December, 2007 Tax Tip
Your Annual Year-end Tax Physical Exam
As we enter the final month of 2007, keep in mind that the window of opportunity for many tax-saving strategies closes on December 31. Therefore, December is, for the most part, the only time to review and implement appropriate strategies that may help reduce your overall 2007 AND 2008 taxes. I emphasize 2008 because the real opportunity for tax savings occurs when you can predict, to a reasonable degree, that your tax bracket in either 2007or 2008 will be lower than your bracket in the other year.
Timing is as important to tax planning as location is to real estate. Therefore, two important strategies to consider are whether you should attempt to defer income from 2007 to 2008 and pay deductible expenses in 2007, rather than 2008. While your relative tax brackets is a major factor in making these decisions, there are other considerations (such as the alternative minimum tax (“AMT”) that could weigh heavily in the decision making process. In this regard, see the caution below.
If it is determined that it would in your best tax interest to defer income to 2008, some ways this may be accomplished include asking your employer to pay your 2007 year-end bonus in 2008, rather than 2007; maximizing your 2007 contributions to your tax-deferred retirement plan, such as 401(k); and, if you are self-employed, delaying customer or client billings so that payment won’t be received until 2008.
If it would be prudent to pay deductible expenses in 2007, a few of the items to consider
include: 1) making your January, 2008 mortgage payment in December (if you do this, contact your lender to find out the latest date it can be paid in order for the interest to be included on your 2007 form 1098 and then verifying that it was received by that date); 2) if you are make quarterly estimated state income tax payments, making the fourth quarter payment (normally due January 15, 2008) by December 31; 3) if you are an employee, having your payroll department increase the taxes withheld from your December paychecks to cover any underpayments of estimated tax you may be facing for 2007 to avoid or minimize potential penalties; 4) paying your real estate tax installment due in the spring of 2007 by December 31; 5) fulfilling charitable pledges and making other charitable contributions by December 31, rather than in 2008; 6) making payments of deductible expenses on your bank credit card (Visa, Mastercard, Discover) by December 31. These are deductible in the year of charge, not the year of payment. CAUTION: Avoid paying state income or real estate taxes in 2007 if you are projected to be in the AMT, as these taxes are not deductible for AMT purposes. Also, there are much more stringent rules for substantiation of charitable deductions that now apply. Be sure to discuss these with your tax professional.
If you own, or are considering owning, securities there are several tax strategies that are very important in your year-end tax planning. Gains and losses are determined on the trade date. The last trade date this year is December 31. Depending upon your situation, you want to consider postponing sales of stocks with gains until January, 2008 to defer recognition. Similarly, you want to consider selling stocks with losses by December 31 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. Important: you should try to avoid 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. 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. This is because the value of the shares will decrease by the amount of the distributions.
A GOLDEN OPPORTUNITY: The current maximum federal tax rate for most long-term capital gains and qualifying dividend income is 15% with individuals in the lowest two tax brackets (10 and 15%) receiving a 5% rate. However, for the years 2008 through 2010 the long-term capital gain and qualifying dividend rate will be ZERO for those in the 10 and 15% brackets. This could present a golden tax planning opportunity in certain situations. If possible, make year-end gifts up to the maximum $12,000 per individual of securities and/or other appreciated assets to family members who are in the lowest two brackets. They would then be able to sell these assets during 2008 through 2010 without incurring a federal tax liability. Caveat: be advised that the new Kiddie tax rules discussed in the following paragraph essentially eliminate the advantage of giving appreciated assets to your children. The opportunity would, however, still apply to non-Kiddie-tax situations.
Just when you rejoiced in the fact that your child had turned 14 and the Kiddie tax no longer applied, Congress changed it to apply to children under age 18 for 2007 (age 19 for 2008 and later). Children who have more than $1,700 in unearned income (e.g. dividends, interest, royalties and capital gains) in 2007 ($1,800 in 2008) must pay tax on that excess income at the parents’ tax rate.
Perhaps the most contentious and controversial provisions in the tax law are those dealing with the AMT. If Congress doesn’t respond with another of its string of temporary fixes, the number of taxpayers that will be subject to the AMT is projected to increase from 4.24 million in 2006 to 23.19 million in 2007. What makes it troublesome for tax professionals is that Congress usually does not act until very late in the year (likely December this year) to extend or modify expiring provisions with another temporary fix until the ultimate fate of the tax is determined. Therefore, effective planning around the AMT is somewhat “iffy”.
In the area of retirement plans, if you are employed, consider a traditional IRA ($4,000 contribution limit - $5,000 if age 50 or over); a Roth IRA (same limits as a traditional IRA) except contributions are not deductible but later distributions are not taxable; an employer sponsored 401(k) plan which allows you to contribute pretax funds up to $15,500, thereby reducing your 2007 income. Note that 2007 contributions to IRA’s can be made up to April 15, 2008.
If you are self-employed you can establish a retirement plan before year end including 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 self-employed strategies to keep in mind in your planning include acquiring and placing equipment into service by December 31 to take advantage of the immediate write-off of up to $125,000; establishing a medical insurance plan; employing your minor children to perform administrative tasks in your business during the holidays; and, if you qualify, deducting a home office.
The foregoing discussion includes only some of the more common tax strategies to consider in your year-end planning. There are many others, several of which may be important to review and perhaps implement in your 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 situations.
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