Volume 26 Number 3, Fall 2005
Now is the Time to Begin Year-end Tax Planning
New for 2006: Roth 401(k)s
Increase in Annual Gift Tax Exclusion
Deductions for Hybrid Vehicles
2006 Per Diem Rates
The Better Way
www.sek.com
Now
is the Time to Begin Year-end Tax Planning
In
a more perfect world, taxpayers would be thinking of ways to save on their
taxes (and putting those plans into action) throughout the tax year. The
reality is that most people think about their taxes only once a year, and
if they could, they would avoid that time, too. Nevertheless, some can be
persuaded to consider their tax situations at least one other time if they
know how much doing so can ease the pain of tax season. Now would be a
good time to start.
End-of-year tax tips generally fall into two groups: the old favorites,
some of which have a few new twists, and new legislation. Some of the old
favorites include the alternative minimum tax (AMT), capital gains,
retirement and education savings, and business planning. Congress, which
has been busy tweaking and tugging on the Tax Code since 2001, passing
five major tax laws over that period, has been especially active this
year, even before the president’s Tax Reform Commission releases its
recommendations. Several new laws have major tax provisions, including the
recently passed energy and Hurricane Katrina relief laws. In addition, the
IRS and Treasury have been very productive, especially regarding guidance
on deferred compensation issues.
All of this adds up to a long list of potential areas for tax savings -
too many to cover the entire list. However, even just checking through
some of the main topics in each of the main groups, it is possible to
uncover some noticeable tax savings before it’s too late to do anything
about it.
AMT. The AMT is the one potential
danger— and an area for tax planning few taxpayers see coming. Since the
AMT is not indexed for inflation, the number of taxpayers affected
continues to increase, potentially affecting over 20 million taxpayers in
2006. While legislation has been introduced that would repeal the AMT,
Congress’s answer to the problem in the past has been to extend the AMT
exemption rather than adding indexing or changing the structure of the
tax. Unfortunately, one of those extensions expires after 2005.
Start planning around the AMT by projecting your income for the rest of
the current year and for the next two years. Starting with the AMT can be
beneficial because the AMT eliminates some deductions; it is
counterproductive to find additional deductions only to lose them to the
AMT. Some of the items that can affect the impact of the AMT include:
- State and local taxes - examine whether it makes sense to pay them in advance;
- Incentive stock options - these may generate AMT income even when sold at a loss;
- Unreimbursed employee expenses - employees and employers can benefit by switching to
an accountable reimbursement plan;
- Income timing - if the AMT is not changed, it may make sense to accelerate income, if
possible;
- Don’t forget the minimum tax credit for deferral items.
Fortunately, some of the benefits provided under the Hurricane
Katrina Emergency Tax Relief Act are not affected by the AMT; however,
the credits available under the recent energy act are.
Capital Gains. The end of the year
is the perfect time to examine investments to minimize capital gain
income. Taking losses on consistently underperforming investments can
offset gains taken on winners, because it may be advisable to sell them to
rebalance portfolios. Remember that losses taken in excess of gains offset
ordinary income up to $3,000 ($1,500 for MFS). Some appreciated stock is
better off not sold, but donated to charitable organizations. These
donations can be deducted at the fair market value of the stock. Capital
gains can also be shifted to family members in lower tax brackets through
gifts of securities. The basis remains the same for donor and donee.
Finally, a recent development is that taxpayers can elect to treat capital
gains and qualified dividends as investment income, taxed at ordinary
income tax rates, if they have deductible investment interest that will
offset it.
Retirement Planning. While
contributions to IRAs may be applied retroactively if made before the
filing deadline, contributions to qualified plans must be made before the
end of the calendar year. Taxpayers who are not already maximizing
contributions to their retirement plans have the ability to reduce their
AGIs by increasing their contributions. This has the added effect of
increasing the deductibility of medical and other deductions subject to
AGI floors. Taxpayers over 50 should examine the possibility of making
"catch-up" contributions. Some taxpayers may have reached
the age at which they must take minimum distributions and should make
certain they have done so.
It is also time for taxpayers to consider conversions from traditional
IRAs to Roth IRAs. This will generate a potentially large tax bill that
cannot be spread over four years as was once possible, but the long-term
benefits may outweigh the current costs. If the value of an IRA has
dropped substantially, a reconversion is possible. The end of the year is
also time to consider options for next year; this year, that includes
considering contributions to a Roth 401(k) or 403(b) plan, into which
employees make contributions from after-tax dollars and can later take
distributions tax free.
