In many cases, the best we can do is delay or postpone taxes. The classic illustration is a "Traditional IRA," where we take a deduction now but pay tax when we withdraw the money from the plan at some distant point in the future. In addition to a current tax deduction, the income on the funds in the IRA plan are allowed to accumulate on a tax free basis until withdrawn. By deferring the tax on our IRA funds in this manner we can accumulate considerable fortunes over time.

Sometimes, even a deferral of 1 year can result in a substantial saving. For example, lets say you have a "once in a lifetime" deal for sale of property that will give rise to a large profit. You have the choice of closing on the transaction in late December or January of next year. If all other factors for this year and next will be the same, I would recommend a delay of the closing until January of next year. By doing so, the large tax on the large profit becomes due April 2005, instead of April 2004. Thus, you get to earn interest on the tax money for an extra, full year. You also get a full year to plan for the tax, and possibly arrange your other transactions to minimize the tax bite on the large gain.

There are also occasions where we can avoid penalties by deferring income or adjusting withholding taxes before year-end. We also look to avoid penalties for not taking enough "required distributions" from your IRA plan. In sum, we use this last opportunity before the end of the year to avoid costly mistakes that you may not even be aware of.

2. Since every taxpayer is unique it is imperative to run the numbers before taking any action. No scratch computations on the back of an envelope are allowed here. You have to intelligently consider the long and short term effects of your decisions, complex and ever-changing tax laws and rates, and ungodly computations, such as the Alternative Minimum Tax. I like to run the numbers for this year and as many future years as can be reasonably estimated. Once I have the information in my computer I can easily change assumptions or run the numbers under different tax scenarios to optimize the plan for the best tax results.

Don't get tax advice from your broker. Most brokers suggest that you offset gains from profitable transactions by selling other securities that have not been profitable before the end of the year. This suggestion represents the "conventional wisdom." Be warned, however, the conventional way of thinking may not be wise for you. As stated above, you first have to run the numbers. Otherwise, you won’t be able to tell if it is better to save your paper losses until next year. Contrary to convention, I am suggesting there are situations where it may be better to pay a small capital gain tax this year so that you can achieve a larger savings next year.

I am not advocating the total overthrow of "conventional wisdom." There are occasions, by luck or coincidence, when your broker is right on target with regard to tax advice. So if you fall within the textbook classification it may be best to follow the crowd and match your gains against losses. It still would be best to have your accountant tell you this instead of your broker. Save your broker for his or her proper function, that is, providing sound investment advice.

While economic motives are paramount, tax consequences cannot be ignored. I encountered an extreme example of what not to do during the 1999 tax season. A long-time, valued client and friend informed me on April 14^th that she had rearranged her entire portfolio. She had been religiously saving and investing in various mutual funds for about 25 years. Her investments did well and everything was going fine until the previous summer. Her broker decided to make a career change and he switched his employer from one large financial institution to another. All of these large financial institutions manage their own mutual funds. For example, Merrill Lynch has it’s own "Utilities Fund," as does Schwab, Fidelity, Prudential, and so on. My client thought it would be a simple matter to switch from "Company A Utility Fund" to "Company B Utility Fund." After all, she wasn’t receiving any cash and both funds were similar, if not identical. Unfortunately, her broker did not warn her of the tax consequences. He should have known she had built up a large profit on these long term investments. He should have realized there would be taxable gains as a result of the switch. He should have advised her to consult with her accountant before the transactions took place. I had the unpleasant task of notifying my client that she owed an additional $22,000 in taxes by the next day. This entire hassle was created simply to accommodate the broker’s convenience in changing employers. My client now owns similar funds with Company B, however, she now has $22,000 less invested in them.

IRA/Roth IRA plans. You don’t have to make a decision about an IRA for this year until April of next year. However, you need to satisfy income limits in order to qualify for most IRA deductions. So you may want to consider postponing that year-end bonus until next year in order to qualify for an IRA this year.

Keogh plans. If you are self-employed and you want something more elaborate than an IRA, it is imperative that you act before the end of the year. There are numerous possibilities and different types of plans available from virtually every financial institution. You don’t have to make your full contribution to the plan until next April (and that usually can be extended by a valid tax return extension), but a Keogh plan must be opened with a minimal deposit before December 31. It is possible to claim a deduction for both an IRA and a Keogh plan, if you satisfy the income limitations. In fact, strange as it sounds, I have seen cases where a contribution to a Keogh plan lowered taxpayers incomes enough so that they then qualified for IRA contributions.

