PricewaterhouseCooper's Guide to the New Tax Rules

PRICEWATERHOUSECOOPERS’

Guide tothe New Tax Rules

PricewaterhouseCoopers

John Wiley & Sons, Inc.

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PricewaterhouseCoopers

John Wiley & Sons, Inc.

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Copyright © 2003 by PricewaterhouseCoopers. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

PricewaterhouseCoopers refers to the member firms of the worldwide PricewaterhouseCoopersorganization.

This document is provided by PricewaterhouseCoopers LLP for general guidance only, anddoes not constitute the provision of legal advice, accounting services, investment advice, orprofessional consulting of any kind. The information provided herein should not be used as asubstitute for consultation with professional tax, accounting, legal, or other competentadvisers. Before making any decision or taking any action, you should consult a professionaladviser who has been provided with all pertinent facts relevant to your particular situation.

The information is provided “as is,” with no assurance or guarantee of completeness,accuracy, or timeliness of the information, and without warranty of any kind, express orimplied, including but not limited to warranties of performance, merchantability, and fitnessfor a particular purpose.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the web atwww.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,201-748-6011, fax 201-748-6008, e-mail: [email protected].

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Library of Congress Cataloging-in-Publication Data:

PricewaterhouseCooper ’s guide to the new tax rules.p. cm.

Includes index.ISBN 0-471-24974-2 (paper : alk. paper)1. Tax planning—United States. 2. Income tax—Law and

legislation—United States. I. Title: Guide to the new tax rules.KF6297 .P75 2003343.7304—dc21

2002015559

Printed in the United States of America.

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ACKNOWLEDGMENTS

A publication of this kind does not come together without the in-valuable contributions of many. In particular, we would like to thankEditorial Director, Mark Friedlich, for his outstanding efforts towardmaking this book a success.

This book is dedicated to the many partners and professionals ofPricewaterhouseCoopers LLP who have spent a significant portionof their careers working with clients in developing strategies de-signed to help build, preserve and maximize wealth.

RICHARD J. BERRY JR.Partner, U.S. Tax Leader

MICHAEL B. KENNEDY

Partner, National Director of Personal Financial Services

BERNARD S. KENT

Partner, Personal Financial Services

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CONTENTS

Acknowledgments vIntroduction xv

Who We Are xviiHow to Use This Book xviiLet ’s Get Started xix

RECENT TAX LAWS AFFECT TAX PLANNINGFOR THIS DECADE 1

CHAPTER 1: The 2001 and 2002 Tax Acts 3Rate Reductions, Tax Credits, and Deductions 6

New 10 Percent Income Tax Bracket 7Reduction in 28 Percent and Higher Tax Rates 7Upper-Income Individuals Won’t Lose Deductions 10Personal Exemptions Won’t Be Lost 11Marriage Penalty Relief 11The Bottom Line 12Child Tax Credit 13Adoption Credit 14Dependent Care Credit 15Alternative Minimum Tax 15

viii Contents

Education Reforms 17Education IRAs 17Section 529 Qualified Tuition Programs 18Employer Education Assistance 20Student Loan Interest Deduction 20Deduction for Qualified Higher Education Expenses 21

Retirement Plan Changes 23Increase in Benefit Limit 23403(b)/457 Changes 23Vesting of Employer Contributions 24Increased Compensation Limit 24Increased 401(k) and SIMPLE Plan Deferrals 25“Catch-Up” 401(k) and SIMPLE Plan Deferrals 26403(b) and 457 Plans 27Larger IRA Contributions 28New IRA/Employer Plan Combination 29New Roth IRA/Employer Plan Combination 29Rollovers 30Rollover Eligible Plans 31Rollover of After-Tax Contributions 31Spousal Rollovers 33Tax Credit for Plan Contributions 33Employer Provided Retirement Planning 34Required Minimum Distributions 34Plan Loans to Owner-Employees 35Small-Business Credit for Plan Start-Up Costs 36Waiver of User Fees 36“Top-Heavy” Rules 37Increased Deduction Limits 37

Estate Tax Changes 39Phase-Down of the Estate Tax 40Loss of Credit for State Death Taxes 42Loss of Full-Basis Step-Up 43More Conservation Easements Deductible 46Qualified Domestic Trusts 46Installment Payment of Estate Taxes 47Repeal of Estate Tax Break for Family Businesses 48

What ’s Next 48

Contents ix

YEAR-ROUND TAX PLANNING STRATEGIES

CHAPTER 2: Investments and Stock Options 51Capital Gains 52

Favorable Rates 52Exceptions to the 20 Percent Rate 53Even Better Rates for Five-Year Gains 54

Qualifying Current Holdings for 18 Percent Rate 56Netting Rules 57Capital Losses 59Wash Sale Rule 60Protecting and Postponing Stock Gains 61Passive Activity Losses 62Careful Record Keeping: Identification of Securities 63Tax-Exempt and Taxable Bonds 64Taxable “Tax-Exempt” Bonds 64Bond Premium or Discount 65Florida Intangibles Trust 66Nonqualified Stock Options 66Incentive Stock Options 68Idea Checklist 70

CHAPTER 3: Retirement Planning 73Employer Plans 75

Qualified Retirement Plans 75Defined Contribution Plans 77Defined Benefit Pension Plans 82

Your Resources 84Keogh Plans 84Simplified Employee Pension Plans 85Traditional and Roth IRAs 86New Tax Credit for Retirement Saving 92Charitable Remainder Trusts 93Tax-Deferred Annuities 93Split-Dollar Life Insurance 94Universal Variable Life Insurance 96

Professional Retirement Services 96Social Security 97

x Contents

Required Retirement Plan Distributions 99Idea Checklist 103

CHAPTER 4: Tax Advantages of Home Ownership 105Tax Benefits of Owning a Home 106

Mortgage Interest 106Home-Equity Loans 107Vacation Homes 108Rental Properties 109Home Office Deduction 110Personal Residence Trust 112

Home Sales 113Principal Residence Gains Exclusion 113

Home Purchases 115Real Estate Taxes 115Mortgage Points 116

Idea Checklist 118

CHAPTER 5: How to Maximize Savings for Education 119Qualified Section 529 Tuition Programs 120What Expenses Qualify? 122Gift and Estate Tax Breaks, Too 125Coverdell Education Savings Accounts 126Roth IRAs 128Traditional IRAs 129Education Tax Credits 130

HOPE Scholarship and Lifetime Learning Credits 130U.S. Savings Bonds 131Home-Equity Loans 132Student Loans 133

Relatives 133Income Shifting and Capital Gains 134Tuition Deduction 135Employer Education Assistance 136Idea Checklist 137

CHAPTER 6: Estate Planning Ideas 141How the Estate and Gift Tax Works 142Amounts Exempt from Tax 142

Contents xi

Gift and Estate Tax Rates 144Planning for Phase-Down and Repeal of the Estate Tax 148Draft a Will 150Review How Your Property Is Owned 150Consider State Death Taxes 151Give Gifts 152Valuation Discounts 153Consider Trusts 154

Credit Shelter or Family Trust 154Life Insurance Trust 155Grantor Retained Annuity Trust 156Qualified Personal Residence Trust 157Dynasty Trust 157Charitable Remainder Trust 158Intentionally Defective Trust 158Qualified Domestic Trust 159Stock Option Trust 160

Give a Roth IRA 160Pay Gift Taxes Now 160Idea Checklist 161

YEAR-END TAX SAVING STRATEGIES 163

CHAPTER 7: Quick Planning Guide 165Tax Reduction 165Tax Deferral 166Income Shifting 168Year-End Capital Gains Checkup 169Year-End Alternative Minimum Tax Diagnosis 170

CHAPTER 8: Accelerating Deductions 173State and Local Taxes 175Interest 176

Business Interest 176Investment Interest 177Passive Activity Interest 177Student Loan Interest 179Personal Interest 181

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Medical Expenses 181Charitable Contributions 182

Property Donations 183Substantiation Requirements 184Deferred Giving 186

Casualty Losses 187Miscellaneous Itemized Deductions 188Moving Expenses 190Idea Checklist 191

CHAPTER 9: Deferring Income 193Year-End Bonuses 194Deferred Compensation 195Stock Options or Stock Appreciation Rights 196Treasury Bills and Bank Certificates 196Dividends 196Installment Sales 197U.S. Savings Bonds 198Annuities 198Individual Retirement Accounts 199401(k) Plans 199Shifting Income to Family Members 199

CHAPTER 10: Year-End Planning for Business Owners 203Year-End Edge for New Depreciation Allowance 204Bigger Tax Advantages for Business Automobiles 206Retirement Plans 207Bonuses and Deferred Compensation 207Income Deferral or Acceleration 208AMT Planning 209Personal Holding Company Tax 209Continuation Planning 210

Buy-Sell Agreements 210Deferred Compensation 211Covenant Not to Compete 211Earn-Out (Contingent Sale Price) 211

The Importance of Early Planning 212Don’t Wait to Plan! 212

A NUTS-AND-BOLTS REVIEW 215

CHAPTER 11: Basic Tax Concepts 217Gross Income 217Adjusted Gross Income (AGI) 218Modified Adjusted Gross Income 218A Tax Credit or a Deduction 219Taxable Income 219Marital Status 220Marginal and Effective Tax Rates 221What Is the Practical Result of Itemized Deductions

Limit and Personal Exemptions Phase-Out? 225Social Security Taxes 225Marriage Penalty 226Accountable Plan 227Tax Effects of Alimony 228Social Security Taxes for Domestic Employees 229Estimated Tax Payments 229Alternative Minimum Tax 231Calculating AMT 233Conclusion 236Appendix A: January Tax Strategy Idea Checklist 237Appendix B: PricewaterhouseCoopers’ Personal

Financial Services 238

About the Authors 240

Index 241

Contents xiii

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INTRODUCTION

To life’s two proverbial certainties—death and taxes—we can safelyadd a third related one: tax changes. Year-in and year-out, the InternalRevenue Code presents a moving target. Congress, while keeping upa steady stream of complaints about the tax code’s complexity andimpenetrability, just can’t seem to leave it alone. Whether there’s amajor overhaul or relatively minor tinkering, there is always somethingnew to worry about or to profit from. Sometimes fairness or simplifi-cation is the goal; other times it ’s a break just for a small group oftaxpayers; occasionally it ’s across-the-board relief. Right now, wehave it all. The Economic Growth and Tax Relief Reconciliation Act of2001 gave us the deepest tax cut since President Reagan’s twodecades ago. It created a new lower rate bracket at the bottom andslashed rates further up the line to the top bracket. That law alsophases out the estate tax, reduces the marriage penalty, gives greatertax incentives to education savings, and allows larger deductions forcontributions to retirement accounts of all kinds. It even helps somepeople temporarily avoid the dreaded alternative minimum tax.

These changes don’t hit all at one time. Instead, they are phased inon varying timetables for this entire decade. Some are in effect for

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only a few years; others don’t start until years in the future. If therewas any doubt before, tax change is now a given and taxpayers haveto cope with it. As if to prove that, Congress has already passedmore new tax laws since the massive 2001 Act, mainly to give sometax relief to businesses and, hopefully, to stimulate the sluggisheconomy. The IRS constantly puts its own interpretation on thingswith a steady stream of new regulations and rulings, which some-times upset years of careful tax planning, as happened this yearwhen it changed the rules for taxation of many split-dollar life insur-ance arrangements.

Rest assured, there’s plenty more change to come. Some of the re-cent changes likely will be made permanent, and some could be re-pealed or delayed. But whatever happens, every year each one of usmust deal with the tax law as it then exists and try to make themost of it. We also have to look ahead to plan our future tax strate-gies based on what we know in the present. That vision is a bit un-settling, because all of the changes made by the 2001 Act arescheduled to vanish after 2010, unless Congress acts to preventthat. The law contains its own demise: Its sunset provision ends allthe changes and leaves us with the Tax Code as it was before themassive 2001 Act.

In effect, this guarantees a decade of dynamic change in everyone’sfinancial and tax life. The shifting tax milieu and its implicationsreach into every aspect of our personal finances, from decidingwhere to live to the education of our children to our investmentstrategies and retirement planning.

What can we do? We can learn and adapt and cope. As complex asit is, the basics of the Tax Code can be understood. Moreover, weowe it to ourselves and to our families to make the effort.

This book will give you the tools you need to begin to sort things out and put them straight. It identifies the four major areas of the tax code that are most affected in this decade of shifting tax sands:

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Introduction xvii

individual income-tax rate reductions, increased child credits, mar-riage penalty relief, and estate tax relief. It also shows how to qualifyfor tax assistance for education-related costs, and how to maximizethe expanded tax breaks for company-sponsored and individual re-tirement plans. The largest share of the current and coming tax re-duction—fully 65 percent—comes from lower marginal income-taxrates for individuals. Child-related items account for 13 percent ofthe cuts, and phasing out the estate tax takes another 10 percent.The remaining 12 percent comes from reducing the marriagepenalty, pension and IRA reform, education incentives, and relieffrom the AMT.

This book spells out the most important features of all these changesas well as the impact of those that occurred in 2002. And it clearlysets forth the opportunities they offer to seize new tax-saving ad-vantages and strategies now and in the coming years.

Who We Are

We are personal financial services professionals at Pricewaterhouse-Coopers, one of the leading worldwide organizations of tax advisers,accountants and auditors. The firm operates in 150 countries andterritories, advising large and small businesses, individuals, govern-ments, and not for profit organizations. Over 300 personal financialservices professionals in the United States provide high net worthindividuals with comprehensive financial planning services includingestate and gift tax planning, income tax consulting and preparation,compensation and stock option planning, investment advisory ser-vices, retirement planning and charitable giving strategies.

How to Use This Book

Chapter by chapter, we clarify the vital sections of the new tax laws,with concrete examples that tell taxpayers what they need to know tobuild a solid base for planning and then to begin to map their owndollar-saving strategies. Remember, however, that oversimplification is

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dangerous. We strongly recommend that taxpayers understand at leastthe basic provisions of the law and the fundamentals of the tax codebefore planning, say, educational savings or stock option strategy—-that is why we wrote this book.

Here’s what lies ahead:

• Chapter 1 spells out the key elements of the new tax acts andother changes, explaining briefly what each major provision andchange does, how it works, and its timing.

• The laws’ impact on investments and stock options is the subjectof Chapter 2. Timing is crucial in this area as various provisions ofthe law phase in and out.

• Retirement planning should be part of each taxpayer ’s strategyfrom the time he or she begins work. Chapter 3 discusses how tomake planning for retirement a reality, and what changes in plan-ning the new laws will entail.

• The tax advantages of home ownership have been received wis-dom for decades. But Chapter 4 explores the subtle differencesthe new law will make when it comes to owning a home.

• The 2001 tax bill provides incentives for education, with extensivespecific provisions affecting primary, secondary, and higher institu-tions. Chapter 5 covers how to maximize savings for education.

• How can you structure your estate for a time when the “deathtax” is gradually phasing out, only to reappear after 10 years?Chapter 6 offers estate planning ideas.

• Chapter 7 sums up important strategies for year-end tax planningin a quick planning guide.

• When preparing your taxes, moving deductions to the previoustax year can save significant dollars, particularly if they are de-ductions that are going to be phased out. Chapter 8 describesthose deductions that may be best to accelerate.

• Chapter 9 applies the same year-end tax saving principles to de-ferring income from one year to the next, when it may be taxedless under scheduled changes.

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Introduction xix

• Year-end planning for business owners incorporates all of the per-sonal strategies previously discussed, but doesn’t end there.There are many additional considerations that can generate taxsavings for business owners and for their companies that can befound in Chapter 10.

• Chapter 11 explains basic tax concepts as they have evolved inthe tax code and puts the 2001 changes into context.

Interspersed through each chapter are a number of special features.The bulk of the text consists of individual “observations”—brief,clear explanations of specific features of the new law and how theywill be applied. There are also occasional passages labeled “cau-tion,” warning of a possible blunder taxpayers might make based ona misinterpretation of the law. In addition, each chapter contains an“idea checklist,” offering readers a quick summary of concepts to beused for taking advantage of the new law and its changes.

Let’s Get Started

It is human, and normal, to be intimidated by the subject of taxes.For most of us, our dealings with the Internal Revenue Service won’tend with a royal tap on the shoulder, but we can benefit greatly ifwe take the initiative and make the effort to overcome such fears.When it comes to taxes, forewarned is forearmed. An investment oftime and effort in forming a strategy for the coming years will payoff, year after year.

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RECENT TAX LAWSAFFECT TAX PLANNINGFOR THIS DECADE

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3

Chapter 1

THE 2001 AND 2002TAX ACTS

The Internal Revenue Code is a work in progress, if ever there wasone. Congress never leaves it alone for long. But every couple ofdecades there are changes that cause people to rethink everything.Their old tax planning strategies no longer work. One of those quan-tum leaps took place last year and is beginning to be felt now.

“Across-the-board tax relief does not happen often in Washington,DC,” President George W. Bush said as he was signing his $1.35trillion tax cut bill into law last year. “In fact, since World War II, ithas happened only twice: President Kennedy’s tax cut in the sixtiesand President Reagan’s tax cuts in the 1980s. And now it ’s happen-ing for the third time, and it ’s about time.”

The president ’s tax cut was large, but the Economic Growth and TaxRelief Reconciliation Act of 2001 is more than a tax cut. It is a hugeand complex changing-of-the-rules of the game—rules that phase inover the entire decade of the 2000s. For well-informed savvy people,this ever-changing scenario offers tax-saving opportunities to plan foryear after year. There is an opportunity to take advantage of eachprovision as it phases in (or phases out), adjusting investments andcompensation strategies, and accelerating (moving into an earlier


4 Recent Tax Laws Affect Tax Planning for This Decade

year) or deferring (delaying to the following year) income and deduc-tions to keep the greatest possible share of income for themselvesand their families.

These tax cuts are powerful enough to affect the economic lives ofmany taxpayers. They surely alter the way people invest theirmoney, save for their children’s education and their own retirement,write their wills, and structure their estates. Professional advisorsare sorting out the mind-boggling array of interconnected changes,and taxpayers are gradually becoming aware of the fundamental im-portance of them.

The first step, however, must be to understand the changes and howthey work. This book aims to make that large task as painless aspossible. In this chapter, we begin by discussing and explaining thedecade-long tax cuts in each of four main areas:

1. Rate reductions, tax credits, and deductions. All taxpayers whoare not subject to the AMT benefit from a new 10 percentbracket, which was carved out of the old 15 percent bracket.For married couples, the 10 percent tax rate applies to the first$12,000 of taxable income and will save them as much as $600a year. In higher brackets, tax rates will fall in stages over thenext five years. The top rate which had been 39.6 percent, paidby the top 1 percent of taxpayers, will fall to 35 percent; the 36percent rate to 33 percent; the 31 percent rate to 28 percent;and the 28 percent rate to 25 percent. The child credit rises inincrements to $1,000, and the credit for child care expensesalso increases. Limits on personal exemptions and itemized de-ductions, which were formerly imposed in stages as incomerose, will be phased out by 2010. There is limited relief from theAlternative Minimum Tax (AMT), although the relief only laststhrough 2004 unless Congress takes further action. Marriedpeople who pay more tax than they would as singles will getsome relief from the hated marriage penalty, beginning in 2005.

2. Education reforms. In 2002, the maximum (nondeductible)contribution that can be made to an educational Individual


The 2001 and 2002 Tax Acts 5

Retirement Account (IRA), now called a Coverdell EducationSavings Account, quadrupled to $2,000. Income from these ac-counts can be withdrawn tax-free to pay for school expenses,including tuition for private and parochial schools and ex-penses for state-approved homeschooling, as well as for col-lege. The so-called Section 529 plan, for parents saving fortuition and expenses at colleges and universities, has expandedto include plans of private institutions. Deductibility of intereston student loans has also been expanded, and there now is ashort-lived deduction for up to $4,000 in college tuition forcouples earning less than $130,000.

3. Retirement plan changes. There also are vastly improved in-centives for retirement savings. The Roth IRA, which is fundedwith after-tax dollars and offers tax-free withdrawal of gains,will be extended to some high-income families who did notpreviously qualify, and the limits on contributions have beenraised. Limits on annual funding for conventional IRAs arebeing phased up from $2,000 in 2001 to $5,000 in 2008, andpermitted employee contributions to 401(k) and equivalentplans will increase year by year to a maximum of $15,000 in2006. Workers who are age 50 or older are now allowed tomake larger contributions, and there are special tax credits tohelp low-income taxpayers save for retirement.

4. Estate tax changes. Reforms of the so-called death tax havecreated considerable estate planning complexities for thewealthiest 2 percent of taxpayers—those who may owe taxeson their accumulated wealth when they die. The amount ex-empt from being taxed has increased to $1 million, and willkeep rising. The top rate has dropped and will continue to falluntil the estate tax phases out entirely in 2010. On the otherhand, unless Congress intervenes, the estate tax will comeback in 2011, just as it would have been if it hadn’t beenchanged at all! And even if the revival of the estate tax is laterrepealed, new rules will require heirs to pay tax on some of thecapital gains from their inherited wealth—a complication thatnever had to be dealt with before.



Remember that these far-reaching changes are not written in stone.Apart from the sunset of the 2001 Tax Act after 2010, Congress al-ready has enacted more legislation that further amends some taxrules. The Job Creation and Worker Assistance Act of 2002, whichwe’ll just call the 2002 Tax Act, primarily introduced or extendedtax breaks for business to help stimulate the economy and to pro-vide relief for New York City businesses hurt by the September 11,2001, terrorist attack. However, there are some provisions affectingindividuals, including larger first-year depreciation deductions avail-able for sole proprietors, the temporary allowance of more personaltax credits against the alternative minimum tax, a new deduction forclassroom expenses of educators, and clarification of the adoptiontax credit rules. The 2002 Tax Act also made a number of changesto the retirement plan rules, especially extending increased deduc-tion limits to simplified employee pension (SEP) plans. The scope ofthe 2002 Tax Act, however, pales in comparison to the fundamentalchanges ushered in by the 2001 Tax Act.

No doubt, there will be more changes ahead. Although none haveyet been enacted, many bills have been introduced to make perma-nent all or various parts of the 2001 Tax Act. President Bushstrongly backs making his monumental tax cuts permanent. How-ever, the current political make-up of Congress—with each housecontrolled by a different party—does not favor immediate action.The situation is further affected by the current budget shortfallcaused by increased military and security spending as well as thebear market and sluggish economy. But, rest assured, the tax climatewon’t remain static.

We now discuss these changes, and what they portend for individualtaxpayers, in more detail.

Rate Reductions, Tax Credits, and Deductions

The 2001 Tax Act contained the largest tax rate reductions sinceRonald Reagan was president. Unfortunately, individuals will not



immediately benefit fully from the cuts. In 2001, the cuts started tobe phased in over five years and will not take full effect until 2006.

New 10 Percent Income Tax Bracket

The 2001 Tax Act created a new 10 percent income tax rate out ofthe lowest part of the 15 percent bracket.

The 10 percent bracket applies to:

• The first $6,000 of taxable income for single individuals ($7,000beginning in 2008).

• The first $10,000 of taxable income for heads of households.

• The first $12,000 for married couples filing joint returns ($14,000beginning in 2008).

Reduction in 28 Percent and Higher Tax Rates

The 2001 Tax Act gradually reduces the previous income tax ratesof 28 percent, 31 percent, 36 percent, and 39.6 percent to 25 per-cent, 28 percent, 33 percent, and 35 percent, respectively. Thetable that follows shows the remaining scheduled rate reductions:

Reduced to (% Rate)

Calendar Year 28 31 36 39.62002–2003 27 30 35 38.62004–2005 26 29 34 37.62006 and later 25 28 33 35.0

Observation

Everyone who pays regular income tax, not just those in low-income brackets, benefits from the new 10 percent category.



Other things to consider include taking itemized deductions (such ascharitable contributions, which are discussed next) in earlier, highertax years. For example, it may be wise to make charitable contribu-tions at the end of 2003 that ordinarily would be made early in2004. Or, you might make deductible state estimated tax paymentsin December rather than in January. (Note: There are some limita-tions on deferring income or accelerating deductions.)

Observation

Since rates will be dropping each year, taxpayers should con-sider deferring ordinary income until later tax years. For exam-ple, it might be wise to postpone exercising certain stockoptions and to delay year-end bonuses and other lump-sumpayments until the following January.

Caution

You must also consider the effects of deferring income or ac-celerating deductions on Alternative Minimum Tax (AMT).

Observation

Taxpayers who anticipate making charitable contributions overthe course of the next several years should consider makingcontributions while still in higher tax brackets, unless the cur-rent tax benefit from itemized deductions is minimal becauseof the income level. If you wish to take a deduction now foryour gifts to be paid to charities in the future, you can con-tribute to a donor-advised philanthropic fund, private founda-tion, or other charitable vehicle.



Observation

Generally, the reduction in marginal rates, particularly thecreation of the 10 percent income tax bracket, enhances thetax advantage of moving income over to children age 14 andolder. When the new rates are entirely phased in, people inthe top income bracket, for example, can save 25 percent intaxes by shifting up to $6,000 in income to a child. That isthe difference between the 10 percent bracket and what willbe the top 35 percent bracket. (Be careful about this, how-ever, because the unearned income of children under age 14is usually taxed under the so-called kiddie tax rules at the par-ents’ marginal tax rate.)

Observation

By 2006, when the reduction in marginal rates is scheduled tobe fully effective, the gap between long-term capital gains andordinary income tax rates will be reduced (assuming the capitalgains rate is not lowered by future tax legislation). This, in turn,should translate into fewer transactions being timed specificallyaround capital gains considerations.

Observation

You may be able to reduce estimated tax payments to reflectthe lower rates. But when figuring estimated taxes, be sure toconsider that your wage withholding for the year may now beless than last year ’s withholding.



Upper-Income Individuals Won’t Lose Deductions

After 2005, the 2001 Tax Act phases out the overall limitation onitemized deductions, which now reduces the value of certainitemized deductions claimed by higher income individuals. In ef-fect, these higher income individuals will have an even greater ratereduction.

In 2002, itemized deductions—except medical expenses; casualty,theft, or gambling losses; and investment interest expenses—are re-duced by 3 percent of the individual’s adjusted gross income (AGI)above $137,300 for unmarried people as well as married couplesfiling joint returns ($68,650 for married individuals filing separately).Although these amounts are adjusted annually for inflation, this rulecan cause you to lose as much as 80 percent of deductions in thiscategory.

The 2001 Tax Act reduces this limitation by one-third for 2006 and2007, two-thirds for 2008 and 2009, and eliminates it altogetherafter 2009.

Observation

The reduction in marginal rates makes tax-exempt invest-ments, such as municipal bonds, relatively less attractive un-less and until those investments match the tax reduction withhigher yields.

Observation

The reduction in marginal rates will also benefit owners ofpass-through entities, such as partnerships, limited liabilitycompanies, and S corporations, each of which subjects itsowner to only one level of individual taxation.

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Personal Exemptions Won’t Be Lost

The 2001 Tax Act also phases out the restrictions on personal ex-emptions that are now imposed on higher income taxpayers. Begin-ning after 2005, those affected will receive what is, in effect, anadditional tax rate reduction.

Currently, deductions for personal exemptions ($3,000 each in 2002)are reduced or eliminated at higher income levels. For 2002, the de-duction must be reduced by 2 percent for each $2,500 ($1,250 formarried people filing separately) or a portion of $2,500 that the tax-payer ’s AGI exceeds $206,000 for joint returns; $103,000 for mar-ried couples filing separately; $171,650 for heads of households; and$137,300 for single individuals. For 2002, personal exemptions arecompletely phased out at $328,500 on joint returns; 164,250 formarried individuals filing separate returns; $294,150 for heads ofhousehold; and $259,800 for single individuals (see Chapter 11 for2003 figures).

Under the 2001 Tax Act, the personal exemption phase-out will bereduced by one-third for 2006 and 2007; two-thirds for 2008 and2009; and eliminated altogether after that.

Marriage Penalty Relief

The 2001 Tax Act helps reduce the income tax penalty that marriedcouples are subject to. However, relief does not start until 2005 andis not fully phased in until 2009.

The relief takes the following two forms:

1. Standard deduction increase. The basic standard deduction formarried couples filing joint returns will gradually increase until it istwice the standard deduction for single filers. (In 2005, the standarddeduction for joint filers will be 174 percent of that for singles, andwill increase each year until it reaches 200 percent in 2009.) Starting

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in 2005, the standard deduction for married taxpayers who file sep-arately will be equal to that for singles.

2. Expansion of the 15 percent bracket. The 15 percent incometax bracket for married couples filing joint returns will graduallygrow to twice the size of the 15 percent bracket for single filers. Be-ginning in 2005, this increase will be fully phased in by 2008.

The Bottom Line

Combining all of the tax reductions discussed thus far, how muchcan an individual expect to save year by year? To answer that, let ’slook at a married couple that files jointly, has two dependent chil-dren, $500,000 of ordinary income (wages, interest, and dividends),and $50,000 of itemized deductions. Here’s how much they wouldsave in 2006 and 2010:

Observation

Married couples who itemize their deductions will not benefitfrom this change if their itemized deductions already exceedtwice the standard deduction amount for single filers.

Observation

Unlike the change in the standard deduction, which will onlybenefit people who do not itemize, the expansion of the 15percent tax bracket will help all married couples with taxableincome in this or higher brackets as long as they are not sub-ject to the Alternative Minimum Tax because more of their in-come will be taxed at a lower rate.

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Child Tax Credit

A taxpayer with dependent children younger than age 17 used to beentitled to a child tax credit of only $500 per child; however, thecredit begins to phase out once the modified AGI (adjusted grossincome with some adjustments that do not affect most taxpayers)reaches $110,000 on a joint return ($75,000 for single individuals orheads of households, and $55,000 for married couples filing sepa-rately). In general, the child tax credit is nonrefundable, whichmeans that a refund is not issued if its total exceeds the tax owed.(More will be said about refundable credits shortly.) However, forlower income families with three or more qualifying children underage 17, the credit is refundable for the amount that their Social Se-curity taxes surpass their earned income credit.

The 2001 Tax Act gradually increases the child credit to $1,000, asrepresented in the following table:

In addition, the child credit is now refundable up to 10 percent of ataxpayer ’s earned income in excess of $10,000 for calendar years

Year Tax ($)Savings overPrior Law ($)

2001–Prior law 154,378 0

2006–Reduction in marginalrates fully phased in

134,710 16,993

2010–Elimination of phase-outof itemized deductions/personalexemptions

122,465 31,913

Credit AmountCalendar Year per Child ($)

2002–2004 6002005–2008 7002009 8002010 1,000

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2001 to 2004 (the $10,000 amount is indexed for inflation begin-ning in 2002). The percentage increases from 10 to 15 percentstarting in 2005. A refundable tax credit is one that results in a re-fund if the credit exceeds the amount of tax owed. For families withthree or more children, the credit, which remains refundable, isavailable if it brings a larger refund than what would be receivedunder the new rules. Also, the child credit will be allowed perma-nently against the Alternative Minimum Tax.

Adoption Credit

Previously, individual taxpayers could claim a credit of up to $5,000per child ($6,000 for a child with special needs) for certain ex-penses associated with adopting a child. Alternatively, employeescould receive income-tax-free a maximum of $5,000 for qualifiedadoption expenses paid by their employers.

Both the credit and exclusion phased out at modified AGI levels be-tween $75,000 and $115,000. The exclusion and the credit for chil-dren, other than those with special needs, had been scheduled toexpire after 2001, however, the 2001 Tax Act:

• Made the adoption credit and the exclusion for adoption ex-penses permanent.

• Increased the credit and the exclusion to $10,000 per child be-ginning in 2002.

• Increased the phase-out range to modified AGI levels between$150,000 and $190,000, beginning in 2002.

• Beginning in 2003, allows the full $10,000 credit for special-needs adoptions to be claimed in the year the adoption is final-ized, regardless of the amount of actual expenses.

Reminder

Unlike some other personal tax credits, the adoption credit canbe claimed permanently against the Alternative Minimum Tax.

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Dependent Care Credit

Currently, a credit is allowed for certain dependent care expensesthat enable parents to work. For most people (those with an AGI over$28,000), this credit amounts to 20 percent of $2,400 (maximum) ofincurred expenses ($4,800 for two or more qualifying children underage 13 or older dependents who are incapable of caring for them-selves). Thus, an individual with two qualifying children is generallylimited to a credit of $960. Those with lower incomes are eligible forthis credit at a rate as high as 30 percent of incurred expenses.

Beginning in 2003, the 2001 Tax Act raises the amount of expenseseligible for credit under “dependent care” to $3,000 ($6,000 for twoor more qualifying children or dependents).

The maximum credit rate is also increased from 30 percent to 35percent, and will phase down more slowly than under the previousrules. For example, after 2002, an individual with two qualifying chil-dren and an AGI of $29,000 will be entitled to a maximum credit of$1,680 (28 percent of $6,000). Taxpayers with two or more qualify-ing children or dependents and income over $43,000 will be entitledto a maximum credit of $1,200 (20 percent of $6,000).

Alternative Minimum Tax

The Alternative Minimum Tax (AMT) was intended to ensure thathigh-income taxpayers who benefit from various deductions, cred-its, and exemptions pay at least a minimum amount of tax. TheAMT is calculated by reducing or eliminating the tax benefits thathave been claimed for regular income tax purposes. Next, an ex-emption amount is subtracted, and the AMT tax rates are applied tothe balance. The taxpayer then compares the result with his or herregular tax and pays the higher amount.

The AMT exemption is available for taxpayers with relatively modestincomes. In 2000, $45,000 was the total exemption amount allowedfor married couples filing joint returns ($33,750 for single taxpayers,

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and $22,500 for married individuals filing separately). Phased outfor higher income taxpayers, the AMT exemption amount has notkept pace with inflation, making it less protective for a growingnumber of middle-income taxpayers.

The 2001 Tax Act raised the amounts of the AMT exemption by$4,000 to $49,000 for married couples filing jointly, and by $2,000to $35,750 for single taxpayers and $24,500 for married individualsfiling separately. However, these increases apply only through 2004.The AMT tax rates remain at 26 percent for the first $175,000 ofAMT income ($87,500 for married individuals filing separately) afterthe exemption, and 28 percent for the balance. The 2001 Tax Actdid not alter the phase-out of the AMT exemption amount for higherincomes.

Example

A married couple with two dependent children has a combinedincome of $200,000; together, they have $45,000 of itemized de-ductions ($30,000 for mortgage interest, $5,000 for property tax,and $10,000 for state income tax). Before the 2001 Tax Actchanges, this couple would have owed approximately $33,700 inincome taxes and no AMT. After the regular tax rate reductiontakes full effect in 2006, that income tax would drop to approxi-mately $28,750. However, because the increase in the AMT ex-emption expires in 2005 and regular taxes become substantiallylower in 2006, they would pay $5,040 in AMT in addition to the$28,750 of regular tax.

Observation

Although the AMT exemption has been increased slightly, tax-payers subject to the AMT may not realize the reductions inthe regular income tax rates. Furthermore, the regular incometax rate reductions themselves will increase many people’s ex-posure to the AMT.

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Education Reforms

The 2001 Tax Act provides improved tax incentives that make edu-cation at all levels more affordable. These are the major enhance-ments:

• Increased limits on contributions to Education IRAs.

• Tax-free withdrawals from Section 529 programs.

• Employer-provided graduate education assistance.

• Expansion of the student loan interest deduction.

• New tax deduction for college costs.

