Hans Kasper, MS-CPA, PSTax Planning 2006
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Practice makes perfect. In addition, in order to excel at most things in life, you need to practice consistently. The same philosophy holds true for managing your taxes. If you only think about taxes when April 15th rolls around, you’re not going to be very successful at managing your tax bill. To minimize your taxes, you need to know the rules and take advantage of year-round tax planning opportunities. The good news is that it’s not too late. 2006 opportunities and pitfalls The tax law changes constantly. New tax breaks -- and pitfalls -- come and go all the time. 2006 is no exception. Literally scores of changes have been made to the tax law that impact 2006 tax year returns. Among those most notable for impacting the largest groups of taxpayers are:
2007 opportunities and pitfalls Despite the number of new provisions that began this year, 2006 does not have a lock on recent changes. 2007 is set to inaugurate several changes of its own, even before tax legislation in 2007 will likely produce still more changes. Here's a list of some of the major ones:
Also noteworthy, starting in 2010 there will be no maximum income level to restrict conversion of regular IRAs into Roth IRAs. Maximizing that opportunity, however, can begin immediately for those taxpayers presently over that limit. This strategy calls for making annual contributions to a nondeductible IRA that can then be converted into a Roth IRA in 2010 when the income cap is lifted. Health Savings Accounts The Health Savings Account, or HSA, was introduced last year for those covered by a high-deductible health insurance plan and not eligible for Medicare. A high-deductible plan is defined as one with an annual deductible of at least $1,050 for individual coverage and at least $2,100 for family coverage. The HSA is a tax-favored savings plan. It allows individuals and employers to make deposits that can be used to pay for qualified health expenses that the individual, his or her spouse, or their dependents incur. The money you contribute to an HSA is tax-deductible, even if you don’t itemize. The interest and investment earnings are not taxable, so the money in your HSA grows tax-free. HSAs offer another significant benefit: you can take tax-free distributions, as long as the proceeds are used to pay for qualified medical expenses. HSA Contribution Limits Basically, your contribution is limited to the lesser of the annual deductible under the health plan, or $2,700 for individuals or $5,400 for families. The additional catch-up contribution limit for individuals 55 and older is $700, $800 for 2007, $900 for 2008, and $1,000 for 2009. FILING BASICS Many people think that the amount of income tax they pay is determined by the amount of their taxable income. The truth is that people with exactly the same amount of taxable income can end up with different tax bills, depending on the filing status they choose. Each filing status has its own tax rates, and your filing status also affects how other tax rules, such as the standard deduction, IRA contribution limits, and tax credits and deductions, apply to you. Filing Status There are five categories of filing status: married and filing jointly, married and filing separately, single, head of household, and qualifying widow(er). The primary factor affecting your filing status is whether you are married or not. If you are married, you and your spouse must decide whether to file jointly or separately. In most cases, you’ll pay lower taxes if you file jointly and you can take advantage of tax credits and benefits that aren’t available to couples who file separately. If you are not married, you use the single filing status or the head-of-household filing status. Heads of household pay a significantly lower tax rate than singles, but to qualify, you must meet the requirement for supporting at least one other dependent. If you are a surviving spouse, you may use the joint tax rates as long as (1) you have a qualifying dependent, (2) you provide more than half the cost of keeping up a home for you and your dependent, and (3) you did not remarry before the end of the tax year. Timing Strategies Timing is also an extremely critical component of tax planning. One of the easiest ways to lower your tax bill is to defer income into the next year and accelerate deductions into the current year. This is a good strategy if you expect your taxable income to be about the same or lower next year. So for example, if you’re an employee and expecting a bonus, you might try to convince your boss to defer payment until January 2007. To postpone investment income, think about investing in certificates of deposit and Treasury bills that don’t mature until next year. Deferring income is easier for self-employed business owners using cash basis accounting. Simply delay your year-end billing so that payments won’t reach you until after the first of the year. The flip side of deferring income is accelerating deductions, and there are a number of ways you can do this. Make charitable contributions or estimated state income tax payments in December instead of January. Pay your January mortgage check in December and you increase your mortgage interest deduction for 2006. You can also pay your first quarter 2007 property taxes on or before December 31 and claim a deduction for the current year. Deferring income and accelerating deductions generally is an excellent strategy, but you need to take your personal circumstances into consideration. If you think your tax rate will be higher next year, perhaps because you expect a raise or your spouse plans to return to work, reversing this strategy may be more appropriate. Also, be aware that accelerating deductions too aggressively could subject you to the Alternative Minimum Tax. Another timing strategy calls for bunching deductions. Some deductions are allowed only after they exceed a minimum amount tied to your adjusted gross income. Unreimbursed medical expenses, for example, must total more than 7.5 percent of your adjusted gross income before you are eligible to claim a deduction. Similarly, miscellaneous deductions, such as unreimbursed employee business expenses, must surpass 2 percent of your AGI before you can claim a deduction. If you're close to these limits, think about bunching as many deductible costs as you can into this tax year. For example, if you’re scheduled for a dental checkup or eye exam in early 2007, see if you can reschedule for December. Other traditional considerations include:
