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Dion Gouws CPA

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General Tax Planning Strategies

This may be a good time to review some tax planning strategies that may help reduce your overall income tax burden. While there has not been any major income tax reform affecting individual taxation this year, there are a few relatively new and basic twists to include in a year-end review. Let us discuss some new legislations and the related year-end income tax strategies.

Year-end Individual Income tax Strategies

In our last month’s Strategies page we discussed some new tax legislations giving short-term relief on simmering issues like, Alternative Minimum Tax, a two-year extension to 2010 on the 15% top tax rate on capital gains and qualified dividend income, Kiddies tax, hybrid Vehicle credit, Roth Conversions, Charitable Donations and Charitable Gifts from IRAs and the related year-end tax planning tools. In this newsletter we will discuss some proven strategies that may help you reduce your taxes once again this year.

The most basic form of year-end planning involves pushing tax bills into the future by deferring income into the next year, accelerating deductions into the current year and shifting Income. The steps that individuals take now can reduce their 2006 federal tax bills and put them in better position to pay less in 2007 and beyond.

Let us look at some common individual situations and relevant tax strategies.

1) Cash Method of Accounting

Opportunities to manage taxes are greater for taxpayers on a cash basis of accounting. If you are self-employed and use the cash method of accounting for income-tax purposes, time late 2006 customer billings so that payment won't be received until 2007.

2) Bonuses


You can delay receipt of anticipated bonuses or incentive compensation coming to you to defer taxation until a future year so that these amounts will not be taxed on your return in 2009. Ask your employer to defer paying your 2008 year-end bonus until early 2009. (The employer may still be able to claim a deduction on its 2008 tax return.)


3) Capital Gains and losses


You can use capital gains or losses within your accounts to offset each other so you don’t have to pay tax on realized gains in the current year. So, if you have a few loser stocks that you wouldn't mind unloading, now is the time. You can sell them to wipe out all your realized capital gains for the year, plus another $3,000 ($1,500 for married filing separately) in regular income. The balance of any loss will carry over to next year. Be careful to avoid a wash sale i.e. buying the same security within 30 days before or after you dump shares. Tax rules disallow the loss if such practice is adopted.


You also need to be mindful of the length of time that you have held the investment – favorable long-term capital gain rates are applicable when you have held the property for more than one year. Don’t spoil the favorable long-term capital gain rate with a short-term capital loss.

4) Convert non-deductible interest to Deductible interest

Interest expense on personal auto loans, credit cards, and most student loans offers no tax deduction. However, interest on home equity loans and investment loans is tax deductible within certain limits. For example, if you have $35000 ready in the bank and you are planning to buy a car and some stock, make sure you use the money to buy the car and get a loan to buy the stock. This will maximize your interest expense deduction and avoid the borrowings on which interest is not tax deductible.

5) Deductible Interest & Real state Taxes

Consider making your January 2010 mortgage payment (which includes December's interest) in late December 2009, so that the mortgage interest will be deductible on your 2009 return (applicable only if you itemize deductions on your income-tax return ).

6) Medical and Miscellaneous Itemized Deductions

Your deductions are limited to the amounts that exceed 7.5% of adjusted gross income for medical expenses and 2% of adjusted gross income for miscellaneous expenses. Bunching two years of your or your family's unreimbursed medical or miscellaneous itemized expenses (such as certain job-related expenses and investment expenses) into one year may allow you to surpass the deduction floors and help you gain an itemized deduction for part of your expenses.

7) Retirement Contributions

Maximize 2009 contributions to any tax-deferred retirement savings plan in which you participate, such as a 401(k) plan or a 403(b) tax-sheltered annuity. If you are age 50 or older, you may be able to make additional "catch up" contributions to your plan.

8) Charitable Contributions

If you are planning to make a charitable donation in early 2010, consider a 2009 year-end donation instead. Contributions charged on your credit card in 2009 count as 2009 deductions, even if you don't receive or pay the credit card bill until 2010.

