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Tax Matters
SUMMARY OF PLANNING IDEAS
1. Maximize your capital losses, review your investment portfolio.
2. Fully fund your retirement accounts
3. Maximize your non-deductible IRA contributions
4. Consider gifts to reduce your taxable estate ($12,000 per year per person)
5. Charitable gifts of appreciated property have more value than cash!!!!
6. Contribute to a Section 529 College savings plan.
7. Make your 4th quarterly State tax estimate before December 31
8. Ensure that your estimated taxes are paid to avoid underpayment penalties.
9. Meet, call or email your friendly Certified Public Accountant!!
(301/770-5822, or CPA@CPAbod.com)
FINANCIAL PLANNER
Consider Taking Advantage of Stock Losses
April 15 is traditionally known as "tax day," since that's the day your tax return is due. We think Dec. 31 is an important tax day as well for informed investors, however, since in most cases that is the deadline for taking steps to reduce your income taxes for the past year.
Here are some areas we suggest you review now before the less recognized Dec. 31 tax day arrives. Keep in mind a new 10 percent tax bracket was put in place for 2004. The former 28, 31, 36 and 39.6 percent tax rates dropped to 27, 30, 35 and 38.6 percent, respectively. In addition to the drop in tax rates, here are some steps you can take to further reduce your tax liability.
Review Your Investment Portfolio
Start by reviewing the securities you have sold so far this year to see whether you have a net gain or a net loss. You might want to use a blank Form 1040 Schedule D as your worksheet to make this task easier. The year ended form can be downloaded from the IRS Web site at www.irs.gov; click on the Forms and Publications link on the home page to reach it.
Group all your short-term gains and losses and net them against each other. Short-term gains and losses are for those securities you held one year or less. Do the same for your long-term gains and losses. Be sure to include any losses you might have carried forward from year ended in each of these calculations.
To determine whether you have a carryforward loss from last year, check your year ended federal tax return. if Line 13 on your Form 1040 shows a gain, or if it shows a loss of less than $3,000, you do not have a carryforward loss. If Line 13 shows a loss of $3,000, chances are that you have a carryforward loss. Review your year ended Schedule D and the capital loss carryforward worksheet to determine whether your carryforward loss is short-term, long-term, or both.
Once you have figured your net short-term gain or loss and your net long-term gain or loss, combine these figures to determine your overall gain or loss. If the result is a net loss, the maximum excess capital loss you're allowed to deduct in one year is $3,000. If your net loss is larger than this amount, it can be carried forward to next year.
If the overall result is that you have a net short-term gain, it will be taxed as ordinary income unless you offset it with deductions or additional losses. If you have a long-term gain, it will be taxed at a maximum federal rate of 20 percent (10 percent to the extent you are in the 10 or 15 percent tax brackets).
Next, review your current holdings to determine whether you should make any other sales before yearend. If you have an overall net gain year-to-date, particularly a net short-term gain, review your portfolio for sales that will result in a loss. When calculating the cost for mutual funds, remember to add any dividends or capital gains you have reinvested into additional shares to your cash investments in the fund.
Also keep in mind that if you sell a security (stock, bond, mutual fund) for a loss, you cannot buy that security back within 30 days after the sale date or else your loss will be disallowed under the "wash sale rules." The loss is also disallowed if you purchased the stock fewer than 31 days before selling it. One way to lock in a loss without being out of the market for 31 days and without violating this rule is to purchase a different, but similar, security - a stock or mutual fund within the same industry, for example.
If you like a stock for the long run but would like to sell it this year for a loss, another strategy is to double-up on the position more than 30 days before selling it. Then after waiting 31 days or more you can sell the higher cost shares. You'll create a tax loss and will still be left with the same number of shares you had originally. Remember to factor in fees and commissions on both the buy and sell transactions before doing this.
For example, let's say you have net long-term capital gains of $ 5,000 so far this year. Also assume that you purchased 200 shares of Company Xs stock several years ago at a total cost of $10,000 and that the stock is now worth $6,000, or $30 per share. You buy an additional 200 shares at a total cost of $6, 100, and after 31 days you sell your original 200 shares for net proceeds of $5,900. Your tax loss is $4,100 ($5,900 - $10,000), and your tax savings is $820 (20 percent of $4,100). You paid $200 in transaction costs, so your net saving is $620. And you still own 200 shares of Company A's stock.
If you have a net loss year-to-date, you may want to review your portfolio for sales that will result in a gain. But don't sell something just to use up your losses - sell only if you have other reasons for doing so as well. After all, excess capital losses aren't lost just because you can't deduct them all in the current year. Capital losses can be carried forward indefinitely until they are used up. Remember to consider capital gains distributions from mutual funds when figuring your tax situation. This year, like last year, fund companies are less likely to pay substantial gains because of the declining markets. This doesn't necessarily mean that a fund won't declare any capital gains distributions. Transactions within a fund's portfolio may still result in a gain, since some of the fund's positions may have been purchased several years ago.
Fund companies generally begin releasing their estimates of year- end distributions in early November. You can contact the fund company or your financial adviser for this information. Be sure to ask whether the expected gains are long-term or short-term.
If you're selling a mutual fund, find out when the ex-dividend date is. If you own the fund on the ex-dividend date, you will be paid the capital gain even if you don't own the fund on the date the gain is actually paid. You may want to sell the fund before its ex- dividend date because you'll have to pay taxes on that gain even if you have a loss in the fund overall.