Family Strategies Here are some tax breaks you may be eligible for if you are raising a family. You parents out there want to be sure to take advantage of every tax-savings opportunity available to you – the child credit, the dependent care credit, the adoption credit, and the earned income credit. In addition, lucky for you, a credit is the best tax break you can get. Deductions reduce the amount of taxable income on which you must pay taxes, but tax credits reduce, dollar for dollar, the taxes you actually owe. There are also tax-smart ways to shift income to your child, which I will also cover briefly. Family Strategies: Child Credit For 2006, the child credit is worth $1,000 for each child who is under age 17 at the end of the calendar year and who qualifies as a dependent. That means if you have three children, the child credit can potentially cut your tax bill by $3,000. In addition, remember that as a result of the 2004 Tax Act, the $1,000 credit remains in effect through 2010. Therefore, if your children are younger, you may qualify for the credit for several more years – unless your income exceeds the phase-out levels. For 2006, the child credit begins to phase out when modified AGI reaches $110,000 for married couples filing jointly, $55,000 for married taxpayers filing separately, and $75,000 for single filers, heads of households, and qualified widow(er)s. The credit is reduced by $50 for each $1,000, or fraction thereof, of AGI above these thresholds. Family Strategies: Adoption Credit There is good news for people who are planning to adopt a child. Two tax benefits offset the escalating expenses of adopting a child. In 2006, the maximum adoption credit is $10,960. Parents who work for companies with an adoption assistance program can receive up to $10,960 in reimbursement from their employer for adoption expenses without paying taxes on that benefit. When you adopt a child with special needs, you are allowed to claim these benefits regardless of actual expenses paid or incurred in the year the adoption becomes final. Family Strategies: Dependent Care Credit Working parents know how expensive childcare can be. So does Uncle Sam. The dependent care tax credit aims to ease some of the burden. Basically, the credit works like this: If, in order to work, you pay someone to care for a dependent under 13 whom you also claim as a dependent, you may be eligible for a tax credit of between 20 and 35 percent of your qualifying expenses. For 2006, the dollar limit on the expenses toward which you can apply the credit percentage is $3,000 for the care of one individual and $6,000 for two or more. The percentage of the expenses you can take as a credit depends on your AGI. These dollar limits must be reduced by the amount of any dependent care benefits provided by your employer that you exclude from your income. The most tax favorable way to manage dependent care payments is to approach your employer's human resource department and sign up for a pre-tax plan that will deduct your monthly payments from your payroll check. This will save you both income taxes and Fica taxes; whereas, the credit only saves you the income taxes. Take note that the dependent care tax break isn't restricted to child-related care costs. If you pay someone to look after an incapacitated dependent of any age or a spouse who is physically or mentally incapable of self-care, you may be eligible for this tax break. Family Strategies: Earned Income Credit Although the earned income credit doesn’t apply only to families with children, eligible low-wage taxpayers with children get the largest benefit. The earned income credit is subtracted directly from the amount of tax you owe... Even if you do not owe any tax to the IRS on your tax return, you might still get some money back. On 2006 returns, the maximum credit can be as much as $4,536 for workers supporting two or more kids. A worker with one child can get a credit worth up to $2,747. For an eligible worker with no children, the credit drops to $399. The credit is phased out as AGI increases. Keep in mind also that taxpayers with investment income of more than $2,700 are not eligible for the credit. Family Strategies: Shifting Income Shifting income to a child in a lower tax bracket is a popular strategy that has been made even more favorable by the Tax Relief Act of 2003. The tax law says you can give a child, or anyone else, for that matter, up to $12,000 in 2006, without being subject to the gift tax. When you transfer assets to a child who is 18 or older, dividends and capital gains can be taxed at just 5 percent for children in the lowest tax brackets. Be aware that if your child is under age 18, the kiddie tax rule applies. This rule says that unearned income above a certain threshold amount is taxed at the parents' top marginal tax rate. For 2006, the kiddie tax threshold is $1,600. That means your child under age 18 can earn up to $800 in investment income without paying any tax and an additional $800 that will be taxed at your child's own rate. Unearned income above that level is taxed at your own top rate, so it doesn’t pay to shift a significant amount of income to a young child. Shifting income to your child can also help by reducing the adjusted gross income on your personal return, which may mean that you’ll lose less of your itemized deductions and personal exemptions. Lowering your AGI may also make you eligible for other tax benefits. Here’s another way to cut the family tax bill. If you have an asset that has appreciated in value that you plan to sell, perhaps to pay for college, consider gifting the stock to your child and having your child sell it. If your child is over 18, the entire gain may be taxed at the child’s lower capital gains tax rate. If you’re a sole proprietor, you can shift income by hiring your children to help in your business. In addition to providing valuable work experience for your child, this arrangement offers significant tax savings to the business. As long as the work your children do is legitimate and they receive reasonable wages, you can deduct their wages from your income and shift the money to your children in lower tax brackets. As an added bonus, if your son or daughter is under 18, you don’t have to pay Social Security or Medicare taxes on the wages you pay. Because of the standard deduction, in 2006, the first $5,000 earned by each child is not taxed. And since it’s earned income, it is not subject to the kiddie tax. The child can earn an additional $4,000 tax deferred if the child contributes to a traditional IRA. Education Strategies Since, in most cases, education accounts for the greatest cost associated with raising kids, you’ll want to pay careful attention to learn all you can about the credits and deductions for education expenses. Keep in mind, however, that these education benefits are available to students of every age. Education Strategies: Tax Credits Two popular tax credits -- the Hope Credit and the Lifetime Learning Credit -- can help defray education expenses for you and your youngsters. In addition, because they are credits, rather than deductions, they take a bigger bite out of your tax bill. The Hope Scholarship Credit – worth up to a maximum of $1,650 per qualifying student – can be claimed for only each of the first two years of college for each student. For the 2006 tax year, this education credit is gradually reduced if your modified AGI exceeds $45,000 for single filers and $90,000 for joint returns. Once a single filer’s AGI reaches $55,000, the credit is eliminated. For joint filers, the cap is $110,000. Education Strategies: Tax Credits Another credit you may qualify for is the Lifetime Learning Credit that provides a maximum credit of up to $2,000 per year. As its name suggests, the Lifetime Learning Credit, can be used by anyone for undergraduate, graduate, and professional degree courses. It is subject to the same