Step By Step

By Staff Writer

October 01, 2003 at 04:00 AM

Share & Print

While the jury is still out on whether the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) is stimulating the economy, the act's provisions have certainly altered the tax-planning landscape. Signed into law on May 28, 2003,

JGTRRA accelerated reductions in the marginal income tax rates, lowered rates for long-term capital gains and qualifying dividends, expanded the 10% tax bracket (and the 15% bracket for married individuals filing jointly), and increased the basic standard deduction amount for married individuals filing jointly. The act also significantly increased the first-year depreciation allowance and the ?179 expense limit for businesses, and bumped up the child tax credit.

Like the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) before it, JGTRRA contains provisions that sunset its changes, with many expiring as early as 2004. In effect, many JGTRRA changes are scheduled to return to

EGTRRA levels in the next two years, and EGTRRA changes are themselves scheduled to expire at the end of 2010. The end result is a strange patchwork of tax benefits and changes that make long-term planning a challenge. The alternative minimum tax (AMT) adds yet another layer of uncertainty. While JGTRRA's temporary increase in AMT exemption amounts will prevent a spike in the number of taxpayers subject to AMT (which would otherwise be likely, given the overall reduction in tax rates), these provisions expire at the end of 2004, setting up 2005 as the year of the AMT if no further action is taken. Add in some of the legislation that's been proposed, and there's a lot to think about.

In case you need reminders, here are 10 issues that you should address with your clients during the final quarter of the year, while there's still time for you to help them lighten their tax burden. You are no doubt familiar with most of them. Recent changes, however, have added some new twists to these tried-and-true maneuvers, and the down-then-up behavior of the stock market may have changed your clients' financial situations during this year of (we hope) economic recovery.

1. Assess each client's current situation

Most tax tips, suggestions, and strategies are of little practical help without a good understanding of a client's current tax situation. This is particularly true when it comes to planning at or around year end.

Encourage each client, either individually or together with you, to review last year's tax return, along with current pay stubs and account statements, and to do a few quick projections to come up with an estimate of his or her 2003 tax situation. This is a year in which nothing should be taken for granted. Lower tax rates, a larger standard deduction for married individuals filing jointly, the new rates for capital gains and qualifying dividends, and advanced child tax credit checks all need to be taken into account. At the very least, such a review can identify any glaring issues that need to be addressed before year end, while there's still time.

2. Address obvious shortfalls

Clients who project that they're going to owe significant amounts can have their employers increase their federal income tax withholding (by completing a new IRS Form W-4), or make estimated payments (via IRS Form 1040-ES). Other strategies can also be implemented to reduce overall tax. Clients who project that they will have significantly overpaid and will be receiving large refund checks can, of course, reduce withholding accordingly.

Clients who have both wage income (receiving a W-2 as an employee at year end) and consulting income (reported on IRS Form 1099-MISC) can make up shortfalls in estimated tax payments through increased withholding between now and the end of the year. There's an added benefit in doing this: Even though the additional federal income tax withholding may have come from the individual's last few paychecks, it's generally treated as having been withheld evenly throughout the year. This may negate a possible estimated tax penalty.

This is also a good time to find out if clients have household employees. In addition to filing Schedule H with their 2003 tax returns and possibly paying employment taxes, a client who has one or more household employees during the year will generally have to obtain an employer identification number (EIN), provide the employee with a Form W-2 by January 31, 2004, and submit a copy of the Form W-2 with a Form W-3 to the Social Security Administration by the end of February.

3. Determine whether or not the AMT will apply

It's important for your clients to know whether or not the AMT may apply. Those subject to the AMT will have a very different planning approach during the last few months of the year.

The AMT results from a set of separate tax rules that exist in parallel to the regular income tax system. Originally intended to prevent the very wealthy from utilizing tax deductions and credits to pay little or no federal income tax, the AMT is exactly what its name implies: an alternative minimum amount of tax that some individuals are required to pay in addition to regular income tax.