Small Business Planning. Small
business owners have many opportunities for tax savings to consider. A
good starting point is a review of the form of business organization.
While S corps and LLCs have offered tax advantages over C corps in the
past, and in many cases still do, the disadvantage of double taxation has
been reduced with the establishment of the tax rate for qualified
dividends. Among other items, the Section 179 deduction for capital
purchases that would otherwise have to be depreciated stands at $105,000,
and can be applied to purchases of up to $420,000. This limitation drops
back to $25,000 after 2007 (unless extended), so now may be the time to
start maximizing each year’s maximum deduction while it’s still this
generous. Establishing employee benefit plans, qualified retirement plans
and medical or health reimbursement plans can provide tax savings to both
employees and the business. Businesses should also not forget the Code
Sec. 199 domestic production activities deduction, which applies to
manufacturers and many businesses not normally considered to be in
manufacturing.
Sole proprietorships can realize tax savings by putting family members
on the payroll. Putting a spouse on the payroll allows the business to
provide tax-free medical coverage for the self-employed individual as the
spouse of a covered employee. Children can earn up to $5,000 tax free, and
also have the opportunity to put the funds into a Roth IRA. The parents
are also not subject to FICA on the wages paid to a child under age 18.
Those who work out of their homes can take advantage of the liberalized
rules for claiming a home office deduction, and if they qualify, can also
deduct travel costs between their homes and where their clients are. In
the event a sole proprietorship has losses and the proprietor has no other
income, it might be advisable to forego some of the business deductions so
as to claim earned income and the EITC.
Recent Tax Legislation. This year’s
energy and hurricane relief acts contain significant tax breaks for
businesses and individuals alike.
The Energy Tax Incentives Act of 2005 contains credits for
energy-efficient improvements to residential and business property and
solar energy property. Year-end planning is especially helpful for
those credits since they don’t start until 2006, under very specific
conditions. The new energy law also changes the above-the-line deduction
for "green" vehicles to a tax credit.
The Hurricane Katrina relief act contains tax breaks for employers who
hire and retain individuals affected by the hurricane, provides tax
incentives for charitable giving, and lifts restrictions on casualty
losses and distributions from retirement accounts. Many donors, not only
to Katrina relief funds but to all charitable organizations irrespective
of use, have been given a special tax incentive to be especially generous
to the end of the year - the usual donation deduction limit of 50 percent
of income for the year has been lifted.
Planning Starts Now. If you have
used year-end tax planning in the past to lower your tax bill for the
current and the upcoming year, now’s the time to call our offices for an
appointment. If you have not taken advantage of year-end planning in the
past, consider calling our offices to maximize the unusually full list of
tax-saving opportunities that this year has to offer. The unusual aspects
of this year’s tax changes —combined with standard year-end planning
techniques that include deferring income and accelerating deductions,
accounting for changing investment, employment or family situations, and
taking full advantage of growing opportunities for tax-favored retirement
savings—present a unique opportunity to maximize your tax savings at
this time.
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New for 2006: Roth
401(k)s
Beginning
January 1, 2006, employers who sponsor a 401(k) plan may offer a Roth
401(k) option as a part of their plan. By adding the Roth 401(k) option,
employees will have the choice to make their contributions on an after-tax
basis, or on the current pre-tax basis. Employer contributions, including
matches, will continue to be deductible by the employer when contributed
and taxable to the employees when received.
There can be significant advantages with the Roth 401(k) option. First,
distributions from the Roth 401(k) portion of the plan will be tax free,
including the earnings, if they are Qualified Distributions. To be
qualified the following conditions must be met:
-the funds must be held in the account for a 5-year holding period, and
-the distribution must be as a result of death, disability, or attainment of
age 59 ½.
Second, there are no income limitations for participating in a Roth
401(k), unlike the current limitations for Roth IRAs.
A third consideration is that employees who like the Roth IRA features
will have the added benefit of higher contribution limits – for 2006:
$15,000, plus $5,000 for employees who are age 50 or older.
If you choose to allow employees to make a Roth 401(k) contribution to
your 401(k) plan, your employees will need to decide whether to contribute
on a pre-tax basis as they have in the past, or on an after-tax basis to a
Roth. This decision will have to be made by each employee based on his or
her personal circumstances. The factors they may want to consider include:
-their current age and years to retirement,
- their current and future rates of income tax, and
- the value of paying taxes up front in order to accumulate tax-free earnings in the
Roth 401(k) account versus the benefit of a current tax deduction and
paying taxes on a regular 401(k) distribution.