Education IRAs

Previously, annual contributions to an Education IRA (now officiallycalled a Coverdell Education Savings Account) for a specific benefi-ciary could not exceed a total of $500 from all donors. The $500limit phased out for individuals with an AGI over $95,000, and formarried couples filing jointly with an AGI over $150,000.

Distributions from these accounts are tax-free up to the amount ofthe beneficiary’s qualified higher education expenses in the yearof distribution. The earnings portion of distributions that exceedthose expenses in any given year is taxable and subject to a 10percent penalty.

The 2001 Tax Act increased the annual limit on contributions toCoverdell Education Savings Accounts to $2,000 per child beginningin 2002. The contribution limit for married couples filing jointly nowbegins to phase out at $190,000, which is twice the limit for single

Caution

All of these changes are scheduled to lapse after 2010 unlessCongress intervenes to extend them.

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taxpayers. Also, corporations and tax-exempt organizations, amongother entities, may contribute to Coverdell Education Savings Ac-counts regardless of their income as long as they adhere to the limitof $2,000 per beneficiary.

Also starting in 2002, kindergarten, elementary, and secondary-school expenses (public, private, or religious) as well as certainafter-school programs qualify as education expenses that are eligiblefor tax-free treatment. Computer equipment, software, and Internetaccess also are included in this category.

Other improvements for Coverdell Education Savings Accounts start-ing in 2002 are:

• A HOPE Scholarship credit or a Lifetime Learning credit may beclaimed in the same year that a tax-free distribution is taken froma Coverdell Education Savings Account, as long as the same ex-penses aren’t used to claim both the exclusion and a credit.

• Contributions may be made to both a Coverdell Education Sav-ings Account and to a qualified tuition program in the same yearfor the same beneficiary without incurring an excise tax that ap-plied before 2002.

Section 529 Qualified Tuition Programs

State-sponsored college savings plans (known as “section 529 plans”after the section of the Internal Revenue Code authorizing them)allow tuition credits to be purchased or contributions to be made to

Observation

Parents should consider whether Coverdell Education SavingsAccounts or Section 529 programs will affect their chances ofreceiving financial aid for college (see Chapter 5).

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college savings accounts on behalf of a designated beneficiary who,before 2002, was taxed when the tuition credit was distributed orreceived to the extent that it exceeded what was contributed on hisor her behalf. Contributors are taxed on any refund from the pro-gram that exceeds the contributions made for a beneficiary.

Under the 2001 Tax Act, private educational institutions may estab-lish plans similar to those of the states. In the private school plans, aperson may purchase tuition certificates or credits, but college sav-ings accounts will not be available.

The 2001 Tax Act made distributions from qualified state tuitionplans tax-free starting in 2002 and ending in 2010 if used to pay forqualified higher education costs. After 2003, this tax-free treatmentalso will apply to distributions made from private school, qualifiedtuition programs.

In addition, starting in 2002, rollovers may be made from one planto another once every 12 months without tax consequences, even ifthe beneficiary stays the same. The prior rule that allowed transfersbetween qualified accounts for different beneficiaries in the samefamily was expanded to include transfers that benefit a first cousinof the original beneficiary.

The HOPE Scholarship credit and the Lifetime Learning credit maybe claimed in the same year that a distribution is taken from a quali-fied tuition plan, but the credit and the exclusion can’t both resultfrom the same expenses.

Observation

This modification enables grandparents to switch tuition-planbeneficiaries among their grandchildren.

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Employer Education Assistance

An employer can pay up to $5,250 per year of educational expenseson behalf of an employee, under an education-assistance plan thatallows that income to be tax-free to the employee and exempt frompayroll taxes. These benefits had been scheduled to expire for anycourse that began in 2002 or later. They were not available at all forgraduate courses.

The 2001 Tax Act, however, extended the exclusion to graduatecourses beginning after 2001 and made the exclusion (for both un-dergraduate and graduate courses) permanent.

Student Loan Interest Deduction

Previously, taxpayers could deduct up to $2,500 annually for inter-est paid on qualified education loans for the first 60 months of the repayment period when interest payments are required. Themaximum deduction phased out for single taxpayers with AGI be-tween $40,000 and $55,000, and for married taxpayers filingjointly with AGI between $60,000 and $75,000. This interest de-duction is available even to those who do not itemize deductionson their returns.

Starting in 2002, the 2001 Tax Act repealed the 60-month limit dur-ing which qualified student loan interest is deductible. This allowsinterest to be deducted on student loans with longer repayment

Observation

Even without this specific tax break, reimbursements by employ-ers for job-related courses, which are those that maintain or im-prove a skill currently used in the recipient ’s trade or businessor are required to continue his or her employment, are tax-free.This does not include courses that lead to a new profession.

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periods. The 2001 Tax Act also increased the phase-out range to$50,000 to $65,000 of AGI for single taxpayers, and $100,000 to$130,000 for married couples filing jointly. The phase-out thresh-olds will be adjusted for inflation after 2002.

Deduction for Qualified HigherEducation Expenses

Although there are many tax breaks for education savings and ex-penditures, there had been no general deduction for tuition ex-penses that were unrelated to a person’s job. The 2001 Tax Actchanged that by providing a deduction for a limited amount of quali-fied higher education expenses paid on behalf of yourself or yourspouse or dependents. The deduction may be claimed both bythose who itemize deductions and those who claim the standarddeduction.

Only a taxpayer with relatively modest income can claim the newdeduction. In 2002 and 2003, the maximum deduction of $3,000may be claimed only if AGI is $65,000 or less, or $130,000 formarried couples filing joint returns.

In 2004 and 2005, the maximum deduction increases to $4,000for those with an AGI of $65,000 ($130,000 for married couplesfiling jointly) or less. A maximum deduction of $2,000 is availablein these years for those with AGI of more than $65,000, but notmore than $80,000 (between $130,000 and $160,000 for marriedcouples filing jointly).

The disadvantages to the new deduction include: It will not beavailable after 2005, and it cannot be claimed in the same year as aHOPE Scholarship credit or a Lifetime Learning credit for the samestudent. Finally, taxpayers cannot deduct expenses taken into ac-count when determining the amount of a Coverdell Educations Sav-ings Account or a tax-free qualified tuition plan distribution (seeTable 1.1). In summary:

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22

Table 1.1 Highlights of Major Education Changes

Highlights Old Law New Law

Coverdell EducationSavings Accountscontribution limit

$500 $2,000

AGI phase-out(single)

$95,000 $95,000

Qualified expenses Higher educationonly

Elementary, second-ary, and higher edu-cation

Section 529 plans

Earnings used foreducation

Taxable Tax free

Employer Assis-tance Programs

Eligible coursework Undergraduatecourses only

Undergraduate andpostgraduate courses

Student loan in-terest deduction

Start of AGI phase-out (single)

$40,000 $50,000

Start of AGI phase-out (joint)

$60,000 $100,000

AGI phase-out(joint)

$150,000 $190,000

Interest paymentseligible of

First 60 monthspayments

No limit

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Retirement Plan Changes

The 2001 Tax Act increased the overall limit on amounts that maybe added annually to defined contribution retirement plans by em-ployers and employees, including 401(k) plans and profit sharingplans, beginning with the 2002 plan year. The old limit was either$35,000 or 25 percent of compensation, whichever was lower. Thatlimit has been raised to 100 percent of compensation or $40,000,whichever is lower. In the future, the dollar limit will be indexed forinflation in $1,000 increments.

Increase in Benefit Limit

The 2001 Tax Act also increased the maximum annual benefit that adefined benefit pension plan can fund. It was raised from $140,000to $160,000, starting in 2002. The limit is reduced for benefitsbeginning before age 62 and increased for benefit payments com-mencing after age 65.

403(b)/457 Changes

The maximum exclusion allowance under tax-deferred 403(b) an-nuities has been repealed and replaced with the 100 percent of

Observation

The increase to 100 percent of compensation is intended to as-sist those individuals whose working histories are interruptedto accumulate more retirement savings. While the increasedlimit applies to all plan participants, it is expected that second-income spouses will be able to make the most use of it.

Caution

This change applies to the allocation limitation, not the deduc-tion limitation.

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compensation limit. In addition, the special alternative elections forcertain 403(b) plans have been repealed. The 331⁄3 percent limitunder 457 (state and local government employee) plans also was re-pealed and replaced with the 100 percent of compensation limit.The maximum dollar limit is now the same amount that applies to401(k) plans.

Vesting of Employer Contributions

The 2001 Tax Act increased many tax incentives for retirement sav-ings, although several are optional, not mandatory. They allow, butdon’t require, employers with qualified retirement plans to adopt thechanges. However, one favorable change for employees is manda-tory: faster vesting of employer-matching contributions.

For plan years beginning after 2001, employer-matching contribu-tions made under a qualified retirement plan or a 403(b) annuitymust vest (i.e., cannot be forfeited) either 100 percent after threeyears or 20 percent per year, beginning with the second year of ser-vice and increasing to 100 percent after six years of service. Thenew vesting schedule applies only to employees who have some ser-vice after the 2000 plan year. These rules will also apply to collec-tively bargained plans in future years.

Increased Compensation Limit

Beginning in 2002, the 2001 Tax Act increased the amount of com-pensation that can be taken into account for retirement plan pur-poses from $170,000 to $200,000. This means that largercontributions and benefits are possible for those with compensation

Caution

The new, more liberal vesting requirements do not apply to non-matching employer contributions. And, of course, individuals’own plan contributions remain 100 percent vested at all times.

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above $170,000. The $200,000 compensation limit will be indexedfor future inflation in multiples of $5,000.

Increased 401(k) and SIMPLE Plan Deferrals

The 2001 Tax Act increased the amount of salary that employeescan contribute to a 401(k) plan. These provisions also apply to403(b) annuities and 457 deferred compensation arrangements. For2002, up to $11,000 or 100 percent of compensation, whichever isless, can be deferred to a 401(k) plan account, after which the dol-lar limit on annual deferrals will increase in $1,000 increments untilit reaches $15,000 in 2006.

The annual deferral limit for SIMPLE (savings incentive match planfor employees) plans that allow deferrals increased to $7,000 in2002, with $1,000 annual increases thereafter until it reaches$10,000 in 2005.

All of these deferral limits will be indexed annually in $500 incre-ments after the increases are fully phased in:

Caution

A highly compensated employee (HCE) may not be allowed totake full advantage of the increased deferral limits after the401(k) nondiscrimination tests are applied.

Maximum Deferral Amount*If Age Is Less Than 50 ($)

Year 401(k) SIMPLE2002 11,000 7,000 2003 12,000 8,0002004 13,000 9,0002005 14,000 10,0002006 and later 15,000 as indexed 10,000 as indexed

* Cannot exceed 100 percent of compensation.

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“Catch-Up” 401(k) and SIMPLE Plan Deferrals

Starting in 2002, taxpayers can elect to make additional pretax de-ferrals if they are 50 years of age or older. These catch-up amountsare: $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in2005, and $5,000 in 2006 and thereafter. The additional catch-upamount allowed under a SIMPLE plan is $500 for 2002, increasingby $500 each year until it reaches $2,500 in 2006. The $5,000 and$2,500 amounts will be indexed for inflation after 2006.

The regular contribution limits and nondiscrimination rules do notapply to catch-up contributions provided the plan permits all eligibleparticipants to make them. Employers are generally permitted, butnot required, to match catch-up contributions:

Maximum Deferral Amount*If At Least Age 50 ($)(Includes Catch-Up)

Year 401(k) SIMPLE 2002 12,000 7,500 2003 14,000 9,0002004 16,000 10,5002005 18,000 12,0002006 and later 20,000 as indexed 12,500 as indexed

* Cannot exceed 100 percent of compensation.

Observation

Highly compensated employees and second-wage earners infamilies are more likely to have sufficient disposable incomeavailable to take advantage of the increases in the electivedeferrals.

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Example

An executive who has more than $200,000 in compensation whodefers the maximum under prior law had an average deferral per-centage (ADP) of 6.18 percent ($10,500/$170,000) for 2001. Themaximum deferral for 2002 produces an ADP of 5.5 percent. Ifthe highly compensated employee is age 50, an additional$1,000 can be deferred, bringing the total deferral to $12,000 in2002 without affecting the 5.5 percent ADP. A lower ADP willallow more of the executive’s elective deferrals to remain in theplan.

403(b) and 457 Plans

The increased limits for elective deferrals, including the catch-ups,apply in general to 403(b) annuities and to 457 deferred compensa-tion arrangements maintained by a state government employer.However, a catch-up contribution cannot be made to a 457 arrange-ment in the three years prior to retirement. But special rules thatapply only to 457 plans allow the annual deferral to be increased totwice the usual annual deferral limit. The rules that reduce the limits

Observation

The allowance of extra contributions by employees age 50 orolder should decrease the amount of corrective distributions tohighly compensated employees and allow more of the execu-tive’s elective deferrals to remain in the plan. In addition, manyexecutives otherwise limited under the plan will be able to takeadvantage of the catch-up provision and increase 401(k) elec-tive deferrals without being either subjected to nondiscrimina-tion tests or limited on the amounts of the annual additions.

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on contributions made to 457 plans by the amounts contributed to403(b) and 401(k) plans have been repealed, effective for years be-ginning after 2001. This allows state government employees to in-crease retirement savings by making an elective deferral to a 457plan and deferring the maximum amount to a 403(b) annuity or a401(k) plan, as well.

Larger IRA Contributions

The 2001 Tax Act increased the maximum annual IRA contributionfrom $2,000, where it had been for nearly 20 years, to $3,000 for2002 through 2004, $4,000 for 2005 through 2007, and $5,000 for2008 and later. The new contribution limit will be indexed annuallyfor inflation after 2008 in $500 increments.

The 2001 Tax Act also permits extra catch-up IRA contributions forthose age 50 or older as of year-end. (The 2002 Tax Act made it ab-solutely clear that an IRA owner doesn’t have to wait to turn 50 be-fore making catch-up contributions; the extra contributions can bemade at any time during that year.)

The maximum catch-up contributions are $500 from 2002 through2005, and $1,000 after 2005:

Increased IRAContribution Limits

Year Regular IRA ($) Catch-Up ($)2002 3,000 5002003 3,000 5002004 3,000 5002005 4,000 5002006 4,000 1,0002007 4,000 1,0002008 and later 5,000 1,000

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New IRA/Employer Plan Combination

Enabling employees to save for retirement through payroll deduc-tions, the 2001 Tax Act permits employers with qualified retirementplans or tax-sheltered annuities to create employer-sponsored IRAsas part of those plans. The new arrangement, which is called aDeemed IRA and will begin in 2003, must meet all the regular IRArequirements.

New Roth IRA/Employer Plan Combination

The 2001 Tax Act allows employees to designate elective deferrals(up to the dollar contribution limits discussed previously) to 401(k)or 403(b) plans as Roth IRA contributions. This “Qualified RothContribution” program will be available as of 2006.

Observation

These increases will give taxpayers and their spouses more op-portunities to save for retirement so they can rely less on em-ployer retirement plans and Social Security. Over long periodsof time, even relatively modest additional savings can accumu-late significantly.

Observation

The income limits for deductible IRAs, eligibility for Roth IRAs,and converting regular IRAs into Roth IRAs remain unchanged.As a result, the only benefit that higher income taxpayers whoare active participants in employer retirement plans (or whosespouses are) will realize from the IRA changes is the ability tomake larger contributions to nondeductible regular IRAs.

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Even taxpayers whose incomes are too high to contribute to regularRoth IRAs will be able to contribute to the new arrangements; theoption will be available to all plan members. Thus, even high-incomeindividuals can designate 401(k) deferrals as Roth IRA contributionsif their plans are amended to permit it.

Designating elective deferrals as Roth IRA contributions convertsthe contributed amounts into after-tax, rather than pretax, contribu-tions, which increases the up-front cost of saving in these vehicles.However, the Qualified Roth Contribution account must adhere toall of the regular Roth IRA rules regarding income tax on distributedearnings (not taxed if distributed after age 591⁄2 and the Roth ac-count has existed for five years), early distribution penalty, androllovers.

Rollovers

In general, the 2001 Tax Act expands one’s ability to move fundsfrom one type of retirement plan to another by allowing rollovercontributions between regular retirement plans, such as 401(k)plans, tax-sheltered annuity plans (403(b) plans), and governmentalretirement plans (Section 457 plans) beginning in 2002. After-taxcontributions to employer plans are eligible to be rolled over begin-ning in 2002. Surviving spouse beneficiaries also have more choiceson rollover plans beginning in 2002.

Observation

Taxpayers will need to balance current and future advantagesand disadvantages of elective deferrals or Roth IRA contribu-tions each year, taking into account the time until distributionand the potential marginal tax bracket at distribution.

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Rollover Eligible Plans

Previously, only IRAs and qualified plans could accept rollovers; thelatter could accept rollovers only from other qualified plans or from“conduit” IRAs (IRAs containing only rollovers from qualified plans),and 403(b) plans could only accept rollovers from another 403(b)plan. The 2001 Tax Act expanded the plans that can accept rollovers,for distributions after 2001, to include 403(b) and 457 plans. Thus,any distributions from 401(k), 403(b), or 457 plans now are eligible tobe rolled into any other plan. As was previously the case, a conduitIRA can be rolled into a qualified plan, 403(b) plan, or 457 plan, butonly if it has not received any regular IRA contributions.

Rollover of After-Tax Contributions

For distributions made after 2001, the taxpayer can roll over after-taxcontributions from employer plans to IRAs along with the taxable

Observation

The previous patchwork of rollover rules has been made a bitmore consistent with these changes. The new rules are espe-cially valuable for those who accept jobs with government ortax-exempt employers after working in the private sector.

Caution

Any grandfathered features (eligibility for 10-year averaging;capital gains for pre-1974 accruals; or tax deferral on unreal-ized appreciation from distributed employer securities) may belost in such a transfer. Thus, before rolling over funds from atax-qualified plan, one should determine his or her continuingeligibility for special tax rules.

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portion of the account at retirement. It will also be possible to rollover after-tax contributions into a new employer plan, provided it isa direct trustee-to-trustee transfer.

Rollovers of after-tax contributions must be accounted for sepa-rately. When they are distributed, special ordering rules apply forthe after-tax account: Earnings are deemed to be distributed firstand contributions last.

Observation

Once an after-tax contribution is rolled over into an IRA, itcannot be rolled back into a qualified plan, 403(b) annuity, or457 plan.

Observation

Before 2002, distributions of after-tax contributions could notbe rolled into IRA accounts or a different employer plan. Thenew, more liberal rules provide a significant benefit by increas-ing your ability to leave funds in tax-deferred status afterchanging jobs.

The downside is that after-tax contributions add a layer of com-plexity. The rules for recovering after-tax contributions fromIRA distributions differ from those for pension distributions.For example, under the 2001 Tax Act, a participant in a quali-fied plan who receives a distribution of $500,000 (including$200,000 in after-tax contributions) can roll over $300,000,keep the $200,000 of after-tax contributions, and pay no tax.However, an IRA owner in the same situation would be taxedon 60 percent of the $200,000 that wasn’t rolled into an IRA.

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Spousal Rollovers

Until now, a surviving spouse who is the beneficiary of a deceasedemployee’s retirement plan could roll over the distribution only intoan IRA. The 2001 Tax Act permits a rollover to the survivingspouse’s own employer-sponsored plan. Thus, after 2001, a spousecan roll this sort of distribution into his or her own 401(k) plan or403(b) tax-sheltered annuity.

Tax Credit for Plan Contributions

For 2002 through 2006, a new nonrefundable tax credit is availableto certain lower-income individuals who contribute to qualified re-tirement plans (including IRAs and Roth IRAs). This credit is in addi-tion to any other deduction available. The maximum annualcontribution eligible for the credit is $2,000.

The credit rate phases down from 50 percent to 10 percent of thecontribution based on the individual’s AGI. It is only available tothose with an AGI below the beginning of the IRA deduction phase-out, and is totally phased out for those with an AGI above $50,000for joint filers, $37,500 for head-of-household filers, and $25,000for single filers. This credit is not available to students, taxpayersunder age 18, or dependents.

Caution

Although this change permits the surviving spouse to consoli-date funds in a single location, rolling into a qualified plan maynot be the best approach because the beneficiary payout fea-tures of qualified plans are usually not as flexible as IRA payoutfeatures. The surviving spouse can preserve greater flexibilityfor payouts to beneficiaries by using an IRA rollover.

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Employer Provided Retirement Planning

The 2001 Tax Act stipulates that retirement planning services pro-vided to employees and spouses are a nontaxable fringe benefitafter 2001. Highly compensated employees qualify for this exclusiononly if services are available on substantially similar terms to all em-ployees who normally receive information regarding the employer ’squalified plan. However, it is expected that employers will be able tolimit the advice they offer to those at or near retirement age.

Required Minimum Distributions

The Internal Revenue Service recently revamped and simplified itsregulations dealing with required minimum distributions from IRAsand qualified retirement plans such as 401(k)s. The 2001 Tax Act di-rected the IRS to revise the life-expectancy factors used to calculateminimum distributions. (The life-expectancy factors in the IRS’s old

Caution

The exclusion is not available for other services associated withretirement planning such as tax preparation, legal, accounting,or brokerage services.

Observation

Retirement planning involves complex income tax, investment,and logistic issues. Several professional groups participate inwhat has become a significant service industry, including ac-countants, attorneys, trust officers, financial planners, and bro-kers. The new exclusion should provide employees with greateraccess to these services.

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rules were from the original proposed regulations in the mid-1980s.)The final regulations issued in 2002 do reflect more recent im-proved mortality experience. First proposed in 2001, the changeshave now been refined and made final.

Plan Loans to Owner-Employees

Starting in 2002, S corporation owners, partners, and sole propri-etors for the first time may borrow from their retirement plans with-out being liable for the “prohibited transactions” excise tax.However, they must adhere to the rules that apply to plan loansmade to other participants. Generally, this means the amounts thatcan be borrowed are limited to whichever is less: $50,000, or halfthe individual’s account balance. Also, repayment with interest mustbe made at regular intervals over a term of no more than five years(longer for loans used to purchase a principal residence).

Observation

The IRS revisions to the proposed regulations thoroughly sim-plify what was an overly complex process fraught with danger-ous tax pitfalls.

Caution

A taxpayer who must take a minimum required distributionfrom an IRA should make sure it has been calculated using thelatest rules. The revisions decrease by a significant degree theamount of required distributions for almost everyone (seeChapter 3 for details).

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Small-Business Credit for Plan Start-Up Costs

To encourage small businesses to establish retirement plans for em-ployees, the 2001 Tax Act provides a tax credit to defray the ex-penses of setting up and operating a new retirement plan. Costspaid or incurred in tax years beginning after 2001 (for plans estab-lished after that date) are eligible for a nonrefundable income taxcredit equal to 50 percent of the first $1,000 in administrative andretirement-education expenses for each of the first three years ofthe plan.

The 50 percent of qualifying expenses that is offset by the tax creditis not deductible; the other 50 percent (and all other expenses) isdeductible as it is currently. The credit is available only to an em-ployer that did not employ more than 100 employees who earnedmore than $5,000 in the preceding year. Also, at least one em-ployee who is not highly compensated must be covered by the plan:

Waiver of User Fees

The 2001 Tax Act relieved employer plans with 100 or fewer em-ployees, and at least one participant who is not highly compen-sated, from paying a user fee for an IRS determination letter requestregarding the plan’s qualified status during its first five years (or theend of any remedial amendment period that begins within those first

2001 Tax Act Prior Law ($) ($)

Deductible start-up cost 1,000 1,000 Plan education expense 1,000 1,000 Total qualifying expenses 2,000 2,000 Credit 500 0 Total deductible expenses 1,500 2,000 Tax savings* including credit 1,085 780 Net cost of plan 915 1,220

* Assuming a 38.6 percent tax bracket for individual owner.

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five years). This user fee waiver applies to determination letter re-quests made in 2002 or later.

“Top-Heavy” Rules

So-called top-heavy retirement plans—those in which key employ-ees receive more than 60 percent of the contributions orbenefits—must provide certain minimum benefits or contributionlevels to less-key employees and vest those benefits earlier thanother plans are required to do. The 2001 Tax Act modified the top-heavy rules effective for years beginning in 2002 or later. A “keyemployee” is one who, during the prior year, was an officer withcompensation in excess of $130,000, a 5 percent owner, or a1 percent owner with compensation in excess of $150,000.

Also, only distributions made in the year prior to the determinationdate (and in-service distributions during the previous five years) aretaken into account when deciding whether the plan is top-heavy.Matching contributions may be taken into account in satisfying theminimum benefit requirements. Another change is that a safe-harbor401(k) plan is not a top-heavy plan, and matching or nonelectivecontributions provided under a safe-harbor plan may be taken intoaccount in satisfying the minimum contribution requirements fortop-heavy plans. Finally, the 2001 Tax Act provided that frozen de-fined benefit plans (or plans in which no key employee or formerkey employee benefits under the plan) are exempt from the mini-mum benefit requirements.

Increased Deduction Limits

The 2001 Tax Act made a variety of changes that can substantiallyraise an employer ’s maximum deductions for retirement plan contri-butions, effective for years beginning in 2002 or later. Thesechanges include:

• The deduction limit for stock bonus and profit sharing plans is in-creased from 15 percent of eligible compensation to 25 percent,

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and money purchase pension plans generally are treated likeprofit sharing or stock bonus plans for purposes of the deductionlimits.

• Employee elective deferrals are no longer subject to deductionlimits and are not taken into account for purposes of applying thededuction limits to other types of contributions.

• For purposes of the deduction limits, the definition of “compen-sation” includes salary reduction amounts under a Section 125cafeteria plan and 401(k) elective deferrals.

Observation

These changes will eliminate the need to have a profit sharingplan in tandem with a money purchase plan because they pro-vide the maximum deduction of 25 percent of compensation.Tandem plans had been the industry standard for small, closelyheld businesses, such as medical practices, that want to accu-mulate and deduct maximum benefits for owner-employees. Inaddition to the advantages of administering only a single plan,the mandatory contribution required by the money purchaseplan can be eliminated, giving the business the flexibility to re-duce contributions during downturns or when funds areneeded for other business purposes, such as expansion.

Observation

In addition to the increase in the deduction limit from 15 per-cent to 25 percent of compensation, the increase to $200,000in the amount of compensation that may be used to figure al-lowable contributions and the increase to $40,000 in allowable

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Estate Tax Changes

One of the most fundamental changes in the 2001 Tax Act is thegradual repeal of the federal estate tax. The estate tax—and an-other death tax called the generation-skipping transfer (GST) tax—began to phase out starting in 2002, and will be eliminated entirelyin 2010. The gift tax is not repealed, but its effect may be reducedunder certain circumstances. As with the income tax provisions,

annual additions will increase deductions for profit sharing plancontributions. These combined changes will allow owners ofsmall, closely held businesses, especially those with few em-ployees, to maximize their plan benefits without the complica-tions of tandem plans. For 2002, for example, a company maydeduct a full $40,000 contribution to a profit-sharing planmade on behalf of a higher paid employee (25 percent of up to$200,000 of compensation, but not more than the $40,000limit on annual additions). For 2001, by comparison, the maxi-mum deductible contribution in this situation was only$25,500 (15 percent of up to $170,000 of compensation).

Observation

An owner of a small, closely held business whose compensa-tion is less than the $160,000 needed to obtain the maximum$40,000 deduction for 2002 can increase the contributionthrough the use of a 401(k) plan. The employee elective defer-ral to the 401(k) plan does not count toward the 25 percent ofcompensation deduction limit.

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all of the estate and gift tax changes in the 2001 Tax Act arescheduled to sunset after 2010. Therefore, the repeal of the estatetax will last for only one year (2010) unless Congress makes fur-ther changes that are signed into law. Accompanying the repeal ofthe estate tax are some income tax changes that may cause appre-ciation in some of a decedent ’s property to be subject to incometax. Currently, all appreciation in property that occurred during adecedent ’s life escapes capital gains taxation. These and otherchanges will cause many people to reconsider and revise their es-tate plans.

Phase-Down of the Estate Tax

The gradual repeal of the estate tax began in 2002 by:

• Increasing the amount that is shielded from estate tax.

• Reducing the top estate tax rate.

Exemption Increases

For 2001, the combined amount that anyone could have givenaway during his or her lifetime or bequeath at death to anyoneother than a spouse without paying gift or estate tax was$675,000. Under the 2001 Tax Act, this exempt amount increasedto $1 million in 2002 for both estate and gift tax purposes. There-after, the exemption amount increases gradually to $3.5 million in2009 for estate tax purposes, and remains at $1 million for gift taxpurposes. (The GST exemption amount, which is $1,100,000 in2002, will continue to be indexed for inflation in 2003, and thenwill increase in tandem with the estate tax exemption amount untilboth taxes are repealed in 2010.) The gift tax will continue toapply to lifetime transfers totaling more than $1 million (not includ-ing up-to-$11,000 annual exclusion gifts) made to anyone, excepta spouse. Both before and after the 2001 Tax Act, there is no limiton the amount that can be given or left to a spouse free of gift orestate tax.

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Rate Reduction

The 2001 Tax Act reduced the maximum estate and gift tax rates thatapply to transfers above the exemption amount. The highest estateand gift tax rate—which had been 55 percent in 2001—fell to 50percent for 2002, then gradually will decline to 45 percent in 2009.

Observation

The 2001 Tax Act did not increase the $10,000 gift tax annualexclusion ($20,000 for most married couples), which allowsrelatively modest tax-free gifts to be made each year to an un-limited number of people. However, this amount is indexed toreflect inflation and was raised to $11,000 ($22,000 for cou-ples) for 2002.

Caution

The increased estate tax exemption will require taxpayers toreexamine their estate plans if their wills and those of theirspouses contain “bypass” or “credit-shelter” trusts, whichmany wills do to ensure that both spouses’ estates receive thefull estate tax exemption. These bequests are intended to leavethe maximum amounts that can be passed on to children orother heirs (or in trusts for their benefits) without incurring es-tate tax. These provisions were designed around the exemptionamounts ranging from the current $675,000 to $1 million (towhich the exemption had been scheduled to be raised in2006). As the exemption increases under the 2001 Tax Act,however, these arrangements will be funded with larger andlarger amounts, and possibly all, of a decedent ’s assets, some-times leaving nothing outright for the surviving spouse.

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Beginning in 2010, the top gift tax rate is scheduled to decline to 35percent, which is the same as the top individual income tax rate willbe under the 2001 Tax Act. The Act repealed the phase-out of thegraduated rates (an extra 5 percent tax that applied to certain gifts orestates greater than $10 million) after 2001. The estate, GST, and gifttax rates and exemptions, from now through 2011, are represented inTable 1.2.

Loss of Credit for State Death Taxes

Prior law allowed a credit against federal estate tax for state deathtaxes paid at a decedent ’s death. The credit could have been ap-proximately 16 percent of the estate. Every state imposed a state

Table 1.2 Year-by-Year Transfer Tax Rates and Exemptions

Highest Estate, GST,Exemption (in $ Millions) and Gift Tax Rate

Year Estate Tax GST Tax Gift Tax (%)

2002 1 1.1 1 50

2003 1 1.1 1 49(indexed)

2004 1.5 1.5 1 48

2005 1.5 1.5 1 47

2006 2 2 1 46

2007 2 2 1 45

2008 2 2 1 45

2009 3.5 3.5 1 45

2010 N/A (taxes N/A (taxes 1 35 (Gift tax)repealed) repealed) 0 (Estate and GTS tax)

2011 and later 1 1.060 1 55 (indexed)

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death tax at least equal to this credit to absorb the benefit of thecredit against the estate tax. The 2001 Tax Act phases out the statedeath tax credit that is allowed against the federal estate tax. Thecredit is 75 percent of the current credit for estates of those whodie in 2002, and will drop to 50 percent in 2003, and 25 percent in2004. In 2005, the state death tax credit will be repealed and re-placed by a deduction for those taxes actually paid to any state.

Loss of Full-Basis Step-Up

Repeal of the estate tax in 2010 will be accompanied by the repealof the present rules, which provide that a beneficiary’s basis (thecost used to figure the gain when property is sold or otherwise dis-posed of ) in assets, acquired from a decedent, is generally “stepped-up” to fair market value as of the date of death. This basis step-upeliminates capital gains tax liability on appreciation in inherited as-sets that occurred during the decedent ’s lifetime. Those who inheritproperty from decedents who die in 2010, however, will receiveonly a limited basis step-up, which will eliminate income tax on amaximum of $1.3 million of gain that accrued during the decedent ’slife. Property inherited by a surviving spouse will get an additional$3 million of basis increase, thereby allowing a total basis increase ofup to $4.3 million for property transferred to a surviving spouse. (Ifthe decedent was a nonresident alien, the aggregate basis increasewould be limited to $60,000, regardless of the beneficiary’s relation-ship to the decedent.)

Observation

The credit represents an important source of revenue for manystates. Some states have enacted their own estate taxes tocompensate for the repeal of this credit and others are consid-ering similar actions, a factor that should be considered whenpeople decide where to live in retirement.

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In addition to the allowable basis step-up, an estate or its beneficiar-ies who acquire the principal residence of a decedent who dies in2010 will be able to qualify for tax-free treatment on its sale if thatdecedent could have qualified. The result can be an additional in-come tax-free gain of a maximum of $250,000.

The estate’s executor will choose which of the decedent ’s assetswill receive the basis increase. (There will be a number of restric-tions on basis allocation to avoid the creation of artificial tax lossesand other effects not intended by the rule.) Certain additional basisincreases will be permitted so that the decedent ’s losses that werenot deducted are not wasted. After permitted basis increases havebeen exhausted, beneficiaries will receive a basis in the propertyequal to the decedent ’s adjusted basis (referred to as a carryoverbasis) or the fair market value of the property on the date of thedecedent ’s death, whichever is less. For property owned jointly byspouses, only the decedent ’s half of the property will be eligible fora basis increase.

Donors and estate executors will be required to report informationabout certain transfers to the IRS and to donees and estate benefici-aries, including basis and holding period information.

Estate planning may help minimize the potential for family strife orlitigation over basis allocation issues after a benefactor ’s death.

Observation

Under the Tax Act of 2001, the executor will be responsible forallocating the aggregate basis increase limits among differentassets and various beneficiaries of the property. If some benefi-ciaries receive higher basis property, the other beneficiariesmay be burdened with higher capital gains if they sell the in-herited property.

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Caution

Only property transferred outright to the surviving spouse orheld in a special form of trust known as a qualified terminableinterest property (QTIP) trust qualifies for the additional$3 million of basis increase for property passing to survivingspouses. Many persons now have testamentary plans in whichbequests to surviving spouses are held in other forms of truststhat qualify for the marital deduction for estate tax purposes,but won’t qualify for the $3 million basis increase.

Observation

For those interested in charitable giving, retirement assets arean excellent choice of assets to leave to charity. Because retire-ment assets qualify for a step-up in basis neither before norafter the repeal of the estate tax and, generally, don’t evenqualify for capital gains rates, income tax consequences can beminimized by leaving the retirement assets rather than otherproperty or cash to charity.

Observation

Before the 2001 Tax Act, retirement and other assets that maynot have been stepped-up were often left to the survivingspouse rather than to children or other heirs. Now the reversemay be desirable, since there could be a need to use the maxi-mum amount of step-up for post-2010 transfers to a survivingspouse. But this decision is complicated by other considera-tions: That only a surviving spouse may make certain favorableIRA withdrawal elections is one example. Careful planning isrequired.

