Year-End Tax Planning

Year-end tax planning is special this year. The new tax law, the market downturn, and other factors provide some unique opportunities and traps. With the right moves in the next few months you can substantially reduce taxes this year and in coming years. The wrong moves, or failure to act, can cost you.

The math of tax cuts. Tax rates are falling. It is not the sharp reduction of the 1981 tax law, but rates will decline gradually through 2006. That means every year you defer income through 2006 saves you money. The biggest benefits go to those in the top tax bracket; their rate eventually will drop by 4.6 percentage points. But taxpayers in every bracket get a cut.

If you still are working, consider deferring salary, bonuses, and raises, and also profits from nonqualified stock options. A deferral even from December to January will save tax dollars. Retirees can delay withdrawals from annuities and retirement plans. Take only the minimum required by law and by your spending needs.

Also, consider shifting some investments. If you earn interest or dividends that exceed your needs, you might put money in a fixed annuity or shift to investments that won’t pay current income for a few years.

Lower future tax rates also make deductions more valuable this year than in coming years. To the extent you can afford it, accelerate charitable deductions from future years to this year. State income and property taxes that ordinarily would be paid in January can be paid in December. But be careful about the stealth taxes discussed in last month’s visit. Check how the Pease itemized deduction reduction and alternative minimum tax might affect your deductions before writing a check this year.

Contributions to retirement plans can produce a double benefit. You might qualify for a deduction or exclusion in the current year against a high tax rate, then get to withdraw the contribution and its accumulated gains in a future year when tax rates are lower.

Taxes and falling stocks. Investors with taxable accounts should be busy this year. The market is down, and a number of mutual funds are down significantly. While nobody likes investment losses, they can be valuable tax planning tools. If you didn’t follow my advice last spring when the market was in a deep trough, you have another chance to turn these sow’s ears into silk purses.

Study your taxable accounts for mutual funds or other investments with paper losses. Sell the investments to realize those losses. They can completely offset capital gains. Any additional losses can offset up to $3,000 of other types of income. Additional losses can be carried to future years until they are exhausted.

You don’t have to get out of an investment in order to take the loss. The tax law lets you buy the identical asset back after more than 30 days have passed.   Or you can buy immediately a similar but not identical asset. For example, you can sell one emerging market fund and buy a competing one. That way, you can keep your Core Portfolio or even your Managed Portfolio intact by swapping out of a losing investment into a competing fund. Check my “Other Funds To Consider Now” list for fund-swapping ideas.

This is a good time to stockpile losses. A number of mutual funds will distribute capital gains later this year, even when the funds are down for the year. Many funds sold stocks throughout the year, either to meet redemptions or because the stocks no longer were attractive. But because the stocks were purchased some time earlier at much lower prices, the funds have gains to distribute to shareholders. Some of the value stock funds with which we earned gains this year also might take some profits and distribute gains before the end of the year.

Before doing a tax sale, be sure to check for any costs. There might be a commission or trading fee if you invest through a mutual fund broker. There also might be redemption fees imposed by the fund if you haven’t held it for a minimum required time. Here’s another factor to consider. If a fund distributes a short-term capital gain, that gain must be listed as ordinary income on your tax return. You cannot offset it with capital losses you took from other investments. You need business losses or deductions (such as charitable contributions) to offset them.

Lower capital gains rates. Here’s a trick you won’t hear much about. You might be familiar with the “super-long capital gains rates.” (See my August 2000 issue or the web site archive.) If you acquired an asset after 2000 and hold it for at least five years, you get a maximum 18% tax rate instead of the regular 20% maximum long-term capital gains rate. (If you are in the 15% tax bracket, the asset could be purchased at any time, not just after 2000, and you get an 8% tax rate after holding more than five years.)

But you can qualify assets purchased before 2001 for the super-long capital gains rate. You do this by filing an election with the IRS to treat an asset as though it were sold on Jan. 2, 2001, and repurchased on the same day. You won’t get to recognize any losses doing this. But you will owe taxes on any paper gains for the assets for which you filed this election. Then when you hold the asset more than another five years you’ll pay an 18% rate on the subsequent gains.

Why would you want to pay a 20% capital gains tax this year to get an 18% rate in five years? It’s a smart move if you have a way to shelter all or most of the gains this year. If you took big capital losses or a large charitable contribution deduction, the election to recognize the gains now can be smart. It also can be a good strategy for assets that hadn’t appreciated much by Jan.  2, 2001, but that you are confident of holding for at least another five years. If you bought value stocks or mutual funds late in 2000, they are good candidates for the election. Or if you are holding technology stocks for the long term that had losses or small gains on Jan. 2, consider making the election.

You don’t have to make the election until you file your 2001 tax return, so you have time to examine the gains and losses in your portfolio and see if there are assets you might hold for at least another five years. The super-long capital gains rate applies to any capital assets: stocks, bonds, mutual funds, homes, collectables, and more.

Beat the AMT. One year-end step that hasn’t changed is the alternative minimum tax. See last month’s issue for details about how the tax is computed.   If it appears that you will be hit by the AMT in 2001, a good move is to accelerate income into this year. That’s because the maximum AMT rate is less than the maximum individual tax rate that you might be subject to next year. You also might want to defer deductions that aren’t allowed under the AMT. If you will not be hit by the AMT this year but might be next year, consider accelerating deductions into this year so you will benefit from them.