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October 2001

Year-End Planning Ideas

Congress and President Bush passed a tax bill earlier this year that's designed to save many taxpayers significant amounts of money. However, due to added layers of complexity and the bill's new traps for the unwary, what you'll personally save depends partly on how well you plan to take advantage of the new tax benefits. This letter discusses some of the opportunities and pitfalls, with an emphasis on ideas you may want to consider before year-end. If you have any questions about how these ideas apply in your situation, or if you want to discuss other planning strategies, please contact us.

Deferring Income and Accelerating Deductions

Because of the time value of money, a dollar spent today costs more than if paid in 2002 or beyond. Thus, an age-old strategy, when it comes to tax planning, is to delay the day of reckoning with the IRS as long as allowed. With the drops in the regular tax rates that began this year and the (hoped for) repeal of the personal exemption and itemized deduction phase outs beginning in 2006, this strategy looks especially appealing right now. Not only does it allow you to hang onto your tax dollars longer, hopefully, you'll also have to spend less of them when it's finally time to pay up because of the scheduled tax rate decreases.

How do you legally put off paying the IRS? The typical approach is to push taxable income into a later year and pull deductible expenses into the current year. For example, on the income side, this could involve participating in a deferred compensation arrangement or, perhaps, structuring a disposition of business or rental property as an installment sale or like-kind exchange. In addition, cash-basis taxpayers who are self-employed frequently have significant flexibility in deferring income into another tax year (for example, by delaying billing so that the money isn't collected until after year-end).

On the deduction side, many taxpayers have tax deductible expenses that can be moved between years. The available options include making at least a portion of 2002's charitable contributions in late 2001, paying property taxes or mortgage interest that will accrue by year end in December rather than January, and completing and paying for minor repair and maintenance (or other deductible) expenses on rental properties before the year is out.

However, as discussed toward the end of this letter, before completing any plans to shift income or deductions between years, it's important to make sure the anticipated savings aren't grabbed by the Alternative Minimum Tax (AMT). You'll also want to estimate your tax liability for at least this year and the next to make sure any shifting between years has the desired effect of reducing your overall tax liability or at least deferring a portion of it without causing an overall increase.

Are You Growing Your Own Tax Shelter?

If you're raising children, you probably already know they can be wonderful, challenging, frustrating, and expensive-sometimes all at the same time. However, looked at purely from a tax standpoint, they can also be a fairly good tax shelter.

What do we mean by this? Consider the fact that as the new 10% ordinary income tax bracket kicks in, the highest individual tax bracket will be almost thirty percentage points more than the lowest bracket. Thus, shifting ordinary investment income to the kids (grandkids) can save big dollars in the right circumstances. For example, suppose you have a 16-year-old daughter who is currently a full-time student and has no income of her own. Assuming you're planning to foot the bill for college, at least some of the savings you've ear-marked for this purpose are presumably in short-term investments since college is only two years away. If so, these investments are probably throwing off ordinary income such as interest and dividends. Depending on your tax bracket and the financial aid impact (if any), gifting some of these assets to your daughter now (up to the $10,000, or for a joint gift from a husband and wife, $20,000 annual gift tax exemption) could save as much as 40% of the income they produce before the investments are used to pay college expenses.

Suppose your college funds are in stocks or mutual funds that still have some appreciation in them even after the rough market we've seen recently and you plan to convert them to more short-term investments. What should you do? It can be beneficial to transfer the stocks or funds (again, subject to the $10,000/$20,000 gift tax exclusion) to the student, who then sells them, and reinvest the proceeds until needed for college. Assuming the student is at least age 14 at the time of the/sale, the tax on the gain will generally be at a 8% or 10% rate rather than the 20% rate that typically applies on a parent's return. (Of course, if the investments are worth less than your basis, you'll normally want to sell them yourself so you can claim as much of the loss as possible on your return.)

Uncle Sam Wants to Help Increase Your Retirement Savings

Between sending most taxpayers a check for $300 a piece (which, presumably, some people have used to fund a retirement contribution), to significantly changing the rules on tax favored retirement accounts, the government has made it a little easier to save for retirement. Here's how to take advantage of some of the changes.

Bigger IRA contributions allowed. The general contributions limit for traditional and Roth IRAs rises to $3,000 in 2002 (or $3,500 if you're at least age 50 by the end of 2002). Thus, on a joint return, a married couple who are both at least age 50 generally will be able to stuff an extra $3,000 (for a total of $7,000) in their Roth IRAs for 2002 if their income is below the $150,000 -$160,000 contribution limit. If the extra cash is available, that's probably not a bad way to help offset some of the less-than-exciting returns most people have seen in their retirement accounts recently. However, even with the IRA improvements, it's still generally better to first fund any available 401(k) account to the extent necessary to get a full employer matching contribution (especially with the faster vesting schedule that will be available next year for employer matching contributions).

