 YEAR-END TAX PLANNING STRATEGIES
Your friends at NDH wish you a happy and healthy holiday season and welcome you to enjoy our year-end tax tips. Cheers!
- NDH Group, Ltd.
Individual Income Tax
Harvest Portfolio Losses
Sell loss positions in 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 2010. 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. Savvy mutual fund investors can lock-in losses and mitigate this 30 day requirement by purchasing similarly classed mutual funds containing a different mix of stocks.
Lock-in Low Capital Gains Rates
Contrary to conventional tax wisdom, consider selling securities before 2011 to lock in low capital gains tax rates. For most investors, long-term capital gains are taxed at 15% through 2010. Absent new legislation, the rate will increase to 20% in 2011. Because the expected tax increase outpaces projected interest rates, investors with future liquidity requirements should consider selling now.
Investors in the 10% and 15% tax brackets currently pay no tax on long-term capital gains. In 2011, this benefit is eliminated. Selling securities prior to 2011 locks in a huge tax benefit.
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.
- Consider exchange-traded funds which often make less tax distributions than mutual funds and have lower expense ratios.
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 acquisitions. Investors may consider debt as an alternative to selling assets or as a mechanism to shelter investment income.
Taxpayers should review their debt positions annually to ensure that they are paying the lowest after-tax rate. Note that not all interest expense is deductible. Interest on home acquisition indebtedness up to $1m 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 in full.
Accelerate Your Charitable Donations
Make donations by year-end for a 2009 deduction. Donations charged to your credit card prior to year-end are deductible in 2009 even if paid in 2010. Increase the tax benefit of your donation by donating appreciated securities.
Donation substantiation rules must be followed. A written acknowledgement from the charitable organization for all donations exceeding $250 is required. You must also retain written support for all cash contributions regardless of amount.
Establish a Donor-Advised Fund
Donor-advised funds are a popular way to make deferred charitable gifts. Donors receive a current year charitable deduction for contributions made to the fund and can later direct distributions to charities of their choice. Donor advised funds are low cost and administratively easy, but they do require a couple weeks to set-up. Act now if you want a 2009 deduction.
Donate Your IRA to Charity
Taxpayers 701/2 and older can contribute up to $100,000 of IRA distributions directly to a qualified charity in 2009. Current rules suspending 2009 required minimum distributions complicate this strategy. If in doubt, consult your tax advisor to weigh the pros and cons.
Increase Withholding to Eliminate Estimated Tax Penalties
If you typically incur estimated tax penalties and have failed to make sufficient estimated tax payments this year, consider increasing your withholding in the final 2009 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.
The rules for avoiding penalty are clear. Simply pay-in, ratably, through withholding or estimated tax payments, 100% of last year's tax liability (110% for high income taxpayers) or 90% of this year's liability.
Congress relaxed these rules in 2009 for small business owners. They are only required to remit 90% of last year's liability ratably throughout the year. Taxpayers with AGI less than $500,000 and who have earned more than 50% of their income from a small business qualify for the exception.
AMT Planning
Alternative Minimum Tax ("AMT") continues to be a problem in 2009. AMT has the effect of disallowing certain deductions and credits; but in application, it's 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 limited options for planning around the AMT, and those options are not much better than paying AMT. Making matters worse, many upper-middle income taxpayers will find themselves perpetually in AMT making even good planning worthless.
The 2009 AMT will operate similar to 2008 AMT except for a slight increase to AMT exemptions. However, planning around the AMT may be a bit more worthwhile in 2009 relative to 2008. AMT planning involves accelerating income and/or deferring deductions (usually not an appealing proposition). However, with tax rates scheduled to increase in 2011 and interest rates low, accelerating taxes might prove beneficial (especially when part of a plan to reduce current AMT).
Fund Retirement Plans
You can save for retirement while deferring tax on current earnings by maximizing contributions to your employer-sponsored retirement plan. The 2009 and 2010 limit for employee contributions to traditional 401(k) plans is $16,500. Participants age 50 and older can make an additional $5,500 "catch-up" contribution. If your employer makes matching contributions, be sure to minimally 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. Those 50 and older can make an additional $1,000 "catch-up" contribution.
