 YEAR-END TAX PLANNING STRATEGIES
The slowing economy and market declines have set the tone for 2008 / 2009 tax policy. At least for now, it appears that the Bush tax cuts will stay in place through 2009 and Congress will continue to consider tax incentives.
Below we list tax planning strategies and significant tax law changes relevant to 2008 / 2009 tax planning.
Individual Income Tax
Harvest Portfolio Losses
Sell loss positions within your investment portfolio prior to year end. Such capital losses will offset capital gains and up to $3,000 of ordinary income. Any realized but unused capital losses will be carried to 2009. Beware, however, of the wash sale rules which will disallow the loss if you repurchase the same or a substantially identical asset within 30 days before or after the sale.
Practice Tax-Efficient Investing
Taxes have a major impact on investment returns and not all investment income is taxed alike. Although your financial objectives should drive your investment decisions, keep in mind the following tax basics of investing:
- Avoid excessive portfolio turnover in your brokerage and/or mutual fund accounts. Capital appreciation is taxed every time a security is sold.
- Avoid purchasing a mutual fund at year-end before its distribution date; otherwise, you may be purchasing an unexpected tax obligation.
- Favor investments generating qualified dividends and long-term capital gains taxed at a maximum 15% tax rate vs. interest income taxed at a maximum 35% rate.
- Beware of tax-exempt private activity bonds – interest is taxable for AMT purposes.
Efficiently Utilize Debt
When debt is appropriately utilized as part of a personal or business investment strategy, significant post-tax benefits can be achieved. Businesses may consider utilizing debt to make year-end asset additions. Investors may consider debt as an alternative to selling assets or as a mechanism to shelter investment income.
Individuals should review their debts to ensure that interest payments qualify for deduction and restructure as appropriate. Interest on home acquisition indebtedness (mortgage) up to $1,000,000 is deductible as is interest on up to $100,000 of home equity indebtedness. Investment interest expense is deductible to the extent of investment income. Interest on borrowings used in a trade or business is generally deductible.
Accelerate Your Charitable Donations
Make donations by year-end for a 2008 deduction. Donations charged to your credit card prior to year-end are deductible in 2008 even if paid in 2009. Increase the tax benefit of your donation by donating appreciated securities.
Note that 2008 brought new substantiation rules for all donations exceeding $250. A donor must receive a written acknowledgement from the charitable organization before timely filing his return. Also, don’t forget that donors must now retain written records for all cash/check contributions regardless of amount.
Establish a Donor-Advised Fund
Donor-advised funds are the fastest growing charitable giving vehicle due to low contribution minimums, cost efficiency and simplicity. Donors receive a current year charitable deduction for contributions. Donor-advised funds are offered by many of the major mutual fund and brokerage firms (i.e. Schwab, Fidelity, and Vanguard).
Donate Your IRA to Charity
Taxpayers 70 ½ and older can make up to $100,000 of tax-free distributions from an IRA to a qualified charity. This tax break has been extended through 2009.
Increase Withholding to Eliminate Estimated Tax Penalties
If you failed to make sufficient estimated tax payments this year and are subject to estimated tax penalties, consider increasing your withholding in the final 2008 pay periods. Income tax withholding is deemed paid evenly throughout the year and can help eliminate penalties when a year-end estimated tax payment may not.
AMT Planning
Despite a year-end “patch” by Congress, the Alternative Minimum Tax (“AMT”) continues to be a big problem in 2008. AMT has the effect of disallowing certain deductions and credits; but in application it’s much more complicated. Therefore, it is usually very difficult to tell whether someone will be subject to AMT without running a detailed tax projection. Even with a tax projection, there are only a few options for planning around the AMT and those options are not much better than paying AMT (i.e. forcing income into the current tax year or avoiding tainted deductions until next year). Making matters worse, many upper-middle income taxpayers will find themselves perpetually in AMT making even good planning worthless.
You may be subject to AMT if: 1) you were in AMT last year, 2) you exercised Incentive Stock Options (“ISOs”), 3) you pay high real estate and/or state income taxes relative to your income, 4) you have ordinary income greater than $175,000, but less than $400,000, and/or 4) you had a large capital gain.
The 2008 “patch” also added two notable AMT relief items. The first item provides relief for individuals who have previously paid AMT on ISOs. The second item permits “nonrefundable personal credits” (e.g. dependent care credit) to offset AMT.
Clients making a large fourth quarter estimated tax payment and/or considering year-end tax planning should seek a tax projection to ensure that the AMT won’t frustrate the intended benefits. Others anxious about AMT may also consider a tax projection with the caveat that most AMT problems don’t have a good fix.
Fund Retirement Plans
You can save for retirement while deferring tax on current earnings by maximizing contributions to your employer-sponsored retirement plan. The 2008 limit for employee contributions to traditional 401(k) plans is $15,500 ($16,500 in 2009) and participants age 50 and older can make an additional $5,000 “catch up” contribution ($5,500 in 2009). If your employer makes matching contributions, be sure to at least contribute enough to receive the full match.