What if you can't contribute to a Roth IRA because your income is over the limit? Potential relief is coming in 2006. At that point, elective deferrals to 401(k) plans can be treated as Roth contributions (if the plan allows).

401(k) deferral opportunities are improved. In addition to the above change, several other new rules in the retirement plan area bode well for participants in 401(k) plans. For example, the salary deferral limit for such plans goes to $11,000 in 2002 and $12,000 in 2003 (the limit for those age 50 and over will be $12,000 and $14,000, respectively). In addition, employees will be allowed to contribute up to 100% of their compensation to the extent it doesn't exceed the applicable deferral limit (and the plan allows it).

Taken together, this means someone such as a spouse reentering the workforce could defer up to 100% of his or her compensation (less any required withholding such as the FICA tax) until the applicable deferral limit is reached. This could really give a boost to the family's retirement nest egg. For example, suppose someone over age 50 re-enters the workforce next year at a salary of $20,000, working for an employer who offers a 401(k) plan with a 25% match on all deferrals. Assuming the plan allows it, such a person could defer up to $12,000 in the 401(k), receive a $3,000 matching contribution, and perhaps even put another $3,500 in a Roth or traditional IRA.

Talk is cheap (and tax free). Although possibly tax free under the old rules, the 2001 Tax Act makes it clear for 2002 and forward that employers can provide (or pay someone else to provide) retirement planning advice to their employees without the value of the advice being taxed to the employees. However, the advice isn't tax-free to highly compensated employees unless it is available on substantially the same terms to each member of the group of employees normally provided with education and information regarding the employer's retirement plan. Thus, employer-paid advice could be restricted to only certain employees based on something besides their compensation level, such as a restriction related to how near the employees are to retirement age.

Qualifying retirement planning advice isn't limited to information about the employer's plan. Thus, it can apply to advice and information regarding retirement planning for a particular individual and how the employer's plan fits into the individual's overall retirement plan. However, the exclusion doesn't apply to services that may be related to retirement planning, such as tax preparation, accounting, legal, or brokerage services.

The bottom line is that with your employer's cooperation, you'll now have a tax-favored incentive to become better educated about your retirement planning needs and options.

Education Related Tax Benefits Are More Attractive Than Ever

The 2001 Tax Act significantly expanded and improved the options when it comes to saving and paying for education expenses. Here are three major changes.

Tuition write-offs coming soon. A new deduction of up to $3,000 is available beginning in 2002 for college tuition costs if your income is no more than $130,000 (on a joint return) or $65,000 (for singles or head of household). Although the deduction is available regardless of whether expenses are itemized, it isn't allowed if you claim the Hope or Lifetime Learning credit for the same student. (You can, though, claim the deduction for one student's tuition while claiming one of the credits for the expenses of another student.) If it appears you'll benefit from this new deduction and you have tuition bills that can be paid in December 2001 or January 2002, delaying the payment until January should be the better option (at least for up to $3,000 of qualifying tuition).

Coverdell Education Savings Accounts now have more to offer. The usefulness of Education Savings Accounts (formerly known as Education IRAs) are greatly enhanced, beginning next year, because of the ability to fund them with up to $2,000 annually per beneficiary (rather than the current $500 limit) and the option of using tax-free distributions from the accounts to fund pre-college education expenses.

For potential contributors whose income is over the limit where contributions are allowed (for example, the limit is $190,000 to $220,000 on a joint return), they can still indirectly fund an account by gifting money to the student who, in turn, can fund the account.

Because of the availability of qualified tuition programs (see discussion below) for college expenses, Education Savings Accounts are probably best suited for pre-college expenses. For example, the costs of home computers used by the account beneficiary, field trips, uniforms, and overnight school trips should all qualify to be paid from such accounts-even where the student is in public school. Because the contributions to the accounts are made on an after-tax basis, the real advantage the accounts offer is the avoidance of tax on the account's earnings.

If Education Savings Accounts make sense in your situation, you can jump start your student(s) account(s) by making a 2001 contribution of $500 by December 31 of this year and another $2,000 contribution in January of next year. Of course, your choice of investment vehicles for your contributions should match the timing of expected use of the funds.

Beginning in 2002, you can claim a HOPE Credit or Lifetime Learning Credit in the same year distributions from an Education Savings Account are excluded from income on behalf of the same student. You just have to use different qualifying expenses for each benefit.

Also beginning next year, you can fund an Education Savings Account and Qualified Tuition Plan on behalf of one student in the same year and take distributions from both types of accounts in the same year. Once again, you just have to use different qualifying expenses for each benefit.

