Most people focus on income and estate tax planning at year-end. In recent visit I’ve given you advice on how to get the most from year-end planning. But I believe you can save more money and build more wealth by planning and making moves at the beginning of the year. This is the best time to make gifts to family members and take other steps. Here are the moves you should consider before the year is too far along.
Make gifts now. Make a gift now and you are sure it is out of your estate and in the hands of loved ones, along with all its income and gains for the year. That’s why I say make annual gifts in January, not December. This is an especially good year to make early-year gifts. Most stock prices still are below last year’s levels, and I anticipate stocks appreciating for most of 2002. If you give stock or mutual fund shares now, you are likely to give away more shares tax-free than in December. That’ true in most years, since the stock market rises most of the time.
Remember not to give away any property in which you have a paper loss. Sell the investment and deduct the loss. Go through your portfolio and sell any losers. You are likely to need them later this year or next year to offset some gains. Give only the cash proceeds from these sales. The best gifts are of property in which you have a gain and that is likely to appreciate.
Use the super-low capital gains tax rates. Most people don’t know that the 1997 tax law created lower capital gains rates in certain circumstances. There are two strategies to consider now that could help you use these lower rates.
Someone in the 15% or lower bracket pays an 8% capital gains rate on property that was held for more than five years before the sale. Suppose you own stock or mutual fund shares that were purchased more than five years ago, and these shares have substantial gains. If you sell, you’ll pay a 20% tax on the gains. Instead, you can give these shares to your grandchild. The grandchild takes the same tax basis and holding period in the shares that you had. That means the grandchild will have a more than five year holding period and can pay taxes on the gains at an 8% rate. That is a substantial family tax savings.
But remember that the capital gains count in determining whether or not the child is in the 15% tax bracket. The benefits of the 8% bracket don’t apply if the amount of gains pushes the grandchild into a higher bracket.
Instead of paying for a grandchild’s tuition, give shares. The grandchild can sell the shares, pay taxes at less than half your tax rate, and use the after-tax proceeds to pay the tuition. That’s one of any number of ways you can benefit from the 8% capital gains tax rate.
Taxpayers above the 15% tax bracket also get a lower capital gains rate, but the rules are a bit different. The lower rate is 18%, and the five-year holding period begins only for property purchased after Dec. 31, 2000. But there is a special election that you still can use, and this might be an especially good time to make the election.
For property purchased before Dec. 31, 2000, you can reset the five-year holding period by recognizing and paying taxes on gains accrued as of Jan. 2, 2001. Then you still have to hold the property for at least another five years. But if you do so, the subsequent gains are taxed at 18% instead of 20%.
The election can be a good move for investments that you plan to hold for another five years and that have high appreciation potential. This is an especially good time to consider the election because of the market’s decline in 2000. You could recognize the gains at what will turn out to be a fairly low historic level. Then you’ll get the 18% tax rate on the gains after that date, and your tax basis will be reset to the value on Jan. 2, 2001.
You also can make the election for investments that showed a loss on Jan. 2, 2001. In that case, you won’t ever get to use the loss on your tax return. But you reset the holding period. For an asset that was temporarily depressed in price a year ago and that you still own, that might be a good move.
The election for capital gains taxes can be made any time before you file your tax return for 2001. To decide whether or not to make the election, you have to do some calculations. Calculate the tax you would have to pay on the gains as of Jan. 2, 2001. Then make assump-tions about when you might sell the investment, how much it might be worth then, and how much the taxes would be at both the 18% and 20% tax rates. Then decide if those potential savings are worth paying taxes now and losing the use of that money the next few years.
Re-evaluate college savings plans. No matter which vehicle you use, the fund probably has some losses in it. That could be a good reason to shift the investments and also move the money into another savings vehicle.
If you are using an UGMA account, that account is in the child’s or grandchild’s name. If you sell, the losses would be on the child’s or grandchild’s tax return. But that doesn’t mean you should refrain from harvesting losses. Capital losses don’t expire. They can be carried forward to future years until fully used by offsetting capital gains or other income. You plan on selling the investments some day at a gain to pay for tuition. Take any losses today so that they will shelter future gains.
Those using a section 529 college savings plan might want to shift to another plan. That’s because you are the account’s owner if you set it up and contributed the money. Under most plans, you have the right to terminate it and take the money back. If the account is worth less than when you put the money in, there is a loss that is deductible on your tax return. Close the account and take your money back. Then move the money in a different state’s plan, to be sure that the IRS won’t claim this is a wash sale and disallow the loss.
You probably want advice from a CPA before implementing this strategy. The loss probably qualifies as a miscellaneous itemized expense instead of a capital loss. That means you can deduct only the amount by which all your miscellaneous expenses exceed 2% of adjusted gross income. You also want to be careful that a large miscellaneous itemized expense deduction doesn’t trigger the alternative minimum tax.