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Stapp Financial Newsetter: Fall 2005
Mid-year tax planning tips
As you probably know, two major tax laws were enacted at the end of 2004. You may be familiar with some of the new tax rules, but now is a good time to see if there were any goodies for you, and, if so, what you need to be doing to take advantage of them. In addition to changes made by the new laws, other planning actions may be beneficial. While the end of 2005 seems a long way off, it's always a good idea to take a look at your tax situation while there is still time to take action. Some planning ideas need to be implemented before year-end to be effective for this year. With that in mind, here are some ideas to consider.
Planning for Individuals . . .
Deducting State and Local Sales Tax. If you itemize deductions, you can deduct either state and local sales taxes or state and local income taxes. While this option clearly benefits individuals who live in states that don't impose a significant income tax, even taxpayers subject to state income tax may find that the sales tax deduction exceeds their state income tax deduction. This is especially true if you make significant purchases this year.
If it turns out that the sales tax deduction is more beneficial than deducting state income taxes, you can choose between claiming the actual sales taxes you paid during the year or an amount from IRS-published tables. The table amount is based on your income level and the size of your family. Saving your receipts to document the sales tax you actually paid (especially if you made or are planning to make significant purchases) may yield a larger deduction than using the IRS tables. But, even if you use the IRS tables, the sales tax on certain big-ticket items can be added to the sales tax amount from the tables. Namely, the sales tax on motor vehicles, whether purchased or leased, aircraft, boats, homes (including mobile and prefabricated), and home building materials (if the tax rate was the same as the general sales tax rate) can be added to the table amount. A motor vehicle includes a car, motorcycle, motor home, recreational vehicle, SUV, truck, van, and off-road vehicle. So, even if you plan to simplify your life and use the IRS tables to figure your 2005 sales tax deduction, be aware of these items and be sure to keep documentation of sales tax paid on them so the tax can be added to the table amount.
Minimize Tax on Capital Gains. Generally, when you sell stock or mutual fund shares, the shares you purchased first are considered sold first. That's usually good news since it's often beneficial to qualify for the long-term capital gain rate by selling shares that have been held more than one year. But, if you are selling less than your entire holding of a specific stock or mutual fund, there may be situations where you're better off selling shares other than those that have been held the longest. For example, the newer shares may have a higher cost-basis (because you paid a higher price for them) that would result in a smaller taxable gain or even a loss. When you want to sell shares other than those you purchased first, you must properly notify your broker as to the specific shares you want sold.
Don't Lose the Benefit of Your Itemized Deductions. If your itemized deductions end up being just under (or just over) the standard deduction, you can double up on itemized deductions every other year and claim the standard deduction in the intervening years. For 2005, the standard deduction is $10,000 for joint filers ($5,000 for singles). For example, if you file jointly and your property taxes (your only itemized deduction) run about $9,000 a year, you will end up claiming the standard deduction each year. Instead, you could pay two years of property taxes in 2005, getting the benefit of an $18,000 itemized deduction that year. In 2006, you would have no itemized deductions (since you paid your 2006 property taxes in 2005) and would claim the standard deduction. By bunching your itemized deductions into 2005, you will get $28,000 of deductions over the two-year period, instead of the $20,000 (ignoring the inflation adjustment to the standard deduction) you would deduct if you just claimed the standard deduction each year. Deductions that can often be shifted from year to year include certain property taxes, the final estimated state income tax payment, your January mortgage payment and charitable contributions.
Consider a Health Saving Account (HSA). HSAs allow you to pay medical expenses on a pretax basis. For 2005, if you meet certain requirements, HSA contributions of up to $5,250 for family coverage and $2,650 for single coverage (plus and additional $600 if you're 55 or older) can be made regardless of your income level and are deductible above-the-line, so you benefit even if you don't itemize or are subject to the high-income itemized deduction phaseout. You can then take tax-free withdrawals to pay uninsured medical expenses. (Withdrawals not used for medical expenses are taxable and, if taken before age 65, subject to a 10% penalty tax.) If you are in good health, you can use an HSA to build up a substantial medical expense reserve fund over the years. And, if you get to age 65 and don't need the funds for health care costs, you can withdraw them for nonmedical reasons and pay only the income tax. So, in addition to paying medical expenses with pretax dollars, HSAs can allow you to save on a tax-deferred basis much like an IRA.
To make deductible HSA contributions, an individual must be covered under a high-deductible health plan (HDHP) and no other health plan. A HDHP has a deductible of at least $1,000 ($2,000 for family coverage) and no more than $2,650 ($5,250 for family coverage). Although they have been around for a while, HSAs have been slow to catch on. One of the biggest problems is that major insurance companies are just beginning to develop products that meet the HDHP requirements. Now that insurance products are more readily available, this a good time to revisit whether an HSA can help you fund your medical expenses as well as possibly build a tax-deferred savings account.
If You Own a Business . . .
Maximize the New Deduction for U.S. Production Activities. For 2005, businesses (incorporated or not) can deduct (for both regular and alternative minimum tax) up to 3% of their qualified domestic production activities income. "Qualified domestic production activities income" is the net income from certain business activities, if substantially all the activity takes place in the U.S. (or its possessions). "Production" is somewhat of a misnomer. In addition to traditional manufacturing, the deduction is available for income from selling personal property that the business manufactures, grows, produces or extracts; construction; producing software, film, or videotape; farming; and processing agricultural products and food.