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More Conservation Easements Deductible

The 2001 Tax Act expanded the availability of special estate taxtreatment for qualified conservation easements by eliminating therequirement that the land be located within a certain distance of ametropolitan area, national park, wilderness area, or an Urban Na-tional Forest as designated by the USDA Forest Service. A qualifiedconservation easement may now be claimed for estate tax purposeswith respect to any land that is located in the United States or itspossessions. These provisions are effective for estates of decedentswho die after 2000.

Qualified Domestic Trusts

A qualified domestic trust (QDOT) qualifies for the estate tax mar-ital deduction when the surviving spouse is not a U.S. citizen.Generally, the estate tax is deferred until the death of the survivingspouse, at which time an estate tax based upon the value of thetrust principal that remains must be paid. If distributions of trustprincipal are paid out to the surviving spouse before death, estatetax also would be payable based on the value of those distribu-tions. Under the 2001 Tax Act, the QDOT principal escapes estatetaxation if the surviving spouse dies in 2010. However, any distri-bution of principal from a QDOT to a living spouse will remainsubject to the estate tax through 2020, but would be free of estatetax in 2021. But because 2021 will occur after the December 31,2010, sunset date, this provision is, in effect, voided by the 2001Tax Act.

Observation

This liberalization may lead to increased use of this technique,which may be attractive to environmentally minded landowners.

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Installment Payment of Estate Taxes

The 2001 Tax Act expanded the availability of estate tax installmentpayment provisions for estates of business owners. To alleviate theliquidity problems of estates comprised significantly of closely heldbusiness interests, qualifying estates may defer the estate tax attrib-utable to the closely held business on an installment basis for up to14 years at a low interest rate. The 2001 Tax Act expanded avail-ability of installment payment relief to certain qualified lending andfinance business interests, as well as to certain holding companystock. In addition, the new law increases from 15 to 45 the cap onthe number of partners that can be included in a partnership orshareholders in a closely held corporation and still be eligible for in-stallment payment relief. These changes are effective for decedentsdying in 2002 or later.

To qualify for the installment payment relief, a lending and financebusiness must meet several technical requirements. In particular, itsstock or debt could not have been publicly traded at any time withinthe three years immediately preceding the decedent ’s death. Also,an estate relying on the relief for qualified lending or finance busi-nesses under the new law must make the installment payments infive years rather than 14. Similarly, an estate taking advantage of thenew holding company rules must pay the tax over nine years.

Observation

It is possible to avoid estate tax entirely in the case of QDOTsthat are established before 2010. QDOTs, therefore, should beconsidered when planning the estate of anyone married to anon-U.S. citizen.

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Repeal of Estate Tax Break for Family Businesses

The 2001 Tax Act repeals the special estate tax deduction for quali-fied family-owned business interests (QFOBI) beginning in 2004.

What’s Next

In this chapter, we have explained the far-reaching effects of the TaxAct of 200l, shown the importance of planning to adjust for its con-tinuing changes, and reviewed the law’s main provisions. Now it istime to discuss in detail how taxpayers should handle their invest-ments to take advantage of the law.

Observation

This provision provides additional relief for an often overlookedissue of estate planning: ensuring sufficient liquidity to pay es-tate taxes. By liberalizing the rules, additional businesses canqualify for this relief. However, they must still comprise at leasta certain minimum percentage of the total estate assets; otherrequirements apply as well.

Observation

This deduction was repealed because the increase in the regu-lar estate tax exemption (discussed above) to $1.5 million in2004 will exceed the total amount of the qualified familyowned business interest deduction, which is limited to$1.3 million, less the estate tax exemption amount. Thus,estates of family-owned business owners will not be hurt bythe repeal, but will not be entitled to an estate tax exemptionany greater than other estates.

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Although people who profit from investments generally must handover some of their gains to the government in the form of taxes, noone has any obligation to pay any more than is legally due, and it isas wise as it is legitimate to plan an investment strategy to takemaximum advantage of what is provided in the tax law. In the nextchapter, we explain how the new law changes the playing field forinvestors.

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51

Chapter 2

INVESTMENTS ANDSTOCK OPTIONS

In today’s difficult investment climate, investors need every edge theycan muster. No investor—whether in stocks, bonds, sophisticatedhedge funds, or simple certificates of deposit—can afford to ignorethe effects that the 2001 Tax Act has on managing a portfolio. Thelaw’s continuing changes over the next decade are likely to requirecontinuous adjustments to minimize an investor ’s federal tax bill.

To the extent that it reduces regular income tax rates, the law re-duces tax liability for interest, dividends, and short-term capitalgains. Thus, even though the tax law does not directly affect long-term gains on assets held for more than a year, its effect is to reducethe marginal advantage of long-term gains by making ordinary in-come investments relatively more attractive. But the advantages forcapital gains are still strong, particularly since earlier tax changesthat became effective in 2001 have added to the tax benefits ofgains on assets held for more than five years.

Investors must also consider the effect of the Alternative MinimumTax (AMT) on any market gains. The benefit of municipal bond in-terest, for instance, is lessened for investors who are subject to theAMT. There is modest relief from the AMT for the years 2001

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through 2004, but after that the tax reverts to its terms before thecut—a fact that investors should keep in mind in planning for 2005.

Many taxpayers will choose to convert some of their investments tonewly liberalized Coverdell Education Savings Accounts or collegetuition savings plans for their children. We describe these strategiesin depth in Chapter 5 of this book.

Investors should also take note that the phasing out of the estate taxhas a catch-22 clause: In 2010, securities in an estate will no longerescape all capital gains when passed on to an heir. Under the newlaw, the heirs’ tax-free gains on inherited property will be limited toa total of $1.3 million. An additional $3 million of gains on propertyreceived by a surviving spouse will also be able to escape capitalgains tax. Until now, many investors have taken it as nearly ax-iomatic that securities with very large gains should be reserved fortheir heirs. In some instances, that strategy may have to berethought because the 2001 Tax Act places a limit on capital gainsthat can pass to heirs tax-free in 2010.

In this chapter, we discuss in detail the many ways taxpayers can ad-just their investment options to minimize the taxes they pay underthe new law. Particular attention is paid to making the best tax useof capital losses, of which there are many this year. We include achecklist of ideas to consider as you plan your investment strategiesfor the decade to come.

Capital Gains

Capital gains income results when you sell or exchange a capitalasset. Examples of capital assets include the shares of stock or secu-rities you own, your personal residence, or a work of art.

Favorable Rates

Long-term capital gains (gains from capital assets held for more thanone year) are usually taxed at a maximum rate of 20 percent whenyou sell the property.

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Investments and Stock Options 53

Example

An individual in the top tax bracket (38.6 percent in 2002) sellsstock that he purchased over a year ago, recognizing a gain of$10,000. His long-term capital gains tax is $2,000—20 percentof $10,000. Had he sold the stock before owning it for more thana year for the same $10,000 gain, his tax liability would be$3,860, that is, 38.6 percent of $10,000.

Exceptions to the 20 Percent Rate

Take note that the long-term capital gains rate is only 10 percent ongain that would be taxed at no more than 15 percent were it ordi-nary income.

Observation

The lower tax rates on long-term capital gains make stock in-vestments more advantageous and reduce the attractiveness of“ordinary income” investments, such as regular IRAs (but notRoth IRAs), tax-deferred annuities, and fixed income invest-ments. However, the 2001 Tax Act ’s income tax rate cuts (seeChapter 1) will close this gap somewhat.

Observation

The capital gains rate is increased effectively in some taxbrackets by the itemized deduction cutback and the personalexemption phase-out (see Chapter 8). Loss of personal exemp-tions and itemized deductions will be less of a problem in thefuture, because the 2001 Tax Act gradually eliminates thesehidden tax rate boosters beginning in 2006. Until then, the mar-ginal tax rate on net long-term capital gains for higher incomeindividuals may be 22 percent or higher, depending on personalcircumstances.

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Example

Assume your 19-year-old daughter ’s regular income (wages, inter-est, and dividends) is taxed at no more than 15 percent, and shesells stock that she purchased over a year ago for a gain of$10,000, all of which would be taxed to her at no more than 15percent if it were ordinary income. Your daughter will be subjectto long-term capital gains tax of $1,000 (10 percent of $10,000),not $2,000 (20 percent of $10,000).

A higher maximum tax rate of 28 percent applies to long-term capi-tal gains from the sale of collectibles (such as art or antiques), andto one-half of the long-term capital gains from the sale of qualifiedsmall-business stock (the other half of the gain on the sale of suchstock, up to certain limits, is tax-free).

Example

An individual who is not an art dealer sells an oil painting fromhis personal collection, which he has owned for many years, for$10,000 more than he paid for it. His capital gains tax liability is$2,800 or 28 percent of $10,000.

Even Better Rates for Five-Year Gains

There has always been a required minimum holding period to qualifyfor long-term capital gains rates. Over the years, it has varied frommore than six months to more than two years. But starting in 2001,capital gains rates that are even lower than the standard ones—18percent and 8 percent—will apply to certain five-year gains on capi-tal assets:

• 18 percent rate. This rate, instead of the usual 20 percent rate,will apply to capital gains from property held for more than fiveyears if the holding period for the property begins in 2001 or later.

• 8 percent rate. This rate, instead of the 10 percent rate, appliesto capital gains from property held for more than five years and

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sold in 2001 or later. There is no requirement for the holding pe-riod to have begun after 2000 to qualify for this low rate, as thereis to qualify for the 18 percent rate.

Example

An individual in the top tax bracket (38.6 percent in 2002 and2003) owns stock purchased more than five years ago on whichhe has a $10,000 gain. If he sold the stock in 2002 to help payhis grandson’s college tuition, for example, his long-term capitalgains tax liability would be $2,000 or 20 percent of $10,000. Ifhe gives the stock to his 17-year-old grandson, who has only afew thousand dollars of taxable income this year from a summerjob, the tax bill would be cut to $800 on his grandson’s sale ofthe stock, saving $1,200.

Observation

The availability of the 8 percent rate for those in the lowest taxbracket presents a great family income-splitting opportunity.You can transfer stock or other assets that you have held formany years to your low-bracket children or grandchildren, whocan then sell the assets (after they turn 14, to avoid the kiddietax) and qualify for the 8 percent rate to the extent the gainsdon’t push their income above the 15 percent bracket (about$28,000 for singles and $46,700 for married couples in 2002,and a bit higher for 2003). This is possible because your hold-ing period carries over to recipients of the property when youmake the gift. As a result, what would have been your 20 per-cent capital gains tax liability becomes your children’s orgrandchildren’s 8 percent capital gains tax—a 12-percentage-point tax savings.

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Qualifying Current Holdings for18 Percent Rate

Investors had the opportunity to qualify assets purchased before2001 for the 18 percent rate by electing to treat any or all of them ashaving been sold and repurchased at the beginning of 2001. Thosewho made this election for readily tradable stock were deemed tohave sold and repurchased it at its closing price on the first businessday after January 1, 2001. The deemed sale and repurchase of othercapital assets, such as real estate or artwork, was treated as made attheir fair market values on January 1, 2001. By making this election,

Caution

Gain on a post-2000 gift of property that was purchased be-fore 2001, however, will not qualify for the 18 percent rate, be-cause the holding period for the person receiving the propertyis considered to have begun when the stock was originallybought. Since that was before 2001, gain on any later sale by aperson in a tax bracket above 15 percent will be taxed at the20 percent rate, even if he or she actually held the asset formore than five years before the sale.

Caution

Gain on stock received from the post-2000 exercise of a stockoption granted before 2001 also does not qualify for the 18percent rate. For the purpose of qualifying for the 18 percentrate, the holding period for the option stock is considered tobegin on the date of the option grant. Therefore, if the optionwas granted before 2001, later gain on the option stock won’tqualify for the 18 percent rate even if it was acquired by exer-cise after year 2000.

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investors were able to start a new post-2000 holding period withoutactually going through the trouble and expense of selling and repur-chasing the property.

Netting Rules

Favorable capital gains rates and the long-term capital gains holdingrequirements may influence when you sell property, which in turnaffects your tax bill. When calculating your capital gains income,keep in mind that the following ordering rules apply to netting capi-tal gains and losses. The rules are fairly complicated, but they

Observation

Making the deemed-sale election for an asset generally waswise only when the current gain was small, future gains wereexpected to be large, and it was almost certain that the prop-erty would be held for another five years. Otherwise, the lossof earnings on the funds used to pay the accelerated capitalgains tax could easily be more than the potential savings fromthe reduced rate on a future sale. Also, making the election forloss property didn’t cause the losses to be recognized in 2001,and, thus, didn’t make them available to offset capital gainsrecognized in 2001. The 2002 Tax Act also clarified that mak-ing the election for investments subject to the passive activityloss rules didn’t result in a disposition that converted passivelosses to nonpassive losses. However, the gain created by thedeemed sale election did free up an equivalent amount of pas-sive losses that may have been used against compensation orportfolio income, such as interest and dividends.

Caution

If you made a deemed-sale election, you cannot revoke it.

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should generally produce the lowest overall tax. Long-term capitalgains and losses (for this purpose, long-term refers to a holdingperiod of more than one year) are divided into three groups deter-mined by tax rates:

1. A 28 percent group (for long-term capital gains from the sale ofcollectibles such as art or antiques, and half of the long-termcapital gains from the sale of qualified small-business stock);

2. A 25 percent group (for part of the gain from the sale of depre-ciable real estate); and

3. A 20 percent group (for long-term capital gains from the sale ofall other capital assets).

Long-term gains and losses within a tax-rate group are first nettedagainst one another.

Net losses within a long-term tax-rate group then are used to offsetnet gains from the long-term tax-rate group with the highest taxrate. If there are net losses remaining, they offset gains from thenext highest tax-rate group.

Example

Assume that for 2002 there will be net losses in the 20 percenttax-rate group. The net losses first offset any net gains in the 28percent tax-rate group, and then offset net gains in the 25 per-cent tax-rate group. This automatically produces maximum taxsavings from the losses.

Long-term capital loss carryovers from 2001 offset net gains for thehighest long-term tax-rate group first, then the other long-term tax-rate groups in descending order.

Example

A net long-term capital loss carryover from 2001 first offsets net28 percent capital gains, then net 25 percent capital gains, and fi-nally net 20 percent capital gains.

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Net short-term capital losses offset net long-term capital gains be-ginning with the highest tax-rate group.

Example

A net short-term capital loss first offsets net 28 percent capitalgains, then net 25 percent capital gains, and finally net 20 per-cent capital gains.

Net long-term capital losses can offset short-term capital gains.

Capital Losses

Capital losses, of which there were many in 2002, are deductibledollar-for-dollar against capital gains. In addition, you may deductup to $3,000 in net capital losses (either short-term or long-term)each year against your ordinary income (such as wages). Amounts inexcess of this figure may be carried forward indefinitely.

Observation

This is especially advantageous for 2002, when many long-termlosses were realized and skittish investors grabbed gains when-ever they could on short-term holdings, which are subject totax at ordinary income rates rather than the more favorablecapital gain rates.

Observation

This netting process also separates out any gains and lossesfrom sales of five-year property that is eligible for even lowerrates, as explained previously.

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Wash Sale Rule

If you hold securities or mutual funds that have substantially de-clined in value and you do not think they will recover anytime soon,you might want to sell them to realize the loss currently. If you wantto maintain a position in this investment category, you can repur-chase other assets of similar quality. But you should not immediatelyrepurchase the same or “substantially identical” (the IRS uses thisterm to broaden the prohibited repurchase to securities and mutualfunds that are not identical to what you had sold but are of the samecategory and type) assets because the wash sale rule will preventyou from taking a tax loss this year unless you wait at least 31 daysafter the sale before repurchasing any “substantially identical” as-sets. If you trigger the wash sale rule, your loss will be suspendedand added to your cost basis (the amount you pay for the securityplus other acquisition costs, such as brokerage commissions; thisamount is then used to figure your gain or loss when you sell the se-curity) in the replacement securities, which will reduce your taxablegain or increase your loss when the replacement securities are sold.

To avoid the wash sale rule, you must buy the “substantially identi-cal” assets at least 31 days before or after the sale of the securitiesor mutual funds. The disadvantage of this is that in the first case yourisk doubling your losses if the value of the investment continues tofall while you are doubled up in it, and in the second case you riskloss of potential price increases if you are out of the investment for31 or more days.

Observation

There is considerable bipartisan support in Congress for an in-crease in the $3,000 limit. Watch for this possible change inupcoming tax legislation.

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Protecting and Postponing Stock Gains

You can no longer effectively use the “short sale against the box”technique to safely lock in your gains while postponing realizingcapital gains from the sale of appreciated assets until the followingyear, as had been possible until a few years ago. Two other strate-gies remain:

1. Buying put options covering stock you own. A put option is anoptions contract that entitles the holder to sell a number ofshares (usually 100) of the underlying common stock at a statedprice on or before a fixed expiration date. Under this strategy,any decline in the price of the stock is likely to be offset, atleast in part, by an increase in the price of the put option.

2. Writing covered call options. A covered call is a trade that in-volves buying the underlying stock and selling a call against the

Caution

Be careful not to trigger the wash sale rule unwittingly. Thiscould happen, for example, if you sell part of your investmentin a security or fund at a loss, and a dividend paid on the re-maining shares is automatically reinvested in the same shareswithin the restricted 30-day period.

Observation

It is always helpful to review your realized and unrealized capi-tal gains and losses, as well as loss carryovers. This is especiallyimportant if you want to reduce your tax bills in future years. Ifyou have unrealized capital losses, consider taking them to theextent of realized capital gains. Also, you may wish to realizeanother $3,000 in losses this year to offset that amount ofotherwise taxable ordinary income.

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stock position. This means that you write (sell) call optionsagainst the stock you own. If the stock price drops, some ofyour unrealized gain will be lost, but the loss will be offset, atleast in part, by a profit resulting from the premium receivedfrom the sale of the option.

More complex strategies include collars and variable prepaid forwards.Capital gains can also be deferred or possibly eliminated through theuse of charitable remainder trusts.

Passive Activity Losses

Investment losses are limited by a complex set of provisions knownas the passive activity loss rules. In general, losses and credits frompassive activities can offset only passive income and may not beused against earned income (such as salaries) or portfolio income(such as dividends or interest). Passive activities generally includeany business or investment activity in which you do not materiallyparticipate. Rental activities (for example, where you own a vaca-tion home and rent it out to others) are treated as passive, with cer-tain exceptions.

Consider the following year-end strategies if you have unusable pas-sive losses:

• Purchase investments that generate passive income.

• Become a material participant in the activity, if feasible, by in-creasing your level of involvement.

• Sell or dispose of your entire interest in the passive activity tofree up the losses.

Observation

Real estate professionals may deduct losses and credits fromrental real estate activities in which they materially participate.

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Careful Record Keeping: Identification of Securities

If you hold many securities, knowing when and at what price youpurchased them will help you maximize your tax savings when yousell them. Because of differences in holding periods and bases, asale may mean either short-term or long-term gain or loss, depend-ing on which securities you sell or are deemed to have sold. Accu-rate record keeping is critical to minimizing taxes. If you redeem anactual security certificate at the time of sale, the securities sold willbe those identified on the certificate. If one certificate representssecurities acquired on different dates or at different prices, you cantell the broker (in writing) which lot you are selling. If you do notidentify securities, you will generally be deemed to have sold thefirst securities acquired, which would have the longest holding pe-riod (and therefore might be taxed at a lower rate), but may alsohave the largest taxable gain.

Observation

Even more restrictive rules apply to certain types of passiveactivities, such as publicly traded partnerships. Publicly tradedpartnership losses can offset only publicly traded partnershipincome, not income from other types of passive activities.

Observation

Mutual fund shares are usually treated in the same way as othersecurities, or you can use their average cost when determiningbasis. Once you apply the earliest-cost or average-cost methodto a mutual fund, you must continue to use that method in fu-ture years for that mutual fund.

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Tax-Exempt and Taxable Bonds

It generally makes sense to invest in tax-exempt securities only ifyou are in a high federal income tax bracket and live in a high in-come tax state. However, depending on the date on which thebond matures and current market conditions, some long-term municipal bonds may produce a higher after-tax yield even inthe 15 percent bracket. The decision also hinges on the sizeof the interest rate differential between taxable andtax-free bonds.

When deciding whether to invest in tax-exempt or taxable bonds,choose the type that will give you the highest after-tax yield withinyour risk tolerance limits, taking into account the bonds’ creditquality and liquidity. As you calculate the after-tax yield on a tax-able bond, remember to include your state tax rate. If you invest intax-exempt investments issued by a political subdivision in a stateother than your state of residence, the income is usually taxable onyour resident state return, even though it is free from federal tax.

Taxable “Tax-Exempt” Bonds

Certain tax-exempt bonds (private activity bonds) are tax-exemptfor regular income tax purposes but are taxable for the AMT. Privateactivity bonds have a slightly higher yield than bonds that are ex-empt from both regular tax and AMT.

Observation

When selling stock that has risen in value, you can lower yourtaxes by identifying the securities in which you have the high-est bases as the ones that are being sold. However, if you holdthese securities for one year or less, any gain will be short-term, subject to tax at ordinary income rates.

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Bond Premium or Discount

If you pay more than face value for a bond, you have paid a pre-mium for it. This is usually the case if the bond’s coupon rate ishigher than the prevailing rate for newly issued comparable bonds atthe time of purchase. You must amortize the premium of a tax-exempt bond by reducing its basis, but you have a choice whetheror not to amortize the premium of a taxable bond by offsetting itagainst the bond’s interest. If you elect to amortize the bond pre-mium, you must do so for all bonds you own or later acquire. If youdon’t amortize the bond premium, you will usually have a capitalloss when you sell or redeem the bond.

If you purchase a bond at a discount from its original issuer, the dif-ference between the issue price and the redemption price (called“original issue discount,” or OID) is interest income. In almost all

Observation

If the AMT will not apply to you in the short term, considerasking your broker or investment advisor to offer you thehigher yielding private activity bonds.

Caution

Just because you may not have been subject to the AMT in thepast, don’t think it can’t hit you in future years. Unlike regularincome tax rates, AMT rate brackets and exemption amountsare not indexed annually for inflation. So AMT liability hasbeen creeping down the income line and has begun to hitmany who are squarely in the middle class. The 2001 Tax Actprovided modest AMT relief beginning in 2001—but onlythrough 2004 (see Chapter 1 for details). So carefully consideryour future AMT exposure before purchasing the higher yield-ing private activity bonds.

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cases, a portion of this interest must be included in income eachyear even though it isn’t received until the bond is redeemed. Tax-able OID bonds, therefore, are best suited for individuals if they areheld in tax-deferred accounts, such as IRA or 401(k) accounts, ortax-exempt accounts, such as Roth IRAs.

The original issue discount rules don’t apply to U.S. savings bonds,notes that mature in one year or less, or tax-exempt bonds (unlessthey have been stripped of their coupons).

If you buy a bond with a market discount—that is, a bond that haslost value since its issue date (usually because interest rates haverisen since it was issued)—gain on its sale will in most cases betaxed as interest income to the extent of the accrued market dis-count. This also applies to municipals.

Florida Intangibles Trust

If you are a Florida resident and pay a significant amount of Floridaintangibles tax each year, consider establishing a Florida IntangiblesTrust or other vehicle that may exempt from the tax the value ofyour intangible assets (for example, stocks and bonds). Note that theimpact of the Florida intangibles tax has been reduced significantlyin the past couple of years, and now is imposed at the rate of only0.1 percent ($1 per $1,000 of intangible assets subject to the tax).

Nonqualified Stock Options

Nonqualified stock options generate compensation income whenthey are exercised equal to the difference between the fair market

Observation

Include the cost of establishing and operating the Florida Intan-gible Trust or other vehicle when determining whether thisplanning idea makes sense for you.

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value of the stock and the exercise price. Subsequent appreciation inthe value of the option stock is taxed at favorable capital gains rates.Most individuals benefit by exercising these options shortly beforethe options expire, unless it is expected that the value of the optionswill be lost because of a stock-value decline or other reason. Earlyexercise at or near the strike price gives up all the downside protec-tion of the option. By holding off on exercise, you can benefit fromthe presumably increased stock value without making a cash invest-ment in the stock. However, if the appreciation potential of the stockis expected to be great, early exercise can be advantageous becauseit minimizes the portion of the gain that will be taxed as compensa-tion (at ordinary income rates) and maximizes the amount that willqualify for capital gains rates. The decision about when to exerciseoptions should also take into account the amount of appreciation todate, the future prospects of the company, and, most important, thepercent of net worth represented by company stock. Some optionplans permit you to pay the exercise price in the form of existingshares, which can be helpful when cash is in short supply.

Withholding of federal income tax, Social Security, Medicare, andstate and local taxes are all due when the options are exercised. Ifthe stock option is exercised and then sold quickly, the cash gener-ated from the sale can be used to help satisfy these withholding ob-ligations. The gain generated may create a substantial tax liability, soadditional planning may be necessary to come up with the cashneeded to pay taxes due April 15.

Observation

If all the stock is going to be held after you have exercised youroption, it is important to plan how to satisfy these withholdingobligations. Some plans allow the use of shares to cover with-holding taxes. Some employers grant “phantom” stock in con-nection with nonqualified options, which can help coverwithholding taxes.

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Incentive Stock Options

The favorable long-term capital gains tax rates make incentive stockoptions particularly attractive. However, careful planning is neededto maximize the benefits of these options if the AMT is a concern.

For regular tax purposes, an incentive stock option (ISO) exercise isnot a taxable event (state and local tax treatment may differ). How-ever, at exercise, the difference between the fair market value of thestock on the date of the exercise and the exercise price is an add-back to an individual’s alternative minimum taxable income. An-other ISO advantage is that there currently are no payroll taxesimposed on exercise. The IRS’s recent attempt to collect FICA taxon ISO exercise was met with enough resistance to cause the IRS toback off indefinitely.

ISOs are subject to a number of requirements imposed by the TaxCode that do not apply to nonqualified compensatory stock options.For example:

• ISOs can’t be issued at a strike price lower than the value of theoption stock on the date the options are granted.

• ISOs can’t be exercised more than 10 years after the options aregranted.

• ISOs aren’t transferable except at death, and during the grantee’slifetime may be exercised only by the grantee.

• ISOs must be exercised within 90 days of termination of employ-ment to be treated as ISOs.

• There is a $100,000 annual limit on ISO grants.

• To get favorable ISO tax treatment, the ISO stock can’t be soldwithin a year of option exercise or within two years of the optiongrant. If option stock is sold before either of these two periodshas run, the option is treated as a nonqualified option, usually re-sulting in compensation income to the option holder.

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Observation

For those not otherwise subject to the AMT, ISO exercisesshould be timed to occur over the life of the option (usually 10years) to minimize the AMT impact and to start the more thanone-year holding period needed to qualify for the 20 percentcapital gains tax rate. If little or no planning goes into an ISOexercise, you could be required to pay taxes earlier or in largeramounts than may be necessary.

Caution

Care should also be taken not to sell or otherwise dispose ofthe stock received from an ISO exercise before one year fromthe exercise date or two years from the grant date, whicheveris later, because before that time you will be taxed at ordinaryincome rates.

Observation

Stock received on the exercise of options that were issued be-fore 2001 does not qualify for the reduced 18 percent capitalgains rate even if the stock is held for more than five years.That ’s because the holding period of the stock for 18 percenttax treatment is considered as beginning on the date the optionwas granted to you—and to qualify for the 18 percent rate, theholding period needs to begin in 2001 or later.

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Idea Checklist

� Carefully consider whether your portfolio should be weightedmore heavily in equities that are eligible for capital gains taxrates, and less heavily in assets that produce ordinary income.However, keep tax considerations secondary to investmentfundamentals.

� Make gifts of capital assets held for more than five years toyour low-bracket children or grandchildren so the gains can betaxed at only 8 percent.

� Review your capital gains and capital loss positions beforeyear-end. Try to offset capital gains with capital losses. Keep inmind the 30-day wash sale rule.

� Make full use of $3,000 in capital losses that can be used tooffset your ordinary income.

� Determine whether tax-exempt bonds are an appropriate in-vestment. If so, consider whether investing in “taxable” tax-exempts will improve your cash yield.

� Florida residents should consider ways to reduce their Floridaintangibles tax liability.

� Executives with incentive stock options should considerwhether to exercise some of them if the AMT does not applyand hold the shares for more than one year (and two years

Observation

It is best to exercise ISOs early in the year if the AMT is likelyto be paid. This gives you the flexibility to sell before year-endand avoid the AMT if the stock drops in value. In this case, youwill only pay ordinary income tax on the actual gain, ratherthan the AMT on the spread between the fair market value atexercise and the exercise price.

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from option grant) to ensure a maximum 20 percent capitalgains rate.

This analysis of how the 2001 Tax Act will affect investments is notintended as a magic formula that will instantly adjust portfolios tominimize taxes. Investors must chart their individual courses, de-pending on their goals, tolerance for risk, and specific circum-stances. This chapter contains the necessary tools to begin that task.

A key goal for most taxpayers’ investment strategies is to accumu-late funds for retirement. Chapter 3 assesses the many ways inwhich the 2001 Tax Act and regulatory changes in 2002 improvethe tax incentives for retirement savings.

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73

Chapter 3

RETIREMENT PLANNING

Thanks to the recent tax law changes, most workers have muchgreater tax incentives to save for retirement than ever before. Thereare much more favorable rules for traditional IRAs, Roth IRAs,Keoghs, and corporate retirement plans. Those who can take advan-tage of these opportunities can lower their taxes now while helpingto ensure their comfort and financial security during retirement.Most of these improvements were ushered in by the 2001 Tax Act.That new law, however, also made retirement planning more compli-cated. The changes don’t all hit at once. Instead, many are phased-in over a number of years. So it takes some knowledge and planningto take advantage of them.

The improvements are particularly welcome now because individualretirement planning is more important than ever. With employer-paid pensions becoming rarer every year and more businessesdownsizing, wage earners face the prospect of financing more oftheir retirement with their own resources. For most people, retire-ment income is likely to come from three sources:

1. Tax-favored retirement plans, perhaps including defined benefitpension plans, but more likely profit sharing, stock bonus, IRAand Roth IRA, and employer-sponsored savings plans. These in-clude 401(k), 403(b) (for employees of tax-exempt organizations),

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simplified employee pension (SEP) and Keogh plans (for theself-employed), savings incentive match plan for employees(SIMPLE) plans for workers in firms with fewer than 100 em-ployees, and 457 plans for government employees.

2. A taxpayer ’s investments outside of tax-favored retirementplans.

3. Social Security.

Under the new law, taxpayers are allowed to increase their contribu-tions to qualified savings plans, with workers age 50 and over permit-ted to make even more generous catch-up contributions—reaching,in some cases, as much as $5,000 a year by 2006. High-income em-ployees who don’t qualify for Roth IRAs will be able to enroll in anemployer-sponsored Roth incentive savings plan, to which they con-tribute after-tax funds but are allowed to withdraw the money and itsgains tax-free, but with no fixed schedule of required lifetime distri-butions. (Roth funds can even be left income tax-free to an heir.)Employer-matching contributions vest—that is, become nonfor-feitable—more rapidly, and the retirement plans will be moreportable, allowing workers more easily to transfer the funds whenthey change jobs. Some lower income workers can even get a taxcredit for as much as 50 percent of the money they contribute toqualified retirement plans and IRAs, which reduces their taxes for theyear of the contribution.

As always, taxpayers must keep in mind the benefits of capital gainstax breaks when planning for retirement. Retirement plans allow tax-free compounding of profits, but in most plans, pay-outs are taxedat ordinary income tax rates in the year they are received. Thosewho expect relatively high income in retirement should weigh themerits of forgoing the tax deferral, investing after-tax funds for re-tirement, and being taxed on sale at lower capital gains rates. How-ever, they should not forget that the Alternative Minimum Tax (AMT)could void much of the advantage. While capital gains, themselves,are not subject to AMT, they can push total income into the AMTrange, subjecting other income and deductions to the AMT.

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Retirement Planning 75

We believe that moderate income taxpayers should use retirementplans and/or IRAs to save for retirement for the following reasons:

1. Putting money aside in a retirement plan clearly segregates and identifies the funds for retirement, thus reducing the temptation to spend the funds for other purposes. Indeed, the penalties for early withdrawal and, in some cases, the un-availability of the funds make it more difficult to use the fundsprematurely.

2. Many 401(k) plans have some portion of the employee contri-bution matched by the employer. The match is not available forsavings outside of the plan.

3. While current tax law may under some circumstances result inhigher taxes at retirement for tax-deferred plan proceeds, it isdifficult to predict personal circumstances many years in thefuture and even more difficult to predict the applicable tax law.

Since most people will benefit from maximizing tax deferral on re-tirement savings, this chapter details valuable planning techniquesand offers suggestions that can help to reduce overall tax bills andmaximize income during retirement.

Employer Plans

Qualified Retirement Plans

When possible, you should think about participating in a qualifiedemployer pension or profit-sharing plan, 401(k) plan, 403(b) plan,

Observation

Some studies have shown that lower income individuals mayactually pay more tax and have less money available to spendin retirement by contributing to 401(k) or other retirementplans. Part of the reason for this is the high marginal tax rateon social security income for moderate income taxpayers (seepage 97).

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Keogh, or simplified employee pension (SEP) plan. Qualified plansmust meet complex participation, coverage, and nondiscriminationrequirements, allowing sponsoring employers to immediately deducttheir contributions. Employer contributions on your behalf are nottaxed to you until you receive them. Your contributions to theseplans reduce your adjusted gross income (AGI) within specified lim-its as well as your current tax bill. This tax deferral is achieved in ex-change for reduced liquidity because you give up immediate accessto the funds. However, some plans permit you to borrow up to spec-ified allowable limits from your account, which gives you access tosome of your savings if necessary. For plan years beginning in 2002or later, even owner-employees, such as sole proprietors, partners,and S corporation shareholders, may borrow from their retirementplans the same way that other employees can, without getting hitwith the prohibitive excise tax that previously applied.

Observation

The savings incentive match plan for employees (SIMPLE) isavailable to employees of companies with 100 or fewer em-ployees who do not have other types of retirement plans.Under this type of plan, employees may defer up to $7,000 for2002. Employers that offer a SIMPLE generally must make anonelective or matching contribution on behalf of each planparticipant.

Observation

There is no longer a “combined plan limit,” which in the pastput a cap on contributions for highly compensated employeeswho participate in both an employer ’s pension plan and aprofit-sharing plan. Now, even if you are highly compensated,you can accumulate larger qualified retirement plan benefits.

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There are two basic kinds of qualified employer retirement plans:

1. Defined contribution plans.

2. Defined benefit plans.

Defined Contribution Plans

A defined contribution plan allows your company or you—or yourcompany and you—to contribute a set amount each year to theplan. Contributions are set aside in an account for you and are in-vested on your behalf. Sometimes you have the right to determinehow the contributions are invested. With a defined contributionplan, you are not guaranteed a set amount of benefits when you re-tire. Instead, you receive the amount in the account, which dependson how much was contributed to it and how successfully the fundswere invested over the years. You get a periodic statement advisingyou of your current account balance.

Defined contribution plan benefits are portable, so if you changejobs, you can transfer your vested benefits to an IRA or possibly toyour new employer ’s plan. Most defined benefit pension plans, onthe contrary, don’t make your vested benefit available before youreach retirement age, unless your benefit is very small (in whichcase, the plan may cash you out).

The most common defined contribution plans are profit-sharingplans, 401(k) plans, stock bonus plans, money purchase pensionplans, and employee stock ownership plans.