Elective deferrals to a SIMPLE IRA in 2009 and 2010 are limited to $11,500. Participants age 50 and older can make an additional $2,500 "catch-up" contribution. SEP-IRA limitations for 2009 and 2010 are the lesser of $49,000 or 25% of compensation.
Roth IRA
If you are eligible to contribute to a Roth IRA you should do so. The ability to contribute begins to phase out for single individuals with modified AGI of $105,000, ($166,000 for joint filers). The maximum contribution allowed is $5,000 plus a $1,000 "catch-up" contribution for those 50 and older.
2010 Roth IRA Conversion Opportunity
Prior to 2010, only taxpayers with AGIs less than $100,000 were permitted to convert from a traditional IRA to a Roth. Congress lifted this limitation for 2010, creating conversion opportunities for all taxpayers. Converters generally recognize income in 2011 and 2012 but future distributions are tax-free. The benefits can be enormous, making this a critical decision for all taxpayers.
You generally want to convert if you:
Other taxpayer-friendly rules that favor converting are:
Many other factors must be considered before making the decision including your existing and projected future tax rates, whether you pay AMT, your time to retirement, and your future estate planning goals among others. Further complicating the choice, many advisors suggest hedging against future tax rates by only converting a portion of your portfolio. We highly recommend consulting your tax advisor to help you make the correct decision for your particular facts and circumstances.
Lastly, don't forget to make your 2009 non-deductible IRA contributions if you plan to convert to a Roth in 2010.
Kiddie Tax
Children under age 19 (24 if a full-time student) pay tax at parents' tax rates on investment income exceeding $1,900 in 2009. Parents should look for opportunities to direct investment income to their kids up to these limits to utilize the child's lower tax brackets. This is commonly accomplished by gifting assets that generate investment income through an UTMA account or trust.
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 for any number of qualifying students. Qualifying student(s) must be an Illinois resident under 21 attending a public or private school.
Education Tax Provisions
The HOPE education credit was renamed the American Opportunity Tax Credit and enhanced for 2009 and 2010 (from a maximum $1,800 to $2,500 per year) and extended to the first four years of post-secondary education. Forty percent of the credit is refundable in these years. The credit is phased out in 2009 for filers with modified AGI starting at $80,000 ($160,000 for joint filers).
In 2009 the Lifetime Learning Credit maximum remains $2,000 and is phased out for individuals with modified AGI starting at $50,000 ($100,000 for joint filers).
As an alternative to the education credits, the Tuition and Fees Deduction may generate greater tax benefits. Run your return multiple ways to determine which option is best.
Education Tax Credits Planning
If you have a child pursuing higher education and you are not eligible to claim either of the education credits , consider allowing your dependent child to claim them on his or her own individual income tax return. The child doesn't need to pay the qualified higher education expenses himself to be eligible for the credit. Note that you would then not be allowed a dependency exemption for your child.
Deduct the Cost of Your MBA
Part-time MBA candidates may obtain larger tax benefits by deducting their education costs as employee business expenses versus taking the Lifetime Learning Credit or the Tuition and Fees Deduction. Qualifying part-time MBA candidates can deduct their education costs if the classes maintain or improve skills used in their current job. The deduction is a 2% miscellaneous itemized deduction and provides no benefit if you're in AMT. Note that the IRS heavily scrutinizes this deduction, so be sure you qualify.
529 Education Plan
A 529 plan is an educational savings vehicle that helps families save for future college costs . T he donor's investments grow tax-free and any distributions for the beneficiary's college are non-taxable. Although there is no federal deduction, many states offer deductions or credits for contributions - Illinois allows a deduction up to $20,000 for married taxpayers. Even if you have a child attending college, consider contributing to a 529 today for a state tax deduction; you can distribute funds for tuition shortly afterward.