A popular retirement savings alternative for individuals who are self-employed is SEP IRA. Contributions to the plan are tax deductible within certain limits, it is relatively easy to establish, and there are no annual compliance burdens to maintain. Therefore, self-employed individuals who do not already have a tax-deferred retirement plan should consider starting one before year-end.

9) Passive Activity

Dispose of a passive activity with suspended losses. When a passive activity has suspended losses, those losses become deductible in the year the activity is sold.

10) Installment Sales

Consider an installment sale of property rather than collecting all proceeds this year.

11) Tax Liability

Finally as it comes upon year-end, be sure you have had enough withholdings, or paid in enough estimated tax. You don’t want to be in a position where you will be penalized for underpaying taxes, nor do you want to give the government an interest-free loan.

Income deferral and expense acceleration strategies are especially effective if you expect to be in the same or a lower tax bracket in the year in which you will be reporting the income on your tax return. However, if you are a high earner facing a limitation on your itemized deductions or if you expect to be in a much higher tax bracket in 2010, deferring income and accelerating payments into 2009 may not be your best course of action. In addition, if you claim high deductions in 2009, you may be subject to the alternative minimum tax.

Two important factors should be kept in mind for application of above-mentioned planning tools: -


• Most strategies must be completed before Dec. 31 to affect 2009 tax levels.

• Only a number of tax-saving opportunities are highlighted here. There are many other tax planning strategies to consider with the assistance of a tax adviser taking into account your individual tax situations.



1) Alternative Minimum Tax

Tax Increase Prevention and Reconciliation Act (TIPRA) has increased and extended the AMT exemption amount to $62,550 for joint filers and $42,500 for single filers through the end of 200X. It now permits certain new credits, such as the dependent care credit, credit for the elderly and disabled, energy –saving credits, tuition credits and certain homeowner credits also for AMT purposes. Previously, credits were allowed to the extent that the taxpayer had regular income-tax liability in excess of the tentative minimum tax, disallowing them for AMT purposes but now they can be used to set off entire regular tax and AMT liability through the end of 200x.

A strategy that is beneficial for regular tax purposes can backfire for AMT purposes because of differences in how the IRS handles certain deductions and income exclusions. For example, AMT is a flat tax rate of 28%. Therefore, for most of the taxpayers in 35% tax bracket, it may be beneficial to accelerate income instead of reducing into 2006 so that it is taxed at the favorable 28% rate.

Time value of money must be considered whenever you accelerate income that would not be taxed until a later time. Also, it may be wise to delay instead of accelerating deductions until a later year when you will not be in the AMT so those deductions can be used when they produce a 35% tax benefit.

If you project that you will be in AMT for 2006, but will not be in AMT for 2007, consider deferring paying real estate taxes, state taxes, year end contributions, investment fees and other miscellaneous itemized deductions until January of 2007.

2) Kiddie Tax

The tax law requires children who have more than a small amount of unearned income ($1,700 in 2006) to pay tax on that excess income at their parents' marginal tax rate. Beginning in 2006, the kiddie tax applies to children under age 18 (formerly, age 14). Due to this change, higher-income parents should consider investing any assets put aside for their under-age-18 children in investments that generate little or no current taxable income (such as U.S. savings bonds, municipal bonds, or growth stock index funds). Also, parents can explore the strategy of shifting income to children, grandchildren or other individuals over age 18 in a lower income bracket. However, such strategy must also be coordinated with a family’s overall wealth transfer strategy, bearing in mind the gift tax exemptions and exclusions.

3) Reduced tax rate on capital gains and qualified dividend income

TIPRA has extended the top tax rate of 15% (or 5% for lower-income taxpayers) on capital gains and qualified dividend income, which was set to expire at the end of 2008 through 2010. In 2011, the rates will revert back to the former income tax rates. Individuals who are business owners of closely held corporations should give thought to taking advantage of the lower tax rates on dividend income.

