Countdown to Tax Savings

The holidays are approaching. You may think of this as a good time to get together with old friends, enjoy the Thanksgiving Day parade and make merry. But your accountant and your tax attorney have a much more profitable idea of what you should do come November and December: take steps to reduce your 2006 tax bill. Spending a few hours between now and December 31 to organize and review your financial and tax situation — and taking action — can save you money next April. Don’t treat your tax life as an unpleasant surprise, like a letter bearing bad news not to be opened until tax time next March or April.

How to start? With a copy of your 2005 tax return and an inventory of your personal, business and investment life for 2006 to date. Good tax planning starts with a little organization, mostly involving financial records. Look at your 2005 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 2005 into 2006? Make any business purchases in late 2005 that continue to give tax benefits in 2006?

Several pieces of major tax legislation were enacted this year, principally the Tax Increase Prevention and Reconciliation Act (TIPRA) and the Pension Protection Act (PPA). Most of the new legislation is quite technical and has little impact on year end tax planning. TIPRA contained the good news that the 15% maximum federal tax rate for dividends and long-term capital gains will be with us at least for several more years. PPA contains numerous provisions affecting charitable giving and exempt organizations, including a much-heralded provision allowing individuals who have attained the age of 70½ to direct that up to $100,000 be distributed from an IRA to charity without any adverse income tax consequences.

In addition, major tax legislation enacted in 2003 and 2004 continues to have an impact on taxes and tax planning for your business. For example, 2004 tax legislation provides that businesses that are involved in manufacturing or other production activities undertaken in the U.S. are able to deduct up to 3% (increasing in 2007 to 6% and in future years to 9%) of their “qualified production activities income.

Take Stock Now: Fill Out a 2006 Tax Return Today

The first action step in all year end tax planning strategies is to take stock now of where you stand today vis-à-vis 2006 taxes. How does 2006 look? How do you expect 2007 to look? Call your tax professional (or pull out some 2006 tax preparation software — or a sharp pencil) and do a draft 2006 tax return based on the year to date and reasonable estimates through the end of the year.

In doing your draft 2006 return, pay particular attention to the alternative minimum tax (AMT) and how close you are to being (or not being) an AMT taxpayer. Much year end tax planning involves trying to steer clear of that stealth tax. The federal income tax rate cuts enacted in 2003, when taken together with the 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 individual state income tax rates up to a maximum of 8.970%, and New York’s top rates are now 6.85% for state taxes and 3.648% for city taxes. These high state and local rates will complicate AMT planning.

Also, pay attention to your projected adjusted gross income (AGI); many tax benefits phase out over a specified range of AGI. For example, eligible individuals may claim a $1,000 credit for each qualifying child if their modified AGI does not exceed $75,000 ($110,000 for joint returns). The amount allowable as a credit is reduced by $50 for each $1,000 (or fraction thereof) by which the modified AGI exceeds $75,000 ($110,000 for joint returns). Your 2006 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, so it may pay to take action earlier rather than later. 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 imperative that your will be updated if it hasn’t been dusted off over the last couple of years. Get money out of your taxable estate by making those fully exempt gifts of up to $12,000 per donee ($24,000 per donee for a married couple) before December 31.

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 (as was explained above) and various other education related tax benefits.