phase-out rules as the Hope Scholarship Credit. You may not claim both credits for the same student’s expenses for the same tax year. Education Strategies: Tuition Deduction If your AGI exceeds the threshold allowed for the Hope and Lifetime Learning credits, you may be eligible to claim a deduction for qualifying higher education, tuition and fees. Be sure to take advantage of it this year if you can. For 2006, the maximum deduction for tuition and fees is $4,000. This maximum applies regardless of the number of students in your household. The tuition deduction is an above-the-line deduction, which means you don’t have to itemize in order to claim it. You qualify for the maximum $4,000 tuition deduction if your modified adjusted gross income is not more than $65,000 for single filers or $130,000 for those who are married filing jointly. Above these levels, a phase-out rule applies. Joint filers with AGIs between $130,000 and $160,000 and single filers with AGIs between $65,000 and $80,000 can claim a tuition deduction of up to $2,000 for the year. The deduction is not available to those with AGIs that exceed these levels. Keep in mind that you cannot take the tuition deduction and claim a Hope credit or Lifetime Learning credit for the same student, but you can claim the education credit for one student and the deduction for another. Remember that tax credits are more valuable than deductions. A $1,000 credit saves you $1,000 in taxes. In the 28 percent bracket, a $1,000 deduction would only save you $280. One final thought: taxpayers who are married and filing separately are barred from taking the education credits and the tuition deduction. Education Strategies: Student Loan Deduction If you’re paying off student loans, you’ll be happy to know that the rules for deducting student loan interest recently became more liberal. Taxpayers can deduct up to $2,500 of the interest paid on a student loan, regardless of how long it takes to repay the loan. In addition, you don’t have to itemize in order to take this deduction. For the 2006 tax year, the deduction is phased out for single taxpayers with AGIs between $50,000 and $65,000. For married couples filing jointly, the phase-out kicks in at AGI of $105,000 and ends at $135,000. Homeowner Strategies: Deductions In most cases, you can deduct all of the interest you pay on any loan secured by your home. Interest is deductible on up to $1 million of home acquisition loans. These are loans used to buy, build, or substantially improve your principal residence or second home and secured by that same residence. Interest on a home equity loan or line of credit of up to $100,000 is also deductible. As long as the home equity loan is secured by your home, it doesn’t matter how you spend the proceeds. Home improvements, college tuition, debt consolidation, or an exotic vacation – it’s up to you. Just be sure you have a plan to pay it back. You will need to itemize your deductions on Schedule A in order to take the mortgage interest deduction. The IRS defines points as any extra charges paid by a homebuyer at closing in order to obtain a mortgage. In effect, points are prepaid interest. Points paid to secure a loan for the purchase or improvement of a principal residence are usually fully deductible in the year you paid them. Points paid to refinance your home mortgage must be deducted ratably over the term of the loan. After the home mortgage interest deduction, the next most important tax break for homeowners is the deduction for real estate taxes. You can deduct the taxes paid on all your real estate. Your deduction is not limited to only two principal residences, as it is with the home mortgage interest deduction. Homeowner Strategies: Selling Your Home You’re in for another valuable tax break when it’s time to sell your principal residence. If you meet certain requirements, you can have a significant profit on the sale of your principal residence without having to pay tax on the gain. Here are the rules. When you sell your home, you can exclude from income up to $250,000 in gains, $500,000 for joint filers, provided that you have both owned and used your home as a principal residence for at least two of the five years preceding the sale. The full tax break is available only once every two years. However, be aware that you may be eligible to claim a reduced exclusion if you were required to sell your home due to a change in place of employment, health issues, or unforeseen circumstances before meeting the two-year principal residence rule. Energy Act credits There are three tax credits you should know about that come from the recent energy legislation. The first is a credit of up to $500 total over the 2006 and 2007 tax years for homeowners who install non-business energy property such as exterior doors and windows, insulation, heat pumps, central A/C and water heaters. The second is a residential alternative energy credit of 30 percent of the cost of eligible solar water heaters and electricity equipment and fuel cell plants. The maximum credit is $2,000 per year for each type of solar equipment and $500 for each .5 kW of capacity for fuel cell plants installed each year. These credits only apply to property that is ready and available for use only after 2005; if it looks like you might get it installed sooner, delay it. Finally, the clean-fuel vehicle deduction for hybrid vehicles switches to a credit of about $2,000, depending on fuel efficiency. For example: if you spent $3,000 in 2006 to remove and install insulation in your home, you would receive a credit against your taxes of $300.00. INVESTMENT STRATEGIES When it comes to investing and taxes, strategy and timing is as important as skill. There are a number of tax-smart investment strategies you may want to consider, especially in light of recent legislation that lowered the tax rate on dividends and capital gains. Investment Strategies: Dividends Dividend income received by an individual shareholder from a domestic or qualified foreign company is taxed at a top rate of 15 percent and at just 5 percent for taxpayers in the 10 percent and 15 percent tax brackets. Prior to the tax law change, dividend income was taxed at the individual’s ordinary tax rate. However, be careful. To receive a dividend that qualifies for the lower tax rate, you must buy the stock as least one day before the ex-dividend date and hold that stock for at least 60 more days. The ex-dividend date is the last date on which shareholders of record are entitled to receive the upcoming dividend. Essentially, what this means is that if you owned shares for only a short time around the ex-dividend date, your dividend income will be taxed as ordinary income and not eligible for the 15 percent rate. Here’s another caveat: not all income payments that are called dividends are qualified dividends in the true “taxed at 15 percent” sense. For example, the money you earn on savings accounts, certificates of deposit, and money market funds is sometimes referred to as dividends, but is really interest and is taxed as ordinary income. You might be wondering whether you should invest more heavily in stocks that pay high dividends. The answer is yes -- and no. Surely, stocks that pay a high dividend are more attractive