4) Roth Conversions

Earlier this year, TIPRA removed the income limit for high earners who want to convert their traditional Individual Retirement Account to a Roth IRA. While elimination of the $100,000 income limit to convert traditional IRAs to Roth IRAs under TIPRA doesn't start until 2010, maximizing that opportunity can begin in 2006 with maximizing contributions in 2006 and each year thereafter to a nondeductible IRA that can then be converted into a Roth in 2010.

5) Hybrid Vehicles

The tax credit for hybrid vehicles applies to those purchased on or after January 1,2006 and could be as much as $3,400 for those who purchase the most–fuel-efficient vehicles. Starting in 2006, this tax credit replaces the tax deduction of $2000, previously allowed for taxpayers who purchased a new hybrid vehicle before December 31,2005 for the clean-burning fuel deduction. The tax credit requires a different certification. Many currently available hybrid vehicles may qualify for this new tax credit, but the specific amount of the credit varies from model to model of eligible vehicle. If you purchase and take possession of a qualified hybrid motor vehicle in 2006, don’t overlook the hybrid tax credit.

6) Charitable Gifts from IRAs

The Pension Protection Act of 2006 allows IRA holders who are 70-1/2 and older to make charitable contributions of up to $100,000 for 2006 and again in 2007 only from their IRAs without realizing income. So, those who are charitably inclined and wish to maximize this temporary benefit, the transfer from IRA to charity must be completed in 2006 for this year's $100,000 benefit cap to apply; the benefit is not cumulative and cannot be carried over to make $200,000 income-tax-free in 2007.

7) Charitable Donations

Taxpayers wishing to deduct charitable donations of cash, clothing, household items and other items must conform to stricter rules. Charitable donations of cash, check, or other monetary gifts are allowed only if the donor can provide a bank record or written communication from the charity indicating the contribution amount, the date the contribution was made, and the name of the charity.

New rules apply to contributions of clothing and household items made after August 17, 2006. In general, the items must be in "good" condition. However, you can still deduct the value of an item that isn't in good if the value of the donation is more than $500 and you include a qualified appraisal with your tax return.

Estimated Taxes

In our last month’s Strategies we discussed “who must pay estimated tax and the related planning tools”. We take up from there to discuss the ways to assess estimated tax, ways of making payment and penalty for underpayment.


Estimating Your Tax


Form 1040-ES, used to pay estimated tax, comes with a worksheet one can use to estimate how much tax one will owe for the current year. Most people don't prefer to use it as it takes them through more detail than may be necessary and is still unable to eliminate uncertainty about the tax liability. The usual way to estimate taxes is comparatively simple:


●   We look at each number on the prior year's tax return and ask whether this year's number is likely to be significantly different and disregard differences in wages because there will be a corresponding difference in withholding.

●    Now we add up all the differences to see how much more or less our taxable income will be for the current year.

●    And then apply the tax rates to see how much difference this will make in our income tax. (If the difference results from a capital gain, we apply the capital gain tax rates.) We can round the number up or tack on an added amount to increase our comfort level about avoiding a penalty.


Many people using this method don't consider changes in tax rates, standard deduction and personal exemptions that result from inflation adjustments. These changes will decrease your tax slightly, so that's one way of providing a cushion of extra payments. Example: Suppose you estimated your 2006 taxable income exactly right, but used the 2005 tax rate schedules to estimate the tax. You would get a refund, because the inflation adjustments for 2006 will result in a lower tax.


Making the Payment


After determining how much you need to pay, you should consider whether to use estimated tax payments or an increase in withholding to pay this amount.