If your employer doesn’t offer a retirement plan you can contribute up to $5,000 to a deductible IRA, and those 50 and over can make an additional $1,000 “catch up” contribution in 2008 and 2009.
Elective deferrals to a SIMPLE IRA in 2008 are limited to $10,500 ($11,500 in 2009), and participants age 50 and older can make an additional $2,500 “catch up” contribution in both 2008 and 2009. SEP-IRA limitations for 2008 are $46,000 or 25% of compensation ($49,000 in 2009).
Roth IRA
If you are eligible to contribute to a Roth IRA you should do so. In order to make a 2008 Roth IRA contribution you must have modified adjusted gross income below $159,000 ($101,000 if you are a single). The 2008 contribution limit is $5,000 plus a $1,000 “catch-up” contribution for those 50 and older. You can contribute to a Roth IRA even if you have already contributed to a 401(k).
Non-Deductible IRA (and Roth Conversion)
If you have not been able to contribute to a Roth IRA due to income limitations, consider making a non-deductible IRA contribution. Under current law, you will be permitted to convert some or all of your IRA to a Roth IRA in 2010, when the AGI limitation is removed. You will be taxed on your account’s appreciation at your marginal tax rates, though Congress allows you to spread the liability over two years. Note, however, that the decision process is more complex if you have significant balances in traditional IRAs due to rules which require basis to be allocated among all of your IRAs.
Education Tax Credits
If you have a child pursuing higher education, and you are not eligible to claim either the Hope or the Lifetime Learning Credits, consider allowing your dependent child to claim them on his or her own individual income tax return. The child doesn’t need to actually pay the qualified higher education expenses themselves to be eligible for the credit. You would not be allowed a dependency exemption for your child though.
Illinois Credit for K-12 Education Expenses
Illinois taxpayers with children enrolled in kindergarten through twelfth grade may qualify for an Illinois tax credit up to $500. The tax credit is 25% of qualified education expenses in excess of $250. Qualifying students must be full-time Illinois residents under 21 attending either a public or private school.
Contribute to a 529 Education Plan
529 plans are the preferred vehicle for tax efficient college education savings. Plan funds grow tax-free and distributions for qualified education costs are non-taxable. Transfers into these plans are eligible for the $12,000 annual gift exclusion. As an added benefit, contributions to an Illinois plan up to $10,000 ($20,000 on a jointly filed return) are deductible on your Illinois return.
Increase in the “Kiddie Tax” Threshold
Beware that kids below 19 (24 if a full-time student) are taxable at parents’ tax rates on investment income exceeding $1,800 in 2008 ($1,900 in 2009). Parents should look for opportunities to direct investment income to their kids up to these limits. This is most commonly done through an UTMA account or trust.
Energy Credits
The credit for household energy efficient improvements which expired at the end of 2007 has been reinstated for the years 2009 through 2016. It has been extended to include biomass fuel stoves, and continues to include skylights, windows, outside doors, high-efficiency furnaces, water heaters and central air conditioners. If possible, delay installation of these items to 2009; the credit will be worth up to 10% of the acquisition cost of the item installed.
Midwest Flood Victims
Midwest flood victims will receive significant tax relief for uninsured flood losses in 2008. Flood losses can be taken as an itemized deduction without the usual casualty loss limitations.
Business Income Tax
Accelerate Planned Asset Purchases Into 2008
In 2008 Congress enacted two significant tax incentives aimed at business investment.
- Congress expanded section 179 small business asset expensing to $250,000 with a cost ceiling of $800,000.
- Congress authorized qualified taxpayers to deduct 50% of the cost of new property purchased and placed in service during 2008 (“Bonus Deprecation”). The property must be MACRS property with a depreciation period of 20 years or less, computer software (off-the-shelf), or qualified leasehold property.
Congress also increased the first-year depreciation limits on automobiles to $10,960 from $2,960.
Consider financing your year-end acquisitions to save cash. The tax savings may offset your entire interest cost.
Manufacturing Deduction
US manufacturers can deduct up to 6% of Qualified Production Activity Income (net income from US manufacturing activities, plus natural resource production, film production, construction, engineering, and architecture). Although the IRS has limited the scope of this deduction to traditional manufacturing activities, any business with a potential manufacturing component should identify such activity.
Write-off Bad Debts
Accounts receivable that become wholly or partially worthless during the year can be written down for an ordinary deduction. It is not enough to simply provide a reserve; you must identify specific receivables which have become worthless during the year.
Holiday Pay and Bonuses
An accrual basis taxpayer is generally entitled to a deduction for January 1, 2009 holiday pay in 2008 if the liability is accrued in 2008 and supported by the company’s holiday pay policy.
Accrual businesses paying bonuses to employees in 2009 can still take a deduction in 2008 as long as: 1) the employee is not an owner of more than 50 percent of the business’s stock; 2) the bonus is accrued on the company’s books before the end of 2008; and 3) the employee receives the bonus within two and a half months after the end of 2008.
Employ Your Minor Children
Business owners with minor children should consider paying them compensation. The business will receive a deduction and the children will pay no or little tax. Furthermore, the child’s earnings could be invested in a Roth IRA for even more tax efficiency.
