exemptions and itemized deductions, or may subject you to the alternative minimum tax (AMT). Consequently, you should not adopt any tax planning proposal contained in this letter without first computing the impact on your overall tax liability, marginal tax rate, and your alternative minimum tax for 2001 and 2002. Therefore,
we suggest that you call our firm before implementing any tax planning technique discussed in this
letter. You cannot -properly evaluate a particular planning strategy without calculating your overall tax with and without that strategy. Please be careful!
WILL CONGRESS PASS AN ECONOMIC STIMULUS TAX PACKAGE BEFORE YEAR END?
As we go to press with this letter, Congress is working on an economic stimulus tax package. The House and Senate are hoping to work out a compromise bill within the next few weeks. However, the process has become politically charged and there is no guarantee we will have a tax package by year end. If passed, the Tax Bill could include additional first year depreciation for equipment, increased periods for carrying back net operating losses, corporate alternative minimum tax relief, expansion of the tax rebate that was paid earlier this year, and various other tax changes. We will continue to monitor this legislation. Please call our office for a status report.
PLEASE NOTE! This letter contains ideas for Federal Income Tax Planning only, State income tax issues are
not addressed.
Before taking any year-end tax planning steps, you should first evaluate the many tax changes under the 2001 Tax Act that could impact year-end tax planning. Let's review selected changes having the greatest impact on your planning.
Across-the-Board Tax Cut. The 2001 Tax Act provides an across-the-board cut in regular individual income tax rates. This is the first cut in the tax rates for ordinary income since 1986, but
the rate reductions will not be fully phased in until 2006. Tax
Tip. The tax rates for the top four tax brackets dropped I% on July 1, 2001, and will drop again in 2004 and in 2006. Obviously, to the extent you can defer your taxable income into these later years, you will not only get the benefit of "deferring" taxes but you will also reduce the amount of your taxes.
Child Tax Credit Increased. For 2000, you were allowed a $500 tax credit for each child under age 17 and the
credit was reduced if your "modified adjusted gross income" on a joint return exceeded $110,000 ($75,000 if single). The 2001 Tax Act increases the child credit as follows-. $600 per child (for 2001-2004); $700 per child (for 2005-2008)-l $800 per child (for 2009); $1,000 per child (for 2010 and thereafter). Furthermore,
beginning in 2001, if your total child credits exceed your entire income tax obligation, you may be entitled to a refund of all or a portion of the excess. This refund (in excess of your tax) is limited to I 0% of your earned income in excess of $10,000 (in 2005 this percentage is increased to 15%).
Expansion of Adoption Tax Credit. If you are considering adopting a child, changes under the 2001 Tax Act may substantially reduce your tax bill. Under current rules, if your income is not too high, you are allowed an adoption tax credit of up to $5,000 per child ($6,000 for special needs children) for qualifying adoption expenses.
After 2001, the adoption credit (1) is increased to a maximum of $10,000 per child (including special needs children), and (2) is not reduced by the alternative minimum tax. Under existing law, the credit
is phased out if your modified adjusted gross income is between $75,000 and
$115,000. Effective after 200l, the adoption credit is phased-out as your modified adjusted gross income increases from $150,000 to $190,000.
TaxTip. lf you are in the process of adopting a child and you
would receive a larger credit under the 2001 Act rules, it appears that expenses paid in 2001 will qualify for the revised credit in 2002 if the adoption is finalized in 2002 rather than in 2001. This is because the adoption credit is taken in the year following the year in which the adoption expenses are paid, unless the adoption is finalized by the end of the year in which the expenses are paid.
New Law Increases Education IRA Contribution Limit from $600 to $2000. The 2001 Tax Act increases the annual limit for contributions to education IRAs from $500 to $2,000
after 2001. This limit applies to the aggregate contributions that may be made by all contributors to one (or more) education IRAs established on behalf of any particular
beneficiary. Caution! Generally, the Act does not change the requirement that contributions to an education IRA must cease once the beneficiary reaches age 18, and that the education IRA must terminate once the beneficiary reaches age 30.