When searching for gains or losses in your portfolio, look at the specific cost for your shares instead of their average cost. If you bought a stock at several different times, you can select the shares you want to designate as sold. But you need to keep a careful record of which shares you designated as sold for future years.
Many people don't know that this approach can also be used with mutual fund shares. Let's say you have been investing regularly in a fund and bought some shares of it in 1990 and 1991, when most prices were higher. If you need a loss, you might sell some of these shares.
Fully Fund Your Retirement Plans
Contributions to 401 (k)s and other retirement plans offered to employees generally must be made before year-end. 401(k) contributions must be deducted from your paycheck.
Let's say you contributed less than the maximum earlier in the year but now find that you have some extra money in your cash reserve. Some employers will allow you to deduct a much larger amount from your year-end paychecks so that you can fully fund your 401(k) plan. This means you'll take home less, but you can cover your expenses with your cash reserve, and your tax savings will pay for part of "I'll your contribution.
Contributions to IRAs have to be made by April 15, while contributions to self-employed retirement plans must be made by the due date of your tax return, including extensions. A Keogh plan, designed for self-employed workers, must be established by yearend, however.
Contribution limits to retirement plans increased in 2004 as indicated in the chart below. The catch-up contribution is also allowed this year if you will turn 50 years old by Dec-31,2004.
Make Charitable Gifts
If made by year-end, charitable contributions are deductible this year. But don't wait until the last minute. While checks mailed and postmarked by Dec. 31, count as being made this year, gifts of securities work differently. If shares of a security are transferred electronically from your account to a charity's account (generally preferable to mailing), the shares must be credited to the charity's account by yearend. If you're gifting shares of a mutual fund, allow several weeks for the transfer to occur. Check with your adviser or with the fund to find out how much time you should allow; some firms won't guarantee transfer by year-end after a certain date.
We recommend gifting appreciated securities instead of selling the security and going the proceeds.
That way you won't have to pay taxes on the gain. For example, if the cost of your long-term holding in XYZ stock is $5,000 and the stock is worth $10,000, your outof-pocket cost for the gift may really only be $5,500 if you're in the 35 percent federal tax bracket ($10,000 $3,500 in federal tax savings from the deduction - $1,000 in capital gains taxes that you won't have to pay). In addition, you may reduce your state income tax.
If you own a security at a loss, you're better off selling it and gifting the proceeds so that you can recognize the tax loss. If you gift a security at a loss, you cannot deduct your loss; you can only deduct the value of your gift.
Gifts to Other People
You can give up to $12,000 to anyone you wish free of gift taxes. If your spouse consents, you can give up to $24,000 to another person. You don't receive a tax deduc\tion for these gifts, but you do shift the income from that asset to the recipient, and you remove the value of the asset - and its appreciation - from your estate.
If you transfer a stock from your account to another account, the gift's value is determined by the average of the high and low price for that stock on the date the recipient's account receives the stock. A mutual fund's value is based on the net asset value on the day of the gift. For those seeking to reduce their taxable estate given the current depressed price levels of many stocks, you can give more shares now than you could earlier in the year. Gifts made by check must clear the bank by Dec. 31 for the gift to qualify as a 2004 gift.
Contribute to a 529 Plan
Contributions to a Section 529 college savings plan or prepaid tuition plan are treated like other gifts to individuals with one important exception: You can give up to five years' worth of gifts in one year. This means a couple can contribute up to $110,000 to a 529 plan this year for an individual if they haven't made other gifts to that beneficiary in 2004 and if the couple files the appropriate gift tax election form.
Make Your Estimated State Tax Payment
Pay your fourth-quarter estimated state tax payment by Dec. 31, to deduct the payment on your 2004 tax return. If you wait until the Jan. 15 due date, you won't be able to deduct that payment until you file your 2005 tax return. Caution: If you owe the alternative minimum tax (AMT), you may not get to deduct this payment, since the deduction for state tax payments is disallowed for AMT purposes.
Pay In Enough Taxes
Make sure to pay in enough taxes to avoid federal and state underpayment penalties. If you incur a taxable gain or have other unexpected taxable income during the year, be sure to adjust your tax payments to compensate. Taxes that are withheld are treated as if paid evenly throughout the year, even if you increase or decrease your withholding rate during the year.
Quarterly estimated taxes, however, don't work this way. In other words, you may not be able to avoid an underpayment penalty for a gain incurred early in the year by increasing your fourth quarterly tax installment. But it's possible to increase your withholding late in the year from income sources such as salaries, pensions and IRA distributions to meet the pay-in requirement and avoid a penalty.
Bunch Your Deductions
Since itemized deductions are phased-out for higher income taxpayers, you could benefit by grouping your deductions in one calendar year. If your adjusted gross income exceeds about $140,000, you'll lose 3 percent in itemized deductions for every dollar your AGI exceeds this limit.
Deductions excluded from this rule are allowable medical costs, theft/ casualty losses and investment interest expenses. Bunching may be particularly helpful for miscellaneous itemized deductions (fees for tax preparation, financial planning and investment advice, for example) that have to exceed 2 percent of your AGI to even be considered a potential deduction.
We encourage you to sit down early and decide whether you need to take any action before yearend to reduce your taxes. We have given you some general guidelines, but we strongly recommend you check with your CPA before making any changes.