2009 Year-End Strategies

Most taxpayers have annually had the option to itemize their deductions or take a standard deduction, and the rationale for making the choice has always been rather simple: take the higher of the two amounts.  However for 2009 the choice can be complicated, and in some cases requires advanced planning to maximize the tax benefits of that choice.

The complications have been brought about by the ability, in 2009, to add real property taxes, new vehicle sales and excise taxes, and disaster casualty losses to the standard deduction, creating a hybrid deduction that is part standard and part itemized.  So, the decision becomes more complicated, especially when deciding whether to: buy a new car this year or not; pay all the property taxes or only the first installment this year; and exercise the option to take a 2009 disaster loss in the current year or the preceding year.

Some taxpayers that only marginally itemize each year have adopted the strategy of “bunching” deductions in one year and then claiming the standard deduction in the alternate year. This technique is applied to tax payments, charitable contributions, some medical expenses and to certain business expenses.  Those employing this technique may need to reevaluate their strategy for 2009, take the hybrid standard deduction and defer the other deductible payments into 2010. 

When making the analysis keep in mind: (1) the property tax add-on to the standard deduction is limited to $500 for single taxpayers and $1,000 for married taxpayers filing jointly and (2) the vehicle tax is only allowed for the sales or excise tax paid on the first $49,500 of purchase price for each new vehicle bought after February 16, 2009 and through the end of the year and begins to phase out for single taxpayers with an AGI above $125,000 ($250,000 for married taxpayers). 

If you marginally itemize your deductions it may be appropriate for you to schedule a consultation with this office prior to the holidays, and defer tax deductible payments and buying a car until after we have determined which strategy is best for your particular circumstances.

If your tax deductions normally fall short of itemizing your deductions or even if you are able to itemize, but only marginally, you may benefit from using the ‘bunching” strategy.

The tax code allows taxpayers to utilize the standard deduction or itemize their deductions if that provides to be a greater benefit.  As a rule, most taxpayers just wait until tax time to add everything up and then use the higher of the standard deduction or their itemized deductions. 

If you want to be more proactive, you can time the payments of tax-deductible items to maximize your itemized deductions in one year and take the standard deduction in the next.  

For the most part, itemized deductions include medical expenses, property taxes, state and local income taxes, home mortgage and investment interest, charitable deductions,
unreimbursed job-related expenses and casualty losses.  The “bunching strategy” is more commonly associated with medical expenses, tax payments and charitable deductions; although, there are circumstances where the other deductions might be come into play.   There are many opportunities to bunch deductions, and the following are examples of the most commonly used with the “bunching” strategy:

• Medical Expenses – You contract with a dentist for your child’s braces. He may offer you an up-front lump sum payment or a payment plan.  By making the lump sum payment, the entire cost is credited in the year paid, thereby dramatically increasing your medical expenses for that year.  If you do not have the cash available for the up-front payment, then you can pay by credit card, which is treated as a lump-sum payment for tax purposes.  If you use a credit card, you must realize that the credit card interest is not deductible and you need to determine if incurring the interest is worth the increased tax deduction.  Another important issue with medical deductions is that only the amount of the total medical expenses that exceeds 7.5% of your income is actually deductible.  If you are caught by the Alternative Minimum Tax (AMT), then only the amount that exceeds 10% of your AGI is actually deductible.  So, there is no tax benefit of bunching medical deductions if the total is less than 7.5% (10% if taxed by the AMT).

If the current year is an abnormally high-income year, you may, where possible, wish to put off making medical expense payments until the subsequent year when the 7.5% (10%) threshold is less.

• Taxes – Property taxes are generally billed annually at mid-year and most locales allow the tax bill to be paid in semi-annual or quarterly installments.  Thus, you have the option of paying it all at once or paying in installments.  This provides the opportunity to bunch the tax payments by paying one semi-annual (or 2 quarterly) installment and a full year’s tax liability in one year and only paying one semi-annual (or 2 quarterly) in the other year.  In doing so, you are able to deduct 1-½ year’s taxes in one year and ½ a year’s taxes in the other. If you are thinking of being late on the property tax payments as means of bunching, you should be cautious.  The late payment penalty will probably wipe out any potential tax savings.

If you reside in a state that has state income tax, the state income tax paid or withheld during the year is deductible as a federal itemized deduction.  So, for instance, if you are making state quarterly estimates, the fourth quarter estimate is generally due in January of the subsequent year.  This gives you the opportunity to either make that payment before December 31st, and be able to deduct the payment on the current year’s return, or pay it in January before the January due date and use it as a deduction in the subsequent year. 