Tax Tip. The 2001 Act allows you to accumulate much more in an education IRA. For example, if you contribute $500 annually to an education IRA, beginning at a child's birth, by the time the child reaches age 18, you will have accumulated $20,223, assuming an 8% annual rate of return. Instead, if you make a $2,000 annual contribution, the amount accumulated in the education IRA by the child's
18th birthday would increase to $80,892.
Education IRAs May Be Used for Elementary and Secondary Schools. Under current law, tax-free qualified education expenses are limited to qualified college and graduate school expenses.
After 2001, you will be able to make tax-free distributions for payment of qualified education expenses to an elementary or secondary school as well as for payment of higher education expenses. This includes public, private, or religious schools (kindergarten through grade
12).
Qualified Tuition Programs. If you have made nondeductible contributions to a qualified state tuition program (a section 529 plan) any earnings accruing on your contributions are exempt from Federal income tax. However, payments from these state-sponsored programs in 2001 for qualified higher education expenses of the beneficiary are taxable to the extent of the income portion of the distribution.
Tax Tip . Distributions after 2001 (including distributions of income) from a "qualified
state tuition program" will be tax-free if used to pay qualified higher education expenses. Consequently, to the extent you can defer the distribution for qualified higher education expenses until 2002, you will avoid having to treat any of the payment as taxable income.
Student Loan Interest Deduction Rules Relaxed. For 2001, you can deduct (whether or not you itemize deductions) up to $2,500 of interest on qualified student loans. You can only deduct interest paid during the first 60 months the interest payments are required, and the deduction is phased out ratably as your modified adjusted gross income increases from $60,000 to $75,000 on a joint return (from $40,000 to $55,000 on a single return). The current rules do not allow you to deduct interest you voluntarily pay while the student loan is in a deferral or forbearance status.
Tax Tip. Under the 2001 Tax Act, for "payments" made after December 31, 2001, the 60-month limitation is repealed and the interest can be deducted even if voluntarily paid while the loan is in deferral or forbearance status. Furthermore, the income phase-out ranges are increased to $100,000 - $130,000 on a joint return, and to $50,000 - $65,000 on a single return. If you do not qualify for this interest deduction in 2001 but you will qualify in 2002, you will save taxes by simply postponing your
student loan payment until after December 3l, 2001. Be sure to first
consider whether your delayed payment will trigger a late payment penalty from the lender.
Generally, it's a good idea to defer as much income into 2002 as possible if you believe that your marginal tax rate for 2002 will be equal to or less than your 2001 marginal tax rate. Deferring income into 2002 could also increase various credits and deductions for 2001 that are phased out, based on your adjusted gross income. If you believe that deferring taxable income until 2002 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 2002.
Beware! If you have already received the check in 2001, 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 200l, 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, 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.
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. You could 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 may appear simple, they are not. It is easy to 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 2001 compensation until 2002. 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.
Planning for Qualified Plan Distributions. Tax planning for qualified retirement plan distributions is complicated.
If you are planning to withdraw funds from a plan, please contact us before making the withdrawal.
Good News! The IRS recently released proposed regulations that may allow you to distribute smaller amounts from qualified plans and IRAs than under the previous rules. If you are currently taking
distributions, or plan to in the near future, please call us. We will help you
determine whether these new rules may help you defer income.
Although your regular income may be taxed at a rate up to 39.1% in 2001, your capital gains tax rate is generally capped at 20% (the rate can be higher if you sell depreciable real estate or collectibles).
Beware! If your adjusted gross income exceeds certain levels, the effective tax rates on your capital gains could actually be higher than the rates described 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.
Watch Out for Incentive Stock Options and AMT. If you have exercised an incentive stock option (ISO)
in 200l, you could unexpectedly trigger the alternative minimum tax (AMT). Your
alternative minimum taxable income includes the fair market value of your purchased stock in excess of the exercise price of your stock. This could create a large tax bill even as the value of your stock plummets.
Tax Tip. If you have exercised an ISO in 2001 and your newly-purchased stock has substantially reduced in value, you may be able to sell the stock on or before December 31, 2001 and avoid the AMT. Please call our office if you feel this situation might apply to you, and we will help you determine your AMT exposure.