now, but that doesn’t mean they are going to perform better than stocks that don’t pay dividends. In addition, here’s something else to consider. If you’re holding stocks that don’t pay dividends, there is no tax bill until you sell those stocks at a gain. In contrast, the tax on dividends applies in the year the dividend is paid. In any case, you should never let tax considerations drive your investment decisions. Be sure that your overall financial objectives guide your investment strategies. Investment Strategies: Capital Gains Tax Similarly, the maximum tax rate on net long-term capital gains was reduced to 15 percent during 2003. If you’re in the 10 percent or 15 percent tax bracket, your net long-term capital gains will be taxed at only 5 percent. To qualify for long-term tax treatment, an asset must be held for more than one year before it is sold. Keep in mind that the net long-term capital gains tax rate from the sales of collectibles remains at 28 percent. These changes in the tax law provide a great opportunity to cut your overall family tax bill by transferring stock – both appreciated growth stocks and dividend stocks – to children age 18 and older who are in lower tax brackets. Investment Strategies: Offset Capital Gains with Losses Knowing when to make the right move is critical for timing your investment decisions. Be sure to periodically review your investment portfolio and determine whether you should initiate any investment moves. You may have some gains to report on your 2006 tax return. If that’s the case, consider whether it makes good investment sense to take some losses to offset capital gains. Net capital losses are fully deductible against capital gains. If your capital losses exceed your capital gains, you can deduct up to $3,000 in net capital losses against ordinary income. That figure is $1,500 if married filing separately. Excess losses may be carried forward to offset ordinary income in subsequent years. Keep in mind that an investment sold at a loss need not be gone forever. If you believe it was a good long-term investment, you can buy it back. Just be sure to wait 31 days; otherwise, you’ll get caught up in the wash sale rule. This rule disallows losses on securities sold if substantially identical securities are bought within 30 days before or after the loss sale. Losses on the sale of securities are not deductible under Code Sec. 1091 if substantially identical securities, or options to purchase such securities, are acquired within 30 days before or 30 days after the date of the sale (“wash sale” rules). Losses on sales of stock options are subject to Code Sec. 1091. This makes it clear that option trading comes within the wash sale provisions. With these tax factors in mind, the following strategies should be considered: Securities with short-term gain. (1) Sell for the gain —Where losses (including carryovers) are sufficient to offset gain and obtain a $3,000 offset against ordinary income. Securities with long-term gain. (1) Sell for gain to achieve a lower rate —If the taxpayer has no ordinary taxable income or income only in a tax bracket below the 25-percent bracket, then part of the capital gain will be taxed in that bracket, thereby achieving an overall lower effective rate of tax. Generally, long-term capital gains are taxed at a maximum of 15 percent (5 percent for individuals below the 25-percent tax bracket). (2) Sell for a gain to be able to make use of losses —One who has losses or loss carryovers may want to make use of them above the $3,000 limit. One may repurchase immediately without tax liability. Securities with long-term loss. (1) Sell to offset already-realized gains dollar-for-dollar, saving the tax on such gains. (2) Sell to realize at least $3,000 loss in excess of gains for the maximum $3,000 offset against other income. (3) Sell for additional loss to establish carryover of long-term loss for subsequent years. Securities with short-term loss. (1) Sell to offset short-term gains, thus saving the tax on such gains, which are taxed at a rate generally higher than that applicable to net capital gain. (2) Sell for additional loss to offset long-term gains. (3) Sell for up to $3,000 loss in excess of gains for a tax-saving deduction from ordinary income. (4) Sell for additional loss to establish carryover of short-term loss for subsequent years. Short-against-the-box transactions. Gain (but not loss) will be recognized when a taxpayer takes an offsetting short position; however, this rule does not apply if the taxpayer closes the short transaction within 30 days after the end of the tax year in which the short position is taken and continues to hold the appreciated stock for 60 days after closing the short transaction (Code Sec. 1259). The 60-day holding period requirement will obviously place some or all of the gain on the appreciated securities at significant risk. RETIREMENT Contributing to a retirement plan can help you achieve a secure retirement, but can also lower your current income tax bill as well. Retirement Strategies: Employer-Sponsored Plans Pre-tax contributions to an employer-sponsored savings plan reduce the amount of taxable wages you report on your tax return, making qualified retirement plans an excellent way to cut your tax bill. If you have a 401(k) and you haven’t arranged to contribute the maximum, try to increase your contributions before year-end. This is especially important if your employer makes matching contributions – which, in effect, represents free money. For 2006, after you’re under 50, the maximum contribution to a 401(k) plan is $15,000. Taxpayers who are age 50 or older can make an additional “catch-up” contribution of $5,000 in 2006 and after. In 2006, employers may begin offering a new “Roth 401(k)” option. Employees with plans that allow this option may designate some or all of their 401(k) contributions as Roth 401(k) contributions. Although these contributions will not reduce the employees’ taxable incomes, the balances grow untaxed and no income tax will be levied on qualified distributions. IRAs The top annual contribution for traditional and Roth IRAs is $4,000 for 2006 and 2007, provided you have earned income to cover the contribution. If you’re age 50 or older, you can make an extra $1,000 catch-up contribution for 2006. Deductible contributions to a traditional IRA reduce your adjusted gross income. A full deduction to a traditional IRA is available, regardless of your income, if neither you nor your spouse is an active participant in an employer-sponsored retirement plan. If you participate in a retirement plan at work, your AGI may limit the IRA deduction. For joint filers, who are both active participants in employer-sponsored plans, the deduction phaseout ranges from $75,000 to $85,000 and for single filers from $50,000 to $60,000. If you don’t participate in an employer-sponsored plan, but your spouse does, the deduction for your contribution is phased out as your joint AGI rises from $150,000 to $160,000. With a Roth IRA, contributions are not deductible, but investment earnings accumulate on a tax-deferred basis and may be withdrawn tax free, as long as you meet certain requirements. Eligibility to contribute to a Roth IRA is phased out as AGI rises