In a nutshell, the AMT rules add certain items and adjustments back into a taxpayer's income to arrive at alternative minimum taxable income (AMTI). An exemption amount that is based upon filing status is subtracted from AMTI and the result is multiplied by a flat tax rate of 26% (28% if AMTI exceeds a specified amount). The result is the taxpayer's tentative minimum tax. If the taxpayer's regular tax is greater than his or her tentative minimum tax, there is no additional AMT. If, however, a taxpayer's tentative minimum tax is greater than his or her regular tax, the difference (the AMT) is added to the taxpayer's regular tax in determining total tax due.

While a complete list of AMT preference items and adjustments can be found on IRS Form 6251, some of the more widely encountered AMT "triggers" include:

oMedical/dental expenses (a percentage of expenses may be added back)

oState and local taxes

oHome mortgage interest for a loan not used to buy, build, or improve a home

oMiscellaneous itemized deductions

oThe exercise of incentive stock options

Additionally, personal exemptions are not subtracted from income when calculating AMTI, so taxpayers with a large number of dependents may find themselves subject to the AMT.

Given the number and combinations of items that can cause a taxpayer to be subject to AMT, it's very difficult to come up with a general rule about who is and isn't subject to AMT, except to say that if a taxpayer's AMTI (factoring in all preference items and adjustments) is less than the taxpayer's AMT exemption amount, the taxpayer will not be subject to AMT. One caveat, though: the AMT exemption amounts phase out for higher incomes.

Clients should not make the mistake of assuming that only the wealthy are subject to AMT. Because key AMT figures aren't indexed for inflation, more and more taxpayers are subject to the AMT each year. For example, for the 2002 tax year, a married couple filing jointly, each earning $50,000, with four dependent children and $26,000 in itemized deductions (including $10,000 in deductible taxes and $4,000 in miscellaneous itemized deductions), would have been subject to the AMT.

AMT is something of a showstopper when it comes to year-end tax planning. That's because even some of the most basic year-end tax planning strategies can have unintended consequences under AMT rules. For example, individuals subject to AMT may find it counterproductive to accelerate deductions into this year since, along with other preference items, the AMT rules add back in certain itemized deductions, and individuals who have been subject to AMT in prior years may have assets that now have a basis for AMT purposes different (usually higher) than for regular tax purposes. Those subject to AMT will have to evaluate any strategy in the context of both regular tax and the AMT.

Had JGTRRA not addressed AMT at all, many of the tax breaks provided by the act would have been effectively nullified by the fact that a large number of new individuals would have been subject to the AMT (an overall lowering of tax rates tends to make more taxpayers subject to the AMT "floor"). However, JGTRRA did temporarily increase AMT exemption amounts, postponing an AMT crunch to 2005.

4. Consider the timing of income and deductions

During the last few months of the year, it's often worth considering ways to manipulate the timing of income and deductions. However, while there are many ways to delay income and accelerate deductions (or, conversely, to accelerate income and postpone deductions), any such actions need to be analyzed not only in terms of the resulting benefit for 2003, but also in terms of the impact on the 2004 tax year. Manipulating the timing of income and deductions will generally be appropriate only in cases where a beneficial result is achieved in terms of the overall tax situation for both years. The fact that accelerating certain deductions will often increase the odds of being subject to the AMT should also be kept in mind.

Nevertheless, clients who expect to be in a different tax situation in 2004 (e.g., in a higher or lower income tax bracket) should consider the extent to which they can obtain an advantage by shifting income and deduction items from one year to another. In addition, clients who typically "lose" deductions because certain deductions (e.g., medical deductions, miscellaneous itemized deductions) approach but don't regularly exceed AGI limitations, or because total itemized deductions come in slightly below the allowable standard deduction amount, will often experience an overall tax benefit by "bunching" income and deductions. Those who successfully implement a bunching strategy lower income and increase deductions in one year to maximize the itemized deductions in that year, and accept higher income and lower itemized deductions (or the allowable standard deduction) in the following year.

