December, 2006 Tax Tip
Year-end Tax Planning Considerations
As we enter the final month of the year this is not only a good time but, for the most part, the only time to review and implement some tax planning strategies that may help reduce your overall 2006 and 2007 tax burdens.
- Mortgage Interest – Consider making your January, 2007 mortgage interest payment in December, 2006 so that the interest will be deductible on your 2006 return. Contact your lender to find out the latest date it can be paid in order for the interest to be included on your 2006 form 1098 that you will receive from your lender. Generally it will only be included if the lender receives the payment prior to year end. If you make the payment prior to year end and it is not included on the 1098, notify your tax preparer so that he or she can make the appropriate adjustment on your return.
- Taxes – If you are making quarterly estimated state income tax payments, consider making the fourth quarter payment (normally due on January 15, 2007) on or before December 31, 2006. This will allow you to take the deduction on your 2006 return. If you are an employee and have federal and/or state income taxes withheld, you may wish to increase the taxes withheld from your final paychecks to cover any underpayments of estimated tax that you may be facing in 2006 to avoid or minimize potential penalties.
Another item to consider is paying your real estate tax installment due in the spring of 2007 in 2006 to obtain a 2006 deduction.
CAUTION: Avoid prepaying state income tax or real estate tax in 2006 if you are projected to be in the alternative minimum tax “AMT”, as taxes are not deductible for AMT purposes. Aside from AMT, if you expect to be in a higher tax bracket in 2007, taking these deductions in 2006 rather than 2007 may not be wise.
- Charitable Contributions – If you will be fulfilling charitable pledges or otherwise making contributions in early 2007, you may want to push them up to 2006. Charitable contributions are not subject to the AMT.
- Credit Card Payments – Be mindful of the fact that deductible items charged on your bank credit card in 2006 are deductible in 2006 even if you pay the credit card bill in 2007.
- Defer Income - The flip side of prepaying deductions is deferring income. If you will be in the same or lower tax bracket next year, it makes sense to push income into 2007, if possible. Ways this may be accomplished include having your employer defer paying your 2006 year-end bonus to 2007; maximizing your 2006 contributions to your tax-deferred retirement plan, such as 401(k); if you are self-employed, delay customer billings so that payment won’t be received until 2007.
- Security Transactions – Gains and losses are determined on the trade date. The last trade date this year is December 29th. Depending upon your situation, you may want to consider not selling stocks with gains until January, 2007 to defer recognition. Similarly, you want to consider selling stocks with losses before the end of the year to reduce other gains you may already have. Keep in mind that only $3,000 of net losses can be deducted in any given year. The balance will carry over to the following year. Also remember you must hold the security for more than one year to receive favorable long-term gain treatment. One strategy you should try to avoid is offsetting a low-taxed long-term capital gain with a short-term capital loss which would otherwise reduce income taxed at a higher bracket.
CAUTION: Many mutual funds pay out dividends and capital gains in December. You want to avoid buying shares in a mutual fund until the ex-dividend date. Otherwise you will receive taxable distributions on shares you just purchased without an economic benefit to you. The value of the shares will decrease by the amount of the distributions.
- Self-employed – Certainly one strategy to consider is establishing a retirement plan before year end. These include a “solo 401(k) plan, a SEP plan (which is the only plan that can be established and funded after the end of the year) or a SIMPLE plan. Other strategies can be establishing a medical insurance plan, employing your minor children to perform administrative tasks in your business during the holidays, and considering your eligibility for a home office deduction.
- Businesses (including self-employed businesses) – Acquire and place equipment into service before the end of the year to take advantage of the immediate write-off of up to $108,000; determine if you qualify for the new deduction for domestic production activities.
- Energy Tax Breaks – Tax credits are available for energy efficient and alternative energy home improvements. Among the items to which the credits apply are energy efficient exterior windows and doors, furnaces and central air conditioning units, and solar water heaters. Credits are also available for the purchase of qualified hybrid and alternative fuel vehicles.
- Charitable Donations of Clothing or Household Items – Be aware of the new rules that apply to contributions of clothing and household items made after August 17, 2006. The items must be in “good used or better” condition and you must have a receipt. Therefore, dropping items in a Goodwill receptacle will no longer qualify. You can continue to deduct the value of an item that isn’t in good or better condition if the value is more than $500 and you include a qualified appraisal with your return.
- Kiddie Tax – Just when you thought that your child had reached 14 and the Kiddie tax no longer applied , Congress changed it this year to under 18 years of age. Children who have more than $1700 in unearned income (dividends, interest, etc.) in 2006 must pay tax on that excess income at the parents’ tax rate. Higher income parents should now consider investing any cash put aside for their children under 18 in investments that generate little or no current taxable income.
- Roth Conversion – Beginning in 2010 the $100,000 income limit has been removed for those who want to convert their traditional IRA to a Roth IRA. If the income limit currently applies and you would like to convert, consider making contributions to a traditional IRA now with the intent of converting to a Roth in 2010. Unless the IRA owner who converts in 2010 elects otherwise, one-half of the income resulting from the conversion will be includible in income in 2011 and the other half in 2012. Under the law in effect currently, the full amount of the income from the conversion must be included in the year of the conversion.
The foregoing discussion includes only some of the more common strategies to consider in year-end planning. There are many others, several of which are important to review and perhaps implement in your particular situation. It is strongly recommended that you consult a knowledgeable tax professional to assist you in the analysis. For many years, I have worked with clients to present a “tailor-made” plan to fit their unique tax situation.