Year-End Tax Planning


It’s that time of year again.  No, I don’t mean it’s time to start preparing holiday fixings or shopping for festive attire.  I mean it’s time for year-end tax planning. Steps taken between now and the end of the year can materially affect your 2005 tax liability.  Don’t treat your tax life like a surprise, not to be peeked at until next March or April.

When to start?  Now.  How to start? With a copy of your 2004 tax return and an inventory of your personal, business and investment life for 2005 to date.  Good tax planning starts with a little organization, mostly involving financial records. Look at your 2004 tax return and think for a few moments about any year-end planning you might have done last year.  Did you move any income or deductions from 2004 into 2005?  Make any business purchases in late 2004 that continue to give tax benefits in 2005?

For the first time in many years, no major tax legislation was enacted this year. However, major tax legislation enacted in 2003 and 2004 continues to have an impact on taxes and tax planning.  For example, 2004 tax legislation provides that beginning in 2005, businesses that are involved in manufacturing or other production activities undertaken in the U.S. are able to deduct up to 3% (increasing in future years to 9%) of their “qualified production activities income”

Take Stock Now: Fill Out a 2005 Tax Return Today.

The first step in all year-end tax planning strategies is to take stock of where you stand today vis-à-vis 2005 taxes. How does 2005 look? How do you expect 2006 to look?  Call your tax professional (or pull out some 2005 tax preparation software) and do a draft 2005 tax return based on the year to date and reasonable estimates through the end of the year.

In doing your draft 2005 return, pay particular attention to the alternative minimum tax (AMT) and how close you are to being (or not being) an AMT taxpayer.  Much yearend tax planning involves trying to steer clear of that stealth tax. The federal income tax rate cuts enacted in 2003, when taken together with counterbalancing state and local income tax rate increases, make it increasingly likely that you will be subject to AMT. Remember, residents of New Jersey earning more than $500,000 are subject to income tax rates up to a maximum of 8.970%, and New York’s top rates are now 7.7% state and 4.45% city.  These high state and local rates will complicate AMT planning.

You should note that 2004 legislation has extended temporary allowances of AMT offsetting credits (for certain nonrefundable personal tax credits, such as the child tax credit, the dependent care credit, credits for home mortgage interest and others) and temporarily increased AMT exemption amounts through 2005.  Also, pay attention to your projected adjusted gross income (AGI); many tax benefits phase out over a specified range of AGI, but some are eliminated entirely if you are even $1 over some threshold AGI amount.

For example, eligible individuals may deduct up to $4,000 of qualified higher education expenses if their modified AGI does not exceed $65,000 ($130,000 for joint returns) and $2,000 if it does not exceed $80,000 ($160,000 for joint returns). No deduction is allowed if modified AGI exceeds the higher threshold by even $1. Your 2005 draft tax return then can be tinkered with using various “what if ” scenarios.  Because taxes affect your personal, business and investment life in different ways, year-end tax planning needs to focus separately on personal, business and investment matters.
Personal Planning

Your year-end personal tax planning should address not only income taxes, but also estate and gift taxes.  Many gift and estate planning strategies (such as charitable lead trusts) are most effective in low-interest-rate environments. Interest rates, while still relatively low, are expected by some to continue to rise in the coming months. Certain planning techniques will not be as beneficial in future months if interest rates increase.  Year-end also is an ideal time to review your estate plan — changes in gift and estate tax laws over the last several years make it wise (if not imperative) that your will be updated if it hasn’t been dusted off in the last couple of years.  In any event, get money out of your taxable estate by making those fully exempt gifts of up to $11,000 per donee ($22,000 per donee for a married couple) before December 31.  Do it now.

Traditional year-end planning steps for income taxes involve deferring income and accelerating deductions.  Deferring a few dollars of income (or claiming a capital loss or deduction that reduces AGI) may make you eligible for hundreds or thousands of dollars of tax reductions.  Tax benefits that phase out if your AGI increases over a threshold level include deductible and nondeductible IRA contributions, the $1,000 per child tax credit, the deduction of up to $4,000 of qualified higher education expenses (but note, the deduction limit abruptly drops to $2,000, and then to zero once the AGI thresholds mentioned in the previous section are crossed) and various other education-related tax benefits.

For employees, this year’s taxable income may be reduced by increasing elective deferrals in 40 (k) plans and similar qualified plans or by deferring year-end bonuses into next year, provided such bonus deferrals are paid within the first two and a half months of 2006.  Also, make sure to spend the rest of the money in your Flex spending account (don’t you need a pair of prescription sunglasses or to have your teeth cleaned?) and to make any necessary adjustments to your cafeteria plan benefits.

Employees need to look at next year now with respect to adjustments to W-4 withholding and retirement plan elections.  Now is the time to figure out how much 2006 compensation to defer into future years.  However, because the tax laws governing non-qualified deferred compensation have been overhauled by new legislation, you should consult your tax advisor with respect to any elections to defer compensation in a non-qualified plan or  arrangement.

Two items of personal yearend tax planning are particularly worth noting. Charitable contributions, especially contributions of appreciated property, are a great way of reducing taxes (including AMT) while doing good.  A check to your favorite charity mailed New Year’s Eve gives you a deduction for this year.  Gifts of stock or other property take more advance planning; contact the charitable recipient now to initiate the process so the deductible gift can be completed by year’s end.

A second year-end planning decision involves payment of state and local taxes by persons who pay estimated taxes. If you will get the full benefit of the itemized deduction for taxes (up to a 35% tax saving), by all means, pay state and local taxes by December 31.  However, beware that the AMT monster may chew up and eliminate any tax benefit of that deduction.  State and local taxes (and lots of other items) are not deductible when calculating AMT.  Suffice it to say, the best way of knowing whether to pay the fourth-quarter estimated tax installment of state and local taxes on December 31 as opposed to January 15 is to do a “what if ” comparison, focusing on AMT.

Employees with incentive stock options (ISOs) should consider exercising some or all of their ISOs before year-end.  This decision should be based on a variety of factors; however, the AMT impact of ISO exercises is particularly important. A program of exercising ISOs annually often can avoid AMT and will start the holding period required to get the 15% capital gains rate (and the ability to get maximum benefit of charitable gifts of the ISO stock).

Finally, for employees with outside income, be aware of a possible underpayment of estimated tax.  Underpayment of estimated tax penalties can be eliminated if your withholding (together with estimated tax payments) fits into one of the safe harbors.