It is time to look at your tax situation and implement strategies that will minimize your 2004 taxes. To impact 2004, you generally need to implement your planning strategies before year-end. The following is a brief overview of a number of year-end tax saving strategies. Some are straightforward, while others require more analysis and review to tailor them to your particular tax and financial situation.
Investments
For 2004, long-term capital gains and qualifying dividend income are subject to a tax rate of only 15%. Given tax rates as high as 35%, this is quite a break. Here are some ways to capitalize on it.
Lower Tax Rates on Dividends.
The favorable tax rates (15%) might make dividend-paying stocks more attractive than they were in the past when dividends were taxed at ordinary income rates. This may cause you to reconsider the make-up of your investment portfolio. However, there are a few catches to the new rule. A key requirement for the lower tax rate on dividends is that the shareholder must own the dividend-paying stock for more than 60 days during the 121-day period beginning 60 days before the stock’s ex-dividend date.
While dividends paid by domestic corporations generally qualify for the lower rate, not all foreign corporation dividends do. Only dividends paid by so-called “qualified foreign corporations,” which include foreign corporations traded on an established U.S. securities market, corporations organized in U.S. possessions, and other foreign corporations eligible for certain income tax treaty benefits, are eligible for the lower rates. And finally, watch out for certain investments marketed as preferred stocks that are really debt instruments. Dividends received on these securities are not qualified dividends.
Lower Tax Rates on Capital Gains.
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 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.
Alternative Minimum Tax
Individuals must compute their income tax liability under two systems—the regular tax system and the alternative minimum tax (AMT) system—and pay the higher of the two amounts. Although AMT was originally designed to apply only to taxpayers who took advantage of certain tax breaks, the current rules encompass many unsuspecting taxpayers. Although Congress has taken certain measures to deal with the problem (such as temporarily increasing the AMT exemption amount for 2003–2005), they are neither significant enough nor last long enough to keep AMT from being an issue for many taxpayers.
Before doing anything else, the initial step in tax planning is to assess your exposure to AMT. A strategy that is effective for regular tax purposes can backfire for AMT purposes because of differences in how certain deductions and income exclusions are handled. You need to understand your AMT position in order to properly assess tax planning options.
Recognizing a large capital gain, deducting a significant amount of state and local taxes, or large miscellaneous itemized deductions (like unreimbursed employee business expenses) can trigger AMT. If these pertain to you (or you suspect AMT might be an issue for another reason), contact us so we can examine your situation and help you plan accordingly.
Education Expenses
There are many tax breaks for education-related expenses. If you or members of your family are incurring these types of expenses now or in the near future, it’s worth examining them a bit more closely. Here are some strategies to consider as year-end approaches.
Tuition Deduction.
In 2004, you can deduct up to $4,000 of college tuition and related expenses, provided your adjusted gross income (AGI) is no more than $130,000 (for joint filers). If your AGI exceeds these limits, you can still deduct up to $2,000 of such expenses as long as your AGI does not exceed $160,000 (for joint filers). Although the deduction is available regardless of whether you itemize expenses, you cannot claim it if you claim an education credit for the same student. Unlike many other tax breaks subject to income limits, this one does not phase out over a range of income. Instead, it’s all or nothing, depending on whether your income is above or below the threshold amounts. If you can benefit from this deduction, but your AGI is at or near the applicable limits, monitor your AGI level between now and year-end and, if possible, take steps to keep it below the limit.
Education Credit Planning.
If you pay college or vocational school tuition and fees for yourself, your spouse, or your children, you might be eligible for either the Hope Scholarship Credit or the Lifetime Learning Credit. These credits reduce taxes dollar-for-dollar, but begin to phase out when 2004 AGI exceeds $85,000 (for married filers). The credits phase out completely when AGI exceeds $105,000.
The Hope credit is only available during a student’s first two years of college and equals 100% of the first $1,000 of tuition and 50% of the next $1,000, for a maximum annual credit of $1,500 per student.
The Lifetime Learning Credit, on the other hand, is available without regard to the year of study, but is a per return (rather than a per student) credit, computed at the rate of 20% on up to $10,000 of qualifying expenses for a maximum annual credit of $2,000.
