Year End Tax Planning

As the end of 2009 approaches, we offer this summary of traditional tax planning techniques, sprinkling in reminders of some new and some expiring tax law opportunities.

As always, year end tax planning must begin with an assessment of whether you expect your marginal tax rate exposure to be higher or lower in the coming year. Federal income tax rates are now widely expected to remain constant for 2010, with the Bush-era tax cuts allowed to expire on December 31, 2010. For our clients in California, however, budgetary measures have already resulted in a temporary .25% increase in all tax brackets effective for 2009 and 2010. (After November 1, 2009 California employees will notice that their withholdings have been increased by 10 %.) Therefore the assessment of your marginal tax rates should be focused primarily this year on your expected volume of income and deductions, rather than anticipated changes in the tax law itself between now and next year. Accordingly, the general rule of deferring income and accelerating deductions will continue to apply in most cases.

Traditional Techniques

Compensation - Some employers will permit employees to defer receipt of anticipated, but unearned salary and bonuses, into a later year. This will require a written agreement between the parties as you cannot accomplish this deferral by simply not accepting or depositing your paycheck until after December 31. A word of caution: salary deferral is not wise if there is any serious concern about your employer’s ability to pay in the future.

Another employee compensation deferral technique would be to delay the exercise of employer non-qualified stock options until after year end. Similarly, self-employed persons and landlords may defer the receipt of fee income by delaying client and tenant billings or temporarily suspending collection efforts on overdue accounts.

Retirement Plans – Pre-tax 401(k) deferrals and retirement plan contributions should be maximized. Current year deductions for contributions made timely in the subsequent year are available for IRA and Keogh account holders. However, Keogh accounts must be opened before December 31 in order to take advantage of this rule.

Required minimum distributions ("RMDs") for persons aged 70 ½ or older have been temporarily suspended for the 2009 tax year. Recent IRS guidance provides that if you’ve already received a 2009 RMD, you have until the later of November 30, 2009 or 60 days after the date of distribution to roll over that amount to an IRA or other retirement plan and avoid paying income tax.

Capital Gain Transactions – Though market conditions and strategic investment considerations may outweigh the tax implications, the simplest way to defer capital gain recognition is to postpone the sale of appreciated assets until the following year. If the closing of a property sale cannot be deferred, the buyer may be pleased to accept installment payment terms that allow you to shift a large portion of the gain into the next year. Interest income will accrue to you on the deferred payments.

Another strategy for minimizing net taxable capital gains is what we deployed very extensively last year and early this year: capturing tax losses. If, however, there are any losses still remaining in accounts that we don’t manage, let us help you to arrange to capture that tax loss now. Even if you don’t have net capital gains this year, the loss will be usable in future years against gains that would later be taken.

Alternative Minimum Tax – As many of our clients have experienced, AMT is essentially a flat tax computation that generally includes all of the income taxed under the regular income tax regime, but disallows deductions for taxes paid, home equity & 2nd residence mortgage interest, employee expenses, and investment–related costs. In addition, the tax code requires adjustments for certain other items that are deemed to receive preferential treatment for regular tax purposes. The net impact of the AMT is to make taxable certain income items that otherwise would have been deferred or exempt and to defer or deny tax benefit for certain exclusions and itemized deductions.

Common Planning Opportunities

  • If you are otherwise going to be subject to AMT in 2009, consider deferring the payment of regularly tax deductible items such as state income and property taxes to the following year. You should weigh the benefits of the deferred payment against any potential penalties for late payment.

  • Consider not using accelerated methods of depreciation or making first-year expensing elections of business equipment if it appears that you will be paying AMT on a regular basis.

  • The bargain element of an incentive stock option is an adjustment item subject to AMT. You can postpone making this adjustment by deferring exercise until a later year or eliminate the adjustment by selling the shares within 12 months of the exercise (i.e. disqualifying disposition) and treating the bargain element as compensation in the year of sale.