from $95,000 to $110,000 for single filers and $150,000 to $160,000 for joint filers. You have until the filing deadline of April 17, 2007, to open and contribute to an IRA for 2006. QUICK TAX TIPS FOR ALL TAXPAYERS: 1. A nonrefundable Hope Scholarship tax credit ($1,650 maximum) available on a per-student, per-year basis for each of the first two years of qualified post-secondary tuition and fees (but not books or room and board). Subject to a phase-out based on adjusted gross income (AGI). Lifetime learning credit (maximum nonrefundable $2,000 tax credit) is available for post-secondary educational expenses. Generally, the lifetime learning credit is subject to the same limitations as the Hope scholarship credit with the following exceptions: (1) the credit is per taxpayer per year (does not vary with the number of students in a taxpayer’s household), (2) the credit is available for an unlimited number of years, and (3) the credit is available for undergraduate, graduate, professional degree and other students acquiring or improving job skills enrolled in one or more courses. 2. You can deduct up to $2,500 of interest on qualified education loans for college or vocational school expenses, even if you do not itemize deductions. Deduction is phased out based on AGI. 3. Nondeductible contributions up to $4,000 ($5,000 if 50 or older) can be made to a Roth IRA. Distributions, including earnings, are tax free when certain requirements are met. The contribution limit is subject to an AGI-based phase-out. 4. An IRA deduction up to $4,000 ($5,000 if 50 or older) is available to all taxpayers who are not covered by an employer-sponsored retirement plan. Taxpayers covered by an employer plan may be eligible for a full or partial deduction, depending on their AGI. 5. If only one spouse has compensation, a spousal IRA can be set up for the nonworking spouse. Each spouse (working and nonworking) may contribute up to $4,000 or $5,000 (if age 50 or older). 6. Exceptions apply to the 10% penalty for early withdrawals from an IRA if the funds are used for: (1) medical expenses in excess of 7.5% of AGI, (2) certain qualified educational expenses, (3) a first-time home purchase for distributions of up to $10,000 or (4) medical insurance for those who are unemployed for at least 12 weeks. Note: IRA withdrawals are still subject to regular income tax. 7. A gain exclusion up to $250,000 ($500,000 if married and filing jointly) is available for sale of a principal residence if the taxpayer(s) owned and occupied the residence for two years of the five-year period ending on date of sale. 8. Interest on certain Series EE savings bonds issued after 1989 are tax exempt if proceeds are used for qualified educational expenses of a taxpayer, spouse or dependent. 9. Keep receipts supporting tax deductions at least four years. 10. Improvement costs may reduce taxable profit upon sale of property. Keep records of improvement costs made to all real estate property at least four years after the property is sold. 11. If “allocated tips” re listed on year-end Form W-2, the amount will be subject to both Social Security and income tax unless records (tip log) verify that a lesser amount was actually received. 12. If stock or mutual fund dividends are automatically reinvested instead of received in cash, maintain good records of all reinvested dividends each year. These reinvestments will increase your cost basis, and reduce gain or increase loss upon sale. 13. Child care expense credit allows up to a 35% tax credit on up to $3,000 of child care costs paid for one dependent or $6,000 for two or more dependents. 14. Taxpayers who attained age 50 prior to January 1, 1986, (born before 1936) and receive a lump-sum distribution from a pension plan or profit-sharing plan may utilize a tax=saving method with 10-year averaging. Ask your tax advisor. 15. Taxpayers investing in certain types of passive business activities (such as limited partnerships) are limited in the amount of loss they can claim to offset other types of income. However, a taxpayer who actively participates in a rental real estate activity can apply up to $25,000 in rental losses against other sources of income—subject to a phase-out rule. 16. Purchasers of so-called hybrid (gas-electric) and other alternative fueled vehicles are eligible for a special tax credit of up to $3,400. (THE FOLLOWING TAX TIPS ARE PARTICULARLY HELPFUL FOR THOSE WHO ITEMIZE THEIR DEDUCTIONS): 1. Insurance policies that cover medical costs are deductible. Disability and loss of income insurance are not deductible. 2. Qualified long-term care insurance premiums are deductible subject to age and dollar limits: Age 40 or less, $280; ages 41 to 50, $530; ages 61 to 70 $2,830; ages 71 and up, $3,530. 3. Special assessments paid on your property are normally not allowed as a current deduction in addition to the real estate tax deduction. But, the interest portion of the special assessments can be deducted as a tax. 4. Loan origination fees, commonly called points, are deductible as interest by a buyer of a new principal residence. Homebuyers are also allowed to deduct seller-paid points. Points paid on refinancing an existing residence must be deducted over the life of the mortgage. 5. Charitable contribution of $250 or more in any one day to any one organization must have written substantiation from the organization. A cancelled check is not sufficient to support the deduction. 6. When making contributions of used furniture, appliances and clothing to nonprofit organization, request a receipt from the organization. Attach a record of the items donated to the receipt for proof of this deductible contribution. Contributions after August 17, 2006, must be in good or better condition to be deductible. 7. Taxpayers who own appreciated stocks or bonds can take advantage of certain tax-saving methods by donating the securities to churches or other nonprofit organizations. 8. If you experienced a casualty loss (flood, fire, theft, etc.) which exceeds 10% of AGI, your tax preparer will explain what information is required to determine your deductible loss, if any. 9. Expenses incurred for education for improving your skills for your present job or maintaining your job may be deducted. Seminars, tuition, books and some travel expenses can be deducted. Travel as a “form of education” is not deductible. Example: French teacher travels to France to maintain general familiarity with the French language and culture—not deductible. However, see Tax Tip 1 for education costs that are deductible even when not job related. 10. Job-seeking costs in the same field of employment are deductible. Successful job placement is not necessary. 11. Part of a legal fee incurred in a divorce or an estate plan may be deductible if it is for advice on the tax consequences. Have your attorney clearly indicate how much of the fee is for tax advice. 12. Expenses incurred for attending conventions, seminars or other meetings which give investment advice to taxpayers are not deductible. 13. Investment interest (land, stock margin account, etc.) is deductible only to the extent of net investment income for the year. Net investment income includes dividends, interest, royalties and short-term capital gains.