FICA Limitations
The limitation for FICA tax increased from $102,000 for 2008 to $106,800 for 2009. It is possible in many self-employed and small business contexts to minimize employment taxes via appropriate structuring.
Standard Business Mileage Rate
The standard business mileage rate for the first six months of 2008 is 50.5 cents/mile. Due to the increase in gasoline prices, the IRS increased the rate to 58.5 cents/mile for the last six months of 2008.
Health Savings Accounts
Consider establishing a Health Savings Account (“HSA”) to pay for qualified medical expenses with pre-tax dollars. An HSA is a tax-favored savings account which is paired with a high-deductible health insurance plan. For 2008, the maximum HSA contribution for an individual is $2,900 and for a family is $5,800. Individuals age 55 and over may make a “catch up” contribution of $900. Moneys not used in your HSA account will roll over to the next year, and earn interest tax-free.
Section 125 Plans
Many small businesses are subjecting employee contributions to a medical plan to withholding and employment taxes despite a relatively easy fix. Payroll providers have become more cost-efficient in providing Sec 125 benefit plans including premium only plans (“POP”). With a plan in place, employees can use pre-tax dollars to pay their share of medical premiums.
Section 132 Qualified Transportation Expenses
Code section 132 allows employees to pay for specific qualified transportation costs with pre-tax dollars under an employer plan. Qualified transportation costs generally include mass transportation (train, subway, bus fares) and qualified parking costs. Standardization has increased the cost-effectiveness of these plans. For those with established plans, note that in 2009 the maximum monthly amounts increase to $120 & $230 for transit and qualified parking costs, respectively.
New in 2009, employees can receive up to $20/month as a tax free benefit if they commute to work by bicycle.
New Rules for Nonqualified Deferred Compensation
Employers face a December 31, 2008 deadline to make sure that all plans that pay deferred compensation either comply with the final regulations under section 409A or have been structured to be exempt from section 409A. The rules generally apply to any plan or arrangement that defers the payment of taxable compensation more than 2 ½ months after the end of the year in which it is earned. The consequences of noncompliance are stiff; previously untaxed amounts must be included in income upon becoming vested and are subject to interest and penalty. Qualified retirement plans (e.g., 401(k) plans), certain fringe benefit plans, and health and welfare plans are excluded from these rules. The rules under 409A are complex, and you should review your plan documents with your advisors to confirm compliance.
New Illinois Pass Through Entity Withholding Requirements for Non-Resident Owners
Beginning in 2009, partnerships, S Corporations and trusts are required to remit tax on behalf of their non-resident owners. Payments are made with Form IL-1000 and are due no later than the pass through entity’s tax return due date. Contrary to other state law, non-resident individuals cannot elect out of withholding treatment unless they elect in to a Composite filing. However, a non-resident owner is not required to file an Illinois income tax return if the withholding payment covers 100% of his Illinois tax liability.
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Gift and Estate Tax
Reports from Washington suggest that the 2009 estate exemption and rates will be extended through 2010 (i.e.: $3.5m exemption and 45% rate – avoiding the 2010 repeal). The same reports suggest that the 2009 structure will be made permanent in 2010 (avoiding the 2011 return to a $1m exemption and 55% rate).
This expected legislation as well as the market slump has reduced the urgency for estate tax planning for much of the working wealthy. However, those with potential estates in excess of $3.5m may have added incentive to plan now that outright repeal is unlikely. Finally, don’t forget that estate tax avoidance is only part of the estate planning picture. Don’t use the increased exemptions as an excuse for becoming complacent with your estate plan.
Annual Exclusion Gifts
In 2008 you can gift up to $12,000 to any person without paying gift tax. The exclusion will increase to $13,000 for gifts made in 2009. For added control and asset protection, you can make these gifts to certain trusts for the benefit of your kids. Annual exclusions are a use it or lose it proposition, so if you have a taxable estate, don’t let them go to waste.
Irrevocable Life Insurance Trust
Purchase life insurance via an irrevocable life insurance trust. If appropriately structured, this will keep the insurance proceeds out of your estate. This simple step can prevent the estate tax from eroding as much as half of your insurance proceeds (which also reduces the amount and cost of life insurance you need).
Consider Asset Protection
Wealthy individuals should consider from time to time whether their asset holdings could be structured to more efficiently protect them from creditor claims. Trusts, entities, insurance, and retirement plans can all play a key role in protecting assets from legal claims.
Illinois Estate Tax Decoupling
Even though the Federal Estate Exemption will be $3.5m in 2009, Illinois only recognizes a $2m exemption for purposes of its own estate tax. Therefore, planning is still appropriate for Illinois residents with estates between $2m and $3.5m. Furthermore, because most estate documents tie bequests to the federal exemption, Illinois residents should review their estate documents with their estate planning attorney. Be sure to consider both whether there is a mechanism to deal with the decoupled exemptions and whether the mechanism produces an acceptable result.
We hope you find these tips useful for current and future tax-planning. Have a happy holiday season, and we look forward to assisting you in the near future.
-NDH Group, Ltd.
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