2008 Year-End Tax Planning
Mr. Obama’s tax policy proposals focused on preserving the tax cuts that were implemented by President Bush in 2001 and 2003 for married couples earning less than $250,000 and single people earning less than $200,000, while reinstating the income tax rates that applied to the upper two individual income tax brackets during the Clinton administration. Accordingly, under Mr. Obama’s tax proposal, the current tax rates of 33 percent and 35 percent would be increased to 36 percent and 39.6 percent, respectively. The proposed tax policy would also apply a 20 percent capital gains rate and qualified dividend rate, and reinstate the personal exemption phase-out and itemized deduction limitation for those taxpayers in the top two tax brackets. Given the current emphasis on reviving the economy, it now appears that the implementation of these tax increases may be deferred.
As we approach year-end, taxpayers should remain focused on their personal income tax liability and those tax saving techniques that may alleviate the inevitable financial burden many associate with April 15.
Recommendations for 2008 year-end tax planning address many concerns and techniques that were useful in previous years, such as the federal alternative minimum tax (AMT), capital gains and retirement planning, but also incorporate some of the new options resulting from the recent enactment of the Emergency Economic Stabilization Act of 2008 (EESA). Due consideration must also be given to many of Mr. Obama’s proposed tax changes (or some iterations thereof) that will likely be adopted in 2009 making the tax planning process even more challenging in 2008.
Alternative Minimum TaxWhen AMT was enacted in 1969, it was originally designed to safeguard against the “very wealthy” exploiting certain tax incentives to avoid paying income tax. However, due to a failure to adequately index available AMT exemption amounts to fairly represent inflation along with a phase-out provision for higher income tax earners and the reduced marginal rates that took effect in 2001, the number of taxpayers subject to AMT will dramatically increase over the next decade. As in previous years, Congress has provided in 2008 under EESA yet another temporary solution to the AMT issues by increasing the AMT exemption from $44,450 to $46,200 for individuals and from $66,250 to $69,950 for married couples. As year-end approaches, it is imperative that taxpayers consider the potential application of the AMT.
Taxpayers that may be particularly vulnerable to the AMT live in states with high income taxes (such as California, New York, Montana, Oregon and Vermont), high property taxes (such as New York, Illinois and New Jersey) and deductible personal exemptions. Other taxpayers prone to the AMT include taxpayers with large long-term capital gains or qualified dividends, large miscellaneous deductions, large deductions for accelerated depreciation and taxpayers who have exercised incentive stock options (the bargain element of an incentive stock option is not subject to ordinary income tax when exercised, but is subject to AMT). As in 2007, taxpayers who have a long-term AMT credit (originating in 2003 or earlier) continue to be eligible for a refundable credit equal to the greater of $5,000 or 20 percent of the unused minimum credit, subject to certain AGI phase-outs. This is primarily intended for taxpayers who received an AMT credit from the exercise of incentive stock options.
To adequately plan for the AMT, a taxpayer should not only project his or her income for the current year but for the next two years as well. Many of the techniques that may be utilized to avoid or alleviate the AMT entail the acceleration of income or the deferment of certain deductions that the AMT calculation does not recognize and should only be considered with the advice of a qualified tax advisor. For instance, if based on the projections a taxpayer expects to be subject to the AMT in 2008 but not in 2009, he or she should consider accelerating ordinary and short-term capital gains income and deferring certain non-AMT deductions, such as state and local income taxes, real estate taxes and investment advisory fees, to 2009. Although this concept may seem counterintuitive to general tax planning principles, the imposition of the AMT rates on ordinary and short-term capital gains income may provide a better result than if the taxpayer’s regular marginal rates applied. Conversely, if the projections demonstrated that the taxpayer would not be subject to the AMT in 2008, but would likely be subject to the tax in 2009, he or she should consider accelerating expenses that are not deductible for AMT in 2008. For instance, a taxpayer may want to prepay state income tax, property tax or home equity debt if the interest expense is not deductible for AMT purposes.