Bigger Contributions Allowed

The 2001 Tax Act increased the overall limit on amounts that maybe added each year by you and your employer to defined contribu-tion plans, including 401(k) plans and profit-sharing plans, beginningwith the 2002 plan year. The previous limit (the lesser of $35,000 or25 percent of compensation) was raised to the lesser of 100 percentof compensation or $40,000 (an amount that will be indexed for

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future inflation). The Tax Act also increased the amount of compen-sation that can be taken into account for retirement plan purposesfrom $170,000 to $200,000 beginning in 2002. This means thatlarger contributions and benefits are possible for the more highlycompensated.

Profit-Sharing Plans

Profit-sharing plans allow employees to share in the company’s prof-its, usually through an employer contribution that is a percentage ofcompensation. Despite what the name implies, profit-sharing plansare not dependent on corporate profits for contributions to bemade. Contribution levels may be changed from one year to thenext. Plan participants generally do not control how the contribu-tions are invested.

401(k) Plans

401(k) plans are defined contribution plans that are genericallyknown as “employee thrift and savings plans.” You, as an eligible

Caution

Highly paid employees may still not be allowed to take full ad-vantage of the increased contribution limits after nondiscrimi-nation tests are applied.

Observation

While the 100 percent limit permits allocation to an individualaccount of the entire salary, the 25 percent limitation on de-ductions for all contributions (except elective deferrals) willapply to prevent a sole proprietor or a one-employee corpora-tion from contributing 100 percent.

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employee, elect in advance to defer part of your compensation tothe plan, and sometimes your employer will match some or all of it.Neither the amount deferred nor your employer-matching contribu-tion is included in your income until distributed from the plan.

A common level of employer-matching contribution is 50 cents forevery dollar the employee contributes, up to a set percentage limit.For example, your employer may contribute 3 percent of your com-pensation if you contribute 6 percent. It is like a guaranteed 50 per-cent first-year return on the amount you contribute.

Your own contributions are vested immediately, but your right tokeep the matching contributions depends on the plan’s vestingschedule. Matching contributions made after 2001 must vest eitherall at once after no more than three years, or at a rate of 20 percenteach year starting with the second year of service. Earlier matchingcontributions are permitted to vest at a somewhat slower rate.

As a 401(k) plan participant, you generally make your own invest-ment decisions, usually by choosing among a variety of funds se-lected by your employer.

401(k) Contribution Limits. For 2002, the maximum amount thatyou can elect to defer to a 401(k) plan is $11,000, subject to certainoverall limits. Future contribution limits will increase considerably,as shown in the chart on page 81. If you are over 50 by the end of a year, you will be allowed to make even larger contributions. Also,

Observation

As an employee eligible for matching contributions, you shouldmake every effort to contribute at least the amount that willentitle you to the maximum available employer-matching con-tribution. Putting in less is like turning your back on a raise.

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contributions you can make up to the dollar maximums are nolonger limited by any set percentage of your compensation.

Example

Sarah, who is 47 years old, reenters the workforce in 2002 on apart-time basis after a child care hiatus of 15 years. Her employermaintains a 401(k) plan that Sarah is eligible to participate in afterthree months of service. Sarah’s husband earns enough to supportthe family, and Sarah wants to put as much of her earnings as pos-sible into a retirement plan on a pretax basis. Sarah expects toearn $10,000 in compensation in 2002 during the time she is eli-gible to make elective 401(k) deferrals. Result: If Sarah wishes to,she may contribute 100 percent of compensation to the plan.Only the annual dollar limit on 401(k) contributions would reducethe amount she can contribute.

Observation

This means that you may contribute the maximum dollaramount to your 401(k) plan for a year, even if that amount ishalf, three-quarters, or even all of your salary for the year. Thisimportant change will be especially useful in boosting retire-ment savings of a second family earner with modest earnings.Under previous law, the amount these lower paid individualscould contribute was very small.

Caution

Although the law allows 401(k) deferrals of up to 100 percentof pay beginning in 2002, this option will be available only inplans that are amended to eliminate any lower percentage ofcompensation limits already specified in the plan.

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Note that even though these pretax contributions allow you to avoidimmediate income tax, they are subject to Social Security tax.

Special nondiscrimination rules apply to 401(k) elective deferrals,but those rules won’t limit the catch-up contributions you make ifyou are age 50 or over. If your employer chooses to match catch-upcontributions, the matching contributions will be subject to thenondiscrimination rules that usually apply to employer-matchingcontributions.

For Small Employers

The savings incentive match plan for employees (SIMPLE) can be setup by companies with 100 or fewer employees that don’t offer othertypes of retirement plans. As its name implies, a SIMPLE plan is eas-ier and less expensive to set up and administer than a standard qual-ified retirement plan. Under this type of plan, employees may deferup to $7,000 for 2002. (For later years, see the chart below.) Em-ployers that offer a SIMPLE generally must make a nonelective ormatching contribution in the 2 to 3 percent range on behalf of eachplan participant.

The 2001 Tax Act also increased the contribution limits employeescan make to SIMPLE plans, as shown in the following table:

Annual 401(k) Elective Deferral Limits*

Age 50 or Older ($) Year Under Age 50 ($) (Includes Catch-Up)

2002 11,000 12,000 2003 12,000 14,000 2004 13,000 16,000 2005 14,000 18,000 2006 and later 15,000 as indexed 20,000 as indexed

* Not more than 100 percent of compensation.

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Defined Benefit Pension Plans

Unlike a defined contribution plan, a defined benefit plan—com-monly called a pension plan—pays a fixed monthly amount of in-come at retirement. The benefit is determined using a formulaspecified in the plan, usually based on your salary and the numberof years you have worked for your employer. Some companies in-crease retirement benefits to help overcome the impact of inflation.

You are entitled to your monthly pension benefit whether or not theplan contributions have been invested well. If the value of the in-vestments falls below the amount needed to fund the promised ben-efit, the employer must contribute more to the plan, so you do notbear the risk of bad investments or a severe market downturn. If theplan ceases to exist, the Pension Benefit Guaranty Corporation(PBGC) pays promised benefits, up to a certain level. Defined bene-fit plans generally do not require or allow employee contributions.

If you retire early, you will usually receive a reduced benefit, and ifyou work beyond normal retirement age, you receive an increasedamount when you begin to collect benefits.

Increase in Benefit Limit

The 2001 Tax Act increased the maximum annual benefit that a de-fined benefit pension plan can fund from $140,000 to $160,000

SIMPLE Plan Maximum Deferrals*

Age 50 or Older ($) Year Under Age 50 ($) (Includes Catch-Up)

2002 7,000 7,500 2003 8,000 9,000 2004 9,000 10,500 2005 10,000 12,000 2006 and later 10,000 as indexed 12,500 as indexed

* Not more than 100 percent of compensation.

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starting in 2002. The limit is somewhat lower for benefits beginningbefore age 62 and higher for payments beginning after age 65.

Nonqualified Deferred Compensation Plans

Nonqualified plans are used to reward individual executives or otheremployees without the need to treat all individuals similarly, if acompany is willing to forgo current tax deductions for its contribu-tions. (The company’s deduction is delayed until the year the in-come is taxed to the executive.)

Observation

If you are a highly compensated employee, consider the bene-fits of coverage under a nonqualified plan. These plans offerthe benefits of tax deferral on both the principal and income,as well as the ability to set aside larger amounts of retirementassets than do most qualified plans.

Caution

The employee is treated as a general creditor of the employerin the event that the company enters bankruptcy. This meansthat if your employer goes bankrupt, you have to get in linewith all the other general creditors to get a portion of your em-ployer ’s remaining assets and you may lose all of your nonqual-ified plan benefits.

Observation

The 2001 Tax Act ’s future income tax rate cuts will increasethe tax savings from deferred compensation plans by decreasingthe amount of tax that you will owe on future plan distributions.

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Under a deferred compensation plan, you elect to defer a portion ofyour salary or bonus until a future date (for example, retirement). Toget the tax savings, you generally must agree to defer the compensa-tion before the period in which it is earned or awarded.

Your Resources

Planning for retirement can include making contributions to Keoghplans, other self-employed retirement plans, or IRAs, and makingafter-tax contributions to employer plans and 401(k) plans, if theyare available to you. Make sure you maximize the tax benefits bycarefully considering the type of plan and whether contributions aredeductible. The 2001 Tax Act broadened your opportunities tomake deductible contributions.

Keogh Plans

If you are self-employed, you can maximize your retirement savingsby taking advantage of self-employed retirement fund (Keogh plan)contributions. You can make a deductible contribution to your ownretirement plan for a year up to the due date (including extensions)of your return. But the plan itself must be set up by the end of theyear for which the contribution is made to take advantage of this de-ferred payment rule.

There are three general types of Keogh plans from which to choose:

1. Profit sharing plan. Annual contributions may be discretionary,up to a certain percentage of self-employment income.

2. Money purchase plan. Yearly contributions based on a chosenpercentage of self-employment income are mandatory.

Observation

The 2001 Tax Act ’s increased profit-sharing contribution anddeduction limits generally eliminate the need to have a money

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3. Defined benefit plan. Contributions are based on complexcalculations. Although this is the most expensive kind of planto operate, older highly compensated self-employed individu-als usually find that it permits them to make the largest tax-deductible contributions.

Keogh contribution and deduction limits are the same as those forother qualified retirement plans, with adjustments for the way theself-employed’s earned income is figured.

Simplified Employee Pension Plans

If you are self-employed or have a small company, you can alsochoose to use this IRA-type plan, in which a percentage of net self-employment income is contributed to the plan (similar to a de-fined contribution Keogh plan). Unlike Keogh plans, SEPs can be

purchase plan. Previously, a profit-sharing plan was often set upin tandem with a money purchase plan to provide the then-maximum deduction of 25 percent of compensation while givingthe employer some flexibility to alter contribution percentages ifneeded. Now that the deduction limit for regular profit-sharingplans has been raised to 25 percent, however, the mandatorycontribution required by a money purchase plan can be elimi-nated without giving up the ability to make 25 percent de-ductible contributions.

Observation

If you are self-employed and have employees, you must re-member that Keogh plans are subject to complex nondiscrimi-nation and coverage rules. You generally can’t cover justyourself if you have half-time or full-time employees over theage of 21 who have worked for you for a year or more.

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established as late as the extended tax return due date for the priortax year. SEPs must also provide comparable benefits for employeeswho satisfy certain liberal eligibility requirements. The 2002 tax billhas made SEPs much more attractive by eliminating the lower 15percent maximum contribution and replacing it with a 25 percentcontribution limit to match the limit of other defined contributionplans. While SEP plans are not as flexible and cannot offer 401(k)features, they offer the benefit of ease of administration withoutsacrificing contributions in many cases.

Traditional and Roth IRAs

Any person under age 701⁄2 (or older for Roth IRAs) with $3,000 ofearned income during 2002 or 2003 can establish an IRA and con-tribute the maximum amount to it. There are two very differenttypes of IRAs (more detail concerning each type follows below):

1. Traditional IRAs. Contributions are deductible if the IRA owneris not covered by a qualified retirement plan or if income require-ments are met; distributions are fully or partly taxable. Nonde-ductible contributions may be made by those whose income levelis too high to take deductions for these contributions.

2. Roth IRAs. If you meet the income requirements (describednext) to make Roth IRA contributions, you should seriouslyconsider doing so. Roth IRAs are an excellent retirement vehi-cle. While contributions are not deductible, earnings paid toyou from these accounts are tax-free as long as certain require-ments are met. Generally, the account must exist for at leastfive tax years, and you must receive the funds after you’vereached age 591⁄2, or as a result of death or disability, or forcertain first-time home purchases (limited to $10,000).

The maximum amount that you can contribute to a Roth IRA for ayear phases out over an AGI range of $95,000 to $110,000 for sin-gles, and $150,000 to $160,000 for married joint-return filers. Ifyou are not above these income levels, you may make a contribu-tion even if you participate in an employer-sponsored retirement

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plan. If your income is above these levels, you are ineligible to con-tribute to a Roth IRA.

Higher Contribution LimitsThe 2001 Tax Act increased the maximum annual IRA contributionlimit beginning in 2002 and permits extra catch-up contributions ifyou are 50 or older as of the end of a year. The higher limit appliesto both traditional and Roth IRAs:

Increased IRA Contribution Limits Regular Catch-Up

Year ($) ($)2002 3,000 500 2003 3,000 500 2004 3,000 500 2005 4,000 500 2006 4,000 1,000 2007 4,000 1,000 2008 and later 5,000 1,000

Observation

The increase in maximum IRA contributions gives you greateropportunities to save for retirement on a tax-favored basis andwill help you to rely less on employer retirement plans and So-cial Security. Over many years, the added savings made possi-ble by the 2001 Tax Act can add up.

Observation

The 2001 Tax Act does not increase the income limits thatapply to deductible IRAs, eligibility for a Roth IRA, or conver-sion of a traditional IRA to a Roth IRA. So if you are a high-income taxpayer, the only benefit you receive from the IRAchanges is the ability to make modestly larger contributions tonondeductible regular IRAs.

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Traditional IRAsYour ability to make tax-deductible contributions to a traditional IRAis limited by your income level if you are an active participant inyour employer-sponsored retirement plan. The maximum deductiblecontribution you can make phases out over the following incomelevels (see Table 3.1):

If you are married, but you and your spouse file separately, your de-duction phase-out range is from zero to $10,000 of adjusted grossincome (AGI), effectively preventing each of you from taking IRAdeductions in almost all cases in which at least one spouse is an ac-tive participant in an employer-sponsored retirement plan.

A nonworking spouse or a working spouse who is not a participantin a qualified retirement plan, but whose spouse is, has a greater op-portunity to make tax-deductible contributions to a regular IRA on ajoint return even though the working spouse is an active retirementplan participant. The availability of this deduction phases out forcouples with an AGI between $150,000 and $160,000.

Table 3.1 Phase-Out of IRA Deductions for Employer

Plan Participants

Singles and Heads Married Filingof Households Joint ReturnsDeduction ($) Deduction ($)

Year Full No Full No

2002 34,000 44,000 54,000 64,000

2003 40,000 50,000 60,000 70,000

2004 45,000 55,000 65,000 75,000

2005 50,000 60,000 70,000 80,000

2006 50,000 60,000 75,000 85,000

2007 and later 50,000 60,000 80,000 100,000

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Conversions to Roth IRAsPreexisting IRAs may be converted into Roth IRAs if your income isless than $100,000 (regardless of whether you are single or mar-ried). You’ll have to pay income tax on these conversions, but notthe 10 percent penalty that applies to early IRA withdrawals. Distri-butions from a Roth IRA within five years of the conversion thatcome from converted amounts will be subject to the 10 percentpenalty tax.

You can change your mind and undo a conversion from a traditionalIRA to a Roth IRA by transferring the funds back to a regular IRA ina direct trustee-to-trustee transfer. This will eliminate the tax liability

Observation

If you qualify, you should always make a contribution to a RothIRA rather than making a nondeductible contribution to a tra-ditional IRA. No deduction is allowed in either case, but theearnings on nondeductible traditional IRA contributions will betaxed to you when you take distributions, whereas there is thepotential for completely tax-free distributions from the RothIRA. Also, there is no requirement that amounts in Roth IRAsbe distributed to you during your lifetime, as there is with tra-ditional IRAs. This allows you to keep the Roth IRA’s tax shel-ter going for your entire life, if you so choose, and pass thetax-free earnings on to your heirs.

Observation

Since stock values fell so dramatically during 2002, this maybe a good time to consider converting a traditional IRA in-vested in equities or stock mutual funds to a Roth IRA. The taxcost will be based on the low valuations at the time of the con-version, and no tax will be owed on future price recoveries.

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from the conversion. You might need to do this, for example, if yourAGI for the conversion year exceeds the $100,000 income limit,making you ineligible to convert. Or you may want to switch back ifthe value of the assets in the Roth IRA has dropped, and you don’twant to pay tax on the conversion based on the higher value of theassets on the conversion date. If you convert to a Roth IRA in 2002,you will have until October 15, 2003, to transfer it back to a tradi-tional IRA, assuming you file a timely 2002 tax return, including ex-tensions. If you file your return before undoing the conversion, you’llneed to file an amended return to report the reversal and eliminateyour tax liability from the conversion.

If you have switched back to a regular IRA from a Roth IRA, youcan reconvert to another Roth IRA and have your tax liability figuredon the basis of the later conversion. However, you cannot reconvertuntil the start of the year after the original Roth IRA conversion wasmade, or, if later, more than 30 days after you switched the RothIRA back to a traditional IRA.

Example

John converted a $100,000 IRA brokerage account (to which hehad made only deductible contributions) to a Roth IRA in January2002, giving him $100,000 of taxable income on the conversion.If the value of that Roth IRA account fell to $70,000 in July 2002,John would nonetheless be liable for tax on $100,000. However,if he transfers the $70,000 directly back to a traditional IRA, hewill wipe out his tax liability from the conversion. Then he can re-convert to another Roth IRA after the waiting period has passed(explained earlier), perhaps before the value of the assets in thetraditional IRA has fully recovered.

Observation

When it comes to IRAs, the earlier contributions are made, thebetter. Take the case of a 22-year-old who contributes $2,000

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Contrast that with a person who waits until age 32 to start contribut-ing to an IRA, but contributes $2,000 for 33 years. The funds alsoearn 10 percent, but at age 65 this person’s account balance is onlyabout $540,000—that is $355,000 less than the person who startedcontributing at age 22, despite $46,000 more in contributions.

Once you establish the retirement savings vehicle or vehicles thatare in line with your goals (and, obviously, for which you are eligibleand which are available to you), you should contribute early andregularly to benefit more fully from the effects of tax-free com-pounding.

annually to an IRA for just 10 years, stopping after age 31. As-suming an annual growth rate of 10 percent, the assets in thatIRA will increase to approximately $895,000 by the time theIRA owner is 65 years old, even though he has contributedonly $20,000 to the account.

Observation

You do not have to wait until you are sure of your income fora year to contribute to an IRA. You can give to either a regu-lar IRA or a Roth IRA at any time and switch accounts byOctober 15 of the following year (if you have extended yourtax return due date until then). For example, if you make aRoth IRA contribution or conversion during 2002 and it turnsout that your income for that year is more than the allowablelimit, you can transfer the funds and their earnings to a regularIRA (deductible or nondeductible, depending on yourcircumstances).

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New Tax Credit for Retirement Saving

The 2001 Tax Act gave those with modest incomes another reasonto save for their retirement. For 2002 through 2006, a new nonre-fundable tax credit is available to certain lower income individualswho contribute to qualified retirement plans and IRAs. The maxi-mum annual contribution eligible for the credit is $2,000 per indi-vidual. The credit is in addition to any deduction available.

Observation

Because many people in their teens and early twenties do notearn enough to save on a regular basis, this is an excellent op-portunity for parents and grandparents to give their childrenand grandchildren a long-term gift costing a fraction of its ulti-mate value. If your children or grandchildren work, considerhelping them set up a kiddie IRA to capitalize on the big bene-fits of tax-deferred compounding (tax-free compounding with aRoth IRA) over long periods of time. It is amazing how muchthe investment can grow if a contribution is made to a tax-favored retirement plan early in life. For example, if you con-tributed $2,000 per year for your child or grandchild while shewas age 16 through 22, and never contributed another dime,assuming a 10 percent growth rate, she would have a retire-ment fund at age 65 of about $1.2 million, with only $14,000in total contributions.

Observation

Giving funds to a Roth IRA for a child or grandchild will alsoallow the child or grandchild to withdraw $10,000 of earningstax- and penalty-free to put toward the purchase of a first home.

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For the lowest income individuals (up to an AGI of $30,000 for joint-return filers; $22,500 for heads of households; $15,000 for all oth-ers), the credit is 50 percent of the eligible contribution. That wouldbe a $1,000 tax credit for a $2,000 contribution. The credit ratephases down from 50 percent to 10 percent of the contribution asAGI increases. It is totally phased out for those with an AGI above$50,000 for joint filers, $37,500 for heads of households, and$25,000 for singles. This credit is not available to students, tax-payers under 18, or dependents.

Charitable Remainder Trusts

Another vehicle to consider for funding a portion of your retirementis a charitable remainder trust. Although complex rules apply, fund-ing such trusts with appreciated securities can provide an alterna-tive to traditional qualified and nonqualified plans because theyallow you to improve your cash flow on a pretax basis.

Tax-Deferred Annuities

If you have made the maximum permitted 401(k) or 403(b) contri-bution, contributed to an IRA, and have a decent portfolio of stocksdesigned to take advantage of favorable capital gains rates when thestocks are ultimately sold, you may want to consider a tax-deferredannuity. The investment earnings (usually from name-brand mutualfunds and other investment alternatives) can compound tax deferredwithin the annuity vehicle until they are withdrawn. It is importantto remember that annuities will ultimately be taxed at ordinary

Observation

This credit will be available to many young taxpayers who areout of school but whose salaries are still modest. Be sure to tellyour children about the new credit and encourage or help themto get started on their retirement saving.

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income tax rates (not capital gains tax rates) when distributed toyou, as with a traditional IRA, even if the money is invested in mu-tual funds that would have been taxed at a 20 percent or 18 percentrate if held outside the annuity. Annuities are similar to IRAs in thatthere is a 10 percent excise tax generally applied to withdrawalsprior to age 591⁄2. Annuities offer a guaranteed payment option thatwill assure a fixed level of payment for your life. You should examinethe expenses and fees charged by the insurance company issuing theannuity to ensure that they are competitive with other investments.

Split-Dollar Life Insurance

Split-dollar life insurance traditionally has been a popular tax-advantaged way to provide life insurance protection to valued em-ployees and company owners. Split-dollar isn’t a type of insurance,but rather is a method of dividing the ownership and rights in acash value life insurance policy among different parties—fre-quently an employer and an employee. Under the most basic split-dollar set-up, the employer agrees to pay policy premiumseach year up to the annual increase in the policy’s cash surrendervalue. The employee pays any remaining premium. The employerretains the right to receive the policy’s cash surrender value fromthe policy’s proceeds, and the employee is able to name benefici-aries of the remaining amount. This type of arrangement requiresthe employee to pay larger amounts of premiums initially, withpayments decreasing (sometimes to zero) as time goes on. Thedeath benefit available to the employee’s beneficiaries decreaseseach year as the cash value increases, but the insurance protectionremains substantial for some time.

The employee is charged with taxable compensation on the insur-ance protection received under a split-dollar arrangement and policydividends or other benefits received, less the amount of premiumsthe employee has paid. This taxable value can be figured from anIRS table or using the insurer ’s term insurance rate, which almost al-ways results in less taxable income.

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Many more complex—and advantageous—split-dollar arrangementshave been developed that entitle the employee to at least some ofthe policy’s cash value. These arrangements are known as “equity”split-dollar. The IRS concluded that this kind of split-dollar was beingvalued similarly to ordinary split-dollar arrangements despite theextra benefits to the employee. As a result, it has proposed somehighly complex rules that it hopes will tax all of the economic bene-fits received in equity split-dollar arrangements.

Under the proposed new rules, both parties to a split-dollar arrange-ment would have to account for it, depending on the type of arrange-ment, either as providing an economic benefit to the employee fromthe employer or as an interest-free loan of policy premiums from theemployer to the employee (unless actual interest is charged). Ineither event, an employee involved in an equity split-dollar arrange-ment would derive less of a tax-free benefit than generally resultedunder the earlier rules.

Where the arrangement is measured by the economic benefit con-ferred, the benefits provided by the employer, including an em-ployee’s right to an increased cash value, less any amount paid bythe employee, is treated as compensation income. Even policy loanscould be taxable. (The IRS hasn’t yet said how equity rights shouldbe valued.) For basic, nonequity arrangements, the annual benefit isthe amount of insurance coverage multiplied by a factor taken froman IRS table, less any premiums paid by the employee.

The proposed rules generally will apply to policies acquired after therules become finalized by the IRS and to earlier-issued policies thatare materially changed after the final rules are issued. However,rules similar to the new proposals from earlier guidance are now inforce. The guidance in Notice 2002-8 applies in the interim. How-ever, taxpayers may rely on the proposed regulations for the treat-ment of any split-dollar life insurance arrangement entered into on or before the date final regulations are published provided that allparties to the arrangement treat it consistently. The IRS also has

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provided rules that allow some employees with preexisting equitysplit-dollar arrangements to unwind them without adverse tax con-sequences if action is taken before 2004.

Universal Variable Life Insurance

Instead of a tax-deferred annuity that will be taxed on withdrawal,think about universal variable life insurance. Like its cousin, thetax-deferred annuity, the universal variable life insurance policyhas an investment component consisting of mutual funds or otherinvestment choices. The investment earnings compound on a tax-deferred basis within the life insurance policy until they are with-drawn. One benefit is that you can borrow the investment earningstax-free. At death, unborrowed earnings are added to the face valueof the policy and can be paid to beneficiaries on a tax-free basis.You should examine the expenses and fees charged by the insurancecompany issuing the policy to ensure that they are competitive withsimilar investments.

Professional Retirement Services

Beginning in 2002, the 2001 Tax Act allows you and your spouse totake advantage of tax-free retirement services from your employer.For the first time, this service can be provided by your employer as anontaxable fringe benefit.

Observation

These split-dollar rules are now extremely complex, and anyonewith an existing split-dollar arrangement or contemplating en-tering into one needs to get expert advice.

Observation

Retirement planning has become a very complicated, difficultprocess involving important income tax, investing, estate

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Social Security

If you receive Social Security payments, you may be taxed on someof the payments you receive. Benefits must be included in income ifyour modified AGI (which generally includes AGI, tax-exempt inter-est, and certain foreign-source income with other minor adjust-ments) plus one-half of your Social Security benefits exceeds acertain base amount. The base amount begins at $25,000 for singleindividuals and $32,000 for married couples filing jointly. Theamount of benefits included in taxable income is the lesser of one-half of benefits received or one-half of the excess of modified AGIplus 50 percent of benefits received over the base amount. A sec-ond threshold of $34,000 for singles and $44,000 for joint returnsresults in more of your benefits being taxable. If this threshold is ex-ceeded, you must include the lesser of 85 percent of benefits or thesum of the lesser of the amount included under the old rules or$6,000 ($4,500 for singles) plus 85 percent of the amount by whichmodified AGI, increased by 50 percent of Social Security benefits,exceeds $44,000 ($34,000 for single individuals).

planning, and other family-related issues. This nontaxable fringebenefit should give you better access to professionals who canhelp you choose the right tools and make the right decisionswhen considering the complex options and opportunities nowavailable when planning for your retirement.

Observation

The calculation of taxable Social Security benefits is not a sim-ple one. It is often loosely stated that this provision will subject50 or 85 percent of Social Security benefits to tax. In manycases, determining the amount of benefits actually subject totax involves complicated calculations.

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Web Site To get information about the Social Security system, seehttp://www.ssa.gov, the Social Security Administration Web site.

Observation

Because the second threshold for the tax on Social Security ben-efits for married filers is only $10,000 more than that for singlefilers, a substantial “marriage penalty” results. For example, anunmarried couple filing separately, each with total income of$37,000—$12,000 of which is from Social Security—wouldeach be taxed on $3,000 of their Social Security benefits. Ifthey were married filing jointly, however, $20,400 of their SocialSecurity benefits would be taxed.

Observation

The Social Security Administration now sends annual state-ments detailing an individual’s earnings, contributions, and es-timated future benefits. If you haven’t received these benefitstatements, use Form SSA-7004, Request for Earnings and Ben-efit Estimate Statement, to obtain a listing of your lifetime earn-ings and an estimate of your Social Security benefit. There is alimited period of time in which to correct mistakes.

Observation

The earnings limit, which previously reduced Social Securitybenefits by $1 for every $3 that benefits recipients age 65through 69 earned over a certain limit, has been repealed. As aresult, those who work beyond age 65 no longer have theirbenefits reduced. However, earnings limits still apply to thosebelow age 65 (see Chapter 11).

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Required Retirement Plan Distributions

You must begin to take at least a specified minimum amount of dis-tributions from your qualified plans and traditional IRAs by April 1of the year after the year you turn 701⁄2. However, if you are stillworking at that time and you aren’t at least a 5 percent owner ofyour company, you do not have to begin to take distributions from acompany retirement plan until April 1 of the year after you retire. Ifyou don’t take the minimum distribution, you will have to pay a 50percent excise tax. Obviously, this is something to avoid.

Before 2001, the amount you were required to take out of your re-tirement plan each year—known as the “required minimum distribu-tion”—was based on a variety of complex factors. You could figurerequired distributions based on your own life expectancy or on thejoint life expectancy of you and your designated beneficiary, whichdecreased the amount of required distributions. By the required be-ginning date, you also had to decide whether you were going to usethe term-certain method or the annual recalculation method to fig-ure your distributions. The whole process was very complicated andhad many pitfalls that trapped unwary retirees, often causing unfa-vorable tax results.

After years of criticism, the IRS proposed new rules that plan mem-bers could use to figure their required distributions for 2001, nomatter which method they used before. In 2002, the IRS finalized

Observation

Minimum distributions are not required from Roth IRAs duringthe life of the owner. This allows the tax advantages of RothIRAs to continue until the Roth IRA owner’s death and allowsthe income-tax-free benefits to be passed to a spouse or otherfamily member.

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and further liberalized these rules. The new rules are simpler, gener-ally spread payouts over a longer time, and give you more flexibilityin naming and changing beneficiaries.

Under the new method, you figure your required distribution simplyby dividing your account balance at the end of the previous year bya factor for your age that comes from an IRS table (Table 3.2). Youuse the same factor whether or not you have named a beneficiary,and if so, no matter how old the beneficiary is. (The only exceptionis if you have named your spouse as your beneficiary and he or sheis more than 10 years younger than you. In that case, required distri-butions are based on your joint life expectancy and are even lower.)Required distributions under the new method are almost alwayssmaller than under the old system.

There also are new, more favorable rules for distributions after theaccount owner’s death. If you have named a beneficiary, the remain-ing amounts in the account are distributed over the beneficiary’s re-maining life expectancy. If you haven’t designated a beneficiary,distributions can be made over a period no longer than your remain-ing life expectancy at the time of death. If you hadn’t started takingdistributions and didn’t name a beneficiary, the balance remaining inyour account at death would have to be paid out within five years,which doesn’t afford much of a tax advantage to your survivors. As aresult, it is very important that you name beneficiaries for your ac-counts and keep them updated as circumstances change.

Caution

Make sure your 2002 minimum IRA distribution is figuredusing the newest rules. For most people, the amount that mustbe distributed is much lower than the minimum distributionthat was required under the old rules.

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101

Table 3.2 Uniform Lifetime Table for Use by Owners

Age Distribution Period Age Distribution Period

70 27.4 93 9.6

71 26.5 94 9.1

72 25.6 95 8.6

73 24.7 96 8.1

74 23.8 97 7.6

75 22.9 98 7.1

76 22.0 99 6.7

77 21.2 100 6.3

78 20.3 101 5.9

79 19.5 102 5.5

80 18.7 103 5.2

81 17.9 104 4.9

82 17.1 105 4.5

83 16.3 106 4.2

84 15.5 107 3.9

85 14.8 108 3.7

86 14.1 109 3.4

87 13.4 110 3.1

88 12.7 111 2.9

89 12.0 112 2.6

90 11.4 113 2.4

91 10.8 114 2.1

92 10.2 115 and over 1.9

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Through postdeath planning such as use of disclaimers or certain es-tate distributions or settlement, the postdeath distribution deferralcan be maximized. If your surviving spouse is the sole beneficiary ofyour IRA, he or she is allowed to treat it as his or her own and namenew beneficiaries, which can further extend the tax-deferral. How-ever, that ’s generally not the case if the IRA is held in trust for yourspouse.

Observation

Beneficiary designation planning can provide children or grand-children with substantial funds for tax-deferred compoundingduring their lifetimes.

Observation

If you continue to work past age 701⁄2, you can hold off takingdistributions from employer retirement accounts, but not fromregular IRAs, until your actual retirement date, as long as youare not a 5 percent owner of the business for which the planwas established.

Observation

Roth IRAs are exempt from the rules requiring distributions tobegin at age 701⁄2. Tax-free buildup can continue within a RothIRA for your entire life. If you don’t need the money during yourlifetime, this can increase the amount of income-tax-free accu-mulations in the account to pass to children and grandchildren.

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Idea Checklist

� Maximize participation in employer plans, especially if youremployer “matches” 401(k) plan contributions. Consider con-tributing the maximum amount permitted.

� If you are 50 or older, consider making extra catch-up con-tributions.

� Make your IRA contributions at the beginning of each calendaryear to maximize the tax deferred buildup.

� Self-employed individuals should consider which self-employment retirement plan is best for them. Remember thatKeogh plans need to be established before year-end for a taxdeduction, although actual contributions can be made as lateas the extended tax return due date.

� Establish a Roth IRA for 2002 if your income level permits. Thismay be done even if you are in a qualified retirement plan andare not permitted to make deductible contributions to a tradi-tional IRA. A Roth IRA is especially desirable if you want toavoid making lifetime distributions required by traditional IRAs.Traditional IRAs have detailed distribution requirements.

� Consider whether converting a preexisting IRA to a Roth IRAmakes sense for you and whether you can manage the tax lia-bility generated from the conversion. This can be an especiallygood move when stock prices are depressed.

� Fund a Roth or other IRA for children and grandchildren whohave earnings but insufficient cash flow to contribute to theirown retirement plans.

� A charitable remainder trust can improve retirement cash flowif funded with highly appreciated assets.

� Review your beneficiary designations on retirement accounts tomaximize the family’s income-deferral opportunities.

The 2001 Tax Act ’s retirement plan changes can help Americans tobe financially secure in their later years. Whether all taxpayers are

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financially able as well as willing to make the change is another mat-ter. This book is an effort to smooth the learning curve for every-body. These retirement planning suggestions and techniques are notuniversally applicable; each person must pick and choose amongthem depending on individual circumstances. The government isproviding more tax help for retirement saving, and the tax breaksstretch across the income spectrum. The 2001 Tax Act truly offerssomething for everyone.

We turn next to the law’s effects on home ownership. Most peopledo not give much thought to the federal tax implications of owning ahome. They know they can deduct mortgage interest and real estatetaxes, but, in fact, many other aspects of owning a home have taxconsequences.

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105

Chapter 4

TAX ADVANTAGES OFHOME OWNERSHIP

Home ownership carries with it many special tax advantages. Thischapter takes up the tax considerations of home ownership in detailand explains how to use the Tax Code provisions to minimize fed-eral tax bills. For instance, a home office has become easier to claimas a deduction. There are tax advantages for vacation home rentals,but the rules on how to treat rental fees and expenses need carefulstudy. Interest on limited amounts of home-equity loans is fully de-ductible for ordinary income tax calculations, however the proceedsare used. But when calculating the Alternative Minimum Tax (AMT),if the loan proceeds are not used for investment purposes, you candeduct home-equity loan interest only to the extent that the loanwas used to improve the house. “Points” paid to secure mortgagesfrom a bank or other lender may be treated in several ways. Finally,there are special tax breaks on gains incurred when selling a house.

The 2001 Tax Act will have some interesting effects on home-owners’ finances as the changes are phased in over the next decade.

For instance, millions of taxpayers may stop itemizing deductions asthe standard deduction for couples gradually rises. By 2010, thestandard deduction will exceed the total deductions that many peo-ple could claim by itemizing. Homeowners will not complain if this

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happens since their total taxes will decline and their tax situationwill be simplified. Some may choose to sell their homes and rent,using the freed capital for other investments. At the same time,people who already rent out their homes will benefit from lower taxrates on their rental income.