  • If you project that you will be subject to AMT in the current year but not in 2010, you may consider accelerating income in order to take advantage of the lower 26% or 28% AMT tax rates.

Itemized Deductions – The timing of certain deductible payments may determine the value of the cumulative tax deductions. In some cases, adjusted gross income (“AGI”) limitations and AMT can erase the entire benefit. To address these concerns, you might bunch certain deductions in a single year in order to minimize the impact of such limitations. The decision will often hinge on whether the net present value of the increased tax benefit exceeds the potential cost of late payment fees or reduced investment return. We can, of course, assist you in evaluating these trade-offs.

Common Planning Opportunities

  • Bunching medical and investment fee payments into one year to minimize the impact of AGI limitations.

  • Using home equity indebtedness to refinance up to $100,000 of credit card or other non-deductible debt.

  • Prepaying or deferring state income or property taxes in order to reduce the impact of AMT.

  • The structure and timing of charitable donations can have a big impact on your year-end tax planning strategy. You may consider accelerating the fulfillment of charitable pledges in years where your AGI is unusually high. Contributions charged to your credit card in 2009 will be immediately deductible, even if the payment of your account balance doesn’t occur until a later year. Giving long-term appreciated securities will provide the dual benefit of a fair market value deduction and the avoidance of capital gains taxes. Individuals aged 70 ½ or older can give up to $100,000 directly from an IRA to a qualified charity without recognizing any taxable income.

  • Taxpayers with charitable contribution carryovers that expire in 2009 will probably want to try to accelerate income in order to maximize the use of the available deduction. The sale and, if desired, immediate repurchase of short-term appreciated securities (so long as the gain would not be offset by accumulated losses...right now, many clients have substantial loss carryovers) and/or taxable bonds (in order to accelerate the receipt of accrued interest) can assist in this effort.

Income Tax Withholding and other Pre-Payments - If it appears that you have underpaid your 2009 estimated taxes, you may be able to make up the shortfall by increasing the withholding on your remaining paychecks or bonus compensation in the final months of 2009. Since withholding is generally treated as having been paid ratably throughout the year, you may be able to eliminate the estimated tax penalty that would have been due for a previous quarter.

If we are not ourselves preparing your taxes, we will be in touch with your tax preparer in December about any issues that should be taken into consideration when preparing tax projections and determining your optimal tax payment schedule. In addition, we will forward tax information for the investment portfolios that we manage for the full year 2009 to your tax preparation in February 2010.

Expiring Tax Provisions – Two special tax breaks are scheduled to expire soon. The first time homebuyer credit is available only for purchases that close before December 1, 2009. The deduction for qualified motor vehicle sales taxes (on the first $49,400) of the cost of a new car or other qualified vehicle is only available for purchases in 2009.

Gift Taxes – All taxpayers are allowed to give up to $13,000 (2009 annual exclusion limit) to as many people as they wish without incurring a gift tax liability. This valuable exclusion should be considered a fundamental, annual component of every estate plan.

Your client service team is eager to work with you to plan for and then execute these transactions as early as possible to avoid any year-end rush.

Roth IRA Conversions

In 2010, the former income ceilings on eligibility to convert regular IRA’s to Roth’s will be eliminated. For the first time, all of our clients will be eligible to convert their existing IRA’s (with their drawbacks of required distributions and full tax exposures on those distributions) to a vehicle that can escape future distribution requirements and, once tax is paid on the conversion itself, is free of future income tax liability.

We believe that this opportunity will be highly attractive for a very large swath of our clients. For many, there is a considerable amount of money and substantial tax liability at stake. We will devote a special communiqué on the detailed planning ramifications later this fall. We suspect that a very large number of IRA’s will be appropriate to convert...very early in 2010…especially since a safety valve exists: any conversion can be "undone" as late as October 15, 2011. From here, we have a 2 year free pass on maximizing a truly rare opportunity to optimize tax and investment planning for substantial portions of many clients’ portfolios.

Ray Edwards

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