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!
Taking Capital Losses to the Extent of Capital Gains Plus $3,000
. If you have already recognized capital gains in 2001, you should consider selling securities that have declined in value prior to January 1, 2002. 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 (for example, the child credit, HOPE credit, and IRA contributions.
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.
Using a Market Downturn to Your Tax Advantage. lf your sales to date have
created a net capital loss exceeding $3,000, consider selling enough appreciated securities before year end to decrease the net 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.
Accelerating Deductions into 2001. If you are a cash method taxpayer, you can generally accelerate a 2002 deduction into 2001 by "paying" it in 2001, unless the expenditure creates an asset lasting substantially beyond the 2001 tax year. Accelerating an "above-the-line" deduction into 2001 may allow you to reduce your 11 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 2001 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 2001 if a check is delivered to the post office, or if an item is charged on a credit card in 2001.
"Bunching" Itemized Deductions. If your itemized deductions fail to exceed your standard deductions in most years, you are receiving no benefit from your itemized deductions. You could significantly reduce your taxes over the long term by bunching your itemized expenses in alternative tax years. This produces tax savings from itemizing in the years when your expenses are bunched, and using the standard deduction in other years.
Tax Tip. The easiest deductions to shift between tax years are charitable contributions, state and local taxes, and your January home mortgage interest payment.
Deduction for Self-Employed Health Insurance Costs. If you are self-employed, a partner, or own more than 2% of an S corporation, your tax deduction for health insurance premiums will increase over the next several years. For 2001, you can deduct 60% of your health insurance premiums as an "above- the-line" deduction, and the remaining 40% is an itemized medical deduction. In 2002, the "above-the-line" deduction increases to 70%. Consequently, postponing your insurance premium payment from 2001 to 2002 will increase your deduction from 60% to 70%.
Be Sure to "Pay" Your Charitable Contribution in 2001. Remember, a 2001 charitable contribution is allowed if the check is mailed on or before December 31, 2001, or the contribution is made by a credit card charge in 2001. 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 your2OOl deductions, you can increase your home mortgage interest deduction by paying your January, 2002 payment on or before December 31, 2001. 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 2001), and other local taxes for 2001 prior to January 1, 2002 if your tax rate for 2001 will be higher than or the same as your 2002 rate. This will allow a deduction for 2001 (a year early) and possibly against income taxed at a higher rate.
Planning Alert! You should not employ this tactic without carefully calculating the alternative minimum tax impact. Also, "overpayment" of your 2001 state income taxes is generally not advisable since a refund in 2002 from a 2001 overpayment may be taxed at a higher rate than the 2001 deduction rate.
Please consult us before you overpay state income taxes!
Social Security Numbers for Dependents. All dependents must have a social security
number, even if they are born as late as December 3l ,2001. If you don't
include a valid social security number for a child (or other dependent), the IRS can disallow tax benefits relating to that child (or other dependent), including the dependency exemption, child tax credit, child and dependent care credit, adoption expense credit, HOPE scholarship credit, Lifetime Learning credit, and earned income credit, as well as the exclusion from gross income of employer-provided adoption assistance payments. If you do not have a social security number for your dependents, please apply to the Social Security Administration for the number using Form SS-5, which can be obtained from any office of the Social Security Administration.
Penalty for Under-Withholding or Underestimating. One way to avoid a penalty for failing to pay or withhold sufficient income taxes for a tax year is to pay 100% of your prior year's tax liability in quarterly estimated payments or through income tax withholding.
Planning Alert! If your 2000 AGI was over $150,000, you must pay in I 10% of your 2000 tax liability to qualify for this safe harbor in 2001.
Tax Tip. If you have not paid sufficient estimates to avoid an underpayment penalty for 2001 and you have wages subject to withholding, you can have additional amounts withheld on or before December 31, 2001. Withholding is deemed paid equally on each quarterly installment date, even if the withholding occurs in December.
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 ideas discussed in this letter, or if you need more information.