Homeowners who continue to itemize will find their deductionsworth slightly less than before because tax rates will be lower. Thiswill be particularly true for those who benefit by dropping out ofthe 27 percent bracket as the upper limit of the 15 percent bracketis raised.

Techniques and tools that will help you maximize the tax benefits ofowning a home are discussed in this chapter.

Tax Benefits of Owning a Home

Generally, you can deduct interest that is paid during the tax yearon several types of debt related to your home or on home-equityloans, as long as they are secured by a qualified residence (yourprincipal residence and one other home).

Mortgage Interest

You can deduct interest on debt that is incurred in acquiring, con-structing, or substantially improving a qualified residence. Together,these debts are referred to as “acquisition indebtedness.” The com-bined amount of debt that can be considered acquisition indebted-ness is capped at $1 million.

Observation

Debt on a maximum of two residences can be counted towardthe $1 million limit. Thus, if you have a city home, a beachhome, and a mountain home, only debt related to your princi-pal residence and one of the other residences can qualify ashome acquisition indebtedness.

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Tax Advantages of Home Ownership 107

Home-Equity Loans

Interest is deductible on up to $100,000 of home-equity loans. Forthe interest to be deductible, the home-equity loan cannot exceedthe fair market value of the residence, reduced by any acquisitionindebtedness.

Interest paid on a home equity loan is deductible for regular in-come tax purposes in almost all situations no matter how the loanproceeds are used. For example, the fact that home-equity loanproceeds are used to finance personal consumption, such as thepurchase of a new car or paying college expenses, does not affectinterest deductibility.

Observation

If you are thinking about the purchase of a second home andyou already have $1 million of acquisition indebtedness, or arethinking about purchasing a third home, consider using a trustto purchase the property, with your children as trust benefici-aries. The trust can rent the property to you at fair marketvalue rates. In other words, if you’ve hit the limit either on yourfirst home or on your first and second homes in aggregate, andyou’re looking to purchase another home, the trust option is agood one from a tax perspective.

Margin interest cannot qualify as mortgage interest even whereyou borrow from your brokerage account to purchase a resi-dence, because margin debt is secured by the assets in youraccount, not by the purchased home.

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Vacation Homes

If your vacation home is a “residence,” the mortgage interest you payis generally deductible. If your vacation home is partly your residenceand partly a rental property (see the discussion that follows), your in-terest deduction must be prorated, along with your other expenses.

A vacation home is generally considered a residence if you use it forpersonal purposes for more than the greater of 14 days per year or 10percent of the number of days the home is rented out at a fair rentalvalue. Personal use is use by you or a co-owner of the property, or afamily member of either, and use by other people who do not pay afair market rental. Days when you are performing maintenance andrepairs on a vacation property are not considered personal-use days.If you own a vacation home and rent it out to others, the amount ofrental activity will affect the tax treatment of rental income:

• More than 14 days personal use/rented fewer than 15 days. Ifyou rent out a home for 14 days per year or less, it automaticallyqualifies as a second residence. Any rental income is tax-free, and

Observation

Consider refinancing nondeductible personal expenditures,such as an auto loan or credit card debt, with a home-equityloan. If the tax savings from the interest deduction are used tofurther pay down the principal portion of the loan, the debtwill be paid off sooner.

Caution

Keep in mind that home-equity interest expense is not alwaysdeductible. If the debt proceeds are used to purchase munici-pal bonds, for example, the interest expense is not deductible.

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any rental expenses are not deductible (except mortgage interestand real estate taxes).

• More than 14 days personal use/rented more than 14 days. Ifyou rent out your vacation home for more than 14 days per year,and your personal use exceeds the greater of 14 days or 10 per-cent of the rental period, the home is a personal residence sub-ject to the vacation home rules. You can deduct a proportionateshare of property taxes and interest attributable to your personaluse. The balance of the interest and taxes can reduce the rentalincome. In addition, you can deduct depreciation and other oper-ating expenses attributable to the rental to the extent of any re-maining rental income. Note that you cannot claim expenses inexcess of the rental income.

• Fewer than 15 days personal use/rented more than 14 days. Ifyou rent your home for more than 14 days and your personal usedoes not exceed the greater of 14 days or 10 percent of the rentalperiod, the vacation home is considered a rental property. Interestand taxes are allocated between personal and rental use of theproperty. In addition, other expenses allocable to the rental activ-ity can be considered in full, even if this results in a loss. The loss,however, will be subject to the passive activity rules discussed next(also see Chapter 2) and generally will be deductible only to theextent of passive activity income. Interest allocated to your per-sonal use of the home is personal interest and may not be de-ductible because the home generally is not considered a residence.

Rental Properties

If your vacation home is fully rented without any personal use, it isconsidered a rental property and is not subject to the special vacationhome rules. As a rental property, taxes, interest, and other expensesare deductible, subject to the passive activity loss rules. Up to$25,000 of passive rental real estate losses can be deducted eachyear against other income such as compensation, interest, and divi-dends, if the owner meets certain “active participation” requirements.

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However, the $25,000 exception is decreased for homeowners withan AGI over $100,000 and is fully phased-out for homeowners withan AGI over $150,000. Passive activity losses that can’t be used cur-rently are carried forward and can be deducted against future pas-sive activity income, or are deducted in full when the activity thatgenerated the losses is disposed of.

Home Office Deduction

Home is where the office is for a growing number of consultants,entrepreneurs, and telecommuters. Although expenses associatedwith use of a residence are generally not deductible, a home officededuction is permitted for certain expenses if a portion of the homeis used exclusively and on a regular basis as the principal place ofbusiness or as a place to meet or deal with customers or clients inthe ordinary course of the home owner’s trade or business.

In addition, home office deductions are available to homeownerswho use a separate structure that is nearby, but not attached to thehome, regularly and exclusively in connection with their trade orbusiness.

Exclusive and Regular Use

To meet the exclusive-use requirement, you as the homeowner mustuse a portion of the residence solely for conducting business. Thereis no provision for de minimis personal use, such as typing a per-sonal letter or making a personal phone call. If you are employed bya company, your use of the home office also must be “for the con-venience of the employer.” Generally, if your employer supplies youwith an office, your home office use wouldn’t meet this test.

Principal Place of Business

Until a few of years ago, “principal place of business” was definedvery restrictively for purposes of the home office deduction, prevent-ing many who worked from their homes from claiming deductions.

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However, a tax law change that went into effect in 1999 opened upthe deduction to many more home office users. In addition to theplace where the central functions of a business are performed, theterm “principal place of business” now includes areas used for abusiness’s administrative or management activities, if there is noother fixed location where the homeowner conducts these activities.This is the case even if most of the other work of the business isdone outside of the home office. So, for example, it will be easier forsalespeople, tradespeople, and manufacturer ’s representatives whowork out of their homes, but perform much of their work at theircustomers’ locations, to claim home office deductions. Here again, ifyou are an employee, use of your home must be for your employer ’sconvenience to claim a home office deduction.

More people who work at home will be able to take a home officededuction. Typical expenses include a portion of rent, depreciation,repairs, and utilities.

Observation

Under this liberalized definition of principal place of business,more individuals will also be able to deduct the cost of travel-ing to and from their home (as their principal place of business)to other business locations. In the past, these transportationcosts were considered nondeductible commuting expenses.

Observation

The rules about the home office deductions are still complex.A separate tax form is required with Form 1040 to claim thededuction. (Self-employed individuals claim home office ex-penses on Form 8829 and on Schedule C; employees use Form2106 or Form 2106EZ and claim them as miscellaneous item-ized deductions on Schedule A Form 1040, subject to 2 per-cent of the AGI floor.)

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Another consideration in evaluating whether it makes sense to takethe deductions is that the portion of the home for which home of-fice deductions are claimed may not qualify for the home sale exclu-sion described later in this chapter.

Personal Residence Trust

A first or second home is an ideal asset to transfer to a personal resi-dence trust—a popular gift tax planning technique (see Chapter 6).In this case, the property is transferred to the trust for a period ofyears, during which you retain the right to live in or use the prop-erty. At the end of the term, the property passes to whomever youchoose, either in further trust or outright. The value of the transfer isdiscounted for gift tax purposes because of your retained right tolive in the residence. In addition, all future appreciation in the valueof the home is transferred free of gift tax.

Although your beneficiaries will own the residence (either in trust oroutright) at the end of the trust term, you can lease the propertyfrom them at a fair rental value. If you die before the end of thetrust term, the property remains in your estate. Consequently, theretained right to live in the property or to use it should be for a rea-sonable period given your age and general health.

Observation

The personal residence trust ’s governing instrument (the docu-ment that creates and “rules” the trust) must prohibit the trustfrom selling or transferring the residence, directly or indirectly,to you, your spouse, or an entity controlled by you or yourspouse, during the time in which the trust is a grantor trust(a trust in which the grantor keeps some interests and controland therefore is taxed on any income from the trust). Thismeans that the grantors will not be able to get the basis step-upat death if they live beyond the trust term. This makes a per-sonal residence trust less attractive for homes that are alreadyhighly appreciated.

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Home Sales

Principal Residence Gains Exclusion

You may exclude up to $250,000 of gain from the sale of yourhome as long as it is owned and used by you as your principalresidence for at least two of the five years before the sale. Qualify-ing married taxpayers filing jointly may exclude up to $500,000.The full exclusion is not available if, within the two-year periodbefore the sale, you sold another home for which you claimedthe exclusion.

Qualifying for the $500,000 Exclusion

A married couple filing jointly may exclude up to $500,000 of gainfrom the sale of their home if:

• Either spouse owned the home for at least two of the five yearspreceding the sale.

• Both spouses used the home for at least two of the five years pre-ceding the sale;

• Neither spouse sold another home at a gain within the previoustwo years and excluded all or part of that gain using the exclusion.

Partial Exclusion

A partial exclusion may be available if you do not meet the two-yearownership and use requirement, or sell your home within two yearsof a previous home sale for which you used the exclusion. If you failto meet either requirement because of a change in employment,health, or other unforeseen circumstance as determined by the IRS,the exclusion is based on the ratio of qualifying months to 24months (or, if less, on the ratio of the number of months betweenthe sale date of a previous home for which the exclusion wasclaimed and the sale date of the current home to 24 months).

For example, suppose a single person owned and used a home as a principal residence for one year (and did not previously use the

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exclusion on another home sale within the previous two years) andmust move for job-related reasons. The partial exclusion rule allowsthis person to exclude up to $125,000 of his or her gain from thesale of the residence ($250,000 exclusion times 12 divided by 24).

Partial Exclusion Rule for Joint Filers

If a married couple filing jointly doesn’t meet all the conditions forclaiming an exclusion of up to $500,000, the gain that is excludedon the home sale is the sum of the exclusion each spouse would beentitled to if both were single. For this purpose, each spouse istreated as owning the home for the period that either spouse ownedthe home.

For example, a couple sells a home that one spouse owned and usedas a principal residence for 10 years and the other spouse used as aprincipal residence for only one year. They sell the home because ofillness. They may exclude up to $375,000 of profit from the sale($250,000 for one spouse, plus $125,000 for the other spouse).

Observation

Special care and planning is needed to preserve the full homesale exclusion in divorce situations.

Observation

Home sellers in hot, upscale real estate markets will have to paycapital gains tax on any profit above the $250,000/$500,000limits. The rollover break that used to defer unlimited amountsof home sale gain, provided an equally expensive residence waspurchased as a replacement, is no longer available. Since the

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Home Purchases

Real Estate Taxes

In general, real estate taxes can be deducted. In the year of a homesale, however, the Tax Code requires the deduction for real estate

Observation

Because a vacation home is not your principal residence, itdoes not qualify for tax-free treatment when it is sold. A resi-dence that you also use as a vacation home can’t be swappedtax-free for another property in a like-kind exchange.

new exclusion is available once every two years regardless ofwhether it ’s been used before, some homeowners may decideto sell before their gains exceed the limits. Then additional gainon their replacement residence could also qualify for the exclu-sion in another two years.

Observation

However, a vacation home could become your principal resi-dence, and, therefore, qualify for the home sale exclusion. Forexample, if you own a principal residence where you haveresided for two or more years and a vacation home, you cansell your principal residence and get the benefit of the homesale exclusion. Then if you move into your vacation home andestablish it as your principal residence for at least two years,you can get the home sale exclusion on its sale.

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taxes to be apportioned between the buyer and seller according tothe number of days each held the property during the year. It doesnot matter that your sales contract contains a different division of re-sponsibility for the taxes.

Mortgage Points

Mortgage points incurred with a home loan are usually significant.A point is a charge paid by a borrower for taking out a loan. Eachpoint is 1 percent of the loan amount. You must amortize mostpoints over the life of the loan; however, you can deduct points youpay for acquiring or making improvements to your main residence inthe year the depts are paid. The deductibility of points depends onwhether the lender assesses them as additional interest or as a ser-vice charge. This is sometimes a difficult determination. Points aregenerally considered additional interest if the lender is charging forthe use of money. If points are assessed for application preparationor processing, they are treated as a service charge and added to thepurchaser ’s basis in the residence and thus are nondeductible.

Observation

Even though the buyer or seller might pay the entire tax, thededuction is limited by the statutory formula.

Observation

You will need your closing statement from a home sale or pur-chase to calculate the amount of deductible real estate taxes.You will also need to know whether the states in which youpurchased or sold a home require prepayment of real estatetaxes or whether such taxes are paid in arrears.

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Points may be deducted in full during the year they were paid if thefollowing requirements are met:

1. Points are paid directly to the lender by the borrower; pointsare treated as paid directly to the lender if the borrower pro-vides unborrowed funds at least equal to the points charged atthe closing or as a down payment or escrow deposit.

2. The loan is incurred for the purchase or improvement of a prin-cipal residence.

3. Points are an established business practice in the area in whichthe loan originates. In other words, banks and other lending in-stitutions in that geographical area typically impose pointswhen granting mortgage loans.

4. The dollar amount of the points is typical for the area in whichthe loan originates.

5. The points are clearly designated as such on the settlement form.

6. The points are expressed as a percentage of the loan amount.

Borrowers who do not satisfy these requirements must amortize thepoints over the life of the loan.

Observation

Do not assume you should pay points when purchasing a newhome. Think about how long you are likely to own the prop-erty. If you expect to sell the property within five years or less,it may be more advantageous to pay a slightly higher interestrate to get a no-points or low-points mortgage loan.

Observation

The most common situations in which points must be amor-tized include the purchase of a second residence and refinanc-ing the principal home’s mortgage.

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Idea Checklist

� Convert nondeductible interest expense into tax-deductiblehome-equity interest expense.

� Know the vacation home rules before renting out your secondhome.

� Consider placing a principal residence or second home in apersonal residence trust.

� Review closing documents from real estate sales or purchasesto find deductible real estate tax amounts.

� If you refinanced your home during 2002, any remaining un-amortized points on the paid-off loan are fully deductible onyour 2002 return.

Owning a home is a cornerstone of the American Dream, and ahome has almost always been most taxpayers’ most valuable asset,both financially and emotionally. The tax law gives home ownershipnumerous opportunities that this chapter has described.

The next chapter discusses saving for education—a high priorityunder the 2001 Tax Act. In the past, many of the Tax Code’s incen-tives for education savings were not available to taxpayers in thehigher brackets. Beginning in 2002, however, families with relativelyhigh incomes are permitted to put away more after-tax money andwithdraw the gains tax-free, which increases their flexibility for fund-ing education for children and grandchildren. Chapter 5 looks at thatin detail.

Observation

The unamortized points remaining when an underlying mort-gage is paid off after a sale or refinancing are deductible in full.

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119

Chapter 5

HOW TO MAXIMIZE SAVINGSFOR EDUCATION

To pay for a child’s quality education, parents will do just aboutanything, even spend their life savings, assume second mortgages,and work at multiple jobs if that ’s what ’s necessary. It gets harderand harder to keep up with college tuition, which is increasing farfaster than the inflation rate.

Fortunately, the Tax Code now offers some real incentives to helpparents fund their children’s education. This chapter describes anumber of helpful tuition-financing techniques. Despite the fact thatthere are more available tax breaks, the best advice is to put asideas much as you can as early as you can.

Until now, many of the education tax incentives weren’t available tothose with higher incomes. But starting in 2002, families withhigher incomes can take advantage of some tax breaks, includingwhat is by far the best educational tax break, the much improvedSection 529 plan. Also starting in 2002, many of the restrictionsthat previously prevented taxpayers from bundling various educationtax breaks together in the same year have been eliminated.

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Qualified Section 529 Tuition Programs

For a number of years, the Tax Code has allowed states to set up“qualified state tuition programs,” often referred to as Section 529plans after the part of the Tax Code that authorizes them. States arepermitted to offer two types of plans:

1. Prepaid tuition plans that allow a parent, grandparent, or otherperson to prepay tuition costs and certain other education ex-penses. Participants are generally allowed to put aside futuretuition by contributing money to these plans, thus assuring tu-ition at today’s tuition rate. These types of plans are generallyavailable only to state residents and are meant to be used fortuition at in-state public schools. About 20 states have theseplans for their residents. Programs differ from state to state,however, and you have to look carefully at the details of your

Observation

Parents should consider the impact that Section 529 programsand Coverdell Education Savings Accounts (formerly called Ed-ucation IRAs) will have on their chances of obtaining financialaid for college. Some advisors suggest that families who wish tomaximize their financial aid use the types of investments thatare favored in the federal financial aid formulas. These invest-ments include retirement savings, life insurance, and home eq-uity. However, there are many reasons not to engage in thistype of planning:

1. The financial aid rules may change before your child is incollege.

2. The favored assets under the federal formula may not be fa-vored for your child’s university-provided financial aid.

3. Most financial aid is in the form of loans, not grants—whyburden yourself or your child with debt?

4. Only a small percentage of parental assets are applied to re-duce each year ’s financial aid.

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How to Maximize Savings for Education 121

own state’s plan. Under current federal financial aid guidelines,these plans reduce your child’s financial aid dollar for dollar.

2. Tuition savings plans that offer more flexibility on contributionlimits and investment choices are not limited to use for atten-dance at in-state schools. They can be used to pay tuition,room and board charges, and other expenses required for en-rollment at almost any higher education institution. Theseplans are available in all 50 states. They are treated as anyother parental asset under federal financial aid guidelines. Thismeans that only 5.5 percent of the plan assets are counted to-ward a family’s expected contribution versus 35 percent of astudent-held asset such as an education savings account or acustodial account. And now that higher education distributionsfrom these plans are excluded from income, the distributionswon’t be included as student income in the financial aid for-mula used in determining the family’s expected financial con-tribution to tuition and other expenses.

As good as Section 529 state tuition programs were in the past,they are vastly better starting in 2002. Previously, earnings on pre-paid amounts were tax-deferred until used to pay for the student ’shigher education. At that time, distributed earnings were taxable tothe student-beneficiary, who was usually in a lower tax bracket thanthe parent or other contributor. The educational fund built up faster,owing to tax deferral, and the tax that was ultimately owed was al-most always much lower than it would have been at the parent-contributor ’s rate.

Starting in 2002, distributions from these state tuition programs thatare used to pay qualifying higher education expenses are completelytax-free. This applies to both prepaid tuition plans and tuition sav-ings plans. As a result, they are a much improved higher educationsavings vehicle.

Also starting in 2002, private educational institutions will be per-mitted to establish prepaid tuition programs (but not tuition savings

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plans) that will have the same tax benefits as state tuition plans, ex-cept that distributions from these private tuition plans won’t be tax-free until after 2003.

Unlike most other tax-advantaged education savings vehicles, thereare no limits to prevent high-income individuals from using 529plans. And substantial sums can be accumulated for a beneficiary—almost $250,000 in some plans.

The private plans should be attractive to many parents and futurestudents, especially families with a history of attendance at a partic-ular private college. It is expected that some institutions will join to-gether to form plans to allow student-beneficiaries to use the prepaidtuition credits at any of the member institutions. Also, tuition creditscan be rolled over from one plan to another as often as once a year.This should provide more flexibility for those who aren’t sure wheretheir children will end up going to college. This rollover option alsoapplies to state tuition plans. For example, the rollover option allowstransfers between the tuition plans of different states, between astate’s prepaid tuition plan and its savings plan, or between a statetuition plan and a private plan. While the federal tax law permitsrollovers, plans are not required to do so. So if flexibility is impor-tant, make sure that the plan permits rollovers.

What Expenses Qualify?

Tax-free qualified tuition plan benefits (both state and private) areavailable to fund tuition, fees, books, and supplies. Most room andboard expenses for students who attend school at least half-timewill also qualify. To figure the amount that can be received tax-free,expenses that would otherwise qualify must be reduced by tax-freescholarship grants, veterans’ benefits, tax-free employer-paid educa-tional expenses, and amounts that qualify for higher education taxcredits. Also, amounts received tax-free from a qualified tuitionplan reduce the amount of education expenses that qualify for thenew tuition deduction discussed on page 135.

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Distributions of earnings that exceed qualified expenditures aretaxed to the beneficiary and generally subject to a 10 percent excisetax. Amounts not used by the beneficiary can be rolled over to an-other beneficiary’s account as long as the new beneficiary is a fam-ily member (including a spouse and, beginning in 2002, a firstcousin), thus keeping the tax benefits working for other family mem-bers. Earnings not used for qualified higher education expenses thatare returned to the contributor are taxed at the contributor ’s rateplus the 10 percent excise tax. Earnings that are distributed becauseof the beneficiary’s death or disability, or because of the benefi-ciary’s receipt of a scholarship, are not subject to a penalty. Also notsubject to the 10 percent excise tax are distributions of earnings thatare taxable because the taxpayer elects to take the credits or deduc-tions described in the prior paragraph.

Contributions to qualified tuition plans may be made only in cash.Unlike Coverdell Education Savings Accounts, contributors and ben-eficiaries are not permitted to fully self-direct the investments inqualified tuition plans. However, most savings plans permit an initialinvestment selection among different investment types, and the

Observation

Beginning in 2002, the Tax Code imposes a 10 percent taxpenalty for taxable distributions not used for education ex-penses. Previously, Section 529 plans had to impose a penaltyon refunds not used for educational expenses. Each state willhave to decide whether to remove its own plan’s penalty fornonqualified use of funds. However, this should not be a factorin choosing a state-qualified tuition plan as long as the planpermits rollovers. If there are funds in the account that will notbe used for education expenses, the account could be rolledover and later distributed from a plan that does not impose apenalty of its own.

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account owner can switch investments once every 12 months andupon any change in account beneficiaries.

Many states also offer tax incentives to their residents, including stateincome tax deductions for some contributions to their state’s quali-fied tuition plans. No state permits a deduction for contributions to a529 plan sponsored by another state. For a listing of the various taxbreaks offered by the different states, link to http://www.collegesavings.org/tax_treatment.htm. Some states have changed or are consideringchanging the tax treatment of these programs to conform moreclosely to the federal tax exemption. Also, some states require a re-capture of the state income tax deduction where funds are with-drawn and/or rolled over to another state’s plan. The recapture isnecessary to prevent the abuse of making contributions solely for thepurpose of receiving state income tax deductions.

In addition to the tax advantages, 529 plans generally offer profes-sional investment management. The plans of some states offer littleflexibility in this regard; their investment choices are somewhat lim-ited. In these plans, your funds usually are invested somewhat more

Caution

There are a number of special rules that coordinate the benefitsof various tax-favored education savings vehicles. For example,if you take distributions in the same year from a Coverdell Edu-cation Savings Account and a qualified tuition program, and thecumulative distributions exceed the amount of higher educationexpenses that qualify for the tax breaks, the expenses must beallocated between the distributions to determine how much ofeach can be excluded. Also, you may claim both a higher edu-cation tax credit—a HOPE or lifetime learning credit—if youotherwise qualify, and receive a tax-free distribution from aqualified tuition plan in the same year for the same student (butonly to the extent that the distribution doesn’t cover the sameexpenses for which the tax credit was claimed).

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aggressively when your child is younger and less so as the time hori-zon to begin paying for college nears. Other plans allow you tochoose among various types of funds. However, don’t expect to beable to time the market too closely. Federal tax law allows invest-ment changes within a plan to be made no more than once a year.Since you are not limited to using your own state’s plan, you canshop around and find one that gives you the kinds of investmentmanagement and choice that suits you. However, keep in mind thatstate tax deductions for contributions are available only to state resi-dents who invest in their own state’s 529 plan. To learn the detailsof these programs offered by the various states, log on tohttp://www.collegesavings.org/yourstate.htm and click on your state.

Another thing to keep in mind is that anyone can set up a 529 plan.You do not have to be a parent. You can set one up naming a grand-child, or nephew or niece, or an unrelated individual as beneficiary.If you later want to change the beneficiary without incurring incometax, you can name another family member of the beneficiary. Youwill need to supply the beneficiary’s social security number whenyou name a beneficiary. But there is generally no reason that thebeneficiary would have to be informed of the plan’s existence. Withthe exception of a few prepaid tuition plans, the beneficiary has norights of any kind regarding a 529 plan. Therefore, the accountowner must carefully consider who will become the successor ownerupon the original account owner’s death. The successor owner couldchoose to direct the money away from the intended beneficiary.

Gift and Estate Tax Breaks, Too

Payments made into qualified tuition programs are considered com-pleted gifts at the time payment is made into the program, eventhough the student-beneficiary may not receive the benefit of the giftfor many years, and even though the donor retains control over theaccount. As a result, the payments are eligible for the $11,000 an-nual gift tax exclusion. In fact, five years’ worth of annual-exclusiongifts can be made in one year to a qualified tuition plan. So a

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married couple could give $55,000 each to the plan of the samebeneficiary in a single year. However, no additional gifts from thecouple could then be made to that beneficiary for the next four yearswithout being subject to gift tax filings (see Chapter 6 for details).Furthermore, contributions and earnings in 529 plans generally won’tbe included in your taxable estate. So your education funding can dodouble duty as part of your estate plan.

Coverdell Education Savings Accounts

Before 2002, you could contribute up to $500 per year to EducationIRAs for any child under 18. The $500 amount was phased out forcontributors with modified adjusted gross income (AGI) between$95,000 and $110,000 for singles and between $150,000 and$160,000 for joint filers. Earnings were tax-free when distributed ifused for qualified higher education expenses, including tuition, fees,books, room and board, and supplies and equipment. A 6 percentexcise tax was applied each year if contributions to Education IRAsfor any one child exceeded $500 from all sources.

Education IRAs were renamed in 2001. They are now calledCoverdell Education Savings Accounts (Education Savings Accounts).Beginning in 2002, the annual per-child contribution limit increasedto $2,000, and the eligibility of married joint-return filers to makecontributions increased to $190,000–$220,000, double the contri-bution phase-out range for single contributors.

Observation

The increase in the annual contribution limit makes EducationSavings Accounts much more useful. In the past, if maximumcontributions of $500 were made for a child at the beginning ofeach year for 18 years and they earned 7.5 percent per year,the Education IRA would have a balance of about $19,000when the child was ready to start college. The increased con-tribution limit will increase that amount to about $77,000.

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An even bigger change starting in 2002 is that tax-free Education Sav-ings Account distributions can be used for kindergarten, primary-school, and secondary-school tuition and expenses as well as forhigher education expenses. Qualified expenses include not only tu-ition and fees but tutoring costs, room and board, uniforms, trans-portation, and extended-day programs. Even some computerequipment and Internet access qualifies if used by the beneficiary andthe beneficiary’s family during a year that the beneficiary is enrolledin school.

Any unused amounts in an Education Savings Account must be dis-tributed before the beneficiary turns 30 or be rolled over into anEducation Savings Account for another family member under age 30.Undistributed amounts are taxed to the beneficiary at that time.Eligible family members include the beneficiary’s spouse, children,brothers and sisters, first cousins, and nieces and nephews. If a dis-tribution is not used for educational expenses, the beneficiary istaxed on the earnings and must pay a 10 percent penalty.

Before 2002, the income exclusion for Education IRA distributionswas not available for any year in which either HOPE Scholarship orLifetime Learning tax credits (see page 130) were claimed. Startingin 2002, however, these breaks are available in the same year as longas expenses for which a credit is claimed aren’t the same ones forwhich a tax-free Education Savings Account distribution is received.

Observation

Your children and grandchildren may be able to benefit from anEducation Savings Account even if your income exceeds theAGI threshold. Anyone can establish an Education Savings Ac-count for your child or grandchild. Grandparents, aunts, uncles,or even siblings can make the contributions, provided their in-come is below the modified AGI limitation, and the IRS agreesthat even a child may contribute to his or her own Education

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Until 2002, contributions to an Education IRA for a year had to bemade by the end of that calendar year. For 2002 and later years,however, you have until April 15 of the following year to make Edu-cation Savings Account contributions.

Roth IRAs

Roth IRAs have a special distribution pay-out rule that makes thema good source of tax-advantaged cash for education funding. If youwithdraw funds from a regular IRA to pay for college while you areunder age 591⁄2, the withdrawal is mostly, if not completely, taxable.With a Roth IRA, however, you can withdraw up to the amount of

Savings Account. Also, starting in 2002, companies may makecontributions to Education Savings Accounts. So if a parent ’sincome is too high to make a contribution, his or her companymay make the contribution to the child’s Education Savings Ac-count. (Such a payment would be taxable compensation to theparent, the same as if the company paid the parent who, inturn, made the contribution to the account.)

Observation

Parents who intend to send their children to private elementaryand secondary schools may want to use Education Savings Ac-counts to help pay those costs and use qualified tuition pro-grams to build a higher education fund. An excise tax that usedto apply if contributions were made to an Education IRA for anyyear that a contribution for the same beneficiary was also madeto a qualified tuition plan no longer applies beginning in 2002.

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your contributions tax-free for any purpose, even if you are underage 591⁄2. Earnings on the contributions are deemed withdrawn onlyafter you have withdrawn all contributions. If you need to withdrawearnings on the contributions to pay for qualified education ex-penses, they will be included in your gross income but will not besubject to the usual 10 percent early withdrawal penalty.

Example

John Smith contributes $3,000 a year to a Roth IRA for 10 years.At the end of that period, he can withdraw his $30,000 cumula-tive contribution both income tax and penalty free. Earnings onthe contributions remain in the account to further compound forhis retirement.

Traditional IRAs

Traditional IRAs are generally not as good a source for funding edu-cation expenses as the other vehicles described in this chapter be-cause all distributions are included in income if all contributionswere deductible. (If nondeductible contributions were made, part ofeach distribution is taxable and part is considered to be a return ofcapital.) However, if an IRA withdrawal is used to pay for qualifiededucational expenses for you or your spouse, child, or grandchild,there is no 10 percent early withdrawal penalty imposed. Qualifiededucational expenses include tuition, fees, books, supplies, and re-quired equipment at a postsecondary school.

Observation

The increased IRA contribution limits that apply beginning in2002 (see Chapter 3 for details) will make this strategy evenmore useful.

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Education Tax Credits

HOPE Scholarship and Lifetime Learning Credits

Taxpayers may be eligible to claim a nonrefundable HOPE Scholar-ship tax credit or a Lifetime Learning tax credit against their federalincome taxes for qualified tuition and related expenses.

A HOPE Scholarship tax credit provides up to $1,500 in tax creditsper student, but only for each of the first two years of at least half-time college enrollment. A Lifetime Learning tax credit is also avail-able, providing an annual 20 percent tax credit on the first $5,000of tuition and related expenses, for a maximum of $1,000 per year.(After 2002, the maximum Lifetime Learning credit increases to$2,000—that is, 20 percent of up to $10,000 of expenses.) TheLifetime Learning credit maximum applies per-household, not per-student, and can be claimed for yourself, your spouse, or your child.Note that only one of these credits can be claimed in any year forthe expenses of a given student.

Students claimed as dependents may not take either credit on theirown tax returns. Qualifying educational expenses that a dependentstudent pays are treated as paid by the person who claims the stu-dent as a dependent for purposes of figuring that person’s HOPEcredit. Amounts paid to educational institutions by third parties, suchas grandparents, are treated as paid by the student (and, in turn, bythe student ’s parents if they claim the student as a dependent).

Observation

This penalty exception does not apply to premature distribu-tions from qualified retirement plans, but it does apply to sim-plified employee pension (SEP) plan distributions, which aretreated as IRAs for this purpose.

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If you are above the income thresholds for these credits (availabilityof the credits phases out between a modified AGI of $40,000 and$50,000 for singles; $80,000 and $100,000 for married couples fil-ing jointly), there may still be some opportunities to benefit fromthe credits. If you forgo claiming your student-child as a dependent,and the child has sufficient taxable income to be able to use thecredit, the tax value of the credit may be more than you lose by giv-ing up the dependency exemption. There is no restriction on thetype of income that may be offset by the tax credit, so a child’s in-vestment income would qualify.

U.S. Savings Bonds

You may exclude from income any interest received on a redemp-tion of U.S. savings bonds purchased after 1989 when you were 24or older if qualifying educational expenses for the tax year exceedthe aggregate proceeds received from a redemption of bonds.

Observation

The higher your income, the better this trade-off is, since yourability to claim dependency deductions on a 2002 joint returnstarts to phase out at $206,000 of adjusted gross income anddisappears completely above $328,500.

Observation

The ability to use this provision in 2002 begins to phase out forsingle individuals with an AGI of $57,600 and married coupleswith an AGI of $86,400. The phase-out range for the interestexclusion is $15,000 for singles and $30,000 for joint-return

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If you are concerned that your income may be too high in the yearof redemption, it might make more sense to invest in growth stocks.This will allow you to manage the capital gains income and youcould transfer the stock to your child on a “just-in-time” basis, to besold at reduced capital gains rates (see “Income Shifting and CapitalGains,” page 134).

Example

Mr. Jones redeems series EE bonds in the amount of $20,000.Mr. Jones paid $12,000 for the bonds in 1990 and would have torecognize $8,000 of interest income upon the redemption. IfMr. Jones has qualifying education expenses of at least $20,000during the tax year in which he redeems the bonds and his in-come is low enough, he avoids income tax on the interest incomefrom the bond redemption. Qualifying educational expenses in-clude tuition and fees spent for the taxpayer, the taxpayer ’sspouse, and dependents of the taxpayer.

Home-Equity Loans

If you need to borrow to pay college expenses, consider a home-equity loan. You can claim the loan interest as an itemized deduc-tion, up to a maximum debt amount of $100,000. However,home-equity debt interest is not deductible for Alternative Mini-mum Tax purposes.

filers. Because the income level is measured in the year thebonds are redeemed (which might be years into the future),you may not be able to take advantage of the provision if in-come levels are too high at that time. The interest incomewould then be subject to tax at ordinary rates.

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Student Loans

You may deduct up to $2,500 of interest paid on qualified educationloans (loans taken out and used solely to meet higher education ex-penses), which you are liable to repay, even if you don’t itemize de-ductions. Interest on loans from relatives or other individuals can’tbe deducted. Before 2002, only the first 60 months of interest pay-ments were eligible. Beginning in 2002, this 60-month limit nolonger applies.

Before 2002, the student-loan interest deduction phased out at amodified AGI level between $40,000 and $55,000 for singles, and$60,000 and $75,000 for married joint-return filers. Now thesephase-out ranges have increased to $50,000–$65,000 for singles,and $100,000–$130,000 for married couples (they will be in-creased for inflation in the future). Many more people can qualifynow for at least some deduction.