If your business is engaged in one of these qualified activities, the new deduction can be significant. But, there is one catch – the deduction can't exceed 50% of the wages paid to employees (W-2 wages) for the year. This could be a problem for businesses that pay little or no wages. Many sole proprietorships do not pay the owner a salary. Likewise, S corporations often pay owners relatively small salaries to minimize their payroll taxes. This means that, after applying the W-2 wages limit, their deduction for U.S. production activities could be significantly reduced.
Business owners who are eligible for the U.S. production activities deduction should look at their compensation policies and consider increasing owner salaries to ensure their deduction is not scaled back. Also, because the deduction is based on net income from qualifying activities, it would be a good idea to take a look at your accounting system to be sure it will allow you to determine the income from qualifying activities as well as expenses directly related to or allocable to that activity. If not, some tweaking of the accounting system may be in order.
Take another Look at Electing S Status. Electing S status often saves a lot of tax because it avoids the double taxation experienced by many C corporations. However, S status is only available if the corporation meets several requirements, including a limit on the number of shareholders. Starting in 2005, some favorable changes to the number-of-shareholders limit may make an S election available to corporations that could not qualify in the past. First, the maximum number of eligible shareholders in an S corporation is increased from 75 to 100. Second, family members (up to six generations) can elect to be treated as one shareholder. Without the election, family members (other than husband and wife) are generally each counted as a shareholder. Making the election, then, reduces the number of shareholders for the number-of-shareholders limitation. (Electing to treat family members as a single shareholder can also be useful for S corporations that otherwise would not be able to admit new shareholders due to the 100-shareholder limit.)
Take Advantage of Expiring Tax Breaks. While it is certainly possible that Congress will extend them, the following credits and deductions are scheduled to expire or be reduced after 2005. Therefore, if you are considering making any of the following expenditures, it might make sense to do so before year-end to ensure you will reap the related tax benefits.
- Hiring individuals whose wages qualify for the work opportunity or welfare to work credits. These credits are available only for wages paid for individuals beginning work before 2006.
- Purchasing qualified electric or clean fuel vehicles (most popular of which are certain hybrid gas-electric vehicles). These credits are scheduled to be reduced by 75% for vehicles placed in service after 2005.
Consider Amending 401(k) Plans to Accept Roth 401(k) Contributions. Earnings on funds in a Roth IRA grow tax-free [as opposed to merely tax-deferred as in a traditional IRA or 401(k) plan]. However, higher-income taxpayers are ineligible to make Roth IRA contributions. Starting 2006, taxpayers covered by a 401(k) plan will be able to designate some or all of their 401(k) contributions as Roth 401(k) contributions. Thus, they will be able to take advantage of tax-free growth in their retirement account just like those who are able to contribute to Roth IRAs. Even better, the 2006 contribution limit to Roth 401(k) plans is $15,000 ($20,000 if age 50 or older), which is much higher than the $4,000 ($5,000 if age 50 or older) limit on Roth IRA contributions.
One Caution: Unlike "regular" 401(k) contributions, contributions that you designate as Roth 401(k) contributions are taxed to you the year they're made. But, the benefit of tax-free earnings on those contributions (provided they're held in the plan for a certain amount of time) will often outweigh the tax-deferral on a regular 401(k) plan contribution. This is especially true if your tax rate is higher when you withdraw the money from you 401(k) plan than it was when the funds were contributed (which could be the case given the current Federal deficit picture). The only "catch" is that an existing 401(k) plan must be amended to accept Roth 401(k) contributions. And, the plan will have to account for the Roth 401(k) contributions (and earnings thereon) separately from regular contributions. Although this potentially attractive benefit is not available until 2006, business owners should consider amending their 401(k) plans now so that they (and their employees) can benefit from making Roth 401(k) contributions in 2006.
Dealing with Estate Tax Uncertainty . . .
You probably know that the House of Representatives passed a bill repealing the estate tax last spring. Although it's far from clear what the Senate will do, opponents of the estate tax appear to have some momentum for action. If not an outright repeal, there's a good chance the estate tax exclusion amount (currently $1.5 million per person) will be raised, perhaps substantially. Thus, it seems likely that far fewer of us will eventually be subject to the federal estate tax. Until things are settled, we recommend that you avoid transfers subject to gift tax (since there is a possibility that you will be able to transfer that property free of estate tax in the future). That said, there are many estate planning moves made for nontax reasons. For example, you may want to make gifts to children or grandchildren just because you love them. As long as you don't trigger any gift tax, there's no reason not to do so. Gifts up to $11,000 per donee can be made in 2005 and sheltered from gift tax with your annual exclusion.
If you are interested in larger gifts, you can still do so without incurring gift tax, but only to the extent you haven't already used your $1 million lifetime exclusion for gifts. Likewise, you may want to transfer assets to trusts (either during your lifetime or at your death) for a variety of reasons, such as professional management, asset protection, or the ability to keep the trust corpus intact. The potential repeal (or scale-back) of the estate tax should not affect those plans. However, as mentioned earlier, at this time we recommend that you avoid any transfers that trigger a gift tax.
Conclusion
This letter is intended to give you just a few ideas to get you thinking about planning for 2005. We would like to discuss your situation in detail to see how these and other planning ideas can be used to reduce your tax bill. Please don't hesitate to call us if you would like more details or would like to schedule a tax planning strategy session.
Sincerely,
Gregory T. Stapp CPA/PFS, CFP
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