Here are some ways to delay income to the following year:

oDelay the collection of business debts, rents, and payments for ser-vices (cash method of accounting)

oDefer compensation

oDefer year-end bonuses

oExchange maturing E Treasury Bonds for HH bonds (delaying the recogni-tion of interest)

oDefer the sale of capital gain proper-ty or take installment payments instead of a lump-sum payment

oPostpone receipt of distributions that are over the required minimum from retirement accounts

Here are ways to accelerate

deductions into this year:

oMake next year's charitable contri-butions this year instead

oPay medical expenses in December

oPrepay deductible interest

oMake state estimated tax install-ment payment in December

oMake alimony payments early

oPrepay next spring's college costs in December (if it qualifies you for added Hope/Lifetime Learning credit or deduction for qualified higher edu-cation expenses)

5. Evaluate clients' use of tax-deferred savings vehicles

JGTRRA's 15% maximum tax rate (5% for clients in the 10% and 15% tax brackets) for long-term capital gain and qualifying dividends does not apply to distributions from traditional IRAs and tax-deferred employer-sponsored retirement plans. Distributions from these vehicles will continue to be taxed at ordinary income tax rates (currently as high as 35%). In addition, JGTRRA's general reduction in ordinary income tax rates has had the indirect effect of slightly reducing the overall relative benefit of tax deferral. As a result, the tax advantages of IRAs and tax-deferred employer-sponsored retirement plans are now somewhat less pronounced.

Yet they're still the best ways to save for retirement. One note, though: Where a client does not qualify to make either contributions to a Roth IRA or deductible contributions to a traditional IRA, non-deductible contributions to a traditional IRA might ordinarily be considered. With JGTRRA, though, look very closely before recommending non-deductible IRAs–the tax issues mentioned above combined with non-deductible IRAs' administrative record-keeping may tip the balance against them.

Also, JGTRRA has had an impact in terms of what investments are best suited for funding a tax-deferred account. To the extent that it works into overall asset allocation goals, it does make sense to concentrate investments that generate long-term capital gains and qualifying dividends in taxable accounts, with IRAs and other tax-deferred vehicles holding investments that generate ordinary income.

The bottom line: Clients who qualify should consider making either a tax-deductible contribution to a traditional IRA (current tax deduction effectively defers income to future years) or an after-tax contribution (no deduction allowed, but qualifying distributions are tax free) to a Roth IRA. For 2003, individuals can contribute up to the lesser of $3,000 ($6,000 if married filing a joint return) or 100% of taxable compensation to an IRA each year. In addition, clients age 50 and older can make an extra "catch-up" contribution of up to $500 this year. Clients generally have until the due date of their 2003 federal income tax return to contribute. For most people, this is April 15, 2004. Additionally, clients should consider maximizing contributions to employer-sponsored retirement plans such as 401(k)s.

Finally, older clients (i.e., over age 59 1/2) with significant balances in traditional IRAs and tax-deferred employer-sponsored retirement accounts may want to consider taking distributions, at least to the extent that they will be able to take advantage of the 10% and 15% tax brackets. This may be particularly appropriate in cases where clients' assets are disproportionately allocated to retirement accounts, or where clients wish to start reallocating assets that generate long-term capital gain and qualifying dividends from tax-deferred to taxable accounts. Obviously, the potential resulting increase in adjusted gross income would have to be evaluated (including any impact on the taxability of Social Security).

6. Urge clients to offer employer-sponsored retirement plans

As with IRAs, the relative advantage of employer-sponsored retirement plans attributable to tax deferral has been slightly diminished in light of JGTRRA's lower overall tax rates and reduced tax rates on long-term capital gain and qualifying dividends. Like IRAs, however, they're still the best deals going in terms of saving for retirement.

Clients who are business owners or have self-employment income should consider establishing and contributing to an employer-sponsored retirement plan in addition to funding an IRA. Such a plan can allow significant dollars to be deferred. Although any eligible employees must also be covered by the plan, certain plans (e.g., simplified employee pension, or SEP plans, and savings incentive match plans for employees, or SIMPLE plans) are straightforward and easy to implement. While SEP plans can be set up after year end, most employer-sponsored retirement plans must be adopted before year end.