Clearly this analysis becomes more of a challenge until Congress provides some certainty regarding the status of AMT for 2009. Under Obama’s proposed tax plan, he does not intend to repeal AMT. However, his plan does propose extending and indexing the temporary increase in the AMT exemption, which would stabilize the number of AMT taxpayers. Coincidentally, if Obama’s tax plan is enacted, the increased tax rates for the upper two tax brackets (described above) will also limit the application of AMT because more high-income taxpayers will be paying at ordinary income tax rates. Accordingly, a taxpayer should instruct his income tax advisor to calculate various projections based on the current AMT exemptions and the projected AMT exemptions and ordinary tax rates that may apply under Obama’s proposed plan in 2009.
Capital Gains and Qualified DividendsAs in previous years, a taxpayer should evaluate his or her capital gains transactions from the sale of investments and consider offsetting the gains with year-end sales of capital investments that have a history of underperforming and will produce capital losses. However, a taxpayer must be aware of the wash-sale rules if he or she intends to sell a loss position and reacquire the position within 30 days. Although the current long-term capital gains rate generally remains at a favorable 15 percent, strategizing the timing of a taxpayer’s capital loss recognition not only alleviates a taxpayer’s overall tax liability but also may inspire a much needed rebalancing of an investment portfolio. In addition, it is also important to note that losses taken in excess of gains may offset ordinary income up to $3,000 ($1,500 for married individuals filing separately) and any remaining amount may be carried forward.
If you believe that the capital gains tax rate change proposed by the Obama tax plan will take effect in 2009, consideration should be given to the timing of the recognition of gain for any long-term, appreciated asset. A taxpayer should have a complete analysis performed by his or her tax advisor to determine whether the potential tax savings provided by selling the asset in 2008 (while subject to a 15 percent capital gains rate) are advantageous enough to justify the costs associated with the sale and perhaps a purchase of similar assets with the proceeds. Commonly, the transaction costs and lost use of the money needed to pay the taxes exceeds the savings provided by the lower capital gains rate.
Due to the capital gains and qualified dividend rate differential between taxpayers in the two lowest tax brackets (5 percent) and those in the highest four tax brackets (15 percent), taxpayers should consider transferring dividend producing appreciated stock to their children or grandchildren. The recipient will take the taxpayer’s basis in the stock transferred; however, assuming the recipient is not subject to the so-called “Kiddie Tax” and is in the lowest two tax brackets, the transfer could result in an immediate 10 percent tax savings on both capital gains and any dividends received following the transfer (15 percent savings for any qualified dividends received in 2009 and thereafter under the Obama plan). Assuming the taxpayer has properly planned with his or her tax advisor to ensure that the transfer qualifies for the annual gift tax exclusion (and the annual generation-skipping transfer tax exclusion, if applicable), he or she will have successfully alleviated his or her tax liability, reduced the overall tax effect on the transferred asset and simultaneously satisfied a family wealth transfer objective. If the child, however, is either under age 19 or a full-time college student under age 24, any amount of the child’s unearned income (e.g., dividends, interest and capital gains) over $1,800 is subject to Kiddie Tax, which either taxes the income at the parents’ top tax rate on the child’s return or adds such income to the parents’ income as ordinary income, qualified dividends, or capital gains distribution on the parents’ return.
Retirement PlanningContributions to traditional individual retirement accounts (IRAs) and qualified retirement plans are an essential component of a successful financial plan that also may provide an opportunity to reduce the taxpayer’s current tax liability. A taxpayer should consider contributing to his own IRA, or a spousal IRA if his or her spouse has little or no earned income and is not currently participating in an employer-sponsored retirement plan. The maximum contribution that can be made to each IRA is $5,000 for 2008 ($6,000 for individuals who have reached age 50), which may be applied retroactively if made before the tax filing deadline. However, the deduction for such contributions is gradually phased out for married couples filing jointly who have adjusted gross income between $85,000 and $105,000 (between $53,000 and $63,000 for single filers). Despite the loss of the tax deduction, the amounts contributed to the IRA will be permitted to grow tax-deferred thereby still providing a good retirement planning option.
