Although it’s too early to know what your taxable income will be in 2005, it’s not too late to plan strategies to lower it by means of legitimate tactics that can impact your total income, the expenses you may deduct against it, or both.
You might want to hold down your taxable income for 2005 by deferring income to 2006 and accelerating expenses when you have the opportunities—especially if you expect to be in a lower tax bracket next year. But you would want to do the opposite—accelerate income and defer expenses—to lift your 2005 taxable income if you expect to be in a higher bracket next year.
Even if you expect your tax bracket to be the same, it would be smart to consider other moves to hold down your tax bills. To determine which strategies are suitable for you, consider them in the sequence in which topics appear in IRS Form 1040, starting with Line 7, “Wages, salaries, tips, etc.”
Salary reduction. There is usually little that you can do about the compensation portion of your taxable income with one very important exception: putting more money into a tax-deferred retirement plan:
Sign up to participate in your employer’s 401(k) plan, if you have not already done so. Raise the portion of compensation that you may defer and have invested in a 401(k), if you have not already authorized your employer to withhold the maximum for this purpose ($14,000 this year, $15,000 next year). Invest additional money in an IRA, if you meet the income requirements, so that you can deduct it on Line 25. The contribution for traditional IRA’s will be fully deductible if your income is $70,000 or less if you are married filing jointly, or $50,000 or less if filing individually. The contribution amount for a traditional IRA is $4,000 or $4,500 if you are 50 or older.
Taxable and tax-exempt interest. If you are now or plan to be invested in taxable bond funds or individual bonds outside a tax-deferred retirement plan, determine whether you would be better off in tax-exempt bonds or bond funds. Calculate whether your income from tax-exempt securities would be more, or less, than your after tax return on income from taxable issues. To make your determination meaningful, be sure to compare funds and bonds of comparable credit quality and maturities.
Dividends. You may have no control over whether dividends which you receive from equity funds or stocks are classified as “ordinary” or as “qualified,” which are taxed at a lower rate. If you get the latter, be sure to confirm that you are differentiating these amounts on your return. Locate the amount in your payers’ Forms 1099—DIV the amount to use in Line 9b of your Form 1040. Whichever class of dividends you get, avoid “buying dividends” by not buying stocks or funds just before their year-end distributions.
Income from a Business. If you operate a business from your home and report your receipts and expenses on Schedule C, you may also be able to deduct a portion of your home’s insurance, repairs and maintenance and utilities costs. You can report them on its Form 8829 attachment.
Capital Gains and Losses. If you want to sell individual securities or fund shares on which you have gains and which you have owned for less than a year, you have a choice: hold them until you have owned them for more than a year and pay taxes at the long-term capital gains rate or swallow the higher short-term rate. If you own securities which are worth less than they cost or their adjusted basis, you may want to sell them in order to take a loss to offset the gains. Capital losses are netted against capital gains. If you have more realized losses than gains, you can take an additional $3,000 of loss to offset your ordinary income. More than that and you will need to rollover that loss to be used in future years. If you do sell a security to realize a loss to offset a gain, note that you must not buy back that security for 30 days to avoid disallowing the loss. Note also that you are allowed to use losses to offset the capital gains on the sale of your home as well as the sale of securities.
Deductions. If you itemize deductions and you expect income to be higher next year, you may have some opportunities to defer or accelerate expenses before year end or defer outlays to 2006. Among them: costly medical and dental procedures, real estate tax payments due early next year and charitable contributions. Or vice versa if you are looking to accelerate expenses into the current year. Paying January’s mortgage payment in December will add mortgage interest to your deductions. If an individual is subject to AMT the early payment of property taxes is not effective in reducing taxable income.