The credits are allowed for tuition paid during the year for education received that year or during the first three months of the next year. Therefore, it may be beneficial to pay part of 2005 tuition at the end of 2004. Parents also can shift an education credit from their return to the student’s by simply forgoing an exemption deduction for the student. This strategy is particularly appealing to high-income parents whose income prevents them from claiming the credit. To benefit from this strategy, however, the student must have sufficient income and therefore tax liability to absorb the credit. It might be necessary to shift income to the student as well, perhaps through gifts of appreciated property (that the student then sells at a gain) or employment in a family business. But, be careful about the impact on a student’s financial aid—shifting income to a student can have a detrimental impact on a student receiving or being eligible for financial aid.
Strategies That Never Go out of Style
Accelerate Deductions and Defer Income.
Virtually any taxpayer, in any year, can benefit from strategies that accelerate deductions or defer income based on the premise that it’s generally better to pay taxes later rather than sooner. For example, cash-basis sole proprietors might delay year-end billings so that they fall in the following year or accelerate business expenditures to the current year. On the investment side, income from short-term (i.e., maturity of one year or less) obligations like Treasury Bills and short-term CDs is not recognized until maturity. Income from those straddling year-end is deferred to the following year.
Manage Your AGI.
Many tax breaks are only available to taxpayers with adjusted gross income (AGI) below certain levels. In addition to some education incentives, other common AGI-based tax breaks include the child tax credit, the $25,000 rental real estate passive loss allowance (phase-out range of $100,000–$150,000 for all taxpayers), and the exclusion of social security benefits ($32,000 threshold for married filers). In addition, taxpayers with 2004 AGI in excess of $142,700 begin losing part of their itemized deductions, to the extent of 3% of the excess. Accordingly, strategies that lower your income or increase certain deductions might not only reduce your taxable income, but also help increase some of your other tax deductions and credits.
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 2004, do so before year-end to avoid a hefty penalty. If you turned age 70½ in 2004, you can delay your 2004 required distribution until April 1, 2005 if you choose. But, waiting until 2005 will result in two distributions in 2005—the amount required for 2004 plus the amount required for 2005. While deferring income is normally a sound tax strategy, here it results in bunching income into 2005, which may push you into a higher tax bracket or have a detrimental impact on other tax deductions you normally claim.
Charitable Giving.
Donations charged to a credit card are 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 2004 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.
Year-end Planning for Your Business
Expense the Cost of More than $100,000 of Business Property.
The section 179 deduction allows business owners to deduct up to $102,000 of the cost of qualifying depreciable property placed in service in 2004. Property eligible for the immediate tax write-off can be new or used and includes “off-the-shelf” computer software. (Even property purchased on the last day of the year qualifies.) However, the allowable deduction cannot exceed your business’s net income and is reduced dollar-for-dollar to the extent the amount of qualifying property placed in service during the year exceeds $410,000. If you have plans to buy a business computer, office furniture, equipment, vehicle, or other tangible business property, you might consider doing so before year-end to maximize your 2004 deductions.
Last Chance for 50% Bonus Depreciation.
The 2003 Tax Act raised the first-year bonus depreciation rate on new business assets from 30% to 50%. However, the 50% depreciation rate expires at the end of the year. Under the bonus deprecation rules, 50% of the cost of qualifying property is deductible in the year the property is purchased and placed in service. This in addition to the regular depreciation allowed for the rest of the cost. For example, a new $150,000 machine placed in service in December 2004 may be eligible for a first-year bonus and regular depreciation deduction equal to $85,718, which is more than 55% of the cost.
Only new property is eligible for bonus depreciation. Unfortunately, real property (other than certain leasehold improvements) generally does not qualify. Like the Section 179 deduction, property can be placed in service on the last day of the tax year and still qualify for the full tax break.
Employ Your Child (or Grandchild).
Employing your children (or grandchildren) shifts income from you to them, which typically subjects the income to the child’s lower tax bracket and may actually avoid tax entirely (due to the child’s standard deduction). There are also payroll tax savings since wages paid by sole proprietors to their children age 17 and younger are exempt from both social security and unemployment taxes. Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA.
When employing your child or grandchild, keep in mind that the wages paid must be reasonable given the child’s age and work skills. Also, if the child is in college or entering soon, excessive earned income may have a detrimental impact on the student’s eligibility for financial aid.
Conclusion
Taking the time now to review your 2004 tax situation gives you a chance to take advantage of a number of year-end tax saving opportunities. Please contact us if you would like assistance in reviewing your situation.
CHECKLIST OF ACTIONS
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