Relatives

Relatives, especially grandparents, with taxable estates (those thatexceed the $1 million estate and gift tax allowance that applies in

Observation

Despite the increases in the phase-out thresholds, many parentswill be shut out of this deduction because their family income istoo high. If borrowing is necessary in these situations, it usuallymakes sense for the student rather than the parent to take outas much of the loan as possible to generate maximum tax bene-fits. The deduction is not available to a child for any year whenthe child is claimed as a dependent on the parents’ tax return.However, the child is not likely to be a dependent when theloan is being repaid following graduation. At that time, parentscan make gifts to the child to help with loan repayment.

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2002 and 2003) may be looking for methods to reduce their estatesdespite coming increases in the amounts that may escape estate tax(see Chapter 6). Payments of tuition made directly to an educationalinstitution do not count against the gift tax annual exclusion amount.Thus, grandparents can write a tuition check directly to the schooland still make an $11,000 tax-free gift to their grandchild withoutowing any gift tax or even reducing the amount that can be passedon free of estate tax. Even multiyear advance tuition payments maybe structured to be gift tax-free.

Income Shifting and Capital Gains

As discussed in Chapter 2, the favorable capital gains tax rates makeit worthwhile to consider shifting income to your children who maypay only a 10 percent (or possibly even an 8 percent, if they qualify)tax on capital gains.

Children or other individuals in the 10 or 15 percent bracket willpay only 8 percent tax on long-term capital gains if the propertythat is sold has been held for more than five years. Unlike the rulefor individuals in higher tax brackets, the asset sold need not havebeen purchased after the year 2000 for the lower rate to apply. Therecipient can turn around and sell the asset without an additionalwaiting period and owe only an 8 percent capital gains tax.

Observation

If you expect to have capital gains from selling stock to pay forcollege or another major expense for a child age 14 or older,consider giving the asset to the child, who can then sell it. As-suming that the child is in a 10 or 15 percent tax bracket, thechild will pay tax at the 10 percent capital gains rate (even ifthe asset is sold the next day) as long as the combined holdingperiod exceeds 12 months. Keep in mind that both your pur-chase price and date of purchase will transfer to gift recipients.

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Tuition Deduction

For 2002 through 2005 only, a limited amount of higher educationexpenses are deductible by itemizers and nonitemizers alike. As withmost education tax breaks, those with higher incomes won’t be ableto claim this. A deduction of up to $3,000 is permitted for 2002 and2003, for singles with an AGI no higher than $65,000 or marriedcouples with income no higher than $130,000. For 2004 and 2005,the deduction limit for these income ranges increases to $4,000, anda maximum $2,000 deduction will be available for those with higherincomes of up to $80,000 for singles and $160,000 for married cou-ples. The deduction isn’t available to those who can be claimed asdependents on another person’s tax return.

There are also other restrictions. The tuition deduction can’t beclaimed for a year if a HOPE or Lifetime Learning credit is claimed

Observation

Remember, the gift tax may apply to gifts over $11,000 fromsingle individuals and $22,000 from married couples.

Observation

To fund college or other expenses for children, consider assetsthat are likely to provide superior capital appreciation overthe minimum five-year holding period. These assets can nowbe held in the child’s name (in a Uniform Gift to Minors Act[UGMA] or Uniform Transfers to Minors Act [UTMA] ac-count) or in trust (as long as the trustee has the ability to dis-tribute capital gains) or be a gift to the child on a“just-in-time” basis, since there would be a carryover pur-chase price and purchase date.

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for the same student. Also, no deduction will be allowed for the partof a qualified tuition plan distribution, savings bond redemption, orEducation Savings Account that represents tax-free earnings; how-ever, the part of the distribution representing a return of capitaldoes qualify for the deduction.

Employer Education Assistance

Many employers, especially larger ones, have benefit plans that pro-vide up to $5,250 a year of education assistance to employees. Thisbenefit is tax-free to employees if it applies to tuition and relatedexpenses, such as fees, books, and certain associated supplies andequipment. Other related expenses, such as meals, lodging, andtransportation, aren’t covered by the income exclusion. The coursesdo not have to be job-related for the benefit to be tax-free. So, forexample, a person who works as a clerk or secretary at a companycould take courses toward a degree in literature, history, or econom-ics and receive tax-free benefits. Tax-free assistance is not available,however, for courses involving sports, games, or hobbies.

Before 2002, education assistance plan benefits weren’t availablefor graduate-level courses. But beginning in 2002 that restriction hasbeen removed, making this an even more flexible education-fundingdevice. As a result, an employee whose employer ’s plan permits itcould receive tax-free benefits to attend graduate school part-timewhile working.

Tax-free benefits are not available to companies whose educationassistance plan discriminates in favor of highly compensated em-ployees and their dependents. However, union employees don’thave to be covered if education assistance was the subject of good-faith bargaining.

If your employer doesn’t have an education assistance plan, but re-imburses you for education expenses, the reimbursement is tax-freeif the education is job-related, that is, if it maintains or improves a

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skill currently used in your trade or business or is required to con-tinue your employment. However, the courses can’t qualify you for anew profession (such as law school courses taken by a CPA or MBA)or be needed for you to meet the minimum educational require-ments for your current position.

If you pay for job-related courses on your own, without being reim-bursed by your employer, you can deduct the expenses on your owntax return as miscellaneous itemized deductions. However, your ex-penses won’t be fully deductible because you can only claim other-wise deductible miscellaneous expenses that exceed 2 percent ofyour adjusted gross income. If your AGI is $100,000, for example,your first $2,000 of miscellaneous expenses is nondeductible. Also,miscellaneous deductions cannot be claimed for Alternative Mini-mum Tax purposes.

Idea Checklist

� Fund a qualified tuition plan, especially if your income exceedsthe threshold for Education Savings Accounts.

� If you qualify, fund an Education Savings Account and a quali-fied tuition plan if you plan to send your children to a privateelementary or high school.

� Have lower income family members establish Education SavingsAccounts for children and grandchildren; alternatively, havechildren contribute to their own Education Savings Accounts.

� Shift capital gains income into a 10 percent (or 8 percent, ifqualified) bracket by giving stock to your children or grandchil-dren age 14 or older.

� If loans are needed to help pay for educational expenses, firstconsider a home-equity loan.

� Be sure relatives know that tuition can be paid directly to aneducational institution in addition to $11,000 annual exclusiongifts, and that up to five years’ worth of annual exclusion giftscan be made at one time to a qualified tuition program.

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� Consider funding a Roth IRA so you can withdraw your contri-butions tax-free and penalty free to pay for college.

� Check the new, higher income thresholds for education tax in-centives for 2002 to see if you qualify for any that you couldn’tuse in past years.

� Consider not claiming your child as a tax dependent if yourchild has enough income to benefit from a higher education taxcredit.

The 2001 Tax Act makes paying for college much more affordable formany (see Table 5.1 on the following page). Parents need creativeways for turning tax burdens into tuition tamers, a need that Congresshas begun responding to in the ways this chapter has described.

Less straightforward, but potentially very rewarding for those willingto plan ahead, are the 2001 Tax Act ’s far-reaching estate and gifttax changes, which are covered in the following chapter.

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139

(continued)

Table 5.1 Tax Breaks for Education

Type of Arrangement Main Features Income Limits

Qualified tuition plans Post-2001 (post-2003for private plan) distri-butions for higher edu-cation expenses aretax-free

Large gift tax-free con-tributions can be madeCan be transferred toother family members

None

Coverdell EducationSavings Accounts

Per-child contributionlimit: $2,000

Tax-free distributionsfor education

Can be used for kinder-garten through post-graduate, includingschool-related computerequipment purchase androom and board

Broad investment choice

Contribution limitphases out between amodified AGI of$95,000–$110,000 forsingles; $190,000–$220,000 for joint filers

Education savings bondexclusion

Interest is tax-free onredemption for higher-education expenses (butnot room and board)

Proceeds can be trans-ferred to Coverdell ESAor qualified tuition planChild can’t own bonds

Exclusion phases out for2002 between a modi-fied AGI of $57,600 and$72,600 for singles, or$86,400 and $116,400for joint filers

Student loan interestdeduction

Up to $2,500 of studentloan interestdeductible, even bynonitemizersCan’t be claimed by taxdependent

Maximum deductionphases out between amodified AGI for 2002of $50,000–$65,000for singles;$100,000–$130,000for joint filers

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140

Table 5.1 (Continued)

Tuition deduction Available for 2002 to2005 only

Maximum $3,000deduction for 2002 and2003

Maximum $4,000deduction for 2004 and2005

Not available if higher-education tax credit isclaimed for the samestudent

Maximum $3,000 or$4,000 deduction avail-able for singles with amodified AGI of up to$65,000 ($130,000 forjoint filers)

For 2004 and 2005,$2,000 deduction avail-able for singles with amodified AGI of$65,000–$80,000, and$130,000–$160,000 forjoint filers

Type of Arrangement Main Features Income Limits

Higher-education taxcredits

HOPE credit: up to$1,500 per studentfor first and second yearof post-secondaryeducation

Lifetime Learningcredit: per household—$1,000 for 2002;$2,000 after 2002

Phases out between amodified AGI of$40,000–$50,000 forsingles; $80,000–$100,000 for joint filers

IRA distributions forhigher-educationexpenses

Taxable to same extentas other IRA distribu-tions, but exempt from10 percent prematuredistribution penalty

None

Education-assistance plan Up to $5,250 ofemployer-provided edu-cation assistance is tax-free

Does not have to bejob-related educationIncludes graduate study

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141

Chapter 6

ESTATE PLANNING IDEAS

The 2001 Tax Act ’s repeal of the federal “death” tax provides lessrelief from estate planning chores than most people expected. Asdetailed next and in Chapter 1, the federal estate tax phases downstarting in 2002 until it is completely repealed in 2010. Amountsexempt from estate tax increase during the transition period, andthe maximum rate of tax on estates and gifts decreases. The gift taxphases down, too, but it is not repealed completely.

Offsetting those advantages somewhat in 2010, however, will besome generally unfavorable changes to the income tax rules for in-herited property, especially for those people with large estates. Dur-ing the phase-down period, when the exempted amount reaches$3.5 million (in 2009), complications with preexisting estate planscould arise that could cause a surviving spouse to receive no prop-erty outright. Proper planning during this period may result in largetax savings for some. Another change may cause some states to addor increase their own death taxes, since they will be losing revenueas a result of the repeal of the state death tax credit. Then in 2011,the repeal of the estate tax will “sunset,” returning all of the estateand gift tax rules back to where they would have been had therebeen no repeal.

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As was previously the case, estate and gift planning strategies canstill protect significant amounts of property from being subject totransfer taxes. However, there is less certainty as to what the bestsolutions will be. This chapter focuses on important planning ideasto consider.

How the Estate and Gift Tax Works

Estate and gift taxes currently work in tandem as a “unified” trans-fer tax system, with basically the same tax rates and exemptionamounts applying to both taxes. It ’s sort of “pay me now or pay melater.” But as the amount exempt from estate tax increases above$1 million in the future, and the estate tax is eventually repealed,the gift tax exemption amount will be frozen at the $1 million level.Also, the gift tax will continue, although at a reduced rate, during2010 when the estate tax is scheduled to be repealed.

Amounts Exempt from Tax

You may transfer $11,000 ($22,000 for most married couples) each year to each of an unlimited number of individuals free of gift tax. To qualify for this annual exclusion, the recipient generallymust have immediate access to the gift, although some gifts in trustcan qualify, as can contributions to a qualified tuition program.

Observation

If you previously used your full gift tax exemption of $675,000,you may think that you can make an additional $325,000 of tax-free gifts in 2002 in addition to your annual exclusion gifts. Thatis not the case, however, due to the way prior gifts are figuredwhen calculating the gift tax owed on current gifts. People whoare already in the maximum 50 percent gift tax bracket can onlymake $250,500 of additional gifts before paying gift tax.

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Estate Planning Ideas 143

Unlimited amounts can be transferred directly to an educational in-stitution or health care provider free of gift tax to pay someoneelse’s tuition or medical expenses.

But there are even bigger breaks. You can transfer unlimitedamounts to your spouse free of gift or estate tax. In addition, youare able to transfer $1 million to children and others without payingany estate or gift tax. If you and your spouse agree to split your gifts,you can give $2 million. Annual exclusion, tuition, medical, andspousal transfers don’t count against this exemption. (Special rulesmay apply, however, if your spouse is not a U.S. citizen.)

Table 6.1 Estate and Gift Tax Exemption Allowances

Estate Tax Exemption Gift Tax ExemptionYear (in $ Millions) (in $ Millions)

2002 1 1

2003 1 1

2004 1.5 1

2005 1.5 1

2006 2 1

2007 2 1

2008 2 1

2009 3.5 1

2010 N/A (tax repealed) 1

2011 and later 1 1

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A special deduction combined with the $1 million exemptionamount now permits qualified family-owned business interests toshelter from gift and estate taxes as much as $1.3 million.

The 2001 Tax Act raises the exemption amount to $3.5 million in2009, as shown in Table 6.1 on page 143.

Starting in 2004, when the estate tax exemption increases to $1.5million, the special deduction for qualified family-owned businessinterests, mentioned previously, will be repealed.

Gift and Estate Tax Rates

After you have exceeded the exemption amount, the estate and gifttax rates outlined in Table 6.2 apply for 2002. Thus, the maximumestate and gift tax rate for 2002 is 50 percent. In future years, themaximum rates are as shown in Table 6.3.

Estate tax rates may be even higher than you think because lifetimetaxable gifts are added to property owned at death for purposes ofcomputing the estate tax rate, although your estate will receive acredit for gift taxes paid on the lifetime taxable gifts.

Table 6.2 Estate and Gift Tax Rates

For Taxable Giftsand Estates Above ($) Rate (%)

1,000,000 41

1,250,000 43

1,500,000 45

2,000,000 49

2,500,000 50

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Currently, the recipient of most property transferred at death re-ceives a basis equal to the fair market value of the property as of thedate of death. This means that income tax is avoided on the increasein the value of the property that occurred during the decedent ’s life,and the recipient can sell the asset immediately and not pay anycapital gains tax.

The rule is different for gifts made during life. Here, the recipientgets your basis, so if he or she sells the gift property after receipt, heor she pays capital gains tax on any appreciation that has occurredsince you acquired it. On the plus side, the gift recipient gets to in-clude your holding period in determining whether a sale by him orher qualifies for favorable long-term capital gains treatment.

Table 6.3 Maximum Estate and Gift Tax Rates

Highest Estate andYear Gift Tax Rates (%)

2002 50

2003 49

2004 48

2005 47

2006 46

2007 45

2008 45

2009 45

2010 35 (gift tax)

0 (estate tax)

2011 and later 55

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With capital gains rates as low as 20 percent—and even lower forchildren and grandchildren who are in the 10 percent or 15 percentincome tax brackets—it still may be worth considering whether life-time giving makes sense in spite of the lack of basis step-up for life-time gifts. Be sure to consider both the income tax and the transfertax consequences.

In 2010, when the estate tax is due to be repealed, the basis step-up (basis is increased to the property’s value at the time of transfer)for assets received from a decedent will be limited. Inheritors ofproperty from decedents dying in 2010 will receive a basis step-upthat will eliminate capital gains tax on a total of no more than $1.3million of gain that occurred during the decedent ’s life. Property in-herited by a surviving spouse will get an additional $3 million ofbasis increase, allowing a total basis increase of up to $4.3 million.

Observation

The dollar limits on basis step-up will not affect smaller estates.However, it will add income tax complications to estate plan-ning considerations for those with larger estates.

Observation

Only property transferred outright to the surviving spouse orheld in a special form of trust known as a qualified terminableinterest property (QTIP) trust qualifies for the additional $3 mil-lion of basis increase for property passing to surviving spouses.Many persons have estate plans in which bequests to survivingspouses are held in other forms of trusts that qualify for themarital deduction for estate tax purposes, but not for purposesof the $3 million basis increase—for example, general power ofappointment trusts or estate trusts. Although these types of

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An estate’s executor will choose which of a decedent ’s assets willreceive the basis increase. Donors and executors will also be re-quired to report information about certain transfers, including basisand holding period information, to the IRS and to donees and estatebeneficiaries.

transfers may be adequate if death occurs before 2010, thesetrusts may not be sufficient if death occurs in 2010 because theopportunity to step up the basis an additional $3 million wouldbe lost.

Observation

In the past, estate plans often provided that retirement assetsor other assets that may not be stepped up be left to the sur-viving spouse rather than children or other heirs. Under thenew law, the reverse may be desirable, since it may be neces-sary to use the maximum amount of step-up for post-2009transfers to a surviving spouse. It is important to consider in-come tax consequences other than the step-up, such as the op-tion to make certain IRA withdrawal elections that areavailable only to the surviving spouse.

Observation

If some beneficiaries receive higher basis property, other bene-ficiaries may be burdened with higher capital gains on the saleof the property they inherit. Planning will be needed to makethe most of available basis step-up and to keep potential forfamily strife over this issue to a minimum.

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Planning for Phase-Down andRepeal of the Estate Tax

What will all of these changes mean for you? They will mean more,rather than less, estate planning.

First, you will have to be sure that during the transition period fromnow through 2009, when exemption amounts are increasing andmaximum tax rates are dropping, your existing will and your overallestate plan still do what you intended. If not, you will have to makeadjustments.

Second, you will need to stay on top of future changes to the es-tate and gift tax rules. Most estate planning experts doubt that thenew rules will be implemented as they are now written. TheHouse of Representatives has passed bills to make the estate taxrepeal permanent, but the Senate hasn’t shown a similar inclina-tion, at least not in the current economic environment with budgetdeficits projected to increase further in coming years. As for com-plete repeal of the estate tax—even for one year—many profes-sionals advise not to count on it. We cannot predict how thepolitical or economic climate will change over the nextdecade—only time will tell.

Planning will be easiest for those with relatively modest estateswhere the increases in the exemption amounts through 2009 could

Observation

For those interested in leaving assets to charity, retirement as-sets remain an excellent choice because retirement assets donot qualify for a step-up in basis either before or after the re-peal of the estate tax.

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eliminate all estate tax liability. Many will not need more than simplewills, without even the usual credit shelter trusts, to avoid estatetaxes during this time. However, if their estates increase in size orthe estate tax returns to its 2001 state after 2010, that won’t betrue. New, more complicated plans will again be necessary.

During the phase-out period, flexibility will be needed. Some es-tate planners have suggested increasing the use of disclaimers (an election to decline the receipt of inherited property) to givesurviving spouses the ability to balance estate tax savings withother financial needs. Wills may benefit from contingency languagethat would cause alternative provisions to kick in if the expectedestate tax changes, repeal, and/or reinstatement do not occur asscheduled.

There are many tax-saving ideas you can use to reduce your estate.They are particularly helpful to high-net-worth individuals. Onequick way to figure out whether you need estate tax planning is tolook at your net worth (what you own less what you owe) and addthe face value of the life insurance you own. If the total exceeds theexemption amount, think about some or all of these planning ideas.

The sooner you act, the better because a gift made now removes fu-ture appreciation from your estate.

Example

Take the case of an individual who used his exemption to make a$600,000 gift in 1987, when that was the maximum exemptionamount. He died in 2002 when the gift ’s value had grown to$2.5 million (assuming it grew at a 10 percent annual rate). Thus,he effectively removed $2.5 million from his estate by actingearly. In addition, the first $400,000 of his estate is sheltered byhis remaining exemption allowance ($1 million allowance for2002 less $600,000 used in 1987). Had he not made the gift, hisestate would have increased by $1.9 million.

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Draft a Will

Many people do not have a will. As a result, their state of residencegenerally will determine who receives their property at death andhow and when the property is received. If you are married withchildren, in most states your surviving spouse will not receive allyour assets. In addition, you will miss the opportunity to generatesome significant estate tax savings for your family.

Even if your estate is less than the estate and gift tax exemption al-lowance, you need a will to name a guardian for your minor children.

Review How Your Property Is Owned

Unless you live in a community property state (Arizona, California,Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wis-consin, and, under certain circumstances, Alaska), in which allproperty acquired during marriage is treated as half-owned byeach spouse, it is important for a married couple to consider howtheir property is owned.

For married couples, joint ownership with right of survivorship canbe the ruin of an otherwise excellent estate plan, because the sur-viving spouse will automatically receive the property at the death ofthe first spouse. You may want it to go to your children or someoneelse. Although no estate tax will be paid because of the unlimitedspousal allowance under the existing law, there might not be enoughproperty to fund other estate planning options, such as the creditshelter or family trust (see page 154).

Observation

Those with large estates should consider maximizing the earlygiving strategy using the $1 million gift tax exemption.

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An asset ownership review can also help determine whether gifts orproperty transfers should occur during life between spouses to makesure that each spouse has sufficient property in his or her namealone to help fund a credit shelter or family trust.

Consider State Death Taxes

The 2001 Tax Act gradually phases out and then completely repealsthe state death tax credit allowable against the federal estate tax.The credit is 75 percent of the prior credit for decedents dying in2002, 50 percent for those dying in 2003, and 25 percent for thosedying in 2004. In 2005, the credit will be repealed and replaced bya deduction for any taxes actually paid to any state on a decedent ’sgross estate.

Observation

This review of your assets will be more crucial than ever as ex-emption amounts increase over the next seven years.

Observation

Almost all states had a state death tax equal to the amount al-lowed as a federal credit. This generated tax revenues for thestates without actually increasing the total amount of estate taxdue by decedents. The state death tax credit is an importantsource of revenue for many states. Some states already have in-creased state death taxes to make up for repeal of the credit.This issue is not yet settled, but ultimately could influence thestate in which you choose to reside during your retirement.

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Give Gifts

Over time, a gift-giving program can remove hundreds of thousandsof dollars from your estate on a tax-free basis. You can give up to$11,000 ($22,000 if your spouse joins in the gift) to each of anynumber of people each year, and you will not have to pay gift tax.These figures will be increased for future inflation. Making these“annual exclusion” gifts removes property from your estate at no giftor estate tax cost, often shifting income-earning property to familymembers in lower income tax brackets. You also remove future ap-preciation in the value of the gift from your estate.

In addition, there is an unlimited exclusion for any tuition you paydirectly to a school or medical care payments you make directly toa health care provider on someone else’s behalf. These tuition andmedical payments are gift tax-free, and they don’t count toward the$11,000 annual gift tax exclusion. Thus, a grandparent can pay tu-ition directly to a school on behalf of a grandchild, pay health insur-ance premiums and the orthodontist for the grandchild’s braces, andstill give the grandchild $11,000 in the same year without using upany lifetime allowance.

Observation

Many formula bequests under existing wills factor in the statedeath tax credit. Estate plans should be examined to make surethat intended results are not changed by this tax law revision.

Observation

Tuition payments for a private elementary school, secondaryschool, or college all qualify for the unlimited gift tax exclusion,as long as a contribution to the school would generate a chari-table contribution deduction. Room and board, books, andsimilar expenses do not qualify for the exclusion.

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It should be noted that payments by parents and grandparents to aqualified tuition program don’t qualify for the unlimited tuition gifttax break. Payments by parents and grandparents to these tax-favored college savings programs do count toward the tax-free annuallimit. However, you can choose to treat a contribution for a benefici-ary that ’s over $11,000 as made equally over five years. Thus, a$55,000 gift to a qualified tuition program for a single beneficiary ina single year can be gift tax-free. For the next four years, though, youcouldn’t give the beneficiary any additional annual exclusion gifts.

Valuation Discounts

Transfers of certain types of assets, typically a minority interest in abusiness enterprise, may permit the use of a valuation discount forgift and estate tax purposes (so that the value for these purposes isbelow market value). The value of the underlying property does notchange, but how the property is owned may generate discounts.

Example

The true fair market value of Asset A is $100. Asset A, for validbusiness reasons, is placed into a vehicle that is friendly to valua-tion discounts, such as a limited partnership. When all the limitedpartnership interests are given to children, the value reported on

Observation

It ’s generally better not to wait until late in the year to makegifts. Instead, it ’s a good idea to get in the habit of makinggifts in January each year. In a good year, an asset that ’s worth$11,000 in January could be worth significantly more by theend of December. By giving early, the postgift appreciationalso escapes gift tax. Even though this strategy might not haveworked well during 2002, its durability has been proven overthe years. There have been vastly more up than down stockmarkets over the years.

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the gift tax return might be only $70, a 30 percent discount fromthe underlying fair market value because of the minority interestand lack of marketability. Limited partnership and limited liabilitycompanies offer many nontax advantages, including retention ofcontrol and some protection from creditors of the donee.

If you own a majority interest in a business, you can make gifts ofnonvoting shares or small amounts of voting shares that would beentitled to a minority discount that would be unavailable if theypassed at your death. Such gifts would not receive a basis step-up atyour death, but future appreciation would be out of your estate. Ifyour lifetime gifts of voting shares brought your voting rights below50 percent, all of your shares would be entitled to a minority dis-count at your death.

Consider Trusts

Credit Shelter or Family Trust

Married couples should have at least this one basic trust if theircombined assets exceed the estate and gift tax exemption allowanceamount ($1 million for 2002 and 2003). Failure to have this trust can

Observation

The IRS has challenged valuation discounts taken when familylimited partnership interests are given away in “deathbed”transfers—those made very close to the time of an individual’sdeath. Also, you must disclose claimed valuation discounts onyour gift tax return.

Caution

If you own a limited partnership, limited liability company, ornonvoting shares while still controlling the entity, you will notget a minority discount on any of the interests you own.

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cost your family hundreds of thousands of dollars in estate taxes thatcould have been avoided.

Spouses with very large estates will still need fully funded creditshelter trusts. However, the increases in estate tax exemptions willrequire those with relatively modest estates to reexamine the im-pact of credit shelter trusts. These provisions ensure that bothspouses’ estates get the full estate tax exemption. Their purpose isto leave trusts for children or other heirs with the maximum thatcan pass to them without estate tax, and to give surviving spousesonly a limited interest in that portion of a decedent ’s estate. Theseprovisions were designed around exemption amounts ranging from$600,000 to $1 million (to which the exempt amount previouslywas scheduled to rise in 2006). As the exemption increases underthe 2001 Tax Act, however, these arrangements will be funded withlarger and larger amounts—and possibly all—of a decedent ’s assets,in some cases leaving nothing outright to the surviving spouse. Ifthe surviving spouse has sufficient assets of other kinds and maxi-mizing estate tax savings is the prime consideration, that may be de-sirable. But in other situations, use of the credit shelter trust couldcause serious financial problems for the surviving spouse.

Life Insurance Trust

If you have a life insurance policy, consider giving the policy to a lifeinsurance trust or having the trust purchase a new policy directlyfrom the life insurance company. If done properly, the policy pro-ceeds can escape estate tax.

Observation

Many wills now automatically increase the credit shelter ’sfunding as the exemption amount rises. You can avoid this byspecifying in your will the maximum amount of your estate thatshould fund a credit shelter trust.

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Grantor Retained Annuity Trust

Sometimes referred to as the “have your cake and eat it, too” trust,this trust is popular because it permits you to give away future ap-preciation on property in the trust while retaining the property’svalue. You even receive an IRS-determined benchmark rate of returnon the value. If the trust assets provide a rate of return over the IRSbenchmark rate of return, the trust ’s beneficiaries will receive theexcess (either in further trust or outright) at little or no gift tax cost.

Typical assets placed in this type of trust include S corporationstock, publicly traded stock, and other assets that are expected togrow quickly. The higher the rate of return, the more assets thatwill go to the trust ’s beneficiaries.

Observation

Life insurance needs for estate liquidity may decrease as theestate tax is phased out and repealed, but the need will not beeliminated because of the loss of full basis step-up and the pos-sibility of reinstatement of the estate tax in 2011. You will haveto take a variety of contingencies into account in drafting andfunding a life insurance trust, particularly the anticipated needby your survivors for quick access to cash.

Observation

Gifts to these trusts are particularly attractive in periods of lowinterest rates such as we are now experiencing because itshould be easier to exceed the IRS benchmark rate of return.(This interest rate varies from month to month based on inter-est rates on U.S. Treasury securities.)

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Qualified Personal Residence Trust

You can transfer a personal residence (either a first or second home)to the beneficiaries of a qualified personal residence trust at a dis-count from the home’s current fair market value. You can live in thehome for the term of the trust and continue to take a mortgage in-terest deduction as well as a real estate tax deduction. When yourinterest in the trust ends, you can rent the home from the trust ben-eficiaries at fair market value rates (an excellent means of further re-ducing your estate).

A qualified personal residence trust is especially desirable if signifi-cant appreciation is expected in the value of the home over time,because the appreciation that occurs after the trust is establishedcan also escape estate and gift taxation (see also page 112).

Dynasty Trust

A dynasty trust allows you to provide for your descendants (usuallyyour grandchildren and more remote descendants) without gift, es-tate, or generation-skipping transfer tax consequences to your de-scendants. Such trusts are typically designed to last for the longestpossible period allowed by law. Typically, the trustee (the individualor entity who manages the trust assets and income) will have thediscretion to pay trust income and principal to your descendants.The trusts are intended to take advantage of some part or the entireamount that you can transfer to your grandchildren or more remote

Observation

Unlike grantor retained annuity trusts, gifts to these trusts areless attractive in periods of low interest rates because thegift tax cost is higher than it would be in periods of higherinterest rates.

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descendants without incurring the generation-skipping transfer tax.This amount is $1 million (as indexed for inflation) through 2003; for2004 through 2009, it will equal the estate tax exemption amountas shown in Table 6.1. A dynasty trust can be established during lifeor in a will.

Charitable Remainder Trust

If you are concerned because you have built up an asset base that isnot producing sufficient cash flow for you, this trust may help. Therate of return is flexible—the cash-flow yield can be improved to5 percent or higher on the value of your asset base. At the end ofthe term of the trust, the remaining trust principal will pass to char-ity. Because these trusts are tax-exempt entities, they generallydon’t pay income tax upon the sale of any low-basis assets used tofund the trust, as you would have to if you sold the assets yourself toreinvest the proceeds at a higher rate.

Intentionally Defective Trust

Transfers into this kind of trust are gifts, but the person making thegift is still liable for the tax on income earned by the trust. The bene-fit? The payment of the income tax provides an indirect advantageto the trust beneficiaries, since what they receive from the trust

Observation

You can use some of the extra cash flow that you receivefrom this asset transfer and establish a life insurance trust foryour family to replace the assets placed in the charitable re-mainder trust, which go to charity at your death. However,life insurance is not a required adjunct to a charitable remain-der trust.

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won’t be diminished by taxes owed by the trust, yet it ’s not consid-ered a further gift to them. The “defective” aspect refers to the factthat the person setting up the trust is liable for income taxes. Nor-mally, that ’s bad. But for high-net-worth individuals, a defectivetrust can save a family a significant amount of estate taxes. Furthertax savings may be obtained by selling property to the trust for apromissory note. If properly structured, the growth in the trust as-sets that exceeds the interest rate on the note may pass to yourheirs free of gift or estate taxes.

Qualified Domestic Trust

A qualified domestic trust (QDOT) is a special trust that qualifies forthe estate tax marital deduction if the surviving spouse is not a U.S.citizen. Generally, the estate tax is deferred until the death of thesurviving spouse, at which time an estate tax must be paid based onthe value of the trust principal remaining. If distributions of trustprincipal are paid out to the surviving spouse before death, estatetax is also generally payable based on the value of that distribution.Under the 2001 Tax Act, the QDOT principal will escape estate tax-ation at death if the surviving spouse dies in 2010 or thereafter.Also, any distributions of principal from a QDOT to a living spousewould remain subject to the estate tax through 2020 but would befree of estate tax in 2021. (Because 2021 occurs after the Decem-ber 31, 2010, sunset date, this latter provision is in effect nullifiedby the Act.)

Observation

It is possible to avoid completely estate tax for a QDOT estab-lished before 2010 where the surviving spouse dies in 2010 orthereafter. QDOTs, therefore, should be considered for use inthe estate plan of any person married to a non–U.S. citizen.

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Stock Option Trust

Consider putting your nonqualified stock options in trust for yourchildren. Although you must pay income tax on the value of the op-tions when they are exercised, you may save your children a big es-tate and gift tax bite. Most option plans must be amended to allowthis type of transfer.

Give a Roth IRA

Fund a Roth IRA each year for family members with at least $3,000of earned income who don’t exceed the income limitation for RothIRA contributions (see Chapter 3) and don’t have sufficient funds (orthe inclination) to make their own contributions.

Pay Gift Taxes Now

Under a peculiar quirk in the Tax Code, it can be less costly to paygift taxes than to pay estate taxes after death. Individuals withlarge estates might consider making large gifts and paying signifi-cant gift taxes prior to death. You must survive at least three yearsafter the payment of a gift tax to realize the savings. Not only willfuture appreciation escape estate tax, but a lower overall transfertax can result. With the prospect of estate tax repeal in 2010,however, the idea of paying any substantial amount of gift tax nowbecomes much less appealing. Very old or unhealthy taxpayerswho may live more than three years are the most likely candidatesfor this strategy.

Observation

Gifts of IRA contributions are an excellent way for parents andgrandparents to help their children and grandchildren accumu-late significant retirement assets. The early start allows the tax-free compounding to build significant asset value.

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Idea Checklist

� Review your will and estate plan to determine what adjust-ments are needed to benefit from the 2001 Tax Act changes tothe estate and gift tax and to avoid potentially costly pitfalls.Especially consider whether you need to change or eliminate anexisting credit shelter trust arrangement.

� Use asset ownership forms that maximize estate tax savings(such as limited liability companies or limited partnerships).

� Review the use of joint ownership.

� Make $11,000 gifts each year.

� Pay tuition expenses directly to an educational institution ormake a payment to a health care provider. Consider a multi-year tuition gift, where appropriate.

� Move life insurance into a life insurance trust.

� Put rapidly appreciating assets into a grantor retained annuitytrust or sell them to an intentionally defective trust.

� Set things up to take advantage of any available valuation dis-counts.

The bottom line is that Congress has opened a window of opportu-nity for taxpayers to optimize their estate and gift planning. It is im-portant to take advantage of these opportunities as soon as possible.

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YEAR-END TAXSAVING STRATEGIES

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165

Chapter 7

QUICK PLANNING GUIDE

Although it is called the 2001 Tax Act, most of its new tax saversdidn’t start to kick in until 2002 and many phase-in over a fewyears. Some of the tax breaks do not begin to take effect at all untilyears in the future. It will be many years before the full tax-cuttingeffect of the law is felt. So it is still a good idea to reduce taxes asmuch as possible for 2002 and 2003 with tried-and-true year-endstrategies. Though this will require a little advance planning, it willbe worth the effort.

What are the best year-end tax-planning strategies? They are thosethat produce the largest overall tax savings, taking both 2002 and2003 into account. There are three basic techniques:

1. Tax reduction.

2. Tax deferral.

3. Income shifting.

Tax Reduction

Tax reduction occurs when you take action that results in paymentof less tax than would otherwise have been due. For example, if youswitch funds from a taxable investment (like shares of stock in a

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166 Year-End Tax Saving Strategies

public company) to a municipal bond that earns tax-free interest,you will reduce your tax bill. Or you may want to consider con-tributing to a Roth IRA that can generate tax-free income instead ofputting the money into a taxable investment vehicle. Another optionis to shift funds from an investment such as a money-market accountor CD, which produces ordinary income, to a stock fund in hopes ofearning some lower-taxed long-term capital gain.

Tax Deferral

Tax deferral is achieved when you earn income now and pay tax onit in the future. Your retirement plan is an example. Although yourretirement investments generate income throughout the years (with2002, for most, being an unfortunate exception), they are generallytaxed only when you receive them.