November 2005— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bold Financial Planning, LLC, a local member of the FPA.
posted by Hillebrand Financial Planning at 10:59 AM
Financial Planning Perspectives
A PRIMER ON CHARITABLE DONATIONS
Americans have long responded generously to people in need. Witness the torrent of checks to the victims of recent hurricanes and earthquakes. But while such acts remind us of the generosity of Americans, they also serve as reminders about the financial side of charity, including:
The proliferation of charitable organizations formed to complement the American Red Cross, Salvation Army and other charities in receiving public contributions and in distributing aid to those who find themselves in need of food, clothing, shelter and medical care. The urgent need to be cautious about which organization to give money to in case you know nothing about the one that is soliciting your contribution. If you don’t have time to check it out, it would be better to stick with organizations with which you are familiar.
The notion that, if you itemize deductions on your income tax returns, you can make tax-deductible charitable contributions that could reduce your taxable 2005 income and, thus, what you will owe on April 15. The Katrina Emergency Tax Relief Act (KETRA) allows unlimited gifts to charity up to a donor’s total income until the end of 2005—and for individuals the gifts do not have to be for hurricane relief efforts. The emergence of new vehicles which may make it easier for large donors to make contributions in accordance with Internal Revenue Service regulations.
It may be useful, therefore—while hurricane, forest fire, mudslide and earthquake victims are on your TV screen—to review a few pointers about today’s individual philanthropy as seen through the eyes of the IRS.
While the IRS does not address all acts of generosity—such as gifts made directly to individuals—it does address the majority of appeals for help which you are likely to receive or hear about from organizations to which contributions do qualify.
You get the idea in a definition on the cover page of the IRS’ essential 19-page Publication 526, Charitable Contributions: “A charitable contribution is a donation or gift to, or for the use of, a qualified organization. It is voluntary and is made without getting, or expecting to get, anything of equal value.” That publication, which can be found at the IRS’ Web site (www.irs.gov), also notes that such organizations “include nonprofit groups that are religious, charitable, educational, scientific or literary in purpose, or that work to prevent cruelty to children or animals.”
Descriptions of such groups as well as examples of both organizations that are not qualified (such as labor unions and chambers of commerce) and contributions from which you may benefit (such as country club dues and university tuition) are in the IRS’ booklet. Be sure to ask whether the entity to which you are making a charitable contribution is a qualified organization or not.
Given the consequences of hurricanes Katrina and Rita, one IRS reminder is especially timely: “You can deduct contributions earmarked for flood relief, hurricane relief, or other disaster relief to a qualified organization (but not) contributions earmarked for…a particular individual or family.”
If you have given used clothing or household goods to flood victims or other needy—or plan to by December 31—you may claim deductions if they went to qualified organizations. Knowing how much you may deduct per item is tricky. The IRS requires that deductions be at fair market value, for which it gives a textbook definition—“the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts”—which is easier to articulate than to implement. (Publication 526 offers a few helpful suggestions.)
To ensure compliance, the IRS warns that donors may be liable for penalties if they overstate the value of donated property. Knowing how much you may deduct in total can also be tricky unless your contributions constitute no more than 20 percent of your adjusted gross income. If they exceed 20 percent, you need to wrestle with an IRS worksheet to determine your limit.
If you know that you will be able to contribute a five-figure total, which you are not yet prepared to allocate among qualified organizations, you may wish to consider a donor-advised fund. Donor-advised funds offer you immediate tax benefits and flexibility in the timing of your actual distributions to charities. You open an account with an irrevocable contribution of, say, $10,000 in cash, marketable securities, and/or mutual fund shares; tell the firm how the money should be invested among several investment pools for growth and/or income, and report your contribution on your 2005 tax return. When ready this year or next, you tell the donor-advised fund firm which organizations should get how much and the firm handles the grants for you.
If your contributions are on a very large scale and you can absorb the costs of its organization and operations, you could establish a tax-exempt private foundation for your charitable contributions under Section 501(c)(3) of the Internal Revenue Code, which you would fund with deductible contributions.
No matter your decision, it pays to do a little research beforehand to make sure that your contribution goes as far as it can to help those it’s intended for.