Qualified Tuition Programs (QTPs) receive a major overhaul. Qualified Tuition Programs (formerly known as Qualified State Tuition Programs) are already a pretty good deal. They provide a tax-efficient way to save for college. Plus, unlike so many of today's tax benefits, there are no income limits for the purpose of funding or taking distributions from QTPs. Thus, they're available to anyone regardless of income level.

Beginning next year, two big changes are coming for these college-funding vehicles that will make them even better. First, qualified distributions from QTPs will be tax-free starting in 2002. Secondly, private colleges will be able to start their own plans (although the earnings portion of qualifying distributions from such plans won't be tax-free until 2004). With these major improvements (along with a few minor ones also included in the 2001 Tax Act), many people will be taking another look at QTPs to see if they provide at least a partial answer to their college funding needs.

With so many different plans available, however, it's hard to know where to start. One place we suggest is to checkout the following websites: www.collegesavings.org and www.savingforcollege.com. In addition, we're always available to help you sort through the tax and financial issues related to funding a college education.

Estate Taxes Are Still a Threat

Yes, we know the estate tax is (perhaps) on its way out-but there's still work to do.

With the jump in the estate tax exemption from $675,000 in 2001 to $1 million in 2002, many couples need to redo their estate plans. For example, under wills that provide for funding a family trust (where income goes to the surviving spouse and remainder to the children) to the extent of the available estate tax exemption, the trust could receive more than was anticipated, while the surviving spouse might receive less. Standard trust funding formulas may need to be replaced with a percentage of the estate cap or a dollar limitation. Alternatively, some people will want to consider providing that the surviving spouse's share is funded first (in trust or as an outright gift).

Next, the by-pass trust could be filled to the extent of the exemption. Finally, if there's any additional property left, it might also go to the surviving spouse.

Flexible language in wills may also be needed because of the risk of incompetence during a period where it's uncertain what's going to happen to the estate tax. Another option is a revocable trust that allows successor trustees to revise the trust's terms as the estate tax laws continue to evolve.

While the scheduled increases in the exemption are likely to occur, the estate tax itself could well be with us beyond its scheduled 2010 repeal. Thus, individuals need to be careful about dumping what might appear to be unneeded life insurance coverage. The insured's health could take a turn for the worse and replacement coverage might not be available at the point the (formerly) insured discovers the estate tax isn't going away or that it comes back.

Even if your estate is unlikely to be subject to estate tax in the future, it's important not to overlook other reasons for doing estate planning. These include setting up a smooth transfer of property that reduces family discord, disability planning, charitable gifts, asset protection, and health care directives.

You also need to watch for changes in the state death tax rules. As the federal credit for state death taxes phases out, states with a so-called pick up tax will be looking for ways to replace their lost revenue, which may require further adjustments to your estate plan.

Employer Credit for Providing Child Care for Employees

One of the more interesting changes in the 2001 Act could be a real boon for closely held businesses, where primarily (or solely) the owners have children needing child care. A new provision makes a 25% business credit available beginning in 2002 for qualifying child care expenses paid for by the business. This will generally be a better deal than the current dependent care credit that requires employees to first pay income and social security tax on their earnings and then use after-tax funds to earn what is normally a 20% credit for their child care expenses.

Expenses qualifying for this new credit include the cost of acquiring, constructing, and operating a qualified child care facility, or the costs of obtaining child care services from a qualified child care facility. A qualified child care facility is generally defined as one that has open enrollment for the business' employees and that doesn't discriminate in favor of highly compensated employees. However, if the facility is the taxpayer's principal trade or business (i.e., the employer is a day care operator), at least 30% of the children enrolled must be dependents of the taxpayer's employees before the new credit is available.

A Final Caution about the AMT and Tax Planning in General

The ideas discussed in this letter are designed to save regular tax. However, before implementing any of them, many taxpayers will need to consider the effect of the alternative minimum tax (AMT). Because of changes made by the 2001 Tax Act (such as the lowering of the regular tax rates), more taxpayers than ever will be impacted by the AMT in the next few years unless Congress acts to change the rules.

And finally, it's worth a reminder that the goal of a planning strategy should be limited to achieving your personal financial objectives in a tax efficient manner. In other words, unless the tax rate on your income exceeds 100%, taking an economic loss to achieve a tax savings just doesn't make sense.

Conclusion

Through careful planning, it's possible your 2001 tax liability can still be significantly reduced. With advance preparation, it may also be possible to make a meaningful reduction in your 2002 tax liability. We're available to assist you in this effort in any way we can. Please don't hesitate to call us with questions this letter may have raised or for additional ideas on reducing your tax bill. We would be pleased to set up a planning meeting with you in the next few weeks while there's still time to implement changes before year end.

If you have questions about any of the provisions explained in this letter or any questions at all about the new tax law in general, please don't hesitate to call. We look forward to assisting you in planning to reap tax savings from all the good things the new law offers.

Very truly yours,

CPA Advisory Group, Inc.

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