Tax Planning and Tax Reduction Strategies

Tax Planning By Wilson Ziegler, Staff Writer

When it comes to sound financial planning, taxes and tax law regulation understanding are both vital elements. A critical component of any financial or retirement plan is a comprehensive tax strategy. In a nutshell, the goal of such a strategy is to capitalize on every opportunity the government makes available to you to cut the taxes you will pay on your income, investments, retirement portfolio and estate.

If you think of tax planning in the concept of tools to pay less in taxes, the most important tool is not something obvious like paper, pencil or a calculator. It is tax legislation. How well you are able to take advantage of the laws in place each year can determine the size of your tax bill.

TIPRA (Tax Increase Prevention & Reconciliation Act)

This important legislation, passed in 2006, follows the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the acceleration of certain provisions by Congress in 2003. TIPRA provides that:

• The reduced 15% tax rate on eligible dividends and capital gains for taxpayers in the 25% and higher brackets (previously set to expire in 2008) is extended to 2010.
• In tax years 2008 thru 2010, the rate on eligible dividends and capital gains will be 0% for those in the 10% and 15% tax brackets.
• After 2010 dividends will be taxed at the taxpayer’s ordinary income tax rate, regardless of whether the dividend is qualified.
• After 2010 the long-term capital gains rate will be 20% (10% for taxpayers in the 15% tax bracket).
• After 2010 the qualified five-year 18% capital gains rate (8% for taxpayers in the 15% tax bracket) will be reinstated with limitations.
• The alternative minimum tax (AMT) income exemption levels were increased in 2006 to $42,500 for single filers and $62,550 for join filers, and the ability to use certain non-refundable personal credits to offset AMT liability was extended through 2006.
• In 2010 and thereafter, all taxpayers will be allowed to convert traditional IRA balances to Roth IRAs. Once converted to a Roth IRA, assets have the potential to grow tax-free.

Pension Protection Act of 2006

The Pension Protection Act (PPA) was signed into law on August 17th, 2006 and contains over 900 pages of provisions designed to strengthen the ailing federal pension insurance program and protect company employee pensions which have struggled during the past decade.

The underlying theme behind the PPA is that the Congress has made it easier for people to contribute more money to their retirement plans and keep it there longer with new more flexible and liberal retirement plan provisions. The bill also tightened minimum funding requirements and placed restrictions on employers that fail to comply with minimum funding rules.

The PPA also addressed some of the more contentious provisions of the original EGTRRA, notably the sunset provision which stated that many of the provisions would expire after 2010. According to PPA, the following EGTRRA provisions are now available indefinitely:

• Higher annual contribution limits for IRAs (currently $4,000) along with catch-up contributions ($1,000 for IRAs, $5,000 for 401(k)s and similar plans, and $2,500 for SIMPLE IRAs).
• Higher salary deferral limits for 401(k), 403(b), SAR-SEP and 457 plans (currently $15,000) and SIMPLE IRAs (currently $10,000).
• Tax-free withdrawals for qualified education expenses from 529 plans.
• Roth 401(k) plans allowing after-tax employee contributions that have the opportunity to grow and be withdrawn income-tax-free under certain conditions. Roth conversions directly from Company Plans (subject to certain rules).
• MAGI (Modified Adjusted Gross Income) limits for traditional IRA deductibility and Roth IRA eligibility will be indexed for inflation in $1,000 increments beginning in 2007.
• Non-Spouse IRA Rollovers from an inherited Company Plan are permitted, and non-spouse rollover provisions apply to Trusts meeting IRS requirements.
• Qualified Charitable Distributions satisfy minimum distributions requirements.
• IRA owners who are 70½ or older can make income-tax-free IRA distributions directly to a charity

Tax Saving Opportunities and Strategies

As a result of TIPRA and PPA, now is a good time to review your portfolio, particularly your asset allocation (investment mix), because you can anticipate the lower 15% (or 5%) tax rate on eligible dividends and long-term capital gains for a longer period. Some things to consider include:

Holding investments in tax-deferred accounts

Because ordinary income producing investments (e.g. Treasury and corporate bonds, certificates of deposit) are taxed at higher rates, evaluate with your financial consultant whether it’s better to hold those investments in tax-deferred accounts. Likewise, real estate investment trust (REIT) shares may be more suitable for tax-deferred accounts because the dividends paid are not eligible for the reduced taxed rate.

Watch out for the Wash Sale Rule

As you assess your portfolio, keep in mind that you can use capital losses to offset capital gains and reduce your tax burden on securities you own. If you do so, make sure you understand the Wash Sale rule which comes into play when your goal is to maintain your position in a security but recognize a capital loss in that same security. One option is to sell the position (realizing the capital loss) and buying the same security. However, the wash sale rule disallows a tax loss if you buy the same (or substantially identical securities) within 30 calendar days before or after the trade date (61 calendar days total).

Rethinking your college saving strategy

Given the 0% tax rate on eligible dividends and long-term capital gains for taxpayers in the 10% and 15% brackets from 2008 through 2010, consider gifting appreciated securities to children or grandchildren who will be 18 or older when they sell the securities. During those three years, your child or grandchild could sell the securities and potentially incur no capital gains tax. (Be sure to check the Kiddie Tax rule).

Prepare now to convert traditional IRAs to Roth IRAs in 2010

The ability for people at any income level to convert from traditional IRAs to Roth IRAs beginning in 2010 may create attractive savings opportunities if, a) Your income is too much for you to make deductible traditional IRA contributions; b) You want to contribute to a Roth IRA but your income disqualifies you; or c) Your IRAs contain only nondeductible contributions and earnings or you don’t currently have any IRAs. Note that this strategy would not work as well if you currently have traditional IRAs consisting of tax-deductible or rollover contributions.

A critical component of any financial or retirement plan is a comprehensive tax strategy. In a nutshell, the goal of such a strategy is to capitalize on every opportunity the government makes available to you to cut the taxes you will pay on your income, investments, retirement portfolio and estate.

If you think of tax planning in the concept of tools to pay less in taxes, the most important tool is not something obvious like paper, pencil or a calculator. It is tax legislation. How well you are able to take advantage of the laws in place each year can determine the size of your tax bill.