Though most people find little humor in the subject of taxes, proper tax planning requires a sense of timing, just like a well-delivered joke. Though you should have your tax strategies in place throughout the year, there are several year-end moves you can make to hold on to your money.
Time your mutual fund trades.
If you’re looking to invest in a mutual fund during the fourth quarter, be careful. That’s because many funds pay out the year’s trading gains to shareholders in December. “You may be better off waiting until after the capital gains distribution,” says Ingrid John, a CPA and director of Capital Management Group in Washington, D.C.
If you don’t, you may be looking at a sizable tax bill if you’re investing outside of your 401(k). Suppose you invested in 1,000 shares of ABC Fund prior to the capital gains distribution. Assume you receive a $4 per-share distribution for a total of $4,000. John says that “unless you hold the shares in a retirement account like a 401(k) or an IRA, you’d owe tax on the $4,000 distribution” whether you take the cash or reinvest the distribution. Bottom line: You’d be taxed on the capital gains even though you didn’t own shares early enough to benefit from the appreciation.
In addition to dodging the tax hit, the fund’s shares will trade at a lower price after the distribution. So track the fund’s activity and buy shares after you see a distribution-related price drop.
On the flip side, it can pay to sell a fund for long-term capital gains before the distribution. Say you’ve been holding shares of an emerging markets fund for the past five years–during which time it has posted laudable returns–and because you believe those markets may cool down, you decide it’s time to sell. On a sale, most or all of your profits will be treated as long-term capital gains, probably taxed at a bargain rate of 15%. However, if you wait until after the distribution, you may receive an unpleasant surprise. Say the fund makes a $4 per-share distribution. In this hypothetical example, you discover that $2 per share (half of the payout) includes net short-term gains and dividends that do not qualify for the low tax rates enjoyed by most stock dividends. On that half of the distribution, you’d owe ordinary income tax, at federal tax rates as high as 35%. For sellers, sooner may be better than later.
Trim the Alternative Minimum Tax.
As its name suggests, the AMT is an alternative tax calculation. You (or more likely, a tax pro who understands this complex computation) must crunch the numbers both ways and pay whichever is higher, your regular tax or your AMT. “We contact our clients near the end of each year,” says John. “We run the numbers to see if they’ll owe the AMT. About two-thirds of them might owe this tax, so we see what they can do about it.” If your financial adviser is not so proactive, take the initiative and schedule a meeting before the holiday parties begin. That may help you avoid one of the nastiest pitfalls in the tax code.
The people most likely to owe the AMT are middle- and upper-income taxpayers who live in high-tax states such as California or New York, according to the Tax Policy Center, a research outfit in Washington, D.C. An estimated 4 million taxpayers owed the AMT in 2006, and that number could surpass 23 million in 2007, unless Congress changes the law.
So how can you reduce your potential AMT exposure?
Avoid year-end prepayments. If you pay quarterly estimated taxes, the last payment for this year is due by Jan. 15, 2008. Traditional tax planning calls for you to make an estimated payment of state and local tax by Dec. 31, 2007. That would entitle you to deduct those taxes on your federal tax return for 2007.
However, state and local taxes are not deductible when calculating AMT income, so making that payment in 2007 won’t help. If you will owe the AMT this year, John suggests you wait until early next year to pay your estimated state and local tax. In 2008, you might not owe the AMT, so that January 2008 payment may turn out to be a valuable tax deduction.
Reconsider capital gains. As mentioned above, long-term gains officially are taxed at no higher than 15%. With AMT, though, that’s not always true of large capital gains. “For taxpayers who owe AMT, under certain circumstances, their effective tax rate on long-term capital gains may be 21%,” says Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants in Washington, D.C. The reasons are complicated, but the result stems from the fact that as you capture gains, your AMT exemption might be phased out, resulting in a higher income that is subject to the AMT. “In this situation, we might advise clients to take some of the gain in December 2007 and the rest in January 2008,” says John. “That spreads the gain over two tax years and may reduce the effective [tax] rate.”
Now for the “good news”: If you are locked into the AMT for 2007, more of your income will be exposed to taxation, but the rates are relatively modest: 26% and 28%. Say you invested $20,000 in speculative stock this year and that stock now trades at $50,000. You’d like to sell and take your profits before
the stock tumbles back to earth. Ordinarily, you’d owe tax on a stock held for a year or less at rates up to 35%. If you’re in the AMT class, though, you can take a short-term capital gain by year-end and pay tax at the lower rates.Convert your IRA into a Roth IRA.
If you are interested in converting a traditional IRA, you should withdraw funds from the account by year-end .
A traditional IRA is usually funded with money that has never been taxed. If so, all withdrawals are subject to income tax.
A Roth IRA is funded with after-tax dollars; therefore withdrawals may be tax-free.
Although converting to a Roth IRA means that you’ll pay income tax on the money flowing out of your IRA at ordinary income tax rates, “The advantage to a 2007 conversion is that it starts the Roth IRA clock at Jan. 1, 2007, even if the conversion is at year-end,” says Ed Slott, a CPA in Rockville Centre, New York. It’s advantageous to “start the clock” early because after five years and after age 591/2, you can take tax-free withdrawals from a Roth IRA. If you convert before the end of the year, the five-year period will end on Jan. 1, 2012. “This technique gives you one of those five years right away,” says Slott, who publishes Ed Slott’s IRA Advisor newsletter.
If your income this year is a maximum of $100,000, you can convert from a traditional to a Roth IRA. (If you pay tax as “married, filing separately,” you are ineligible for a Roth IRA conversion, no matter what your income.)
“We have clients who are consultants or independent contractors,” says John. “They can time their invoices so they wind up some years with little income, but they still have deductions for mortgage interest, property tax, and so on. For those people, we suggest a Roth IRA conversion.”
With low income, such clients owe little or no tax on a Roth IRA conversion. As early as 2012, once they pass age 591/2, they can tap that Roth IRA whenever they’d like, for tax-free income.
Year-End Plannning Checklist
Gain by losing. Unload the losers in your portfolio to offset any capital gains you’ve taken this year. An additional $3,000 in net capital losses can be deducted on your tax return.
Avoid wash sales. A wash sale occurs when shares of a security are sold at a loss and an essentially identical security is purchased within 30 days. Whether you bought the securities before or after the sale, if it was within 30 days, deducting the loss for tax purposes would be disallowed.
Be charitable with your winners. Instead of writing a check, donate appreciated secur
ities held more than one year. You’ll be able to write off their full value and avoid the capital gains tax obligation.
Give appreciated stock to your college student. In 2007, a student in the 18- to 22-year-old age group can sell the shares and owe only 5% in tax, in most cases. Starting in 2008, “kiddie tax” rules will clamp down on this opportunity.
Press the “on” switch. If you’re self-employed, a business owner, or a professional, now is an optimal time to buy needed equipment. Section 179 of the tax code allows you to deduct these expenses right away: In 2007, first-year write-offs up to $125,000 worth of equipment purchases are permitted. To get this tax break for 2007, the equipment must be in place and used by Dec. 31. Even if you make the payments in 2008, you still can deduct the purchase price in 2007.