BUSINESS STRATEGIES Business Strategies: Structure The structure of your business determines how your business income is taxed. If you are planning to start a business, consider your options carefully to determine whether a C Corporation, S Corporation, partnership, limited liability company, or sole proprietorship is best for you. While small businesses often start out as sole proprietorships or partnerships, many owners eventually explore the transition to another entity. If you’re already in business, it makes sense to review your business structure periodically to determine if it’s still the best option for you. Business Strategies: Expensing Deduction Typically, when a business buys property that has a useful life of more than one year, the cost must be depreciated over the life of the asset. However, under new provisions in the law for Section 179 expensing, for 2006, you can immediately elect to deduct 100 percent of the cost of up to $108,000 (2007 at $112,000/$450,000/$562,000) in new and used personal property put into service before year-end. The Section 179 allowance is phased out on a dollar-for-dollar basis when qualifying assets costing over $420,000 are placed in service with the total phase out limit at $528,000 (2007 at $450,000/$562,000). The section 179 deduction is planned to go to $25,000 in 2010 and after. You should also know that the cost of computer software, which previously had to be depreciated, generally over 36 months, is now eligible for the expensing deduction. Keogh plans for self-employed individuals Self-employed individuals (sole proprietors and partners), if they are going to set up a Keogh plan for the current year, must do so by year-end. However, contributions may be made up until the due date (plus extensions) for filing the return for that year. SEPs and IRAs, on the other hand, can be set up after year-end. Small Business Tax Credits The Working Families Tax Relief Act of 2004 did extend through this year several expiring credits affecting businesses. These include the research and development tax credit, the welfare-to-work credit, and the work opportunity tax credit. Additional Business Strategies If you’re self-employed, in 2006, you can deduct 100 percent of amounts paid for health insurance for yourself, your spouse, and your dependents. The amount is taken as an individual deduction from gross income to arrive at AGI. You can also deduct one-half of your self-employment tax. Several of the strategies we’ve already discussed today apply to small businesses as well. I’m referring to deferring income and accelerating expenses, and to contributing to a retirement plan. However, there are several other strategies you want to be aware of that may be of help to you. Do you have some debts you haven’t been able to collect? A business bad debt is deductible by a cash basis taxpayer only if an actual cash loss was incurred or if the amount deducted was included as income. Be sure to make the most of your deductible expenses. Business-related auto expenses, travel, meals and entertainment costs, and interest expenses are all deductible. Just be sure to keep good records. Employment of family members The employment by a businessperson of his or her spouse provides the business with a tax deduction for reasonable compensation paid, while providing the spouse with all available employee benefits. The cash compensation may be invested in an IRA and/or in voluntary contributions to a qualified retirement plan. The employment of children or other family members offers opportunities for family income splitting and for taking advantage of other benefits attending employee status. The earned income of children under age 14 will be taxed at the child's presumably lower tax rate. The earlier in the year that employment takes place, the greater the benefits for the family. Sole proprietorships can realize tax savings by putting family members on the payroll. Putting a spouse on your payroll allows your business to provide tax-free medical coverage for yourself as the spouse of a covered employee. Children can earn up to $5,150 in 2006 and $5,350 in 2007 tax free, and also have the opportunity to put the funds into a Roth IRA. You are also not subject to FICA on the wages paid to your children under age 18. If you work out of your home, you can take advantage of the liberalized rules for claiming a home office deduction, and if you qualify, you can also deduct travel costs between your home and where your clients are. New manufacturing deduction Businesses should also not forget the Code Sec. 199 domestic production activities deduction, which applies to manufacturers and many businesses not normally considered to be in manufacturing. The deduction amounts to three percent of either taxable income derived from a qualified production activity or all taxable income, whichever is less, but limited to 50 percent of the W-2 wages paid during the calendar year. The amount of the deduction will gradually increase, reaching nine percent of qualified production activity income by 2010. Energy Act opportunities The Energy Tax Incentives Act of 2006 provides tax credits for builders of new energy-efficient homes sold or acquired in 2006 and 2007 and for installation of fuel-cell power plants. There is also a deduction available for the cost of energy-saving improvements to commercial buildings. The key effective date in that case is the “placed in service” date, which must be after December 31, 2006, to qualify. The energy-efficient commercial building property must be installed as part of interior lighting systems, the heating, cooling, ventilation, or hot water systems, or the building envelope and must meet a 50 percent energy-reduction standard. The maximum deduction is generally $1.80 per square foot. Business vehicles Many small businesses depend on vehicles owned or leased either by the company or by the proprietor. Business owners should be aware of several changes that may affect their decisions in using vehicles for business purposes. To counter the effects of rising gasoline prices, the IRS increased the standard mileage rate for business use of vehicles to $0.445 per mile for 2006. While the standard mileage rate is advantageous for owners of inexpensively operated vehicles, businesses that use more costly transportation may wish to use expensing and depreciation. While the expensing limitation for SUVs with a gross vehicle weight of 6,001-14,000 lbs. has been reduced from $100,000, it still allows up to $25,000 to be expensed. For 2007, smaller passenger vehicle depreciation remains at $2,960 for the first year in service, $4,800--year 2, $2,850--year 3, $1,775--year 4 and after. Light trucks and vans are entitled to an $3,260 the first year, $5,200--year 2, $3,150--year 3, $1,875--year 4 and after. QUICK SELF-EMPLOYED TAX TIPS: A) Equipment Expensing Election: Up to $108,000 of qualifying business equipment purchased in 2006 may be expensed currently in lieu of depreciation. (Separate limits apply to business autos and SUVs.) Items expected to last more than one year: Provide a separate listing. Do not duplicate other expense categories. Include description, date purchased and cost. Provide actual receipts if available. B) Business Use of Home Deduction: If an area of the home is used regularly and exclusively for business, a deduction for a portion of mortgage interest, taxes, insurance, utilities and depreciation may be allowed. If business use of the home is established, a mileage deduction for travel between home and other