With 2005 winding down, it’s time once again to consider year-end tax planning. To impact 2005, you generally need to implement your planning strategies before year-end. The following is a brief overview of a number of year-end tax savings strategies. Some are straightforward, while others require more analysis and review to tailor them to your particular tax and financial situation. As always, you can call on us to help you sort through the options and implement strategies that make sense for you.
Assess Your Alternative Minimum Tax Exposure
The first step in year-end planning is to see whether you might be subject to AMT this year or next. Taxpayers must compute their taxes under both the regular tax and AMT rules and then pay the greater of the two. Although AMT was originally designed to apply only to taxpayers who took too much advantage of certain tax breaks, the current rules encompass many unsuspecting taxpayers. Being in the world of AMT puts a whole new spin on tax planning because many great planning strategies that make sense in a regular tax situation completely backfire in an AMT scenario.
Certain items can increase your risk of AMT, including exercising incentive stock options, recognizing substantial long-term capital gains, and deducting a significant amount of state and local taxes or miscellaneous itemized deductions (like unreimbursed employee business expenses). But no one is safe from AMT anymore, and planning when AMT applies is tricky because each situation is unique. Therefore, if you have any of the items mentioned or suspect AMT might be an issue, please contact us so we can help you review and plan for your particular situation.
Defer Income and Accelerate Deductions
The most common year-end tax planning strategies are those that defer income from the current year to later years and those that move deductions from later years into the current year. The underlying reason is that it’s better to pay taxes later rather than sooner due to the time value of money.
So, how do you shift income and deductions between tax years? The most common techniques are using income or deductions that you can easily control. For example, defer a year-end bonus to January 2006 rather than December 2005. For sales of property, consider an installment sale that shifts part of the gain to later years when the installment payments are received.
On the deduction side, move charitable donations you normally would make in early 2006 to the end of 2005. Do the same with real estate taxes or state income taxes. If you own a cash-basis business, delay billings so payments are not received until 2006 or accelerate payment of certain expenses, such as office supplies and repairs and maintenance, to 2005. Of course, before deferring income, you must assess the risk of doing so.
The Energy Tax Incentives Act of 2005 replaced the $2,000 deduction available for hybrid vehicle purchases made before 2006 with a credit of up to $3,400 for hybrid vehicles purchased after 2005. At first blush, delaying hybrid vehicle purchases to 2006 to take the credit seems to be the best deal. However, that is not necessarily so. You might actually be better off making the purchase before the end of this year and cashing in on the existing $2,000 deduction. To figure out where you stand on this issue, you must assess (1) the expected amount of the 2006 credit compared to the $2,000 deduction available for 2005 and your expected marginal tax rate for 2005, (2) the impact of the credit phase-out rules, (3) your projected 2006 AMT situation, and (4) whether the emissions standards will make your desired vehicle ineligible for the credit in 2006.
Increase Charitable Giving
Ordinarily, the amount of cash donations to IRS-approved public charities that an individual can deduct in any year is limited to 50% adjusted gross income (AGI). Any charitable contribution deduction is also potentially subject to phase-out if your AGI exceeds $145,950 in 2005. Given the horrendous tragedies that occurred in 2005, Congress has modified these rules for most cash contributions made between 8/28/05 and 12/31/05. Such contributions are deductible—without any reduction under the phaseout rule—up to 100% of your AGI when combined with donations made earlier in the year.
This makes 2005 a particularly good year to make charitable contributions if you are so inclined. And, if you charge the contribution to a credit card, it is deductible in the year charged, not when payment is made on the card. Thus, charging donations to your credit card before year-end enables you to increase your 2005 charitable donations deduction even if you’re temporarily short on cash or simply want to defer payment until next year. Note, however, that any interest paid with respect to the charge is not deductible.
Adjusting Federal Income Tax Withholding
If it looks like you are going to owe income taxes for 2005, consider bumping up the federal income taxes (FIT) withheld from your paychecks now through the end of 2005 so that your total tax payments (estimated payments plus withholdings) equal at least 90% of your estimated 2005 liability or, if smaller, 100% of last year’s liability (110% if your 2004 AGI exceeded $150,000). On April 15, 2006, you will still have to pay the taxes due less the amount paid in, but you won’t owe any interest or penalties.