Homebuyer Credit
To spur the stagnant housing market, Congress initially passed the First-time Homebuyers Credit in 2008. The credit was little more than an interest free loan at the time, but it has been expanded significantly. The credit has been extended to include principal residence purchases through April 30, 2010. The maximum credit is $8,000 for "first-time buyers" and $6,500 for "long-time residents". The credit phases out at an AGI of $225,000 for married filers ($125,000 for single filers) and is only available on homes with a purchase price of $800,000 or less.
Prepay State Taxes
If you itemize deductions and anticipate owing state taxes, consider paying your fourth-quarter estimate or projected 2009 state tax liability by year-end. You benefit by accelerating your state tax deduction from 2010 to 2009. Note that taxpayers who pay AMT will not benefit.
Energy Credits
A 30% credit, capped at $1,500, is available for the cost of certain energy-efficient property or improvements in 2009. Qualifying property includes high-efficiency heat pumps, air conditioners, and water heaters. It also may include energy-efficient windows, doors, insulation, and certain roofing. Furthermore, there is no limit on the credit amount for qualifying solar electric costs, qualified small wind energy costs, and qualified geothermal heat pump costs.
Special Tax Break for New Car Purchases
The 2009 stimulus package provided a deduction for state and local sales and excise taxes paid on the purchase of qualified new vehicles before Jaunary 1, 2010. Deductible sales or excise taxes may not exceed the amount of the tax attributable to the first $49,500 of the vehicle purchase price . The deduction is phased out for single filers with AGI exceeding $125,000 ($250,000 for joint filers). Unlike prior years, this deduction may be claimed in addition to the state and local income tax deduction on Schedule A.
Health Savings Account
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 2009, the maximum HSA contribution for an individual is $3,000 and $5,950 for families. Individuals age 55 and older may make a "catch-up" contribution of $1,000. Moneys not used in your HSA account will roll over to the next year, and earn interest tax-free.
Business Income Tax
Accelerate Fixed Asset Additions
Significant tax incentives for business investment have been extended through 2009. Therefore, businesses should consider accelerating planned asset acquisitions into 2009 before the incentives expire.
Bonus Depreciation. A business can deduct 50% of the cost of new equipment immediately. The remaining 50% is depreciated under normal accelerated depreciation rules. Qualifying property includes business assets with depreciation periods less than 20 years and qualified leasehold improvements.
Code Sec. 179. The election to expense fixed asset additions continues at expanded levels through 2009. The election can be made on the first $250,000 of qualifying asset purchases. The deduction phases out for businesses with more than $800,000 of qualifying asset purchases in the year. The Sec 179 deduction will return to $125,000 in 2010 with a phase out beginning at $500,000.
NOL Carryback Period
Under a special law enacted in 2009, all businesses can elect to carryback net operating losses ("NOLs") incurred in taxable years beginning after December 31, 2007 and before January 1, 2010 for up to five years instead of the standard two years. Small businesses that made the five-year election on their 2008 returns are not eligible to make another election in 2009. The rules permit businesses to offset 50% of the available income from the fifth taxable year preceding the loss and 100% of all income in the remaining four carryback years.
R & D Credit
The research tax credit is not directed solely at large manufacturing firms; smaller firms including software and other service companies are also eligible. The tax credit equals 14% or 20% of qualifying R&D, depending on the method you elect. Some of the eligible costs include improvements to existing processes, testing for new or improved products and certain software development. The research credit is set to expire after December 31, 2009 but will likely be extended in one of the year-end tax bills.
Manufacturing Deduction
US manufacturers can deduct up to 6% (9% in 2010) of Qualified Production Activity Income (net income from US manufacturing activities, natural resource production, film production, construction, engineering and architecture).