job locations may be allowed. Special rules apply for inventory storage and daycare. C) Per Diem Mean Rates: In lieu of using actual expenses incurred for meals and incidental expenses, self-employed individuals and employees may deduct per diem amounts equal to or less than IRS-approved rates. The rate for meals and incidental expenses (IM&E) depend on location. Provide detailed list of dates and locations of business travel. D) Auto Loan Interest: Self-employed taxpayers are allowed a deduction for the business portion of auto loan interest. Note: Business portion of auto loan interest for an employee is considered nondeductible personal interest. E) Self-Employed Health Insurance Deduction: Up to 100% of health insurance premiums may be deducted. The deduction is not allowed for any month that the self-employed individual or his or her spouse is eligible to participate in a subsidized health plan maintained by an employer. F) Health Savings Accounts (HSAs): Self-employed individuals and employees covered by a high deductible health plan (deductible between $1,050 and $5,250 for individual coverage and between $2,100 and $10,500 for family coverage) can make deductible contributions to HSAs. For self-only coverage, contributions are limited to the lesser of the plan deductible or $2,700 ($3,400 if age 55 or older). For family coverage, contributions are limited to the lesser of the plan deductible or $5,450 ($6,150 if age 55 or older). HAS distributions are tax and penalty free if used for qualified medical expenses. G) Simplified Employee Pension (SEP-IRA) and SIMPLE Plans: Employers can make a tax-deductible contribution to an employee’s SEP-IRA. The contribution is limited to 25% of wages up to a maximum contribution of $44,000. Employer contributions are not included in the employee’s current taxable wages. Self-employed individuals may contribute up to 20% of net self employment (SE) income (after deduction for SE tax) limited to a maximum contribution of $44,000. SEP-IRAs must be established by the due date of the return (including extensions). Savings Incentive Match Plans for Employee (SIMPLE), which involve different limitations, are also an option for small businesses but unlike SEP-IRAs, they must be established by October 1 of the tax year. VEHICLE EXPENSE TIPS: · Travel expenses between home and a temporary work location within your metropolitan area are not deductible unless one of two tests are met: (1) you have one or more regular work locations away from your home or (2) you qualify for a business use of home deduction. · A work location is considered temporary if employment is expected to last and actually does last for one year or less. Commuting expenses for going between the taxpayer’s home and a temporary work location outside the metropolitan area where the taxpayer lives and normally works are deductible. · Taxpayers claiming deductions for any business use of vehicles must divide the expenses as follows: personal portion, commuting portion and deductible business-use portion. See mileage breakdown below. · There are two methods to determine the deduction for automobiles and trucks used for business: (1) actual expenses, or (2) standard mileage rate of 44.5¢ per mile. You may claim the standard mileage method whether you own or lease your vehicle. · For each vehicle used for business the following information is needed: (1) total miles driven this year; (2) mileage breakdown between business, commuting and personal; (3) vehicle description; (4) date vehicle first used for business; (5) [Cost basis] – [Trade-in Value] = [Net Price]. [Net Price + Sales Tax] = [Total Cost]. If you use standard mileage allowance, no other information is necessary. · If you purchased a vehicle this year and do not use standard mileage allowance you also need to provide (1) a copy of the sales invoice, (2) parking and tolls; (3) gas, oil and lubrication, (4) repairs, maintenance, car washes; (5) tires/supplies; (6) insurance; (7)vehicle license/registration fees; and (8) garage rent. · Certain Hybrid and other Alternative Fuel Vehicles are eligible for a tax credit. Please indicate on Line 3 if you have purchased such a vehicle. · Recordkeeping: Your vehicle expenses will not be allowed by the IRS without adequate records or sufficient evidence verifying business use. Daily records provide the best protection in case of an audit. FINAL YEAR-END TIPS Year-End Tips: Charitable Deductions For most people, making charitable contributions is synonymous with writing a check. I’d like to propose that you look at some other means of sharing your good fortune. Donating appreciated assets that qualify for the long-term capital gains treatment can actually do more to cut your tax bill. When you give appreciated long-term securities to a nonprofit, you deduct the full market value of the asset at the time of the donation and you avoid paying capital gains tax on the appreciation. Now, even though the capital gains tax has dropped to 15 percent, zero tax beats 15 percent any day and you get the benefit of a deduction. However, don’t wait until the last minute. You’ll need to allow time for processing these transactions. Here’s another suggestion. Clean out your closets and basements. When you donate clothing, household goods, and furniture, you can write off the fair market value. According to the Internal Revenue Service, and I quote, "fair market value is the amount at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts." As a practical matter, be aware that the fair market value of used property is likely to be well below what you paid for it. In any case, be sure to ask the charity for a receipt. The better the documentation, the more secure your deduction. Keep in mind, too, that volunteering to help others may also bring tax deductions. There is no deduction for the value of the services you provide to a charity, but you can deduct some costs associated with volunteering. Deductible expenses include your out-of-pocket costs for transportation, lodging, and meals when you travel in connection with charitable work as long as there is no significant element of personal pleasure or vacation. You can also take a deduction of 14 cents per mile plus parking fees and tolls for your philanthropic driving. Other charitable deductions include the cost of supplies such as stamps, stationery, and the like that your charitable work requires. Limit charitable deduction for contributions of clothing and household items Effective for contributions made after August 17, 2006, no deduction is allowed for a charitable contribution of clothing or household items unless the clothing or household item is in good used condition or better. The Treasury is authorized to deny by regulation a deduction for any contribution of clothing or a household item that has minimal monetary value, such as used socks and used undergarments. The fair market value-based deduction for contributions of clothing and household items present difficult tax-administration issues, as determining the correct value of an item is a fact-intensive, and thus also a resource-intensive, matter. It is expected that the Treasury, in consultation with affected charities, will exercise assiduously the authority to disallow a deduction for some items of low value, consistent with the goals of tax administration and ensure that donated clothing and household items are of meaningful use to charitable organizations. Substantiation requirements Effective for contributions made in taxable years beginning after August 17, 