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Year-End Tax Planning

Year-End Tax Planning

December 31st is right around the corner so time is running out for 2006 tax planning for 2006. Some strategies are tried and true – others are new as a result of recent legislation. And so without further introduction…

The traditional strategy of deferring income and accelerating deductions continues to make sense for those taxpayers not subject to the Alternative Minimum Tax (“AMT”).

Deferring income into 2007 means settling up with Uncle Sam need not be done until April of 2008. W-2 taxpayers will have a tough time here but the self-employed should have some flexibility.

Accelerating deductions into 2006 will lower current year taxable income. An additional mortgage payment or prepayment of real estate taxes are a couple of examples. In addition, “bunching” deductions may overcome any IRS-imposed “floors” (such as the 2% of AGI minimum on miscellaneous itemized deductions or 7.5% of AGI minimum on medical expenses) making disallowable deductions deductible. Say that 10 times fast!!

State estimated tax payments for the 4th quarter aren’t due until 1/16/07. However, making payments by 12/31/06 will secure an additional federal deduction for the current tax year.

Finally, for those taxpayers subject to AMT, the strategy of income deferral and acceleration of deductions will result in a permanent loss of tax benefits. It’s important to be careful if any of the following apply:

  • capital gains are a large portion of total income
  • total deductions are large relative to total income
  • you live in a high tax state (e.g. NY, CA)
  • incentive stock options (“ISOs”) were exercised

For taxpayers with income in excess of $150,000, the IRS requires a combination of withholding and/or estimated payments equal to or greater than 110% of 2005’s liability or 90% of the estimated 2006 liability. Estimated payments are recorded when paid whereas withholding is deemed to be withheld equally throughout the year.

You may find yourself with insufficient withholding if you had large lump-sum components to your income. Common examples include bonuses, stock option exercises and vesting of restricted stock.

A common fix is to increase payroll withholding. For taxpayers receiving qualified plan distributions, ask the trustee or custodian to withhold some/all of the distribution. If cash flow is a concern, making an estimated payment instead will “stop the clock” on the calculation of interest due to insufficient withholding.

The maximum pre-tax 401(k) contribution for 2006 is $15,000. An additional $5,000 contribution is available for taxpayers age 50 or older. Be sure to maximize your contribution to lower your AGI and increase your tax-deferred investment dollars.

The maximum IRA contribution for 2006 is $4,000. An additional $1,000 contribution is available for taxpayers age 50 or older.

Consider a Roth IRA if your income is less than $110,000 (single filers) or $160,000 (married joint filers).

A Roth conversion is available if your AGI is less than $100,000.

Finally, the self-employed might consider establishing a retirement plan such as a SEP-IRA. For 2006, the maximum contribution can be as high as $44,000 depending upon the amount of self-employment income.

The favorable stock market in 2006 means gifting appreciated securities instead of cash might make sense. Doing so avoids capital gains taxes that would be due at sale yet preserves the charitable deduction.

Also available for consideration is a Charitable Remainder Trust (“CRT”). The idea is to gift appreciated securities to the trust, sell the security to avoid capital gains taxes and enjoy an income stream until the trust terminates (with ultimate distribution of trust assets to a charity).

Finally, a new strategy (thanks to The Pension Protection Act of 2006) allows for “qualified charitable distributions” from an IRA. This is a complex strategy that benefits taxpayers in specific situations. Please refer to our 9/5/06 commentary on PPA for additional information.

A common strategy for securities you wish to hold but currently have an embedded “paper loss” is to sell the securities, realize the tax loss and repurchase the securities. Be careful not to run afoul of the wash sale rules.

Capital losses are disallowed if you sell and repurchase a “substantially identical security” within a period beginning 30 days prior to and ending 30 days after the sale. You must wait 31 days or, should you wish to maintain exposure to that security (or sector), consider purchasing a security that will not meet the “substantially identical” test such as an exchange-traded fund (“ETF”).

Consider paying your children for household chores. They can use this “earned income” to fund a Roth IRA. Payroll withholding is a non-issue as wages do not include domestic service in a private home. Further, wages attributable to employment by a parent in a private home are exempt from social security taxes.

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These are some of the more common strategies. Additional strategies are available. Use of any strategy is dependent upon the specifics of the situation. Have questions? Give us a call or send us an e-mail and we’ll be happy to discuss your situation with you.

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