Sale of a vacation home. Many clients in lower brackets do not have any tax problems until they sell a vacation home or some other long-term investment. Unlike the sale of your principal residence, the sale of a vacation home is fully taxable. If you owned the home for a long time you may have a large profit when you sell. If you get in touch with us before you go to contract we may be able to suggest tax savings strategies (perhaps an "installment sale"). Even if we don’t have an opportunity to review the contract, if you call us before the end of the year we may be able to suggest other tax savings strategies, such as early payment of deductible expenses to alleviate the tax bite. Most commonly, it often helps to pay the state tax on the gain before December 31.

Grouping of deductions. Many taxpayers file "short forms" every year without realizing potential savings that may be achieved by careful timing of payments. To illustrate, assume that an unmarried taxpayer has itemized deductions (medical expenses, taxes, mortgage interest, contributions, etc.) of $4,500 every year. Since this is less than the standard deduction this taxpayer files a "short form." What could this taxpayer do?

Elderly taxpayers.
Ideally, we should start our retirement planning when we are very young. In a "text book" situation, we would take tax deductions for our pension contributions while we are still working and in higher tax brackets. Then we would pay tax at lower rates when we withdrew the funds from our plans after retirement. It doesn’t always work out this way, especially for affluent taxpayers that remain in high tax brackets after retirement. Either way, planning opportunities abound as we approach retirement age and even long thereafter. Some of the most common situations I encounter in this area are as follows:

Social Security planning. The decision as to what age to start collecting benefits should be based on economic factors. Unfortunately, many elderly people make this choice for emotional or other personal reasons. I’ve heard all sorts of stories, such as, "I may die before I get to collect a penny!" Or, "I want to collect what I’ve earned before the system goes bust!" Even my own mother filed her claim the minute she turned 62, without even a hint or a telephone call to her dedicated accountant. Had she called I would have forewarned her that she would have to pay income tax on part of the benefits. If I recall correctly, the problem was exacerbated by the fact that my father was still working. If she knew about the tax consequences she would have postponed her decision to collect until age 65.

In the near future there will be economic reasons to decide to collect early. The ratio of benefit recipients to workers paying into the system has increased to an alarming rate. To make matters worse many of our country's jobs are being exported overseas. In a couple of years, there simply won’t be enough workers around to pay for all the retiring "baby boomers." Although drastic changes to the system are necessary I don’t think our lawmakers will get around to it in the near term due to what I’ll call "political inertia." It would be politically untenable to cut Social Security benefits at this time. Our leaders will probably wait until it is too late before they take any action. So you may be inclined to dip into your benefits early, while you are still allowed to do so.

Social Security benefits become partially taxable as your income exceeds certain limits. Income, for the purpose of the lower limits, includes your regular adjusted gross income plus half of your social security benefits plus all of your tax exempt income. This limit starts at $25,000 for single taxpayers and $32,000 for married taxpayers filing jointly (usually $0 for married filing separately). If your income is below these limits you will pay no tax on your benefits. In this situation you should avoid unusual transactions that might push you over the limit. For example, if you need cash and are considering selling stock that will generate a large profit, you might consider selling half this year and half next year. Better yet, you might consider borrowing on margin against the stock until a more opportune time, or until another source of funds arises.

Perhaps you can time your other income to lessen or eliminate the tax on social security benefits. You may also use the grouping of deductions and other ideas expressed herein to lessen the blow. However, you may not use tax exempt bonds to reduce the tax on your social security benefits. As stated above, you have to add back all of your tax exempt dividends and interest in the determination of whether your benefits are taxable. Thus, for some people, these tax-exempt bonds are really not tax exempt. If I were to recommend tax-exempt bonds to someone in this situation I would be grossly negligent. The clear choice here would be to opt for the higher yield available on a US Treasury bond, or consider another secure, taxable instrument.

Pension distributions/rollovers/severance packages. I have witnessed many cases where corporate takeovers or cost cutting measures have forced clients into early retirement. The process is often complicated by the "lump sum" payment of pension benefits and/or 401k plan accumulations, severance packages, stock options, and other benefits. The usual strategy is to "roll over" any "qualified plan" distributions, thereby continuing the tax deferral. However, if you don’t plan to go back to work, you may be in a lower tax bracket next year, and a completely different strategy might make sense. Perhaps in your case only a partial rollover is advisable. Depending on your situation, there can be planning opportunities or tax pitfalls.

