November, 2005 Tax Tip
A Further Look at Year-End Tax Planning Strategies
On October 18, 2005, the President’s Advisory Panel on Federal Tax reform endorsed recommendations designed to drastically simplify taxes for individuals and families. We’ve all heard the word “simplification” attached to several tax legislations in the past. We also know that each tax bill that has been enacted in the name of simplicity has made the tax laws more complex than ever. Why bring this up? Because the current recommendations would eliminate or substantially limit many of the long-established popular deductions. These include the home mortgage interest deduction, charitable donations, and state and local tax deductions, including deductions for state income and real estate taxes.
These proposals are a long way from becoming law as tax bills must originate in the House of Representatives and then go to the Senate and a joint House and Senate Committee to be ironed out before a final bill is sent to the President. It does, however, give insight into the critical need for simplification that is stirring the pot and the minds of the bi-partisan politicians and lobbyists in Washington. Having said that, we can no longer feel totally secure about how long these deductions might be with us. Therefore, 2005 year-end tax planning takes on a new perspective – should you grab the deductions while the grabbing’s good?
As I alluded to in last month’s Tax Tip on year-end tax planning (available at my website, www.rontaxcpa.com), the normal procedure is to defer income to the following year and accelerate deductions into the current year. There are exceptions to this rule, a few of which are mentioned in the article. Assuming the norm is the recommended situation for you, here are some strategies that may be useful in lowering your tax liability for 2005:
Situation: You have paper loss(es) and actual gain(s)
Strategy: Sell by December 31st to reduce gain
Situation: You have paper gain(s) and actual loss(es)
Strategy: Sell by December 31st to reduce net losses to $3,000 (the maximum deductible amount in any year)
Situation: You want to take a paper loss but you want to hold on to the security
Strategy: Avoid a “wash sale” - whereby loss is denied if the same security is acquired within 30 days before or after the sale - by doubling up (buying more and selling the original shares 31 days later); buying the same security 31 days after the sale; or buying a similar security in a different company
Situation: You are considering a late-year purchase of a mutual fund
Strategy: Hold off until after “ex-dividend” date to avoid “phantom taxable income”. If you acquire before the ex-dividend date, the dividend or capital gain distribution you receive will decrease the value of your fund shares by a like amount, therefore leaving you with a tax on the distributions, but no increase in value of your fund shares.
Situation: You have made three separate purchases of 100 shares of the same stock at different prices and you now wish to sell 100 shares
Strategy: If you don’t tell your broker which shares to sell, the IRS will consider that you sold the shares in the order purchased. If the first purchase was at the lowest price, you will have a larger capital gain. Therefore, you may wish to tell your broker to sell the highest cost shares to reduce the gain.
Situation: You itemize deductions and can pay additional expenses before year-end
Strategy: Consider making 1/06 mortgage payment, paying balance of ’05 state taxes, 2nd installment of real estate tax, and charitable donations; Also determine whether payment of medical and miscellaneous expenses would give a deduction in light of 7½% and 2% limitations:
IMPORTANT: Bank credit card charges are deductions in the year charged, not the year paid!
WARNING: Accelerating deductions may not be prudent if income is very high (you may lose 3% of itemized deductions other than medical, investment interest, and casualty losses if AGI is greater than $145,950). If so, try to reduce AGI below that amount (take capital losses, contribute to retirement plan, etc.) especially if you’ll be in a higher tax bracket in ’06, or you’re subject to the alternative minimum tax (“AMT”).
NOTE: The AMT would be eliminated under the Advisory Panel’s proposals
Estimated Tax Underpayment
Situation: You are facing an estimated tax underpayment penalty
Strategy: Have additional tax withheld from remaining payrolls to cover the shortfall. The additional withholding is treated as withheld ratably in ‘05
Situation: You’re self-employed and wish to defer income to 2006
Strategy: Defer billings to clients/customers or, if you sell a product, delay shipping to avoid accrual of income. This may also reduce ’06 estimated tax payments
Situation: You also wish to accelerate deductions to ‘05
Strategy: Consider the $100,000 allowable expense for business equipment if the property is placed in service by 12/31/05; have needed repairs done; purchase supplies; consider a Keogh plan (must be in place by 12/31) or SEP
NOTE: Accelerating deductions may also cause or increase a net operating loss which can be carried back
Why are retirement plans tax-favored?
- Contributions are made with pre-tax dollars (deductible from income before tax is computed)
- Contributions and their earnings are not taxed until distributed
- When distributed after retirement, lower tax rates may apply
Situation: You are considering contributing to a Roth IRA or converting to a Roth IRA
Strategy: In a Roth IRA, contributions are not deductible and distributions not taxable. There is an AGI limitation of $100,000 to convert. This may be controllable by planning. The distribution from the regular IRA is taxable
Situation: You wish to make the maximum contribution to a traditional IRA
Strategy: While you have until 4/15/06, contribute early (maximum $4,000 per spouse, unless over age 50, in which case maximum is $4,500); If active participation in employer-sponsored plans, deduction is reduced if AGI is greater than $49,999 single, $69,999 joint, and eliminated if $60,000 single, $80,000 joint,
Situation: You wish to make a maximum contribution to an employer-sponsored retirement plan
Strategy: If your employer or you, as self-employed, has a 401(k) plan, you can defer up to $14,000 of pay before the end of ’05 (additional $4,000 if over age 50),
If your employer or you, as self-employed, has a SIMPLE retirement plan, can make a maximum $10,000 contribution for ’05,
Set up a Keogh plan before year-end if you’re self-employed. You have until 4/15/06 (plus extensions) to contribute to it, or
Establish a SEP plan – maximum contribution for 2005 is $42,000 (other limitations apply). You have until 4/15/06 to establish the plan and 4/15/06 (plus extensions) to contribute to it
Situation: You have losses from passive activities (e.g. rental activities)
Strategy: Sell property with unused passive losses to an unrelated party; If you are a real estate professional (more than ½ of your services are in real estate business(es) and more than 750 hours total) you can use losses in full; You can deduct losses from rental real estate activities involving “active” participation up to $25,000, subject to phase-out if your income exceeds certain levels
- If you qualify, take a home office deduction. Under current law there is little reason not to take a home office deduction
- Consider making year-end gifts to family members
- Under new law, you can take the higher of a sales tax deduction or a state income tax deduction - so hunt down and keep those receipts!
The foregoing are several of the many strategies that are commonly used to reduce or defer income taxes. These may or may not be appropriate for you. On the other hand, strategies not presented here may be highly recommended. As each case is unique, it is highly recommended that you consult a qualified tax professional.
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