A word of caution about the itemized deduction for taxes!  Taxes are only deductible for regular tax purposes.  So, to the extent you are taxed by the AMT, you derive no benefits from the itemized deduction for taxes.

• Charitable Contributions – Charitable contributions are a nice fit for “bunching” because they are entirely payable at the taxpayer’s discretion.  For example, if you normally tithe at your church, you could make your normal contributions during the year and then prepay the entire subsequent years’ tithing in a lump sum in December of the current year, thereby doubling up on the church contribution one year and having no deduction for charity in the other year.  Normally, charities are very active with their solicitations during the holiday season, giving you the opportunity to make the contributions at the end of the current year or simply wait a short time and make them after the end of the year.

If you think a “bunching” strategy might benefit you, please call this office to discuss the issue and set up an appointment for some in-depth strategizing.  

Increased business spending for durable goods and capital items indicates that businesses are beginning to loosen their purse strings. From a tax standpoint, this is also a good time to consider capital purchases, thanks to some extraordinary tax benefits available through the end of the year.   If your business is considering expansion or capital purchases, now may be the time to act—because without Congressional action, which is unlikely due to increasing federal budget woes, the following business benefits will no longer be available after the close of 2009.

• Bonus Depreciation - Under the first-year bonus depreciation rules, taxpayers may generally claim an additional first-year depreciation deduction equal to 50% of the cost of qualified property placed in service in 2009. This bonus depreciation deduction is allowed for both regular tax and AMT purposes.  Qualified property includes equipment and machinery that is purchased new and placed into service before the end of the year.

• Luxury Auto Limitations - Generally, vehicles weighing 6,000 pounds or less are classified as luxury vehicles, and the first-year depreciation is 20% of the cost of the vehicle but limited to a maximum of $2,960 ($3,060 for light trucks), regardless of the cost of the vehicle. However, for 2009, and at the taxpayer’s election, that maximum is increased to $10,960 ($11,060 for light trucks).  This increase is attributable to the bonus depreciation allowable for 2009.

• Enhanced Expensing (Sec. 179) - For equipment and machinery placed in service in 2009, the maximum expensing allowance is $250,000; it phases out when the cost of eligible property placed in service during the year exceeds $800,000.  Barring any change by Congress, the $250,000 and $800,000 amounts will reduce to $125,000 and $500,000 in 2010, and drastically decline to $25,000 and $200,000 in 2011.

• Quick Write-Offs for Most New Farming Machinery and Equipment - Those engaged in a farming business have the opportunity to depreciate qualifying new farming machinery and equipment over a 5-year period, instead of over the generally-applicable 7 years.  To qualify, the original use of the property must have begun with the taxpayer after December 31, 2008, and before January 1, 2010. Grain bins, cotton ginning assets, and fences or other land improvements aren’t eligible for the 5-year write-off period. 

Generally, farming machinery and equipment also qualifies for the increased expensing and bonus depreciation deductions previously discussed, providing extraordinarily large tax write-offs for 2009.

• 15-Year Write-Off for Leasehold Improvements - Qualified leasehold improvements, restaurant improvements, and retail improvements completed and placed into service before January 1, 2010 may be written off over 15 years instead of the usual 39 years. This more than doubles the annual write-off for these improvements.

The options for writing off capital expenditures in 2009 make it possible to customize the write-off for virtually all businesses through careful pre-year-end planning.  So whether you wish merely to optimize the write-off for capital purchases already made, or you wish to plan additional purchases to take advantage of the special 2009 tax write-offs, give this office a call.  Together we can strategize to maximize your benefits and minimize your tax liability.  

Year-end has historically been a good time to plan tax savings by carefully structuring capital gains and losses.  Conventional wisdom has always been to minimize gains by selling “losers” to offset gains from “winners,” and where possible, generate the maximum allowable $3,000 capital loss for the year.

Long-term capital losses offset long-term capital gains before they offset short-term capital gains. Similarly, short-term capital losses offset short-term capital gains before they offset long-term capital gains. (“Long-term” means that the stock or property has been held over one year.) Keep in mind that taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income or AGI.  Individuals are subject to federal income tax at a rate as high as 35% on short-term capital gains and ordinary income. But long-term capital gains are generally taxed at a maximum rate of 15%. 