To help you and your employees make this decision, Smith Elliott Kearns
& Company, LLC will provide an online calculator on our website
at www.sek.com. In addition, we expect that numerous media articles will
be written that will provide financial guidance.
There are a few things you will need to know to help you decide whether
to offer a Roth 401(k) alternative in your 401(k) plan.
- You may not have to start a new retirement plan. In many cases, you will simply
amend your plan to add a Roth 401(k) provision.
- The Internal Revenue Service will issue guidance on how to complete employees’ W-2
forms for Roth 401(k) contributions. (At this point, we expect that the IRS will provide a new code to use on the W-2 form for the Roth
contributions.)
- Payroll service providers will have to update their payroll programs to
accommodate Roth 401(k) contributions.
We have a full-service Pension Department located in our Chambersburg
office. For questions about your specific plan, please contact Phil
Ritchie, Terry Eisenhauer or Chuck Balch at 717-263-3910 or call toll free
at 888-272-7351.
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Increase in Annual Gift
Tax Exclusion
Donors
will be able to make larger tax-free gifts in 2006. The annual gift tax
exclusion will rise to $12,000 next year, up by $1,000 over the current
amount. The increase is due to inflation. Thus, couples can give anyone up
to $24,000 next year free of gift tax and without having to tap their
$1-million lifetime gift tax exemption. These gifts offer an easy way to
reduce your estate.
In 2006, a couple with three married children and five grandkids can
decrease their estate by $264,000 if they give $24,000 to each child,
spouse and grandchild.
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Deductions for Hybrid
Vehicles
Purchasers of
the 2006 Toyota Highlander Hybrid can now take advantage of a $2,000 tax
deduction for buying a "green" vehicle. The IRS has announced
that the 2006 model of the Toyota Highlander Hybrid qualifies for the
clean-burning fuel deduction. The deduction of $2,000 for vehicles placed
in service in 2005, is scheduled to drop to $500 in 2006. No deduction
will be allowed after 2006 unless Congress extends it.
The IRS has also certified the 2006 Lexus RX 400h for the clean-burning
fuel deduction along with the 2005 models of the Toyota Prius, Honda
Insight, Honda Civic Hybrid, Honda Accord Hybrid, and Ford Escape Hybrid.
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2006 Per Diem Rates
The IRS has updated the
amounts that are deemed substantiated for lodging, meal and incidental
expenses while traveling away from home without the need to produce
specific receipts. Per diems for both the high-cost and other localities
jumped by double digits, far outpacing inflation.
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The Better Way
Hi Bracket
heard of an investment fund based on hedging transactions that was doing
well. Fed up with traditional investments, Hi called his broker and
invested a moderate amount.
After year end, Hi got the reporting package from his brokerage firm
and along with his other 1099s, W-2s, 1098s and receipts, went to get his
tax return prepared. Great! Another year done by early March.
About a month later, Hi got a letter from the investment fund stating
that his K-1 would be delayed until late May and advised him to consult
his tax professional as to his alternatives. What is a K-1 and what is
this all about?
As it turns out, the investment was in a limited partnership that did
not report through the brokerage firm. This K-1 reporting was not due
until April 15 (not January 31) and could even be extended. Now he had to
pay for an amended return, additional tax and interest. Also, the
complexity of the investment necessitated many additional schedules in his
return further raising the cost.
The Better Way would be to make sure the structure and administrative
cost of an investment is worth the earnings potential. Partnerships,
"S" Corporations, LLCs, estates and trusts report directly to
the investor and the timing of reporting is uncertain.
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www.sek.com
Should I refinance my
mortgage? How much do I need to save for my child’s college education?
As accounting professionals, these are some of the questions that are
posed to us on a daily basis. We want to serve you, so our web site
provides interactive financial calculators and other tools to assist you
with some of the day-to-day questions and concerns that may arise.
While these financial tools are not a substitute for financial advice
from a qualified professional, they can be used as a starting point in
your decision making process.
To access the calculators (and other helpful aids), go to www.sek.com
and look at the links on the left side of the home page. The first link,
"Information Center," will send you to a calendar of tax events
and a whole library of federal tax forms.
The second link will take you to "Financial Tools," which
includes calculators for questions on taxes, mortgages, retirement,
investments, personal finance and more - over 90 interactive calculators.
The third link, "Tax Alerts," gives you the latest
information which changes the first of every month.
As always, check with our professionals for help with your specific
situation.
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