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December 2001

Q. I'm interested in improving my year-end tax planning. Do you have any advice regarding planning areas or strategies to consider, especially in light of the 2001 tax legislation?

A. The general trend of the 2001 tax legislation is to lower future years' tax rates, particularly in the upper brackets, and particularly in 2006 and later. Five tax brackets will see a decrease in the tax rate. For example, the legislation carved out a new lower tax rate of 10% from the existing 15% tax bracket at the lowest income levels. For 2001, most individual taxpayers have already benefited from this reduction via advance refund checks ($300 to $600), issued prior to 12/5/2001.

From a planning perspective, the small decrease in the five tax brackets means that tax deductions postponed to next year will be worth less to you in tax savings than if they could be deducted this year. Conversely, the tax bite on income deferred from this year to next will be lessened due to the decrease in tax rates. As with everything else in life, the devil is in the details, so careful planning and discussion with your advisor are needed before implementing any specific tax reduction strategy. To assist in reducing your 2001 tax bill, we are noting below a number of areas that you should review prior to the year's end. Remember, it's too late to do your 2001 tax planning on the eve of April 15th.

Retirement Money
If you haven't already done so, consider contributing the maximum to your company-sponsored retirement plan, such as a SIMPLE IRA, 401(k), etc. Check whether you have the option to make additional contributions, wage deferrals, or commission deferrals, into the plan prior to December 31, 2001. Ask if any or all year-end bonus payments might be contributed to the plan, particularly if there is a company match available.

IRA Contributions
To the extent that you have already met contribution limits to your employer-sponsored retirement plan, consider funding a 2001 IRA account. See other areas of our site to determine which IRAs are available to you. The earlier you fund the IRA the more you will save. If need be, consider partially funding an IRA with amounts less than the maximum permitted.

Required Minimum Distributions for IRAs
Regular readers already are aware of the confusion generated by the January 2001 release (and subsequent "clarification") of proposed regulations to simplify the calculation of required minimum IRA distributions and, in many instances, to reduce the required amount. Consider following the regulations in 2001, although they won't be mandated until 2002. As murky as the regulations are, the bottom line is that implementing them for the 2001 tax year can reduce your taxable income. This is not an issue for the faint of heart to tackle without assistance, due to the 50% penalty assessed on distribution shortfalls.

Itemized Deductions
Remember, a dollar of deduction is worth more before January 1, 2002 than after. Therefore, steps should be taken to accelerate their payment. Generally fruitful areas to review include:

  • Interest expenses - Prepay your January 1, 2002 mortgage payment on or before December 31, 2001. Ideally, you will mail this payment in time for the mortgage company to record its receipt and include this amount on your 2001 Form 1098 (Statement of Mortgage Interest Paid). Some companies include these year-end payments if the envelope is postmarked on or before December 31, while others use a strict date-of- receipt methodology. To simplify your 2001 Form 1040 filing, you want your 2001 Form 1098 to include all interest payments made during the calendar year without having to explain any differences to the IRS, so mail early.

  • Charitable contributions - Several last minute savings techniques are still available. For example, you might donate in-kind items such as clothing, furniture, household effects, automobiles, etc. If you donate appreciated property (notably stock), in many cases you will receive a deduction for the full current value of the stock without ever paying tax on the gain. Also, you can make year-end donations with a credit card, even though the charge is not paid until early next year.

  • Miscellaneous itemized deductions - This is an area that generally requires a multi-year outlook, due to the 2% of income threshold that must be exceeded in order to enjoy a deduction. Be careful to reasonably ascertain the nature and amount of all possible deductions that fall into this "catch-all" category. In many cases these expenses, including employee business expenses, union and professional dues, business subscriptions, investment-related fees, tax preparation costs, etc., are incurred on a regular basis. In any one year, their total may not exceed your 2% threshold; however, this total may be exceeded if you can bunch their payment into one taxable year. With some forethought, you may be able to ensure that payment of all your renewals, purchases, and fees coincide with one calendar year. This may include paying some portion of a prior year's bill, the current year's bill, and the bill for up to one year's future service, all in one calendar year. You may need to chart out your current and future payments in this area. A word of caution: always quantify your intended outcomes to ensure you succeed in obtaining a deduction without falling into the alternative minimum tax trap. Consult with your advisor for assistance.

  • Tax payments as deductions - Verify, to the maximum extent possible, that you have paid your complete projected 2001 state and local income tax liability by December 31, 2001 via your withholding and or estimated tax payments. You may even wish to accelerate payment of any fourth-quarter state (not Federal) estimated tax payment, normally due by January 15, 2002, to December 31, 2001, or earlier. Remember that many states now accept credit card authorizations. Of course, the infamous alternative minimum tax must likewise be considered in this area as well.

  • Tax payments as pre-payment credits - Not only do we wish to lower our tax liabilities, we wish to avoid unnecessary penalties as well. Penalties for underpayment of estimated taxes and/or withholding generally may be avoided if we pay either 100% of last year's tax liability (line 57 of 2000 Form 1040), or 90% of this year's tax liability. Plenty of exceptions to this general rule exist, so verify your specific situation with an advisor. One way to address any shortfall is to have your employer immediately modify your Federal and/or state tax withholdings on your final paychecks for the year. If your withholdings fall terribly short, ask your employer to process a "voluntary additional tax payment." In this situation, you make a payment to your employer, who then includes this amount with their deposits to the tax authorities and includes the amount in your year- end W-2 totals. This technique often gives retroactive protection from penalty that a quarterly estimated tax payment does not.

  • Capital losses - Recognize capital losses prior to the year-end rush. Capital losses may be used in two ways. First, they may offset any recognized capital gains, including capital gains distributions from mutual funds. Second, they may generate up to a $3,000 tax deduction in any one year. Any net capital losses in excess of $3,000 are carried forward to subsequent tax years. Discuss with your advisors the ability to recognize any paper losses that you may have, while still continuing to participate in the market. This situation can be realized through a number of techniques that avoid the "wash sale" rules. The best technique for you depends on your individual circumstances as well as your prognosis for the market over the next few weeks.

  • Long-term versus short-term gains - What to do if you have a significant, short-term gain available (less than one year), but you believe that the market may not hold onto that gain for the remainder of the required one-year holding period? Discuss with your advisor the advantages of selling a deep in-the-money call option against this position, which can essentially lock in the gain, while deferring the sale date to a time after your one year holding period is attained. As a bonus, the premium that you receive for selling the call option also may be awarded with long-term capital gain treatment. Remember: the holding period is measured on the trade dates, not the settlement dates.





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