All of this means that having long-term capital losses offset long-term capital gains should be avoided where possible, since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. Avoiding this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains. However, this is not just a tax issue; investment factors also need to be considered. It would not be wise to defer recognizing gain until the following year if there is too much risk that the property’s value will decline before it can be sold. Similarly, one wouldn't want to risk increasing a loss on property that is expected to continue declining in value by deferring its sale until the following year.

To the extent that taking long-term capital losses in a different year than long-term capital gains is consistent with good investment planning, a taxpayer should take steps to prevent those losses from offsetting those gains.

However, historical tax-planning logic may not apply this year for the following reasons:

• Increasing Capital Gains Rates - The special long-term capital gains rates that have been in effect since 2003 sunset (end) at the end of 2010 and return to the pre-2003 levels of 10% and 20%! These federal rates are currently 0% for taxpayers in the 15% and lower tax brackets and 15% for those in higher tax brackets. Although only talk up to this point, proposals have been floated  to raise the rate to 20% as early as 2010, plus tack on a 4.5% surtax for the wealthiest taxpayers.  Individuals with large long-term capital gains in their investment portfolios might consider selling those holdings to take their gains now at the lower tax rates.  The good news here is that the wash sale rules do not apply to assets sold at a gain. So if you like a stock, you are free to buy it back right away. If your state doesn’t have a lower tax rate on capital gains, then the additional state tax you’d pay from selling profitable capital assets will need to be weighed against the federal tax you’d potentially save when deciding whether to make tax sales before year-end.

• Raising Marginal Tax Rates – With record deficits, taxes have to go up—campaign promises notwithstanding—and we can expect that to happen in the near future.  The only questions are when, how much, and for whom?  Conventional wisdom has always been to defer income, but with a potential for increased taxes it may be appropriate to consider accelerating income to take advantage of the current lower tax rates.

It may be in your best interest to review you current year tax strategy with an eye to the future to maximize your benefits from gains or losses associated with capital assets.  Please call this office for assistance. 

Next year will be a pivotal one for retirement planning, as it will be the first year in which taxpayers will be able to convert funds in regular IRAs (as well as qualified retirement plans) to Roth IRAs regardless of their income level. 

This new conversion option poses significant tax planning challenges and opportunities for 2009, 2010 and 2011.   Presently (in 2009), taxpayers with modified adjusted gross income (1) (AGI) in excess of $100,000 may not convert investments in traditional IRAs into investments in Roth IRAs.  This includes converting amounts from SEP-IRAs or SIMPLE IRAs.

There are two big advantages of the Roth IRA: all future earnings and distributions at retirement will be tax free, and the Roth IRAs are not subject to the required minimum distribution rules.  Although conversions are taxable, except for previously non-deductible amounts, they are not subject to the 10% premature distribution tax. 

Big changes coming next year - For tax years beginning after 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing a separate return will be able to convert amounts in a traditional IRA into a Roth IRA (currently they are barred from doing so).

There are other tax advantages: Because distributions from Roth IRAs are tax-free (if they are qualified distributions), they may keep a taxpayer from being taxed in a higher tax bracket than would otherwise apply if he were withdrawing taxable distributions, don't enter into the calculation of tax owed on Social Security payments, and have no effect on AGI-based deductions. What is more, the benefits flow through to beneficiaries of Roth IRA accounts, who also can make tax-free withdrawals from such accounts (they are, however, subject to the same annual post-death minimum distribution rules that apply to beneficiaries of regular IRAs).

Should you make an IRA-to-Roth IRA conversion? Generally taxpayers with the following tax profiles should consider making a conversion:

• Taxpayers that still have a number of years to go before retirement and time to recoup the conversion tax dollars;  

• Are in a lower than normal tax bracket in the year of conversion;

• Anticipate being taxed in a higher bracket in the future; and

• Can pay the tax on the conversion from funds other than non-taxed retirement funds.

Complicating factor for 2010 conversions - A unique income inclusion rule will apply for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. This requires some careful planning since, without Congressional action, the current lower tax brackets of 35%, 33%, 28%, and 25% will revert to their pre-2001 levels of 39.6%, 36%, 31%, and 28% after 2010. 

What do to this year. Taxpayers who intend to take advantage of the new conversion option next year should consider the following strategies:

• Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They'll reduce their 2009 tax bill and, if they make the conversion to a Roth IRA next year, they won't have to pay back the tax savings until 2011 and 2012.

• High-income taxpayers should consider making nondeductible IRA contributions this year. They can then roll over the accounts into Roth IRAs next year at no tax cost.