November 2005— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bold Financial Planning, LLC, a local member of the FPA.
Many self-employed people want to hire family members to work for them. But as with many things in life, there’s a right way and a wrong to do this. Doing it right can promote family togetherness. But it can also create tax savings for you.
How so? In essence, you are shifting business income to a relative. And your business can take a deduction for reasonable compensation paid to an employee, which in turn reduces the amount of taxable business income that flows through to you according to the AICPA’s financial literacy Web site, www.360financialliteracy.org.
Of course, you have to do it right. The IRS can, for instance, question compensation paid to a family member if the amount doesn't seem reasonable, considering the services actually performed. Also, the AICPA says to be sure that your business complies with child labor laws when hiring a family member who's a minor.
There are other benefits to hiring a family member. As a business owner, you are responsible for paying Federal Income Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes on wages paid to your employees. FICA is the law requiring employers and employees to pay Social Security and Medicare taxes. FUTA is the law that establishes federal unemployment taxes.
As with wages paid to all employees, wages paid to family members are subject to withholding of certain taxes in some states. Typically, the payment of these taxes will be a deductible business expense for tax purposes. But if you hire family member – a child, spouse, or parent as an employee – to work for your business you may not have to pay FICA and FUTA taxes.
For instance, you don’t have to pay FUTA taxes for services performed by your child who is under 21 years old. And you need not pay FICA taxes for your child who is under 18 and works in your trade or business or a partnership owned solely by you and your spouse, according to Working for Yourself (Nolo Press, $39.99). For family members under age 18, the parent does not have to withhold for FICA, Medicare, FUTA and SUTA. If the spouse is employed, one does not have to withhold for FUTA and SUTA, but must withhold for FICA and Medicare.
For example, Jacob, age 15, proofreads press releases for his mother’s public relations business, which is operated as a sole proprietorship. Jacob is his mother’s employee, but she doesn’t have to pay FUTA taxes until Jacob turns 21 and need not pay FICA taxes until he reaches 18.
Of note, these rules don’t apply if you hire your child to work for your corporation or your partnership, unless all the partners are parents of the child. In other words, you must pay both FICA and FUTA taxes in the aforementioned cases. For example, Jack works in a landscaping business that is half owned by his father and half owned by his father’s brother. FICA and FUTA taxes will have to be paid because it’s a partnership and not all the partners are Jack’s parents.
Also of note, if your child has no unearned income (dividend income or interest) then you must withhold income taxes from your child’s pay only if it exceeds the standard deduction for the year. The standard deduction for 2004 was $4,850, but it’s adjusted every year for inflation. Children who are paid less than this amount need not pay any income taxes on their earnings. You must, however, withhold incomes taxes if your child has more than $250 in unearned income for the year and his or her total income exceeds $750. If you pay your child more than $600 or more during the year, you must file a Form W-2 reporting the earnings to the IRS. Regardless of how much you pay your child, each year you should fill out and have your child sign IRS Form W-4, Employee’s Withholding Allowance Certificate. If you pay your child more than $200 per week, keep a copy of the form for your records and file a copy of the form with the IRS.
For small business owners who are engaged in what is often called succession planning, hiring children can provide non-tax benefits as well. Children who play a role in a business can help it survive past the owner’s involvement. “Family Affair: The Emotional Issues of Succession Planning,” which can be found in the Journal of Financial Planning’s July 2005 issue, is one story worth reading on the subject.
Meanwhile, if you employ your spouse to work in your trade or business, the payments are subject to FICA taxes and federal income tax withholding, but not FUTA taxes. This rule doesn’t apply if your spouse works for a corporation, even if you control it, or a partnership, even if your spouse is a partner along with you. In that case, you will have to pay FUTA taxes.
If you employ a parent in your trade or profession, meanwhile, his or her wages are subject to income tax withholding and the FICA taxes, but not FUTA taxes.
November 2005— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Bold Financial Planning, LLC, a local member of the FPA.