Deferring the receipt of taxable income can save you money, even ifit produces little or no tax savings, because you can use your moneylonger before paying the IRS. That means greater compounding ofearnings for you. On the other hand, accelerating income, even if youthink you will be in a higher tax bracket in later years, means you willpay the IRS sooner than otherwise might be required. Loss of the useof that money cuts down on the advantage you hoped to attain.

Caution

When doing your tax planning, don’t forget about investmentfundamentals. You want to find a prudent investment balancebetween risk and reward, taking into account your age, yourfamily situation, and other factors. Taxes are important, butthey’re far from your only consideration. Work taxes into youroverall financial plan, but don’t let them be the driving forcebehind your decision-making.

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Quick Planning Guide 167

Another deferral technique is to accelerate deductions from a lateryear to an earlier year so that you get their benefit sooner. But don’t“over accelerate” deduction items to defer taxes. Remember that toget the deduction sooner, you usually have to lay out the dollarssooner, which means you lose the use of those dollars. For example,an individual in the 38.6 percent tax bracket for 2002 and 2003who accelerates a $5,000 deduction into 2002 defers $1,930 oftax. This may make economic sense if the deduction is shifted fromJanuary to December, but it is not beneficial for long periods of timebecause the funds you had to use to generate the deduction wouldlose more investment income in five months than the amount yougain from accelerating the tax deduction at 38.6 percent for oneyear. If you are in the 15 percent bracket, you generally should notaccelerate any deductions that could be paid later than February.Further care should be taken because not all expenses can be accel-erated without limit. Also, moving up certain deductions, such asstate income taxes, could trigger the Alternative Minimum Tax(AMT) (see Chapter 10).

Observation

Sometimes a single move (see “Income Shifting,” that follows)can combine tax reduction and tax deferral. Tax rates abovethe 15 percent bracket will be dropping again in 2004. So ifyou can shift ordinary income from 2003 to 2004, you willnot only defer your tax liability, but you will also owe tax at alower rate (assuming that your financial circumstances areabout the same from year to year). Even without a rate cut in2003, you can achieve a similar result by shifting income from2002 to 2003 if you expect to be in a lower tax bracket in2003 due to a change of circumstances, such as divorce orretirement.

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Income Shifting

Income shifting generally involves transferring income-producingproperty to someone who is taxed at a lower rate. One example isgiving dividend-paying stock to a family member who is taxed at alower rate. For example, you may have stock in a mature companythat isn’t growing much but pays a healthy dividend. If you’re in the35 percent tax bracket for 2002, you will pay $350 in taxes onevery $1,000 worth of dividends you receive. If you give some ofthe stock to a child or grandchild in the 15 percent tax bracket, taxon the dividends will be cut to $150 per $1,000.

Tax-saving techniques are described in Chapters 8, 9, and 10. Beforeturning to these chapters, however, it is important to review how cap-ital gains and the AMT affect your tax liability this year (see below),when year-end tax saving strategies may work very well for you.

Observation

Starting in 2002, when dependents will benefit from the 10percent bracket, the potential tax savings from shifting ordinaryincome such as interest and dividends could be even greater.Tax on dividends can be as little as $100 per $1,000.

Caution

The so-called kiddie tax (which taxes children’s investment in-come at their parents’ rate) keeps this family income-shiftingstrategy from working for children under age 14. All but a smallamount of the unearned income of a child under 14 is taxed athis or her parents’ top rate.

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For more details on accelerating deductions, see Chapter 8. Formore on deferring income, see Chapter 9.

Year-End Capital Gains Checkup

With a few exceptions, 2002 was a terrible year for stock marketinvestors. After a recession-plagued 2001 that was also burdenedwith terrorist attacks and fears, the market was weighed down by avery sluggish 2002 recovery and the concerns about a possible dou-ble-dip recession. Then just as the markets were starting to showsome signs of life, the corporate governance scandals hit and thebottom fell out. With the bear market fully in place, even improvingeconomic news in the third quarter wasn’t enough to sustain anyrallies. Consumers kept spending, but some corporate earnings weredisappointing and some past earnings were restated downward,causing corporations to be cautious about their spending. The tragicevents of September 11, 2001, also continued to overhang oureconomy and financial markets.

Those who took profits on long-term gains near market highs willget the benefit of favorable capital gains tax rates. Investors whosegains are short-term are less fortunate. Those gains are taxed at reg-ular income tax rates.

If you are among the majority of investors with recent losses, youmay be able to get some tax advantages from them. You can offsetcapital gains—even short-term gains—and up to an additional$3,000 of other income with your losses.

For example, suppose you have a $10,000 gain on some stock in acompany that has done well over the years, but which you think isdue for a fall. If you sell some other stock at a $10,000 loss, you willbe able to sell your gain stock and fully offset your tax liability withyour loss. If you recognized a total of $13,000 of losses during theyear, you could offset your $10,000 capital gain and use the extra

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$3,000 loss to offset $3,000 of other income, such as interest, divi-dends, or compensation income. If your excess losses come to morethan $3,000, you have to carry them over to future years, whenthey can offset capital gains and up to $3,000 of ordinary income(for more details about capital gains and losses, see Chapter 2).

You have a great deal of flexibility at year-end to control the timingof investment decisions in order to maximize your tax savings. Asyear-end approaches, review your investment results. Calculate rec-ognized gains and losses and compare them with unrealized gainsor losses you currently hold. (See Chapter 2 for more information onnetting capital gains and losses.) As we said before, in making thesetax decisions, you must also consider your individual financial andpersonal situation and the economic viability of particular invest-ments. Taxes are but one factor to consider.

Year-End Alternative Minimum Tax Diagnosis

The AMT is a separate tax system under which certain types ofitems receive different—usually less favorable—tax treatment thanunder the regular income tax system. For example, state and localincome taxes and real estate taxes are deductible under the regularsystem but are not deductible under the AMT. And the standard de-duction, personal exemptions, some medical expenses, interest onhome-equity loans, and miscellaneous itemized deductions, whichyou can claim for regular tax purposes, don’t reduce your AMT.Also, the bargain element on incentive stock options (ISOs) that youexercise (the difference between the exercise price and the stock’svalue at exercise) isn’t subject to regular income tax in the year ofexercise but is subject to the AMT. You must calculate taxes underboth systems and pay the higher tax bill. (For a more detailed expla-nation of the AMT, see Chapter 11.)

Planning for the AMT can be difficult because many factors can trig-ger it. If you believe that you are within range of the AMT, year-endstrategies may help reduce your tax liability. If you are subject to the

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AMT, you may want to go a counterintuitive route and do the oppo-site of the normal year-end tax planning strategy. For example, indi-viduals subject to the AMT might benefit from accelerating ordinaryincome items into 2002 and deferring until 2003 deductions thatare not allowed for AMT purposes, such as state and local taxes andmiscellaneous itemized deductions.

If your 2002 year includes any of the items in the following list, youmay need tax planning to avoid the AMT:

• Exercise of incentive stock options (as opposed to nonqualifiedstock options) for which the stock is held past December 31, 2002.

• Large prior-year state or local tax balance due, paid in April 2002.

• Large fourth-quarter state or local estimated tax payment made inJanuary 2002, rather than in December 2001.

• Expenses that exceed 2 percent of income for investment man-agement or tax-planning services or unreimbursed employee busi-ness expenses.

• Tax-exempt municipal bond income from “private activity bonds.”

• Business interests owned in S corporation or partnership form, inwhich these entities own significant amounts of depreciable assets.

• Large long-term capital gains.

• Interest on home-equity debt that is deductible for regular incometax purposes.

• Passive activity losses that are allowable for regular tax purposes.

Now that the three basic tax-planning strategies have been re-viewed, we move on to more sophisticated techniques, startingwith accelerating deductions, which is the subject of Chapter 8.

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173

Chapter 8

ACCELERATING DEDUCTIONS

Accelerating deductions into an earlier year gives taxpayers theirbenefits sooner. If tax rates are higher in the earlier year, the deduc-tion also is more valuable because it offsets income that is taxed at ahigher rate. That was the case for deductions that were acceleratedfrom 2002 into 2001, and it also will be true for 2003, because ofthe next 2001 Tax Act rate cut, which is scheduled for 2004. Withno tax rate differential between 2002 and 2003, however, accelerat-ing deductions usually will only generate earlier—not larger—taxsavings. Nonetheless, those who expect to be in a lower tax bracketin 2003 for other reasons may get both tax benefits from accelerat-ing their deductions into 2002.

Your goal is to use deductions to their full potential, keeping in mindthat itemized deductions provide a tax benefit only if their total ismore than the standard deduction amount.

Example

The standard deduction for a married couple filing a joint returnfor 2002 is $7,850. If you accelerate deductions from 2003 into2002 and it turns out that your 2002 itemized deductions totalless than $7,850, your effort won’t have increased the amount of

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deductions you can claim in 2002. In addition, you will have lostthe opportunity to take that accelerated deduction in 2003 whenit might reduce your taxes.

Equally important is something everyone knows but few act on—keep track of your deductions as they occur, not six or sevenmonths later. Nothing is more painful than trying to reconstructcredible expenses that are barely remembered; nothing is easierthan keeping expense records current and ready for a running starton accelerated deductions.

If you determine that it pays to itemize deductions for the currentyear (based on the figures listed next), there are certain steps youcan take to move up deductible expenses. As a general rule, youshould pay deductible bills and expenses received this year, ratherthan waiting until next year to pay them.

If you want to move up deductions into this year, you can mail acheck for a deductible item postmarked as late as December 31and still claim it on this year ’s return, even though the check won’tbe cashed until next year. In the same way, deductible itemscharged on a credit card by year-end can generally be deducted onthe current year ’s return, even if the credit card bill is not paid untilthe following year.

If your itemized deductions come close to the standard deductionamount each year (for 2002 the standard deduction is $7,850 forjoint returns and $4,700 for singles), you can benefit by “bunching”itemized expenses in alternative years so that you can itemizeevery other year. Bunching strategies include planning larger chari-table gifts, making January mortgage payments in December, accel-erating or delaying real estate taxes and state and local income taxpayments, and timing elective surgery and other medical expensesprior to year-end (though keeping in mind that cosmetic surgery isnot deductible).

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Accelerating Deductions 175

State and Local Taxes

State and local income taxes and real estate taxes are deductible inthe year paid.

If you would benefit from accelerating deductions, consider De-cember payments of state and local estimated taxes that are due inJanuary. You also could move up the payment of any balance duein April to the previous year-end, but it may be more beneficial toinvest those funds for the 31⁄2-month period, particularly if yourmarginal tax bracket is below 27 percent.

If you have an unusually large amount of income in 2002, and willhave a large balance due on your state or local return in April 2003,you should consider prepaying the amount in December 2002, sothat you can “match” the state and local tax deduction with the in-come that generated it. This technique can help you avoid or mini-mize the impact of the AMT on your 2003 tax return.

Observation

Deduction bunching works best for those who don’t have re-curring deductible expenses every year in excess of the stan-dard deduction amount. For example, if you pay mortgageinterest and state and local taxes each year that are more thanyour standard deduction amount, bunching won’t help you. Butif you have itemized deductions each year that are close to,but under, the standard deduction amount, bunching couldwork well for you. You might be able to itemize one year andclaim the standard deduction the next, increasing your overalldeductions and reducing your tax bills.

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Interest

You can’t deduct all interest paid on borrowed money. There aresix different kinds of interest for tax purposes—home mortgage(see Chapter 4), business, investment, passive activity, studentloan (see Chapter 5), and personal—and the deductibility of eachtype is treated differently. Generally, the way borrowed funds areused determines their category.

Business Interest

If you “materially participate” in the operation and management of apass-through entity (a partnership, LLC, or S corporation) or an un-incorporated business, you may generally fully deduct interest onbusiness-related borrowings.

Also, the IRS and most courts say that interest on a sole proprietor ’sbusiness-related tax deficiency is nondeductible personal interest.

Caution

If you are subject to the Alternative Minimum Tax (AMT), youmay lose any tax savings that result from the deduction of stateand local taxes because the deduction is not permitted in cal-culating the AMT.

Caution

For purposes of determining whether you can deduct interest,managing your investment portfolio is not considered a busi-ness. Deductibility of investment interest is more limited, asdiscussed next.

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Investment Interest

Interest on money that you borrow to purchase “portfolio” invest-ments (such as stocks, mutual funds, bonds, and the like) that pro-duce dividends, interest, royalties, or annuity income is deductibleonly to the extent that the portfolio produces taxable income. Youmay carry forward indefinitely any excess and deduct it against yourinvestment income in later years. To maximize your deductible in-vestment interest, try to match investment income with investmentinterest expenses. Note that such interest is not deductible to theextent that the borrowing was used to purchase or carry tax-exemptmunicipal bonds.

You can also elect to include long-term capital gains as investmentincome against which investment interest may be deducted. If youmake this election, however, these gains will be taxed at ordinaryincome rates rather than at the lower capital gains rates. The effectof the election is to save tax currently on your excess investment in-terest expense at a 20 percent capital gains rate. This electionmakes sense when you expect that you will have excess investmentinterest expense for the foreseeable future.

Passive Activity Interest

Your share of interest incurred or paid on a passive activity invest-ment is, in most cases, deductible only up to the amount of your in-come from all passive activities that year. A passive activityinvestment is generally:

1. An investment in an operating business in which you do not“materially participate”; or

2. An investment in real estate or another “tax shelter.” However,renting real estate to yourself or your business won’t generatepassive income. Generally, all limited partnership investmentsare considered passive activities.

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You may carry forward any excess passive losses and use them tooffset passive activity income in future years. Also, you can usuallydeduct suspended passive losses in the year you sell your interest inthe particular investment. When there is a sale or other dispositionof a passive activity in a taxable transaction, net passive losses areapplied first against income or gain from other passive activities.Then any remaining losses are reclassified as nonpassive and canoffset nonpassive income such as compensation income or portfolioincome, including interest and dividends.

Example

In the year you sell your ownership interest in a real estate limitedpartnership, you have $10,000 of passive losses left after offset-ting all available passive income for the year, including any gainfrom the sale of the property used in the activity. On your returnfor that year, you may deduct the $10,000 against your nonpas-sive income sources.

If your adjusted gross income (AGI) is under $100,000, a special ex-ception permits you to deduct as much as $25,000 of passive rentalreal estate losses resulting from interest and other deductions if youactively participate in the management of the business. This excep-tion phases out as AGI increases to $150,000.

Example

You own a beach house that you rent out for the season eachyear. You have an agent who handles rentals, but you set therental terms, approve tenants, make decisions involving mainte-nance and repairs, and hire contractors to do the work. Your per-sonal use of the property is a very small percentage of the rentaltime. In this situation, you are an active participant in the rentalreal estate activity.

If your AGI is $100,000 or less, you may deduct up to $25,000 oflosses from the activity each year against your other nonpassive

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income. If your AGI is $125,000, you can deduct up to $12,500 ofrental activity losses. But in any year that your AGI is $150,000or more, you cannot deduct any of the losses against nonpassiveincome.

There are even more liberal rules for investments in low-incomehousing and for individuals and closely held corporations that meetthe definition of a “real estate professional.” (See IRS Publication527, “Residential Rental Property,” for details concerning what ittakes to qualify as a real estate professional.) Tougher rules apply tolosses from interests in publicly traded partnerships; losses fromthese activities can only offset income from the activity until the in-terest is disposed of.

The passive activity rules are extremely complex, and if you thinkyou may be subject to them, you should consult your tax advisor.

Student Loan Interest

There is an above-the-line deduction (these deductions are sub-tracted directly from your gross income to calculate AGI)—avail-able even to individuals who do not itemize deductions—forinterest paid on a qualified education loan. For 2001, you coulddeduct up to $2,500 for interest paid on qualified education loans,but only if the interest was paid during the first 60 months of therepayment period. The maximum deduction phased out for singletaxpayers with an AGI between $40,000 and $55,000, and formarried taxpayers filing jointly with an AGI between $60,000 and$75,000.

For 2002, the maximum deduction stays at $2,500, but the 2001Tax Act repealed the 60-month limit (see Chapter 5 for more de-tails). It also increased the phase-out range to $50,000–$65,000 ofAGI for single taxpayers and $100,000–$130,000 for married cou-ples filing jointly. The start of the phase-out thresholds will increasefor inflation after 2002.

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The elimination of the 60-month limit means that starting in 2002,the deduction is available for interest paid on student loans eachyear, even if the repayment extends for more than five years.

Example

You finished college with $30,000 in student loan debt, whichyou have arranged to repay over 10 years. Although you were adependent of your parents while you were a student, you will nolonger be claimed on their tax return. Before 2002, you wouldhave qualified for the student loan interest deduction only for thefirst five years of interest payments. Now, however, you maydeduct up to $2,500 of interest for each of the 10 repaymentyears, subject to the income limits.

Qualifying loans generally include only debt incurred solely to paythe higher education expenses for yourself, your spouse, or yourchildren or grandchildren at the time the debt was incurred. Loansfrom relatives do not qualify. You must be the person legally re-sponsible to repay the loan in order to deduct the interest. Youcan’t deduct interest that you may pay, for example, on yourchild’s loan. Nor can you deduct interest on a revolving credit linenot earmarked specifically for higher education expenses. You arealso not eligible for the deduction in years when you are claimedas a dependent on someone else’s tax return.

Observation

Many student loans have repayment terms that extend well be-yond five years. So the removal of the 60-month limitationmeans that interest on student loans will be deductible muchmore widely.

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Personal Interest

Interest incurred on car loans, credit cards, or IRS adjustments orany other interest falling outside the other five categories is gener-ally not deductible. If you can obtain a favorable interest rate, youshould consider taking out a home-equity loan to pay off any ofthese debts, because the interest on a home-equity loan of up to$100,000 can be claimed as an itemized deduction, except for thepurposes of the AMT (see Chapter 4).

Medical Expenses

You can deduct unreimbursed medical expenses (including those ofyour spouse and dependents) to the extent that they exceed 7.5 per-cent of your AGI (10 percent for the AMT). Doctors’ and dentists’fees, hospital bills, and prescription drugs are deductible to the ex-tent not covered by insurance. In addition, your payments for healthinsurance and certain long-term care insurance and long-term careexpenses are included as medical expenses.

If medical expenses seem likely to be close to or exceed the 7.5percent floor this year, consider accelerating elective treatment orsurgery (keeping in mind that cosmetic surgery is generally not de-ductible as a medical expense) and paying for it before year-end. Ifthe floor will not be reached this year but might be reached nextyear, consider the opposite strategy: delaying payment of medicalbills whenever possible.

Other opportunities if you are self-employed include thefollowing:

Observation

Although cosmetic surgery isn’t generally deductible, the costof radial keratotomy to correct vision without requiring pre-scription lenses is an allowable medical expense.

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• For 2002, self-employed individuals may deduct 70 percent of theannual cost of health insurance for themselves, their spouses, andtheir dependents. The deduction percentage is slated to increaseto 100 percent in 2003.

• This deduction is not allowed for months during which you are el-igible to participate in an employer-provided health insuranceplan (including a spouse’s plan). Note that this allowance is an“adjustment to income” rather than an itemized deduction.Therefore, it can be taken even by nonitemizers and is not re-duced for itemizers at higher income levels.

• A self-employed person also may deduct a percentage of the costof long-term care insurance premiums, as long as the individual isnot eligible for any employer-provided long-term care insurance(including under a spouse’s plan).

Charitable Contributions

Charitable contributions are one of the most flexible deductible ex-penses, because you can usually control their timing and amount.For example, you could accelerate deductible expenses by making acontribution in December rather than January. A contribution isconsidered made at the time of delivery (mailing a check constitutesdelivery, assuming that it clears in due course). You cannot take adeduction based only on a pledge—you must actually make thecontribution.

In general, you can deduct contributions to qualified charities of upto 50 percent of your AGI. These deductions are also allowed forAMT purposes. Any excess can be carried forward for five years.

Observation

If you plan to make charitable donations for the next few years,you should consider making them sooner while you are still in ahigher tax bracket (the 2001 Tax Act lowers tax rates in coming

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Property Donations

Special rules apply to donations of property to charities. If you do-nate appreciated property, such as securities or land, your deduc-tion is based on the property’s current market value rather than onits original cost. Contributions of appreciated capital gains property,however, are limited to 30 percent of AGI unless a special electionis made to reduce the deductible amount of the contribution.

Instead of selling property that has been held for longer than oneyear and has appreciated in value and then donating the proceeds,consider donating the property itself. If you sold the property anddonated the proceeds, you would pay capital gains tax on any ap-preciation, while receiving a deduction for only the amount of cashthat ’s left to contribute to the charity. If you donate appreciatedproperty directly to a charity, you escape the capital gains tax andreceive a deduction for the property’s full fair market value.

years). You can establish a donor-advised philanthropic fund as ameans to get a current deduction and earn a tax-free return untilyou wish to donate the funds to particular charities. Donor-advised philanthropic funds can be established through commu-nity foundations as well as certain mutual fund companies andother financial and charitable organizations. The minimum con-tribution to establish the fund can be as low as $10,000.

Observation

Unreimbursed expenses you incur as a volunteer, includingmileage driven in your car, are deductible. The mileage ratefor purposes of the charitable deduction is 14 cents per milefor 2002.

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If property that you are considering donating to charity has de-creased in value, you should sell it and donate the proceeds. In ad-dition to the charitable deduction, the sale will generate a capitalloss that can be used to offset other capital gains and up to $3,000of other income.

For contributions of appreciated property to a private foundation,the restriction that used to limit the charitable deduction for gifts ofpublicly traded stock to your basis in the stock no longer applies. Afull fair market value deduction for contributions of “qualified appre-ciated stock” is permitted. Such stock must be a long-term capitalasset traded on an established securities market. No more than 10percent of the value of all of a company’s outstanding stock may becontributed.

Any charitable contribution of property other than marketable secu-rities that is worth more than $5,000 ($10,000 for gifts of closelyheld stock) must be supported by a qualified appraisal completed bythe extended due date of your tax return. The appraiser and a repre-sentative of the charitable organization must sign Form 8283 or thededuction will be denied. Additional requirements apply to contri-butions of art if a deduction of $20,000 or more is claimed.

Substantiation Requirements

The general substantiation requirements for a deductible charitablecontribution are:

Observation

The deduction for contributions of long-term capital gainsproperty to a private foundation is generally limited to 20 per-cent of AGI for any year. Any excess can be carried forwardand deducted for five years, subject to the 20 percent limit.

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• Cash contributions under $250. A canceled check is acceptableas long as no goods or services are received in exchange.

• Cash contributions of $250 or more. These contributions mustbe acknowledged in writing by the charity. You must obtain thisdocumentation from the charity by the date your tax return isfiled or the due date of the return (including any extensions),whichever is earlier. The acknowledgment must state whether thecharity provided any goods or services in return for the contribu-tion and, if so, provide the information required for quid pro quocontributions (see the following discussion).

Observation

This rule applies only if $250 or more is given at one time. Forexample, if over the course of a year, you make several contri-butions of $200 to the same charity, the substantiation require-ment does not apply.

Caution

The IRS has instructed its examiners to look closely at dona-tions of used autos. Donate only to reputable charities and donot be aggressive in valuing your donated auto. Be sure to keepevidence of its condition, such as photos and maintenancerecords and receipts.

• Noncash contributions under $250. The donor should retain adetailed list of the items contributed, including the estimatedvalue of the goods.

• Noncash contributions of $250 or more. The donor must obtaina receipt that describes the donated property (and indicates anygoods or services received in exchange). The charity is not re-quired to place a value on the property. For noncash contribu-tions over $500, additional information must be included withthe donor’s tax return.

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• “Quid pro quo” contributions over $75. A quid pro quo contri-bution is one that is partly a charitable contribution and partly apayment for goods or services. The charity must provide thedonor with a written statement that includes a good-faith esti-mate of the value of the goods or services provided and must in-form the donor that the contribution deduction is limited to thepayment in excess of the value of the goods or services. Contri-butions are fully deductible if goods or services received from thecharity are only of nominal value or if only an intangible religiousbenefit is received.

Deferred Giving

The most common form of charitable contribution is the “currentgift,” for which you transfer control of money or property to a char-ity and you keep no control over it.

In recent years, however, “deferred giving” has become increas-ingly popular. This involves an irrevocable transfer to a charitywhose ultimate use of the property is deferred to some time in thefuture. For many, deferred gifts provide the best of all worlds: acurrent charitable deduction, a retained income stream (or a futureinterest in the property for your beneficiaries), a charitable contri-bution to a favorite organization, and a reduction in the donor’staxable estate.

If you make substantial charitable contributions each year, considerestablishing a charitable lead trust or charitable remainder trust toaccomplish some of these desirable results.

In a charitable lead trust, you donate property to a trust that guaran-tees to pay the charity a fixed amount or a fixed percentage of thefair market value of the trust ’s assets for a certain number of years.At the end of the term, remaining trust assets revert to you or to adesignated beneficiary, such as a child or grandchild.

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In a charitable remainder trust, you transfer property to a trust, andthe trust guarantees to pay you or a designated noncharitable ben-eficiary a fixed amount or a fixed percentage of the fair marketvalue of the trust ’s assets (figured annually) for life or a term ofyears. At the end of the term, the remaining assets are transferredto a charity.

Casualty Losses

If you have experienced a natural disaster or another casualty andsuffer property damage, a casualty loss deduction is available tohelp lessen the blow of any unreimbursed losses (casualty lossesare deductible to the extent that they exceed $100 beyond

Observation

The rules for establishing these charitable-giving vehicles arecomplex. If you are planning to make a large gift, contact yourtax advisor to discuss how they work.

Caution

Deductions are not allowed for transfers to charitable organiza-tions involving the use of split-dollar life insurance arrange-ments if the charity pays any premium for the donor. Employersoften use split-dollar life insurance arrangements to provide asubstantial amount of insurance coverage for key executives oremployees. Split-dollar life insurance is permanent insurancepurchased under an arrangement in which the company andthe individual share the cost of the policy as well as its benefitsand proceeds.

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insurance reimbursement). In general, the amount of the loss is thelesser of the decrease in fair market value of the property or youradjusted basis (generally, your cost less depreciation deductions) inthe property. Insurance reimbursements reduce the amount of theloss. In addition, the first $100 of each loss is nondeductible.However, if several items are damaged or lost in the course of asingle casualty, the $100 floor is applied only once. Finally, onlytotal allowable losses in excess of 10 percent of the AGI may bededucted.

Example

Your home was severely damaged by a lightning strike, and yourloss, after insurance reimbursement, is $20,000. The first $100 ofthe loss is not deductible. If your AGI is $70,000, $7,000 of theremaining $19,900 loss also is nondeductible. Thus, your casualtyloss deduction would be $12,900 ($19,900 minus $7,000).

If your loss occurs due to a presidentially declared disaster, such asan earthquake or hurricane, you can claim the loss either on yourtax return for the year in which it occurred or on the prior year ’sreturn.

Miscellaneous Itemized Deductions

Certain miscellaneous expenses, mostly those related to employ-ment, including job search expenses and investments (other than

Observation

Claiming the loss on the earlier year ’s return (by filing anamended return, if necessary) may get you a refund faster, butyou should do the calculations both ways to see which choiceresults in the largest tax savings.

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investment-related casualty and theft losses) are deductible only tothe extent that they total more than 2 percent of your AGI. For ex-ample, if your AGI is $80,000, only miscellaneous itemized deduc-tions totaling more than $1,600 are deductible.

Therefore, it may be desirable to “bunch” these kinds of expenses tobring the total above the 2 percent floor at least every other year.

You can generally deduct (subject to the 2 percent floor) unreim-bursed payments made in a given year for:

• The cost of unreimbursed job-related education or training.

• Unreimbursed business use of automobiles.

• Subscriptions to business or professional publications (includingpayment for next year ’s subscription).

• Membership dues in business or professional associations (includ-ing the following year ’s dues).

• Tax preparation and planning fees.

• Investment expenses, such as investment advisory fees or a safe-deposit box.

If you receive tax preparation or investment advice or certain otherfinancial services under a fixed-fee arrangement, you may be able totake deductions this year for payments covering a period that ex-tends into next year. If you are delaying your deductions, you willwant to make these payments after the end of 2002.

If you buy and sell securities, you should familiarize yourself with thedefinitions of “investor” and “trader.” The vast majority of individuals

Observation

Miscellaneous itemized deductions are not deductible in theAMT computation. Therefore, the AMT is a consideration whenplanning any acceleration of these deductions.

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who buy and sell for their accounts are investors. Investors deducttheir investment expenses as a miscellaneous itemized deduction,subject to the 2 percent floor and the itemized deduction phase-outat higher incomes. Traders, however, may deduct their expensesagainst their trading income. It ’s difficult to convince the IRS or thecourts that you are a trader unless you do a very large volume ofshort-term trades.

Moving Expenses

If you relocate because of a new job or business, you may be able todeduct certain moving expenses, including the costs of transportinghousehold goods and traveling to your new residence. For these ex-penses to be deductible, your new job must be at least 50 miles far-ther from your former residence than your old job was from yourformer residence.

Not deductible are pre-move house-hunting expenses, temporaryliving expenses, the cost of meals while traveling or while in tempo-rary quarters, and the costs of selling or settling a lease on the oldresidence or purchasing or acquiring a lease on a new residence.Employer reimbursements of deductible moving expenses are gener-ally excluded from the employee’s gross income, and deductible ex-penses not reimbursed by the employer are an “above-the-linededuction” instead of an itemized deduction.

Observation

Employers often reimburse all of their employees’ movingcosts, including any tax liability for moving-expense reimburse-ments, when an employee is moved for the employer ’s conven-ience. Some of these reimbursements must be reported astaxable wages.

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Above-the-line deductions are subtracted directly from your grossincome to calculate AGI. They may be claimed both by itemizersand by those who take the standard deduction.

Depending on your situation, the following idea checklist may pro-vide some help in reducing your tax bill.

Idea Checklist

� If your employer offers flexible spending accounts for medicalor dependent care expenses, use them. These accounts allowyou to pay these types of expenses with pretax dollars, offeringa real savings.

� If you have self-employment income and want to deduct contri-butions to a Keogh retirement plan, you must establish the planby December 31, even though you can wait until the due dateof your return (including extensions) to fund it. Alternatively,you may make deductible contributions to a simplified em-ployee pension (SEP) plan, which can be both established andfunded after December 31 (see Chapter 3).

� Evaluate your form of business entity. Net income from a soleproprietor business, a partnership, or an LLC may be subject toself-employment tax; however, not all income passed throughfrom an S corporation is subject to the tax. If you work part-time for a business in addition to your full-time job, be sure youdon’t fall under the “hobby loss” rules; otherwise you may notbe able to take losses.

� Personal property taxes such as those required for automobilelicense plates or tags are deductible if they are ad valorem (thatis, based on the value of the property).

� If you have children in college, consider purchasing residentialproperty near the school and renting it to your son or daughter.By doing this, you build equity in the property and can take thetax deductions associated with a rental property as long as you

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charge fair market value rent (subject to the passive activityrules explained in Chapter 2).

� Business owners need to remember that they can deduct onlycompensation that is deemed reasonable for services they andtheir family members provide.

This chapter described many tools and techniques that can help youuse deductions at the end of 2002 and future years to lower yourtax bills.

Chapter 9 sets forth a tax planning strategy called income deferralthat can be an important part of your overall tax planning program.

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193

Chapter 9

DEFERRING INCOME

Deferring income from one year to the next can be a very effectivetax planning strategy, especially for those in high tax brackets be-cause they will save the most. For tax purposes, many two-incomefamilies qualify as high-income individuals. Almost all individuals re-port their income and deductions using the cash method of account-ing (in which income is reported in the year it is actually orconstructively received and expenses are deducted in the year theyare paid), which gives quite a bit of flexibility in using tax-deferralstrategies.

The key to saving from income deferral is that income is not taxeduntil it is actually or constructively received. For example, if a tax-payer does work for others, he or she will not be taxed until the yearin which payment is received. So, deferring billing at year-end will re-sult in more income being received and taxed in the following year.

Observation

The 2001 Tax Act makes income deferral even more valuablein some years because income tax rates are scheduled to dropin 2004 and 2006. Deferring income to a lower-tax year notonly delays payment of tax, but lowers the overall tax bill.

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Some examples of situations in which income deferral may be usefulfollow.

Year-End Bonuses

If you expect to receive a year-end bonus or other special type oflump-sum compensation payment, you may want to receive it andpay taxes on it in 2003 rather than in 2002. Your employer canprobably still deduct the bonus this year if the company is on theaccrual method of accounting (which most larger companies are), aslong as its obligation to pay you is established before year-end andpayment occurs within 21⁄2 months after year-end (March 15, 2003,for a calendar-year company).

Example

The company where you work uses the accrual accountingmethod, is on a calendar year, and has an incentive bonus programfor which you qualify. In December 2002, the company’s directorsdeclare the bonus and set the amount of the payments, which willbe paid on January 30, 2003. The result is that the company “ac-crues” its deduction in 2002 when it becomes liable for paymentof the bonuses, but your tax liability is delayed until 2003.

Caution

This strategy of delaying payment of bonuses to the next yeardoes not work for most payments to company owners: Thecompany’s deduction for payments to partners, S corporationshareholders, owner-employees of personal-service corpora-tions, or shareholders who own more than 50 percent of a reg-ular corporation is deferred until the year the bonus is actuallypaid to the owner—so the company is unable to accrue its de-duction for the year in which the bonus was declared if it isnot paid until the following year.

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Deferring Income 195

Deferred Compensation

You may want to consider an agreement with your employer so thatpart of your earnings for this year are paid to you in the future, per-haps over several years. This will delay your tax obligation and re-duce the tax rate on the income because future tax rates will dropover the next few years. If you can wait until you are retired to re-ceive the deferred compensation, you may be in a lower taxbracket, further reducing your tax bill on that income. In this type ofarrangement, interest is often added by the company to compensateyou for the delay in receiving the money.

The postponed compensation will not be taxed to you or be de-ductible by your employer until you actually receive it. But SocialSecurity tax and Medicare tax are generally due when the income isearned. If you are already over the FICA wage base for the year($84,900 for 2002), you won’t owe any additional Social Securitytax, but you and your employer will each owe the 1.45 percentMedicare tax on the deferred amount. No additional Social Securitytax or Medicare tax will be owed in the future when you receive thedeferred compensation.

Unlike a qualified retirement plan, which generally must cover abroad range of employees, this nonqualified type of deferred com-pensation arrangement can usually be made for an individual em-ployee. If you are interested in a deferred compensation plan, youshould discuss it with your employer without delay, because such aplan can only cover income you earn in the future, not that whichyou have already earned.

Caution

When you defer compensation, you are treated as a generalcreditor of your employer. If your employer goes into bankruptcy,you could lose your deferred compensation.

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Stock Options or Stock Appreciation Rights

If you have nonqualified stock options or stock appreciation rights,in most cases, you will have taxable compensation income whenyou exercise them. Delay exercising them until next year if postpon-ing income would be to your advantage.

If you have incentive stock options, exercising them does not resultin compensation income if the ISO stock is held for required periodsof time (at least two years after option grant and one year after exer-cise). If you meet these requirements, you won’t owe any tax untilyou sell the option stock, and then your gain is taxed at favorablecapital gains rates. But the spread between the option price and thefair market value at the time you exercise the option is added to yourincome for AMT purposes. (See Chapter 11 for a discussion of ISOs.)