Similarly, a taxpayer may want to consider a contribution up to a maximum of $5,000 for 2008 ($6,000 for individuals who have reached age 50) to a Roth IRA if he or she is not restricted by the income limitations, which gradually phase out the allowed contribution for married couples filing jointly who have adjusted gross income between $159,000 and $169,000 (between $101,000 and $116,000 for single filers). Although contributions to a Roth IRA are not deductible for tax purposes, the income earned in the account may be free of federal income tax when the taxpayer makes withdrawals.
To take advantage of the benefits of a Roth IRA, which, in addition to tax-free earnings, also includes the option of making additional contributions to the account after age 70-1/2 and the avoidance of the mandatory distribution rules applicable to IRAs during the owner’s lifetime, a taxpayer may want to consider converting an existing IRA to a Roth IRA. Although the conversion will result in an immediate tax recognition, the added benefits of a Roth IRA described above may make this a useful wealth transfer vehicle. In 2008, only individuals with modified adjusted gross income below $100,000 may convert their IRAs to Roth IRAs; any minimum required distribution amounts received by the individual from IRAs will not count toward the $100,000 limitation. It is important to note that beginning in 2008, a taxpayer who otherwise qualifies for a Roth IRA conversion and receives a distribution from an employer plan may roll the distribution directly from the employer plan to the Roth IRA.
Contributions to a qualified retirement plan, such as an employer-sponsored 401(k) or 403(b), are funded with pre-tax money and therefore are not includible in the taxpayer’s gross income. The maximum contribution to a qualified retirement plan is $15,500 for 2008 ($20,500 for individuals who have reached age 50) and such contributions must be made before the end of the calendar year. Similar to an IRA, the account grows tax-deferred, therefore, the taxpayer is not taxed on his or her contributions and earnings until the taxpayer makes a withdrawal from the account. It is important to note that an individual may be permitted (if offered by his or her employer plan) to allocate a portion or all of his contributions to a Roth 401(k) or 403(b). As with a Roth IRA, the contributions will be made with after-tax money but the distributions may be taken free of federal tax. Unlike a Roth IRA, a Roth 401(k) is subject to the mandatory distribution rules, which require that minimum distributions from the account must begin in the year following the year the participant turns age 70-1/2. However, a participant may roll over his or her Roth 401(k) to a Roth IRA to avoid having to make such distributions during his or her lifetime. Over time, this could result in more after-tax wealth.
As part of Obama’s economic stimulus package, he would permit retirement accountholders to take penalty-free hardship withdrawals of 15 percent from an IRA, up to $10,000, through 2009 and retrospectively for 2008. Further, he has proposed to suspend IRA and qualified retirement plan minimum distribution requirements that now apply to accountholders over age 70-1/2.
Charitable GivingTaxpayers can increase their charitable deductions by donating marketable securities that have appreciated in value to their favorite charity or a donor advised fund. They can take a deduction up to 30 percent of adjusted gross income for the securities’ fair market value on the date of the gift. The deduction is also allowed for AMT purposes. If, however, the securities were sold first and then the net proceeds contributed to the charity or donor advised fund, the taxpayer will generally incur either regular tax or the AMT on any capital gains.
The charitable rollover, which permits individuals who are at least 70-1/2 years old to distribute up to $100,000 of their IRA balance to a charity tax-free, has been extended by EESA. The extension applies to distributions made in 2008 and 2009. As in 2006 and 2007, taxpayers may not take an itemized deduction for the contribution and the amounts contributed are not includible with charitable contributions for purposes of applying the annual AGI itemized deduction limitations; however, the amount contributed will count toward the taxpayer’s required minimum distribution for 2008. Situations where a charitable rollover may be worth considering include where the taxpayer’s retirement distributions make up a large part of his or her taxable income, where he or she is subject to a phase-out of itemized deductions, where he or she does not itemize deductions or itemizes only for the purpose of obtaining charitable deductions, or where his or her IRA distribution results in higher taxation of social security benefits. Charitable rollovers may be made
to public charities only, and not donor advised funds or private foundations.
It is also important to note that EESA provides a temporary change to tax law regarding charitable cash gifts to Midwest disaster relief efforts. While, under the existing law, the maximum amount deductible by an individual in any one year is 50 percent of adjusted gross income, that limit is being increased temporarily to 100 percent for cash gifts made to Midwest disaster relief efforts during 2008.