Worth noting are the profit-sharing and 401(k) plans currently being marketed to self-employed individuals and small business owners with no full-time employees (other than a spouse) who want to put away as much income as possible. These one-participant 401(k) plans [called, among other things, "solo" 401(k)s and "mini" 401(k)s] offer the same benefits of regular profit-sharing plans and 401(k) plans, but without most of the associated administrative costs. With these plans, a client can elect to defer up to $12,000 of compensation to the plan for 2003 ($14,000 if age 50 or older by the end of the year), just as with any 401(k) plan. In addition, as with a traditional profit-sharing plan, the client can make a maximum tax-deductible contribution to the plan of up to 25% of compensation if they've incorporated (slightly less than that if the client is a sole proprietor). As with other retirement plans, contributions for 2003 cannot exceed the lesser of $40,000 or 100% of your compensation.

7. Weigh impact of Roth IRA conversions or reversals

JGTRRA's tax breaks may make Roth IRA conversions more palatable to clients who have wanted to convert but who were not willing to digest the resulting infusion of taxable income. In fact, clients with traditional IRAs who find that they will be in the 10% or 15% marginal tax bracket for 2003 (for married couples filing jointly in 2003, the 15% bracket applies to taxable income up to $56,800) should consider converting the maximum amount of IRA funds possible while still staying in the 15% bracket.

Clients with a 2003 modified adjusted gross income of $100,000 or less can convert some or all of their traditional IRA funds to a Roth IRA. Although income tax will be due on any amounts converted during the year, qualifying distributions from the Roth IRA, when made, will be completely free of federal income tax.

Clients who converted traditional IRA funds earlier in the year also have the unusual opportunity to re-evaluate their decision. This can be particularly helpful when IRA assets decline significantly in value after a conversion. The amount of income tax that results from the conversion of a traditional IRA to a Roth IRA is based on the fair market value of the traditional IRA at the time of conversion (assuming no non-deductible contributions have been made to the traditional IRA). A client who converted a traditional IRA worth $100,000 in January will have to include the $100,000 value of the traditional IRA in his or her income for 2003. But what if the IRA investments (now in a Roth IRA) are now worth only $50,000?

If the funds are left in the Roth IRA, the client will include the full $100,000 fair market value of the traditional IRA at the time of conversion in his or her 2003 income, even though the IRA investments may actually now have a fair market value of $50,000. Luckily, clients in this situation can recharacterize their Roth IRA back to a traditional IRA. Recharacterizing won't restore the $50,000 that the IRA investments have lost in value, but it will mean that income taxes won't have to be paid on the original conversion. For conversions made during 2003, recharacterizations can be effective as late as October 15, 2004. Clients should thoroughly understand the rules before proceeding, and know that if they recharacterize a Roth conversion before the end of the year, they'll be prohibited from reconverting to a Roth IRA again until next year.

8. Think through investment decisions

JGTRRA reduced the tax rate on long-term capital gains. For sales and exchanges on or after May 6, 2003, individuals in marginal income tax brackets of 25% or higher pay tax on long-term capital gains at a rate of 15%. Individuals in the 10% and 15% marginal tax brackets pay tax on long-term capital gains at a rate of 5% (for tax year 2008, these individuals will actually pay no tax at all on long-term capital gains). JGTRRA applies these same rates to qualifying dividends received at any time during the tax year.

Even with JGTRRA's lower marginal tax brackets, this means that the tax on short-term capital gain can be as much as 20% higher than the tax on long-term capital gain. Tax considerations alone should never determine what investments clients sell, or whether clients sell investments at all.

However, all other things being equal, clients should generally take advantage of the low long-term capital gains rate by trying whenever practical to sell investments that will generate long-term capital gains before selling investments that will generate short-term capital gains.

JGTRRA did not change the capital loss limitation of $3,000, nor did it allow capital losses to be applied against qualified dividend income (which of course is now taxed at long-term capital gain rates). This means that clients who are considering selling investments that will generate losses should be aware that the losses can offset recognized capital gains plus up to $3,000 of ordinary income (up to $1,500 of ordinary income for married individuals who file separately).