• High-income taxpayers planning to make large conversions in 2010 and pay the tax in 2010 rather than deferring the tax until 2011 and 2012 should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income.  Instead they should consider doing the reverse, accelerating income into 2009 and deferring deductions until 2010 to help reduce the conversion tax in 2010.

Conversions can be tricky!  So if you are considering a conversion in 2010 it might be appropriate to call for an appointment so we can help you properly analyze your conversion options.

(1) With respect to conversions to Roth IRAs, the AGI is modified by eliminating a number of income exclusions, but does not include the income resulting from the conversion itself, nor does it include any Required Minimum Distributions.

It goes by many names; Solo 401(k), Mini 401(k) and single-participant 401(k).  We will use Solo 401(k) in this article to describe probably the best type of pension plan for owner-only businesses.  It provides for larger contributions, including a Roth option for a portion of the contribution and the ability to borrow funds from the plan at reasonable rates.  As a result, Solo 401(k) plans have become more attractive options than SEP-IRAs, Simple IRAs or profit-sharing or money purchase plans.  In addition, if the plan permits and most do, assets for other retirement plans can be rolled over into the Solo 401(k) plan.  

Generally, Solo 401(k) plans are a natural fit for two categories of businesses.  The first includes independent contractors, sole proprietors, and owner-only C or S corporations. The second is those who have dual incomes.  They are W-2 wage earners as employees of a company that offers a 401(k) plan who also have consulting income from corporate directorships or freelance work that requires them to file a schedule C as a sole proprietor.  Since the 401(k) contribution limits apply to each individual for the year and not the individual plans, if the taxpayer has multiple 401(k) plans, he or she needs to make sure that not more than the annual limit is contributed to the combination of plans.

For 2009, the rules limit employer contribution (profit-sharing contribution) to 25% of compensation.  The employee can also make salary deferral contributions up to $16,500.  Together, these contributions cannot exceed the lesser of $49,000 or 100% of compensation.  In addition, if the employee is age 50 or over he or she can make an additional catch-up contribution of $5,500. 

Example – Susan Lewis, age 49, is the sole employee of an incorporated business. Her earned income is $100,000 in 2009. Under the law, Susan can contribute $25,000 to a SEP-IRA ($100,000 x .25), $14,500 (11,500 plus 3% of $100,000) to a Simple IRA and $25,000 to a profit-sharing or money purchase plan.  However, she can contribute $41,500 to a Solo 401(k) plan ($25,000 employer contribution plus $16,500 employee deferral) still under the $49,000 maximum for the year. If Susan were age 50 or over, she could also make a catch-up contribution of $5,500, increasing her 401(k) contribution total to $47,000.  

Note: Generally, 401(k) plan contributions for an unincorporated business will be slightly lower than the above amounts. For unincorporated businesses, compensation is net profit minus half of self-employment taxes minus employer contributions.

In some cases, 401(k) plan contributions for an unincorporated business may be slightly lower than the above amounts.  For unincorporated businesses, compensation is net profit minus half of self-employment taxes minus employer contributions.

Although single-participant 401(k) plans are limited to the business owner and his or her spouse, business owners should note the added benefits of having his or her spouse as the business’s only other employee.  Having the spouse on the payroll gives the business owner the opportunity to shelter some or all of his or her income by having the spouse make an elective deferral to a 401(k) plan in addition to the business making a profit-sharing contribution.  Although the spouse and the business would be responsible for their respective share of employment taxes on the salary, combined employer and employee contributions can be up to the lesser of $49,000 (for 2009) or 100% of compensation. This limit applies separately to the business-owner and spouse, thus allowing a combined total of up to $98,000 (for 2009).  In addition, if age 50 or over, each individual could defer an additional $5,500 each year.

Potential downside - If a business grows and begins hiring employees, the single-participant 401(k) plan must become a full-blown 401(k) plan subject to other more stringent rules including discrimination testing that can serve to limit contributions by highly-paid executives.  Many providers recommend that businesses with immediate expansion plans not set up one of the Solo 401(k) arrangements.  Caution: If the business owner has other businesses or is part of a controlled group of corporations, partnerships, proprietorships or affiliated service groups, the employer aggregation rules may apply and the employees of those other businesses may have to be considered for purposes of meeting qualification and minimum coverage requirements for the Solo 401(k).

For additional information regarding Solo 401(k) plans and how it might fit into your tax strategy and retirement planning, please give this office a call.  If you are considering a Solo 401(k) plan for 2009, be aware that the plan must be set up before year’s end.