Minimum IRA distributions. Under the Internal Revenue Code, "The term "required beginning date" means April 1 of the calendar year following... the calendar year in which the employee attains age 70 ½..." Why our legislatures have to complicate things in this way is beyond me. I often wonder who the lunatic was who thought of using your "half birthday." Why couldn’t they just leave it at age 70 or 71? To translate this into plain English, you have to start taking distributions from your "Traditional IRA" by approximately age 70. IRS has recently lightened up with regard to the amounts you are required to withdraw from your IRA each year. But the distribution rules are still extremely complex and decisions you make when you start taking distributions can be binding for years to come. Your choice of beneficiary will also have an impact on future computations. If you have a substantial amount of assets in IRA plans you must seek competent tax advice with regard to formulating a distribution strategy.

Modest Income Elderly People. Many elderly clients get by on their social security benefits and modest pension or other income. Some of them are not even required to file tax returns, until a "once in a lifetime" transaction occurs. That might be sale of the family farm, in which case it is likely my client is now a millionaire. More commonly, it is the sale of the long time family residence, which has dramatically escalated in value over the years, and is now fully paid off. Even if the gain is not taxable, my client now has income from investing the money received on the sale. If you, or your parents, are in this situation, you should consider taking larger IRA distributions this year while you can still pay little or no taxes. It is probable that you (or your parents) still have real estate tax deductions to offset the IRA income. You can repeat and re-evaluate this strategy at the end of next year if the ranch, house, stock, artwork, or whatever has not yet been sold. The longer you have to plan for this "once in a lifetime" transaction the more you will be able to save in taxes. Consider the fact that, eventually, someone has to pay tax on the funds accumulated in a traditional IRA. This tax can be close to 50% (including NY State and NY City) if you are forced to take the IRA distribution at an inopportune time. This tax can be zero if you carefully plan the timing of your IRA distributions.

Bad Financial Year.
Perhaps you suffered a disaster, such as a fire or flood, or extraordinary medical or other expense. Maybe it was a financial disaster, such as a failed business. Whatever the reason, if you had a bad year you can take solace in the fact that you won’t be paying as much tax as usual. In extreme cases, you may be entitled to loss "carry-forwards" and "carry-backs" to other tax years in addition to a refund on this year’s return. The planning opportunities depend on the nature and extent of the loss, and are too complex to get into now. Suffice it to say that you may want to consider any measure that would accelerate income into this year. If you have a large profit on a stock or other investment, consider selling before year end. If you have a "traditional IRA," consider a "roll-over" into a "Roth IRA." With steps like this, and other careful planning, you can make the best of a bad financial year.

Wealthy & Upper Income Taxpayers

Watch out for the AMT.
Don’t worry if you don’t understand all of the intricacies of the Alternative Minimum Tax. Even accountants get lost in this area. I’ll bet the lawmakers who concocted this mess don’t have the vaguest idea of what’s going on. What you need to know is that this is a separate tax system that is imposed on you only if you haven’t paid enough tax under the regular system (in the government’s view). State and local income and property taxes are not deductible for AMT purposes. So if the AMT applies this year, you will not save anything by paying your state estimated tax early. The same holds true for property taxes and many other deductible items. If the AMT applies your best bet would be to give us a call or email so that we can arrange to play with the numbers a bit and determine your options.

Charitable gifts.
Gifts of appreciated property (for example, a stock you have held for many years that has substantially increased in value) to a qualified charitable organization receive preferential tax treatment. It is possible to get a deduction for the full value of the property without paying tax on the profit.

Charitable organizations have come up with ingenious devices to maximize your tax benefits. You can transfer stock now, in trust, and retain the right to the income for your life. At the same time, you have achieved a large tax deduction in the current year, and you have removed the property from your taxable estate. Contact your favorite charity for more information, but contact us to check it out before you sign anything.

Gifts to family/friends.
There is no income tax deduction for gifts to family and friends. However, if you have much more than you need, you should consider an estate planning program of annual gifts to your loved ones and eventual heirs in order to avoid the oppressive estate tax imposed on wealthy taxpayers. The law allows you to give $11,000 per year, per person before incurring any responsibility for filing a gift tax return. If you are married you can take advantage of "gift splitting," and thereby double the annual exemption to $22,000 per person. However, you must file gift tax returns to elect "gift splitting" even if no tax is due.