Lower Tax Rates on Capital Gains
Long-term capital gains and qualifying dividend income are subject to a tax rate of only 15% for taxpayers in a regular tax bracket of 25% or higher and 5% for taxpayers in the lower regular tax brackets. Given tax rates as high as 35% for other types of income, this is quite a break. To be eligible for the lower 15% capital gain rate, a capital asset must be held for more than a year. So, when disposing of your appreciated stocks, bonds, investment real estate, and other capital assets, pay close attention to the holding period. If it’s less than one year, consider deferring the sale so that you can meet the greater-than-one-year period. While it’s generally not wise to let tax implications drive your investment decisions, you shouldn’t ignore them either.
When selling stock or mutual fund shares, the general rule is that the shares you acquired first are the ones you sell first. However, if you choose, you can specifically identify the shares you’re selling when you sell less than your entire holding of a stock or mutual fund. By notifying your broker of the shares you want sold at the time of the sale, your gain or loss from the sale is based on the identified shares. This sales strategy gives you better control over the amount of your gain or loss and whether it’s long-term or short-term.
Harvesting Capital Losses
It’s always a good idea to periodically review your investment portfolio to see if there are any losers you should sell. This is especially true as year-end approaches, since it’s the last chance to offset capital gains recognized during the year or to take advantage of the $3,000 ($1,500 for married separate filers) limit on deductible net capital losses. But, don’t forget the wash-sale rule. This rule defers your loss if you purchase a substantially identical security within the period beginning 30 days before and ending 30 days after the date of sale.
Retirement Plan Distributions
If you’re age 70½ or older, you’re normally subject to the minimum distribution rules with regard to your retirement plans. Under these rules, you must receive at least a certain amount each year from your retirement accounts. You can always take out more than the required amount, but anything less is subject to a 50% penalty on the shortfall amount. Thus, if you haven’t taken your required distribution for 2005, do so before year-end to avoid a hefty penalty. If you turned age 70½ in 2005, you can delay your 2005 required distribution until April 1, 2006 if you choose. But, waiting until 2006 will result in two distributions in 2006—the amount required for 2005 plus the amount required for 2006. While deferring income is normally a sound tax strategy, here it results in bunching income into 2006, which may push you into a higher tax bracket or have a detrimental impact on other tax deductions you normally claim.
Year-end Gifts to Family Members
Year-end is ideal time to make gifts. The first $11,000 of gifts ($22,000 for married couples who split gifts) made by a donor to each donee in calendar year 2005 is excluded from the amount of the donor's taxable gifts. This exclusion increases to $12,000 for gifts made in 2006.
Making use of the annual exclusion can save estate tax because the cash or other assets comprising the gifts, and the post-transfer growth in their value, are removed from the donor's estate at no transfer tax cost. This year, $1.5 million is exempt from federal estate tax and jumps to $2 million next year. Also, state death tax exemptions may be lower than the federal exemption so that even if a gift is not needed to save federal estate tax, it could save state death tax.
Making a direct payment of another individual's tuition or medical expenses is not a taxable gift. Contributions to tax-favored qualified tuition programs and Coverdell education savings accounts don't qualify for this tuition exclusion. Instead, they are treated as present gifts that can qualify for the gift tax annual exclusion, with the option of treating contributions in a single year as being considered made over a five-year period, which might be done where the single year gift exceeds the annual exclusion amount.
Sometimes, gifts can save family income taxes. This can occur in a number of ways. Take a gift of stock to a grandchild, for example. For federal tax purposes, long-term gain on a sale of the stock by the grandchild may be taxed at 5% whereas it could be taxed at 15% if the grandparent retained the stock and sold it. The spread could be 10% and 35% for gain taxable as ordinary income. For gift property that yields income, savings can be realized if the donee is in a lower marginal bracket than the donor. Maximum savings will be realized, however, for a gift to a child of the donor only if the child is a least 14 by the end of the year in which the income is received. For a child who is still under 14 at that time, some of the income may be taxed at the parent's highest marginal rate as a result of the "kiddie tax" but some savings are still possible.
Taking the time now to review your 2005 tax situation gives you a chance to take advantage of many year-end tax saving opportunities. This letter highlights selected strategies, but there are many others that might also apply to your particular situation. If you would like to discuss the strategies mentioned here or other ideas for reducing your 2005 tax liability, please don’t hesitate to call us.
¹ Any tax advice included in this written or electronic communication was not intended or written to be used, and it cannot be used by the taxpayer, for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.