Clients should also be aware that capital losses are more valuable when applied against short-term capital gains or ordinary income (since every dollar offset is a dollar that would otherwise be taxed at ordinary income tax rates) than against long-term capital gain.

JGTRRA also generally provides that qualifying dividends are now taxed at the same rates that apply to capital gains. To qualify, dividends must be received by an individual shareholder from domestic and qualified foreign corporations. A number of restrictions and limitations apply, however. For example, if a shareholder doesn't hold a share of stock for more than 60 days during the 120-day period surrounding the ex-dividend date, the dividends received on the stock aren't eligible for the new capital gains rate (for certain preferred stock, the period is 90 days during the 180-day period surrounding the ex-dividend date).

In addition, many clients may incorrectly assume that certain dividend payments qualify for the special tax treatment. For example, mutual fund distributions will generally only qualify for special tax treatment to the extent that the distributions represent qualifying dividends being passed through by the fund (of course, any portion of the distribution that represents long-term capital gain will also benefit from JGTRRA's lower rates). Any portion of the distribution that represents ordinary income (e.g., interest) will be subject to tax at ordinary income tax rates. Similarly, most REIT dividend distributions will be taxed at ordinary income tax rates, as will dividends paid by credit unions, mutual insurance companies, mutual savings banks, and savings and loan institutions.

9. Take advantage of increased special depreciation allowance and ?179 expensing

JGTRRA provides for an additional first-year depreciation deduction equal to 50% of the adjusted basis of qualified property. (Essentially, JGTRRA expanded and extended the 30% additional first-year depreciation deduction allowed by the Job Creation and Worker Assistance Act of 2002.) To qualify, property generally must, among other requirements, be acquired after May 5, 2003, and before January 1, 2005, and placed in service before January 1, 2005 (January 1, 2006, for certain property).

In addition, JGTRRA significantly increased the ?179 expensing election limit from $25,000 to $100,000. This election (in effect, allowing the full cost of property to be deducted this year rather than depreciated over three to five years) can be made for depreciable tangible personal property that is purchased for use in the active conduct of a trade or business and placed in service in taxable years beginning in 2003, 2004, and 2005. This $100,000 limit is reduced, however, by the amount by which the cost of qualifying property placed in service during the tax year exceeds $400,000 (so a complete phase-out of the election occurs at $500,000).

These provisions give business owners a tremendous ability to reduce income by purchasing needed equipment and accelerating equipment purchases scheduled for next year. Business owners may find this an option that can be used effectively in conjunction with other tax planning measures. For example, the taxable income that would be generated by the conversion of a traditional IRA to a Roth IRA might be balanced by the equivalent purchase of business equipment that qualifies for full expensing under ?179.

10. Make Gifts

Charitable gifting will continue to generate a tax benefit in the form of a corresponding federal income tax deduction. JGTRRA's lower marginal tax rates have, however, to some degree lessened the relative value of itemized deductions. That is, a dollar in itemized deductions now has a smaller impact on tax than it would have had before JGTRRA.

In addition to making gifts to charity, clients can benefit from making non-charitable gifts as well. For 2003, a client can generally give up to $11,000 ($22,000 for a married couple) to as many individuals as he or she desires without incurring any gift tax consequences. Be aware, however, that after December 31, 2003, clients lose the opportunity to take advantage of their 2003 annual exclusion.

Gifting appreciated assets continues to make sense for most clients, since a client who gifts appreciated assets won't have to pay tax on the gain. Instead, any tax is deferred until such time as the recipient disposes of the property.

Worth noting is JGTRRA's 5% tax rate on long-term capital gains for individuals in the 10% and 15% marginal tax brackets. Consideration should be given to the possibility of gifting appreciated assets to family members (who are at least age 14) in these lower tax brackets, since they can then pay the resulting tax at the 5% rate. Also bear in mind that these individuals, as long as they remain in the lower tax brackets, will pay no tax at all on long-term capital gains provided that they sell the assets in tax year 2008.

James Walsh is editor-in-chief at Forefield Inc. () in Marlborough, Massachusetts, which publishes FMA Advisor, Web-based advice management software.

NOT FOR REPRINT