Write-off Bad Debts
Many businesses are struggling to collect their accounts receivables this year. Accrual taxpayers can convert these losses into a tax benefit by writing down receivables that become wholly or partially worthless during the year. Note that 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
Accrual businesses can currently deduct 2009 year-end bonuses paid in 2010 as long as: 1) the employee, combined with immediate family, does not own more than 50% of the company's stock; 2) the bonus is accrued on the company's books before year-end; and 3) the company pays the bonus within 2.5 months after year-end. Accrual taxpayers can also generally deduct January 1, 2010 holiday pay in 2009 if they accrue the liability in 2009 and it is supported by the company's holiday pay policy.
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 will remain $106,800 for 2010. It is possible for self-employed and small businesses to minimize their employment taxes via appropriate structuring.
Standard Business Mileage Rate
The standard business mileage rate is 55 cents/mile in 2009 and 50 cents/mile in 2010 and 14 cents/mile for charitable mileage.
Small Employer Pension Plan Startup Cost Credit
If your small businesses did not have a pension plan during the previous three years you may be eligible to claim a nonrefundable credit for expenses to start and administer a new employee retirement plan. The credit applies to 50% of the first $1,000 in qualified administrative and retirement-education expenses for each of the first three plan years.
Employer-Provided Child Care Credit
For 2009, employers may claim a credit of up to $150,000 for supporting employee child care or child care resource and referral services. The credit is allowed for a percentage of "qualified child care expenditures" including for property to be used as part of a qualified child care facility, for operating costs of a qualified child care facility and for resource and referral expenditures.
Section 125 Plans
Many small businesses require employees to fund medical insurance plans with after-tax contributions 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 include mass transportation (train, subway, bus fares), qualified parking costs and qualified bicycle commuting expenses (purchase of a bicycle, improvements, repairs and storage). Employees may receive benefits for both mass transportation and qualified parking costs during the month, up to the maximum monthly limits for both, as they are not mutually exclusive.
Standardization has increased the cost-effectiveness of these plans. For those with established plans, note that currently the maximum monthly amount for mass transportation and qualified parking is $230, and bicycle commuting expenses is $20. Maximum monthly amounts for 2010 may change based on inflation.
Deferred Compensation Plans
It is critical that clients and their professional advisors comply with Code Sec. 409A of the Internal Revenue Code when setting up deferred compensation plans. If these plans are not appropriately structured, the potential income deferral may fail. During 2010, taxpayers can expect more Code Sec. 409A guidance, including direction on a Code Sec. 409A correction program. The IRS also intends to publish final regulations on income inclusion under Code Sec. 409A.
Illinois Pass-Through Entity Withholding Requirements for Non-Resident Owners
New for 2008 and continued into 2009, Partnerships, S corporations and trusts are required to remit tax on behalf of their non-resident owners to ensure compliance with Illinois tax laws. Payments are made with Form IL-1000 and are due by the original due date of the entity's return. Contrary to other state law, non-resident individuals cannot elect out of withholding treatment unless they elect to do a Composite filing. Non-resident entities, however, may elect out by filing Form IL-1000-E. Note that non-residents are not required to file an Illinois income tax return if their withholding covers 100% of their tax liability.
Gift and Estate Tax
The outlook for 2010 estate tax changes by the day. If Congress doesn't act, the estate tax will be repealed effective January 1, 2010 and then reappear in 2011. Most likely Congress will pass a two year extension of current law (i.e.: $3.5m exemption and 45% rate). However, a majority in the Senate prefer a permanent change to a $5m exemption and a 35% rate. Most commentators expect action by year end or in early January.
Any permanent estate tax change would likely include provisions to reduce the effectiveness of popular planning tools while grandfathering existing structures. Therefore, a wait and see approach to planning may have a cost. Furthermore, the low interest rate environment makes it a great time to plan.
Annual Exclusion Gifts
In 2009 and 2010 you can gift up to $13,000 to any person without paying gift tax. 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.
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
Illinois recognizes only a $2m exemption for purposes of its own estate tax. Therefore, planning is appropriate for Illinois residents with estates valued over $2m even if you are below the federal exemption. Although Illinois passed a relief provision in 2009 to permit deferral to a surviving spouse, many existing plans are not structured to take advantage of this relief.
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