2006, the substantiation rules for money contributions is significantly aligned to the substantiation rules for property. In the case of a charitable contribution of money, regardless of the amount, applicable record-keeping requirements are satisfied only if the donor maintains, as a record of the contribution, a bank record or a written communication from the donee showing the name of the donee organization, the date of the contribution, and the amount of the contribution. The record-keeping requirements may not be satisfied by maintaining other written records. Currently, taxpayers are required to have a contemporaneous record of contributions of money, but many taxpayers may not be aware of the requirement and do not keep a log of such contributions. The provision is intended to provide greater certainty, both to taxpayers and to the Treasury, in determining what may be deducted as a charitable contribution. Year-End Tips: Flexible Spending Accounts Flexible spending accounts are a great way to reduce your taxable income while planning for medical or childcare expenses you will face in the coming year. Once you decide how much you want to contribute, your employer deposits the money in your accounts pre-tax, so you don't pay taxes on the dollars you contribute. The major drawback to flexible spending plans is the use-it-or-lose-it feature. The IRS says any amounts unused at the end of the year can be carried over for two-and-a-half months and used to pay for expenses during that time. After that, any unused funds will be forfeited. So if you’re already in a plan, check your balance. If there are still funds, you might want to schedule dental cleaning, buy a pair of prescription sunglasses, or even stock up on certain over-the-counter medications, which the IRS recently announced can be paid for with flexible spending account money. Year-End Tips: Avoid AMT Finally, and I almost hate to bring this up but, in addition to income tax, more and more taxpayers are finding themselves subject to the alternative minimum tax, the dreaded AMT. The AMT was designed years ago to make sure that the wealthy pay their share of taxes. However, because the AMT is not indexed for inflation, more and more taxpayers are finding themselves affected. Some of the items that can trigger the AMT include a higher than average number of dependency exemptions, large deductions for state and local income taxes, higher real estate taxes, high miscellaneous itemized deductions, and medical expenses. Exercising incentive stock options can also subject you to this costly tax. Congress has been given another year to address the increasing number of families affected by the AMT. In the meantime, the Working Families Tax Act of 2004 includes an extension for individual AMT relief in the form of an expanded exemption. As a result, taxpayers can benefit from the higher exemption amount through 2006. Unfortunately, the AMT defies most traditional tax planning strategies, but if you think you might be affected, you should discuss the matter with us. AMT credit A special change in November helps those who paid AMT on incentive stock options. We do not have all of the data on this change yet; however, it appears that you will be able to obtain a credit (read refund) for taxes paid in 2000 to 2005 on incentive stock options. This credit will be refunded over the next five years. Avoiding penalty on underpayment of estimated tax
Toward year-end a
person should have a pretty good picture of his or her income for the
year and should know whether enough estimated tax was paid in the first
three installments to avoid the penalty for underpayment (subject to
certain exceptions, 90 percent of final tax liability must be paid in
installments to avoid the penalty. The last installment is due by January
15 of the following year. Generally, the penalty on underpaid earlier
installments cannot be eliminated by overpaying the last one. However,
it may be possible to eliminate the penalty by having one's employer
withhold additional amounts of income tax to make up for the shortfall.
This works because withheld tax is treated as paid in equal installments
over the whole year, regardless of when withheld. As an alternative to
the 90 percent rule, a taxpayer may avoid penalties under the
safe-harbor rule if the taxpayer has adjusted gross income of $150,000
($75,000 for married taxpayers filing separately) or less, and the
installment amount due is based on 100 percent of the tax shown on the
return for the preceding tax year.
Various year-end
planning strategies for losses other than losses from securities
transactions, which are separately discussed above, should be
considered. Specifically, there may be planning opportunities in one or
more of the following areas:
In addition, a
taxpayer who qualifies as a head of household or as a surviving spouse
entitled to use joint return rates in the current year but who will not
qualify next year may want to accelerate some of next year's income into
this year to take advantage of his or her present lower rate schedule.
The Economic Growth
and Tax Relief Reconciliation Act of 2001 repealed estate and generation-skipping transfer (GST)
taxes with respect to decedents dying and transfers occurring after
2009, but leaves the gift tax intact. Numerous changes are made to the
transfer tax system for decedents dying and gifts made in the years
preceding the repeal. Beginning in 2002, the 5% surtax on estates was
eliminated, increases in exclusions from the estate tax are phased in,
and the maximum estate and GST rates are gradually reduced. Although the
gift tax is retained, phased-in reductions in the maximum tax rate will
continue until the top marginal gift tax rate falls to 35% in 2010. The
gift tax exclusion is $1 million for gifts. The changes in this area are
complex and will make planning difficult. To complicate matters, these
provisions are set to expire after 2010. Next Year What tax opportunities and strategies should be considered at the beginning of the tax year?
The beginning of
the new year may also be an opportune time for tax planning. While the
short-term benefits may not be quite as dramatic as those flowing from
year-end planning, the long-term benefits, consistently applied, may be
far greater. Tax rate reductions and other recent tax law changes may
affect the traditional tax-planning strategies discussed below. Many of
these changes will affect retirement planning (e.g., increased
contribution and benefit limits for qualified plans and IRAs and greater
flexibility in rollovers from one type of account to another.
Planning for
individuals includes reducing AGI to minimize taxable income and the
impact of the phaseout of itemized deductions and personal and
dependency exemptions of high-income taxpayers (note, however, that in
2007, the itemized deduction phaseout and the personal exemption
phaseout begin to be phased out). In addition, reducing AGI increases
the amount that may be claimed for itemized deductions, which are
deductible only to the extent they are in excess of a specified
percentage of AGI. These include the deduction for miscellaneous
itemized deductions (allowed to the extent in excess of two percent of
AGI); the medical expense deductions (allowed to the extent in excess of
7.5 percent of AGI); and casualty losses (allowed for amounts in excess
of 10 percent of AGI).
If you have any questions, please call Hans at 425-485-7853 or email Hans at hkasper@hkmscpa.com Hans Kasper MS-CPA
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