To illustrate the potential estate tax savings, a wealthy married couple could give $22,000 to their son and $22,000 to their daughter by the end of December of this year, totally free of any tax. They could give another $22,000 each to their son and daughter next January. Since each child will receive $44,000, the total amount of tax free gifts will amount to $88,000. By removing this $88,000 from the parents’ estates, they will save $36,000 in estate taxes if they are in the maximum estate tax brackets. Looking at this from a tax standpoint, it cost only $52,000 for this couple to make $88,000 worth of gifts to their children. You decide who you want to inherit your estate, Uncle Sam later or your heirs now.

In addition to the $11,000 annual exclusion, you can pay someone’s medical or educational expenses without incurring a gift tax liability, provided you fulfill the technical requirements of Internal Revenue Code Section 2503(e)(1). And Section 529 allows you to "average" contributions to a Section 529 Plan over 5 years, so that $55,000 can be gifted before year end without any gift tax liability.

On a related note, I suppose the new "Education IRA’s" are worth a look. I'm not overly enthused by them because of all the limitations and the paperwork involved. In many cases the administrative costs and my fees to explain and interpret the rules negate any benefits. On the other hand, I highly recommend state tuition savings plans. If you have to pay tuition, you may as well get a state tax deduction for it (or at least part of it). New York has a great plan that allows you to deduct up to $5,000 per year ($10,000 on a joint return). For more information go to www.nysaves.org.

Remember that payments to these plans do not qualify for federal tax deductions, although the income earned on the funds is exempt until withdrawn for educational purposes. The main benefit is a current NY state tax deduction. For NY City residents a $5,000 contribution can save about $500 in combined state and city taxes.

Marriage or Divorce.
Way back in 1954 the tax rates were designed to give married couples a break. Thus, the rates for joint returns were set a few percentage points lower than for single returns showing the same income. Although the rates have changed a couple of dozen times since then, we still have lower rates for joint filers in today’s tax code. This works well when only one spouse is employed, as was the norm back in 1954. Even today, when only one spouse has income, you receive the intended break when you file a joint return. The problems occur when both spouses have income. Since we now have to combine their income we will probably end up in a higher tax bracket than if the couple remained single. Instead of a tax break we have what’s called the "Marriage Penalty Tax."

I stated above that you cannot make general rules when it comes to tax planning. But in this area I can come pretty close. If both spouses have substantial incomes it will probably be better to delay the wedding date from late December until January 1. If only one spouse has income it would probably be fruitful to speed up the legal wedding to before December 31, even if the celebration and formal ceremony are scheduled for next year.

Conversely, but for the same reasons, if a divorce is pending, and only one spouse has income, you should consider a delay in filing the papers until after the end of the year. That is, of course, assuming you and your former mate are still on speaking terms and can work out the rest of the details. You also have to be willing to sign the same return as your former spouse. This can be a risky proposition because you may become liable for your former spouse’s taxes, simply by signing that joint return.

Finally, if both spouses have income, it would probably be best to speed up the legal separation so that it takes place before December 31.

Self-employed taxpayers.
Self-employed individuals have more leeway than other taxpayers. They can take advantage of any of the previously mentioned strategies that may apply. They can also structure their business transactions to achieve the most efficient tax results. In many cases you can delay or accelerate billings and/or payments. Even if you are short on cash, it may be possible to buy equipment (or pay some other tax-deductible item) on your credit card. Thus, you may be able to get a needed deduction this year while you pay for it next year. Extreme care is necessary because the rules are more complicated when it comes to business clients, especially when you are dealing with inventories or accrual basis taxpayers. Also, that computer or other equipment that you bought must be put to business use before December 31. It is not enough to simply pay for it by year-end; you have to actually take it out of the box and hook it up. There are other limitations, but the myriad of planning opportunities for the self-employed is endless.

The foregoing is only a sample of the tax planning opportunities that may be available to you. There is still time to save taxes if you act before year-end. Contact us for more information or to discuss your particular situation.

Peter G. Masullo, CPA
New York, NY
Tax Planning & Estate Planning
www.cpa-taxlawyer.com