1) Estimated Tax Payments


There are two ways to figure each payment.

a) Regular Installment Method


One of the easiest ways to make quarterly payments is to estimate your total tax liability for the year and divide by four. For nearly all taxpayers, the due date for the first estimated tax payment of each year is April 15 — the same day the return is due for the previous year. Subsequent payments are due June 15, September 15, and January 15 of the following year. Although they're considered quarterly payments, they're not all three months apart. Note that if you itemize deductions, it may be to your advantage to make your fourth quarter estimated tax payment in December, not January, so you can deduct it a year earlier.


When you make estimated tax payments you need to enclose Form 1040-ES. It asks for your name, address, social security number and the amount you're paying. You don't have to justify your estimated tax payments. All you're saying is "here's a payment on account. Estimated tax payments don’t go to the same address as your return. So, check the instructions for Form 1040-ES for the proper address.


b) Annualized Income Installment Method


If your year’s income starts off low and ends up high (say because you have huge fourth-quarter capital gains), you should probably use the “annualized method”. This is an exception to the general rule that your four estimated tax payments should be equal. Under the annualized method, estimated payments correspond to your cash flow, so you won’t owe big installments on the earlier due dates before you have the money to pay them. Under this method calculation is very complicated, but it sometimes reduces the penalty by a substantial amount. If you use the annualized income installment method to figure your estimated tax payments, you must file Form 2210. But if you don't want to fill out the form, you don't have to do anything until the IRS does the math and sends you a bill.


2) Increasing Your Withholding


In order to increase the amount of federal income tax withheld from your paycheck, you need to file a new Form W-4 with your employer. This form contains several worksheets, and the instructions tell you to "complete all worksheets that apply." You can fill out the worksheets if you want, but there's no particular need if the only thing you're doing is increasing your withholding to cover tax on investment income.


There are two ways to increase your withholding on this form. One is to reduce the number of allowances you claim on the form. This can be a little complicated, because you don't necessarily know how much your withholding will change when you change your allowances. The amount depends on your income level.


Another way is to request an "additional amount" to be withheld from your paycheck. This makes it fairly easy to determine the amount of the increase when you file Form W-4. Keep an eye on your paycheck stubs to confirm that the change was properly made and had the effect you anticipated.

There’s a special benefit to this approach: extra withholding that comes late in the year is treated the same as if it was spread evenly over the year. You can use this approach to avoid late payment penalties. 


Example: Suppose you realize in May that you need to pay $10,000 estimated tax for the year, and you've already blown the first $2,500 payment that was due April 15. You can avoid the penalty altogether by increasing your withholding for the rest of the year by $10,000. This back-loaded withholding can be used retroactively to abate the penalty. This is a real penalty-saving opportunity just for W-2 wage earners.


Penalty for Underpayment


The penalty for underpayment of estimated tax is figured the same as interest. You determine the amount of the underpayment for each period of time and the number of days in that period, and then apply an appropriate interest factor. The interest rate is adjusted from time to time based on market interest rates.


Example: Suppose you make estimated tax payments of $5,000 per quarter, thinking that $20,000 would be enough to cover 90% of your tax liability in a year when the prior year safe harbor wasn't available.


It turns out that $25,000 was required to cover 90% of your tax liability, so you should have paid an additional $1250 per quarter. The amount of your underpayment is $1250 for the period from April 15 to June 15, $2500 from June 15 to September 15, $3750 until January 15, and $5,000 until April 15, 2007 when you file your return with your payment.


Assuming that the recently announced rate for underpayments (third quarter of 2006) is 7%, the underpayment penalty would be roughly $234.


The penalty is not deductible, even if it arises because of investment or business income. If you underpay only a small amount, or you correct the underpayment quickly, the penalty will be small.


So you see, even if the estimated–tax rules apply to you, there are easy ways to lessen the pain. /p>



To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the internal Revenue Code, or (ii) promoting, marketing or recommending to another party any tax related matters addressed herein.

Important note: Many exceptions, definitions, and special rules in the law have been paraphrased, simplified, and/or omitted. Readers should not take specific action based on this summary without first consulting the statute and regulations or seeking advice from a qualified professional.

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