By Kevin McPherson, CPA
Income taxes are probably one of your largest annual expenditures. So, just as you would shop around for the best price for a car, you should consider opportunities to reduce or defer your annual tax bill. Even though 2007 is coming to a close, there is still time to reduce your taxes and plan ahead for 2008.
Your 2007 year-end planning should begin with a projection of your Adjusted Gross Income (AGI) for both 2007 and 2008. AGI includes all income (i.e. salary, self-employment income, interest and dividend income, capital gains and losses, and taxable retirement plan distributions) minus certain “above the line” deductions (i.e. traditional IRA contributions, self-employed heath insurance, 50% of your self-employment tax). This is an essential element of tax planning, as many tax deductions and tax credits are tied to your AGI. If you “itemize,” is equally important to estimate all potential “itemized” deductions (i.e. mortgage interest, property taxes, charitable contributions, brokerage expenses, unreimbursed business expenses) for both years. Together, these estimates will give you a good idea of your taxable income and your marginal tax rate (the rate at which your last dollar of income is taxed).
Whether you should defer or accelerate income and deductions between 2007 and 2008 will depend to a large extent on your marginal tax rate. To the extent you can control the timing of income and deductions, you should make decisions that will result in the lowest aggregate tax for these two years. If shifting income and deductions between years does not reduce your aggregate tax bill for 2007 and 2008, you should defer as much tax into 2008 in order to benefit from the time value of money.
If you are able to control the timing of some of these items, try to accelerate or defer income into the year with the lower marginal tax rate, while paying deductible expenses in the year with the higher marginal rate. Some of the types of income that may more easily be controlled are:
· Year-end interest and dividend payments from closely held corporations,
· Rents and fees for services (delay or accelerate billings),
· Commissions (close sales in December or January to accelerate or defer income),
· Distributions from taxable retirement plans.
However, it is important to note that income cannot be deferred to 2008 if it was constructively received in 2007. Constructive receipt occurs when you have the right to receive payment or have received a check for payment even though it has not been deposited.
Some of the more common deductions that should be considered when tax planning are:
· Charitable Contributions
The donation of appreciated stock is a great way to reduce your tax bill, as you don’t have to pay capital gains on the appreciation and you get the fair market value of the appreciated stock as a deduction on your tax return. If the stock has declined in value, sell the stock first and then donate the sale proceeds. This allows you to obtain both a capital loss and a charitable contribution deduction.
· State and Property Taxes: Consider making both your fourth quarter state estimated payment and your January, 2008, property tax payment in December, 2007.
· Medical Expenses and Miscellaneous Deductions
Since these expenses are deductible to the extent they exceed 7.5% and 2% of AGI respectively, they should, where possible, be bunched in a year in which they exceed these AGI limits. If you are self-employed, don’t forget that 100% of medical insurance premiums are deductible without limitation.
· Traditional IRA and 401(k)Contributions: If you are not in a position to maximize your contributions in both 2007 and 2008, consider making your contribution in the year with the higher marginal tax rate. However, keep in mind the potential cost of not being invested in the market if you are considering delaying your retirement contribution.
· Capital Losses
If you anticipate large capital gains for 2007, consider selling stocks that have depreciated since their purchase. These capital loses may be used to offset capital gains. Net capital losses of up to $3,000 may be deducted against ordinary income. However, be aware of the “wash sale” rule, as the capital loss is disallowed if the same stock is acquired 30 days before or after the sale.
If this weren’t complicated enough, all of this planning must be done with an eye to the Alternative Minimum Tax (AMT). This is a separate tax calculation with a completely different set of tax rates (flat 26% or 28% after an exemption amount) and deduction rules which usually are less generous than the regular rules. Gone are the deductions for state and property taxes, itemized miscellaneous deductions, personal exemptions and numerous others, while it includes certain items in income (i.e. the “spread” on incentive stock options) that are excluded under the regular rules. Taxpayers are subject to AMT when their AMT tax liability is greater that their “regular” tax liability.
The AMT was designed to ensure that the wealthiest didn’t dodge the tax bullet, however, since it is not indexed to inflation, and Washington has yet to pass their annual AMT “patch,” significantly more middle-class Americans are expected to be affected this year. As the New York Times recently reported, without the AMT “patch,” 23 million taxpayers (up from 4 million in 2006) are expected to be hit by AMT this year, with an average cost of $2,000. And depending on each taxpayer’s circumstances, people with income as low as $50,000 may be impacted.
So, when you are doing your year-end tax planning, it is essential that you consider the potential impact on both your regular tax liability and your AMT tax liability. If you fall into AMT, a little more number crunching may be in order to minimize your 2007 tax liability.
Kevin McPherson, CPA is a manager with Mengel, Metzger, Barr & Co. LLP. He can be reached at 585/423-1860 or Kmcpherson@mmb-co.com
Reprinted with permission of The Daily Record 2007