Treasury Bills and Bank Certificates

If you invest in short-term securities, you can shift interest incomeinto the next year by buying Treasury bills or certain bank certifi-cates with a term of one year or less that will mature next year. Ifyou buy a bank certificate, you must specify that interest be cred-ited only at maturity.

Dividends

If you have a voice in the management of a company in which youown stock, you may want to take steps to see that dividends are

Caution

If you are a “corporate insider” as defined under Securities andExchange Commission rules, you should contact your financialand/or legal advisor, because you are subject to special limita-tions on the sale of your option stock. (See Chapter 2 for moredetails on stock options.)

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paid in January 2003 rather than in late 2002. This will shift yourtax liability on the dividends to 2003, since you won’t receive thedividend income until the later year.

Installment Sales

You generally owe tax on profits from the sale of property in theyear in which you receive the sale proceeds. To defer income from asale of property, consider an installment sale, in which part or all ofthe proceeds are payable in the following year or later. In that case,tax will be owed as you receive the payments. Part of each paymentyou receive will be a tax-free return of your cost or basis, part willbe interest taxed at regular income tax rates, and part will be capitalgain. Make sure that future payments are secured and that interest ispaid on any unpaid balance.

You need not decide to report 2002 deferred payment sales on theinstallment method until you file your 2002 tax return (in 2003).This gives you more time to decide whether to be taxed on profitsin 2002 or in 2003 and later years. If you choose not to report onthe installment method, you must elect out of it. Also, if you doelect out, you could be liable for tax on income that you will not re-ceive until later years.

Caution

If the property being sold has been depreciated, usually someof the gain will be taxed, or “recaptured,” at regular incometax rates. This recapture gain is subject to tax in the year ofsale, even if you elect installment reporting. That is true even ifyou don’t receive any payment in the sale year. So be sure toget enough upfront cash to at least cover your tax liability onrecaptured income.

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U.S. Savings Bonds

Many people are aware that the interest earned on series EE U.S.savings bonds is tax-deferred for up to 30 years. However, most peo-ple are not familiar with their newer “cousins”—series I U.S. savingsbonds. Series I bonds provide the same tax-deferral opportunities asseries EE bonds. The major difference between these two bonds isthe way the interest is calculated. Series I bonds pay an interest ratethat is indexed for inflation.

Annuities

You can defer current investment income you now earn, such asstock dividends, bond interest, and interest on savings and money-market accounts, by transferring the funds into deferred annuities,which shelter current earnings from tax. You won’t owe tax on a de-ferred annuity until payouts begin. However, to get this benefit, yougenerally have to tie up your funds until you are at least 591⁄2. Similarto IRAs, deferred annuities will incur a penalty tax on prematurewithdrawals, subject to certain exceptions.

Caution

Special rules limit the use of the installment method. For exam-ple, inventory items and publicly traded stock do not qualify forinstallment-sale reporting. Also, installment notes in excess of$5 million may be subject to an interest charge by the IRS.

Observation

The series I bonds are one of a very limited number of invest-ments whose return is guaranteed to keep pace with inflation.Both EE and I bonds can be bought at your bank in various de-nominations. Purchases of these bonds are limited to $30,000per person, per year.

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Individual Retirement Accounts

If you earn compensation or self-employment income, you can es-tablish a Roth IRA or a regular IRA, assuming you meet income re-quirements. (See Chapter 3 for more information about IRAs.)Although your income level may disqualify you from getting themaximum benefits from these savings vehicles, you may still findsome limited advantages. For example, even though you may not beable to deduct contributions to a regular IRA or qualify for the po-tential tax exemption of a Roth IRA, you may make nondeductiblecontributions to a traditional IRA no matter how high your incomeis and benefit from tax-deferred earnings until you withdraw yourmoney, usually at retirement.

401(k) Plans

401(k) plans are qualified retirement plans established by an em-ployer under which employees can defer up to $11,000 of their com-pensation income in 2002 or $12,000 in 2003 (these limits arehigher for those age 50 or older). As with an IRA, the earnings arenot taxed until they are withdrawn. Contributions to these plans aremade on a pretax basis, meaning that you aren’t currently hit withincome tax on the amount you contribute. That makes it easier foryou to put more money into your account. (Social Security taxes,however, are owed on amounts you elect to defer to your 401(k) ac-count.) Also, many employers match a portion of employee deferrals.Many 401(k) plans allow you to borrow from your accounts beforeretirement, if the loan is repaid on a regular schedule. (See Chapter 3for further discussion of 401(k) plans.)

Shifting Income to Family Members

Shifting income to children or other family members in lower taxbrackets is an excellent long-term planning strategy for higher-income individuals. As a general rule, family income shifting should

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be done early in the year to get the most tax savings. It is never tooearly to begin planning for 2003 and later years.

Children age 14 or older are taxed at single individual tax rates (10percent on the first $6,000 of taxable income and 15 percent onhigher amounts up to $27,950 in 2002). You can also shift capitalgains income from your 20 percent capital gains tax rate into achild’s lower 10 percent rate, or even an 8 percent rate for a five-year gain (see Chapter 2).

The issue of who actually controls the funds—you, or your child orgrandchild—can determine the success of strategies that seek to usea child’s lower tax rate. If you keep too much control over the trans-ferred asset, the IRS may say you really haven’t transferred it for taxpurposes, and will tax you on its income or sale.

The easiest way to effectively shift income is to use a custodial ac-count, either a Uniform Gift to Minors Act (UGMA) or a UniformTransfers to Minors Act (UTMA) account. Keep in mind that statelaws typically give the child access to UGMA/UTMA funds at age18 or 21.

If you want to limit your child’s access to the transferred assets be-yond what an UGMA/UTMA account permits, consider a trust. Butbe wary of trust tax brackets. For 2002, the 15 percent bracketstops at $1,850 of taxable income, and the top bracket starts at$9,200. Also, trusts don’t qualify for the 10 percent tax rate that ap-plies for individuals.

Observation

A few states, such as Alaska, California, and Nevada, allow theseaccounts to continue to age 25 under certain circumstances, asopposed to the cut-offs at 18 or 21 in most other states.

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If you are planning to shift income to children under age 14, keep inmind that a kiddie tax is imposed on their unearned income (such asinterest, dividends, and capital gains) over $1,500 in 2002. This in-come is taxable to the child at the highest tax rate of his or her par-ents. However, there are techniques that you can use to shift incometo your children and avoid the kiddie tax.

You are permitted to shift enough assets to a child under the age of14 to produce up to $1,500 of total 2002 unearned income. The first$750 of that unearned income will be offset by the child’s standarddeduction, and the next $750 is taxed at the child’s 10 percent rate.

Example

A six-year-old child has $1,900 of interest income in 2002 and noearned income. His or her 2002 standard deduction of $750 is al-located against his or her unearned income, and the remaining netunearned income is $1,150. The first $750 of the remaining$1,150 is taxed at the child’s tax rate. The remaining $400 is taxedat the parents’ top tax rate.

Unearned income $1,900

Less: Child’s standard deduction (750)

Remaining unearned income 1,150

Less: Amount taxed at child’s rate (750)

Remaining taxed at parents’ top tax rate $ 400

Observation

A transfer of assets that produces $1,500 of income to a childunder the age of 14 can save a family in the 38.6 percent taxbracket $504. When interest rates and investment rates of re-turn are low, transfers of substantial assets can be made with-out going over the $1,500 unearned income limit. Note thatasset transfers should be coordinated with the gift tax rules.(See Chapter 6 for a discussion of this strategy.)

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Another technique is to transfer assets that generate little or no cur-rent taxable income. For example, consider giving a child under theage of 14:

• Growth Stocks or Growth-Stock Mutual Fund Shares.

• U.S. series EE and series I savings bonds (the interest on whichmay be tax deferred).

• Tax deferral products, such as annuities and variable life insur-ance contracts.

• Closely held stock of a C corporation.

These assets can be converted into investments that produce cur-rently taxable income after the child is age 14, because income andany capital gains recognized on the conversion will be taxable at thechild’s tax rate, usually 15 percent for ordinary income (and only 10percent on the first $6,000 of taxable income) and 10 percent forlong-term capital gains—8 percent for five-year gains.

Chapter 10 goes beyond the personal strategies discussed in the pre-vious chapters and provides many additional considerations that cangenerate tax savings for business owners and for their companies.

Caution

Savings bonds held in your name may qualify for tax-free treat-ment when used to pay for your child’s college education. Ifyou transfer these bonds to your children, this exclusion will belost. Because of income limitations on this tax-free treatment ofsavings bonds, however, it is not available to high-income ormany middle-income individuals. Even if loss of the educationtax break isn’t a factor for you, it is still a good idea to pur-chase new savings bonds for children rather than transferringyour own bonds to them. That ’s because you would be taxedon the bond’s accrued interest as of the transfer date. So un-less the bonds are very new and the accrued interest amount issmall, it is better to start with new bonds in the child’s name.

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203

Chapter 10

YEAR-END PLANNINGFOR BUSINESS OWNERS

Year-end planning for business owners incorporates all of the per-sonal strategies previously discussed, but doesn’t end there. Thereare many additional considerations that can generate tax savings forbusiness owners and for their companies.

Business tax savings of sole proprietorships put more money directlyin hands of the business owner. Where the business is operated as apassthrough entity—an S corporation, partnership, LLC or LLP—year-end business tax planning must be done at both the entity andthe individual levels to gain maximum advantages. That is becausethese entities don’t generally pay income taxes on their earnings.Rather, their income, deductions, and credits are passed through totheir owners and reported on their own returns. Individual ownersof these types of entities, therefore, need to consider the individualyear-end tax strategies already outlined in Chapters 7, 8, and 9, andalso consider strategies that their companies might use that willwork to the owners’ individual tax advantage and yet can be recon-ciled with the company’s business goals. It ’s not an easy task, but itis potentially quite rewarding: For each $1,000 of income that a

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passthrough business can defer or each $1,000 of deductions it canaccelerate, the owner in the top federal income tax bracket will save$386 of current federal income tax. $100,000 of combined com-pany year-end income/deduction shifting saves $38,600. $1 mil-lion—$386,000. And sometimes there are payroll tax, and state andlocal income tax savings as well.

The individual income tax situations of owners of businesses that areoperated as C corporations aren’t as directly affected by the com-pany’s year-end tax strategies as are owners of passthrough busi-nesses. But in those cases, taxes saved by the C corporation’ssuccessful tax strategies result in more capital available for theeveryday use of the business, for expansion, or for dividend pay-ments. So business owners should seriously consider some of the fol-lowing strategies for themselves and their companies.

Year-End Edge for New Depreciation Allowance

Traditionally, one of the most important of year-end decisions re-lated to capital expenditures. In 2002, there is an extra tax incen-tive to put business property in service—an accelerated deductionfor an extra 30 percent of its cost. The new deduction was enactedas part of the Job Creation and Worker Assistance Act of 2002,signed into law in March 2002. It is meant to provide an incentivefor businesses to start spending to help stimulate the economy. Un-like regular depreciation deductions on business property placed inservice in the last quarter of the year, which are reduced drasticallyif more than 40 percent of nonrealty business assets are placed inservice in that quarter, this “bonus” or “special” depreciation al-lowance is available no matter how much property is placed in ser-vice near year-end.

For income tax purposes, business property other than real estate istreated as having been placed in service at the middle of the year,regardless of the actual date it was purchased and placed in service.

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Year-End Planning for Business Owners 205

That ’s known as the half-year convention. For five-year businessproperty, it results in a 20-percent first-year depreciation allowance.If too large a portion of nonrealty business assets is placed in ser-vice in the fourth quarter, however, each asset is treated as havingbeen placed in service in the middle of the quarter in which it wasplaced in service. This is called the mid-quarter convention. For five-year property, it could result in a depreciation deduction of only 5percent. But what the IRS calls the special depreciation allowanceisn’t affected by the timing of the asset ’s placed-in-service date.The 30-percent deduction is available no matter when during theyear qualifying business property is placed in service.

The special deduction is available for most nonrealty business prop-erty with a 20-year or shorter useful life that qualifies for acceler-ated depreciation; computer software; and certain commercialleasehold improvements. To qualify, the property must be acquiredafter September 10, 2001, and before September 11, 2004, andgenerally must be placed in service before 2005. Purchases of usedproperty are not eligible for the special depreciation allowance.

As shown next, the special depreciation allowance produces a largeup-front tax benefit.

Illustration

If you put $100,000 of business equipment into service during2002, the usual depreciation deduction is $20,000 (20 percentof $100,000). With the new special depreciation allowance,however, the first-year deduction increases to $44,000. That is30 percent of $100,000, plus the usual 20 percent of the re-maining $70,000 of the cost.

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If a business qualifies to expense the cost of up to $24,000 of cer-tain property in the year it is placed in service, the expensing de-duction is taken first; then the special depreciation deduction isapplied; finally the regular depreciation allowance is taken againstthe remaining basis.

While tax considerations aren’t paramount in a business’ equipment-buying decisions, they are a factor, and are more important this yearbecause of the extra available deduction. Something else to keep inmind is that there is no AMT adjustment caused by the special de-preciation allowance. So the tax break won’t be lost if the companyis subject to alternative minimum tax.

Bigger Tax Advantages forBusiness Automobiles

Deductions for business automobiles are usually quite limited: Thefirst-year deduction generally can’t exceed about $3,000. But toallow the special depreciation allowance to apply for business autopurchases, this limit temporarily has been increased to $7,660. Toget this break, an automobile must be used more than 50 percent ofthe time for business. It is anticipated that this will translate intosimilar increased tax breaks for leased business autos. As with otherequipment, the added tax break isn’t going to cause a business to

Illustration

For property that ’s subject to the stricter mid-quarter rulewhere relatively too much property is placed in service in thefinal quarter of the year, the usual deduction would be only$5,000 for fourth-quarter purchases. With the special depre-ciation allowance, however, the deduction would be $33,500(30 percent of $100,000, plus 5 percent of the remaining$70,000 of the cost).

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run out and purchase vehicles that it doesn’t need. But if a businessis considering such a purchase, the extra tax break would weigh inits favor.

Retirement Plans

If this is the year that a business has decided to start a qualified re-tirement plan, the plan must be formally established by year-end forcontributions to be deductible this year. Contributions (up to thelimits spelled out in Chapter 3) will be deductible this year if madeby the extended tax return due date.

Businesses that miss the year-end deadline can still establish andmake deductible contributions to a Simplified Retirement Plan (SEP)by their extended tax return due date. However, SEPs have strictercoverage requirements than regular qualified plans and generallyaren’t as flexible or customizable. And unlike qualified corporate re-tirement plans and Keogh plans, SEPs can’t be set up as definedbenefit pension plans, so they are less suitable for quickly funding alarge benefit for an older owner/employee.

Bonuses and Deferred Compensation

A corporation using accrual, rather than cash, accounting can take acurrent deduction for bonuses it declares this year that are paidwithin the first 21⁄2 months of the following year. The company getsan accelerated deduction and the employee-recipient gets to deferthe income. Note, however, that this ideal tax strategy doesn’t work

Caution

Those who plan to set up retirement plans should immediatelyconsult a retirement planning specialist. It takes a while to takecare of all of the required formalities.

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for bonuses paid to majority shareholders, or to owners with any in-terest in an S corporation or a personal service corporation.

Compensation that is deferred for more than 21⁄2 months into thenext year is subject to different rules. In that case, the corporation’sdeduction is delayed until the compensation is paid to the em-ployee. Year-end also is a good time to consider whether to estab-lish a deferred compensation plan for key employees.

Income Deferral or Acceleration

Generally a C corporation, like an individual, will want to defer in-come and accelerate deductions, where possible, to cut currenttaxes and defer tax liabilities into the following year. For corpora-tions on the accrual method of accounting, this may not be as easyto do as it is for cash method individuals or businesses. However,even for them, certain recurring items may be currently deducteddespite the fact that they won’t be paid until the following year.There also may be times when a company can come out ahead byreversing the standard strategy by accelerating income into the cur-rent year. That ’s the case, for example, where the corporation is in alower tax bracket in the earlier year than it expects to be in for thefollowing year.

Although corporate tax rates are graduated, they don’t increase in astraight line as does corporate taxable income. Instead, the first$50,000 is taxed at 15 percent; then the next $25,000 is taxed at 25percent, and the $25,000 after that is taxed at 34 percent. Corporatetaxable income between $100,000 and $335,000 is taxed at 39 per-cent, to take back the benefit of the 15 percent and the 25 percenttax brackets. Then between $335,000 and $10 million, the marginalrate drops back to 34 percent. (The effect of this is that corporationswith taxable income between $335,000 and $10 million are taxed ata flat rate of 34 percent.) Then, between $10 million and $15 mil-lion, the rate goes up to 35 percent, and then there’s another bubble

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rate of 38 percent between $15 million and $18.33 million to re-cover the benefit of the 34 percent rate. Corporations with taxableincome above $18.33 million are taxed at a flat 35 percent rate.

While all of this seems rather complex, it does present year-end taxsaving strategies for corporations in some situations—especiallythose that are under either the 39-percent or the 38-percent bubblesthis year that expect earnings to pick up next year and push theminto a higher bracket. If possible, these companies should try to ac-celerate enough income or defer enough deductions to take maxi-mum advantage of the lower bracket this year.

AMT Planning

Smaller corporations are generally exempt from the alternativeminimum tax (AMT) if their average annual gross receipts for eachthree-year period is $7.5 million or less. (New corporations are ex-empt for their first year, but can’t average more than $5 million ofannual gross receipts for the first three-year period to avoid AMTafter that year.) The AMT is a complicated tax that requires manyitems to be refigured in a way that often reduces their tax benefit.If a company’s average annual gross receipts for the current three-year period are approaching the $7.5 million mark, it should atleast consider the impact of becoming subject to AMT. If the cur-rent increased gross is an aberration, the company probably wouldbe better off avoiding AMT liability where possible. If the companyis growing rapidly and is sure to be subject to AMT in the future, itstill may pay to hold off for another year before crossing thethreshold.

Personal Holding Company Tax

To prevent high-bracket individuals from using closely held C corpo-rations to shelter investment income, these corporations are liablefor a tax at the top individual rate (38.6 percent for 2002) on their

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undistributed personal holding company (PHC) income. To be sub-ject to this PHC tax, more than half of a corporation’s stock mustbe held by five or fewer individuals and 60 percent of its incomemust come from items such as rent, royalties, interest, and divi-dends. Rents are subject to a number of special rules to keep actualreal estate companies from being hit with the PHC tax.

Corporations near the PHC threshold of 60 percent should try toavoid additional PHC income, or to increase non-PHC business in-come to keep the PHC income percentage below 60 percent.

Continuation Planning

In addition to income tax planning, year-end is a good time for busi-ness owners to contemplate the eventual transfer of their business,whether to family members, other shareholders, key employees, orto an external third party. Owners must also take into account thefinancial strength of the business, financial position of the buyer,available sources of funding, collateral and financial guarantees, taxconsequences to both parties, and cash flow issues. The timing ofthe transfer and who will retain ownership control are also criticalconsiderations. To manage these complex issues, owners shouldhave access to advisors who can help them make effective andtimely decisions. Early planning and a sound grasp of objectives areparticularly important among family-owned organizations whereagreement about family roles contributes to a smooth transition.There are many things to consider.

Buy-Sell Agreements

There are two distinct categories of buy-sell agreements: cross-purchases and redemption agreements. Occasionally, there will be ahybrid of the two types. Under a redemption agreement, the com-pany will fund the buyout using its cash or debt. In a cross-purchase,the shareholder sells stock to other shareholders, not the company.This gives the buying shareholder an increase in the tax basis of his or

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her stock equal to the purchase price and reduces tax in the futurewhen the stock is subsequently sold.

In many cases, there is not enough cash either at the entity level orheld by other shareholders to fund the entire purchase. Often life in-surance that is held individually or by a partnership is used to fundthe cross-purchase portion of a buyout, with the balance funded bythe company through a redemption.

Deferred Compensation

This method refers to income that is deferred until a future point intime. Typically, an employee/shareholder has been undercompen-sated and a deferred compensation obligation has been establishedto recognize that fact. Paying an outgoing owner deferred compen-sation is advantageous to the buyer because the deferred compen-sation payments are tax-deductible, whereas payments for his or herstock are not. However, the seller usually will prefer payments forstock, the gains from which are subject only to favorable capitalgains tax rates.

Covenant Not to Compete

This is a legal contract that prohibits (for a specific period of time) aseller from competing with the buyer on the business being trans-ferred. A buyer will frequently offer a portion of the purchase consid-eration in exchange for the seller signing such a restrictive covenant.This form of consideration is usually deductible to the buyer over a15-year period and is taxed as ordinary income for the seller.

Earn-Out (Contingent Sale Price)

This refers to a transaction in which the price paid is not fixed butinstead fluctuates based on the future performance of the acquiredentity. Typically, the actual price will be tied to future revenuegrowth or future profitability over one to five years.

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The Importance of Early Planning

Most people find it difficult to discuss issues relating to illness, re-tirement, or death. Business owners who avoid addressing theseeventualities, however, may make succession planning a low prior-ity, putting family members or other loved ones at risk. Lack of timeis another often-cited factor; as in estate planning, busy owners caneasily put off succession planning to some undefined future time.However, the importance of early planning cannot be overstatedsince it greatly increases the likelihood that owners will meet all oftheir stated objectives.

From a financial perspective, the best strategy is to transfer an op-eration on the brink of value explosion, and some owners attemptto time their transitions accordingly. Although at this stage thebusiness owner may have no clear picture of future control andmanagement, this should not deter the saving of estate tax. Thepractical truth is that there will never be a clear picture of futurecontrol and management.

The effective succession plan has considerable flexibility to dealwith changing circumstances, and usually involves several differenttypes of trusts to maintain some degree of control. The importantthing is not to structure the “perfect” plan up front, but to plan asearly in the game as possible.

Don’t Wait to Plan!

• Tax laws reward advance planning with reduced estate taxes.

• There is a greater likelihood that the business will retain maxi-mum value for the next generation.

• In family perpetuation, owners have an increased ability to com-plete long-term transfer time lines.

• Succession plans with longer time lines are inherently more flexi-ble and may have better financial outcomes.

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• Conflicting aspirations within a family regarding the timing of thetransition can be resolved.

Chapter 11 moves away from planning suggestions and techniques.It takes a close-up view of the book’s basic concepts. Understand-ing these commonly used words and phrases is critical to makingthe best use of the tax planning strategies and tools discussed inthis book.

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A NUTS-AND-BOLTSREVIEW

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217

Chapter 11

BASIC TAX CONCEPTS

Tax planning is a difficult, time-consuming activity at best. Fortu-nately, any taxpayer who reads this book is likely to have learned agreat deal about effective tax planning. This chapter contains defini-tions of key tax terms. These definitions, which are really a combi-nation of glossary, encyclopedia, and FAQs, constitute anindispensable reference source for taxpayers.

Earlier chapters described things you may be able to do at the endof the year to reduce your tax bill. At the end of this chapter, youwill find valuable suggestions for steps you can take in January aspart of your tax minimization program.

Gross Income

Gross income includes all types of taxable income: wages andbonuses, taxable interest, dividends, state tax refunds, alimony,business income, capital gains, IRA distributions, taxable pensionsand annuities, rent, partnership distributions, unemployment com-pensation, and taxable Social Security benefits.

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218 A Nuts-and-Bolts Review

Adjusted Gross Income (AGI)

Adjusted gross income is your gross income less certain “above theline” deductions. These deductions include:

• Deductible IRA contributions (see Chapter 3).

• Medical savings account contributions.

• Employment-related moving expenses (see Chapter 8).

• One-half of self-employment tax.

• 70 percent (100 percent after 2002) of health insurance premi-ums paid by self-employed individuals (see Chapter 8).

• Keogh and SEP contributions for self-employed individuals (seeChapter 3).

• Penalties on early withdrawals of savings.

• Student loan interest.

• Educators’ classroom material expenses.

• Alimony paid.

Your AGI affects the extent to which you can deduct medical ex-penses, casualty and theft losses, charitable contributions, and othermiscellaneous items. At higher levels of AGI, your ability to benefitfrom some additional itemized deductions and personal exemptionsis reduced or eliminated. (The 2001 Tax Act starts to reduce thishidden tax rate increase in 2006.)

Modified Adjusted Gross Income

A number of tax breaks are reduced or eliminated as modified ad-justed gross income (MAGI) exceeds certain levels. These includethe adoption credit, the exclusion for employer-provided adoptionassistance, the exclusion for interest on savings bonds used forhigher education, IRA deductions, Education IRAs, Roth IRAs,higher education tax credits, the child credit, and the student-loaninterest deduction.

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Basic Tax Concepts 219

MAGI is generally higher than adjusted gross income. That ’s be-cause various tax breaks that normally reduce AGI are disallowed incalculating MAGI under the different definitions.

A Tax Credit or a Deduction

Tax credits are more valuable than tax deductions because theylower your tax liability dollar for dollar. A $100 tax credit reducesyour taxes by a full $100. Examples of tax credits are the HOPEscholarship and lifetime learning tax credits, the child credit, thechild care and dependent care credits, the adoption credit, and theforeign-tax credit.

A tax deduction reduces your taxes by the amount of your expensesmultiplied by your marginal tax rate. The lower your tax rate, thesmaller your tax benefit from a deduction. In the 38.6 percent taxbracket, a $100 tax deduction lowers your taxes by $38.60. In the15 percent bracket, that same $100 deduction reduces your taxesby only $15.

Taxable Income

Taxable income is the amount of income on which you actually paytax. It is calculated by adding your income from all sources and sub-tracting allowable deductions and exemptions:

Observation

It is unwise to pursue tax deductions by spending money ondeductible items merely to cut your tax bill. You have to spendmore money than you will save in taxes. Keep in mind that atax deduction is of real value only if it reduces the after-taxcost of an expenditure that you would be inclined to makeeven if it were not deductible.

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Marital Status

Your marital status on the last day of the year determines which ofthe four tax rate schedules applies. If you were single for most of theyear but marry on December 31, the tax law treats you as marriedfor the entire year.

Changes in marital status can affect year-end planning. Two individ-uals with substantial incomes who plan to get married in 2003might benefit from accelerating income into 2002 to avoid the so-called marriage penalty (see page 226) on that income.

Widows and widowers are allowed to file a joint return with theirdeceased spouse in the year of the spouse’s death, and to use joint-return rates for up to two additional years if they have a qualifyingdependent. Widows or widowers who may be eligible to use themore favorable married filing jointly rates in 2002, but not in 2003,could benefit from accelerating income into the earlier year (seeTable 11.1).

Taxable Income Computation

IncomeWages $350,000Interest, dividends, and capital gains 26,000Business income and rental real estate income 5,000Other income 4,500Total income $385,500

Adjustments to IncomeMoving expenses (3,500)Alimony (60,000)Total adjustments to income $ (63,500)Adjusted gross income $322,000Itemized deductions (after phase-out applied) (6,000)Exemption (phased out due to income level) NoneTaxable income $316,000

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Marginal and Effective Tax Rates

Marginal tax is the tax on the next dollar. Effective tax is the averagetax rate on all of your income. For example, assume that you aremarried, filing a joint return, and receive:

Taxable Income $300,000Bonus 50,000

Total Taxable Income $350,000

Table 11.1 2002 Tax Rates and Projected 2003 Tax Rates

Taxable 2002 Marginal Taxable 2003 Marginal Effective

Income Tax Tax Income Tax Tax Tax Rate

($) ($) (%) ($) ($) (%) (%)

Single Individuals

0 0 10 0 0 10 0

6,000 600 15 6,000 600 15 10

27,950 3,893 27 28,400 3,960 27 13.9

67,700 14,625 30 68,800 14,868 30 21.6

141,250 36,690 35 143,500 37,278 35 26.0

Over 307,050 94,720 38.6 Over 311,950 96,236 38.6 30.8

Married Filing Jointly

0 0 10 0 0 10 0

12,000 1,200 15 12,000 1,200 15 10

46,700 6,405 27 47,450 6,518 27 13.7

112,850 24,266 30 114,650 24,662 30 21.5

171,950 41,996 35 174,700 42,677 35 24.4

Over 307,050 89,281 38.6 Over 311,950 90,714 38.6 29.1

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The bonus is taxed at 38.6 percent. You would pay $19,300($50,000 x 38.6 percent) in taxes on that bonus. Your marginal taxrate is 38.6 percent.

Your marginal tax rate also determines the tax benefit of a deductibleexpense. For example, if you were in the 27 percent bracket and had$5,000 of medical expenses in excess of 7.5 percent of your AGI,which you claimed as an itemized deduction, you would reduce yourtaxable income by $5,000, saving $1,350 in tax dollars ($5,000 x 27percent).

Your effective tax rate is the average rate at which all of your incomeis taxed. To determine this rate, divide your tax liability by your tax-able income. If your 2002 taxable income on a joint return is$150,000 and the amount of tax due is $35,410.50, your marginalrate is 30 percent, but your effective tax rate is only 23.6 percent($35,410.50 / $150,000 = 0.2361).

How do high levels of income and itemized deductions and personalexemptions affect my marginal tax rate? For 2002 and 2003, high-income individuals are faced with statutory marginal tax rates of 30percent, 35 percent, and 38.6 percent. Marginal rates are evenhigher, however, if your AGI exceeds certain levels. This is becausemost itemized deductions are reduced by 3 percent of AGI in ex-cess of set income thresholds (but you can’t lose more than 80 per-cent of your deductions), and personal exemptions phase out or areeliminated at certain income levels. See the following charts for2002 deductions and exemptions and 2003 projected thresholds:

Caution

Your marginal tax rate is less determinative of the tax benefit ofa deductible expense if your income is above $137,300 for2002, since at that income level you begin losing some of thebenefit of your itemized deductions.

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2002 ITEMIZED DEDUCTION AND PERSONAL EXEMPTIONS

Married Head ofSingle Joint Separate Household

Standard Deductions

Regular standard deduction

$4,700 $7,850 $3,925 $6,900

Additional standard deduction (elderly and/or blind taxpayers)

$1,150 $900 $900 $1,150

Kiddie tax deduction

$750 $750 $750 $750

Itemized Deduction Phase-Out

Deductions reduced for AGI exceeding

$137,300 $137,300 $68,650 $137,300

Personal Exemption

Each person

$3,000 $3,000 $3,000 $3,000

Personal Exemption Phase-Out

Exemptions reduced for AGI exceeding

$137,300 $206,000 $103,000 $171,650

2003 ITEMIZED DEDUCTION AND PERSONALEXEMPTIONS (PROJECTED)


Standard Deductions

Regular standard deduction

$4,750 $7,950 $3,975 $7,000

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Additional standard deduction(elderly and/or blind taxpayers)

$1,150 $950 $950 $1,150

Kiddie tax deduction

$750 $750 $750 $750

Itemized Deduction Phase-Out

Deductions reduced for AGI exceeding

$139,500 $139,500 $69,750 $139,500

Personal Exemption

Each person

$3,050 $3,050 $3,050 $3,050

Personal Exemption Phase-Out

Exemptions reduced for AGI exceeding

$139,500 $209,250 $104,625 $174,400

The existing rules reducing itemized deductions allow you to claimat least 20 percent of your deductions regardless of your incomelevel. Also, this limit does not affect deductions for medical ex-penses, casualty losses, and investment interest.

Observation

The limit on itemized deductions increases the top marginal taxrate for high-income individuals by 1.17 percent. The phase-outof personal exemptions increases the top marginal tax rate forthese families and individuals by approximately 0.75 percent forincome in the phase-out range for each exemption claimed.

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What Is the Practical Result of Itemized DeductionsLimit and Personal Exemptions Phase-Out?

High-income individuals can end up paying federal taxes at a mar-ginal rate of about 42 percent. For a family of four, the rate could be45 percent and higher if more personal exemptions are claimed. Ifstate and local income taxes are taken into account, marginal taxrates can exceed 50 percent.

Social Security Taxes

If you are employed, you are subject to a 7.65 percent tax rate (6.2percent for Social Security and 1.45 percent for Medicare). Your em-ployer also pays the same rates to the government. If you are self-employed, you pay a 15.3 percent self-employment tax (12.4percent for Social Security and 2.9 percent for Medicare). Self-employed individuals are entitled to deduct one-half of their self-employment tax. The maximum annual earnings subject to the SocialSecurity tax are $84,900 in 2002. This amount will increase for2003. All earnings are subject to the Medicare portion of the tax.

If you work while collecting Social Security benefits and are age 62through 64, your benefits are reduced by $1 for every $2 that youearn above $11,280 in 2002 ($940 per month). This limit will in-crease for 2003. In the year you turn age 65, you lose $1 for every$3 of earnings above $30,000 ($2,500 per month) in 2002, but onlyfor months before your 65th birthday. If you are 65 or older, earn-ings do not cause a reduction in your benefits.

Observation

The 2001 Tax Act will start to eliminate the phase-outs of item-ized deductions and personal exemptions beginning in 2006.

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If you work while collecting benefits, you also should consider thatyour earnings will be subject to income tax and payroll taxes, andthese earnings also may subject some of your Social Security bene-fits to income tax. If your AGI plus half of your Social Security bene-fits plus your tax-exempt interest equals more than $25,000 ifyou’re single or $32,000 if married, half of the excess amount up tohalf of your benefits is taxable. If your specially figured income ex-ceeds $34,000 if single or $44,000 if married, up to 85 percent ofyour benefits may be subject to income tax.

Marriage Penalty

The marriage penalty results because the marginal tax rate is higherfor married couples than it is for two single individuals with thesame total income. For example, two single persons, each with tax-able income of $100,000 in 2002, will each be taxed at the 30 per-cent marginal rate. If these two people are married, 28,050 of theirtotal taxable income in 2002 (the amount above the $171,950threshold) will be taxed at the 35 percent rate. Total tax for the twosingles: $48,630. As a married couple, the 2001 tax would jump to$51,813.

If, however, one spouse has a much higher income than the other,there may be a marriage bonus. For example, a single person with$200,000 of taxable income in 2002 pays tax at a 35 percent mar-ginal rate on $58,750 of it. If that same person were married andhis or her spouse had no income, the couple would pay a marginalrate of 35 percent on only $28,050 of the income using joint-re-turn rates.

Some married couples may benefit by filing separately. For example,it may make sense to file separately if one spouse is in a lower taxbracket and has large medical bills. The AGI threshold limiting thededuction of these medical expenses would be lower, allowing alarger deduction.

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Accountable Plan

Business expenses reimbursed by your employer may be included asincome on your Form W-2 unless your employer reimburses underan accountable plan. An accountable plan requires documentationbefore a return is filed of all advanced or reimbursed expenses andthe return of any excess amounts. Expenses reimbursed under anonaccountable plan can be included in your income and are de-ductible, as are unreimbursed employee business expenses, as mis-cellaneous itemized deductions, if you have receipts and otherrequired substantiation.

Observation

It is important to work out the numbers before deciding whatto do. Over the years, Congress has added “penalty” provi-sions to the Tax Code to discourage married people from filingseparate returns. So filing separately may seem like a good ideafor one reason or another but might result in higher taxes over-all than if you file jointly.

Observation

The 2001 Tax Act takes some action to reduce the marriagepenalty (see Chapter 1), but the most important of thesechanges do not begin to take effect until 2005. The marriagepenalty is still with us and will continue to be with us, albeit toa lesser extent, even after the 2001 Tax Act changes are fullyphased in by 2010.

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Tax Effects of Alimony

Alimony is included in the gross income of the person receiving itand is deductible by the person paying it.

Payments to an ex-spouse are not treated as alimony for tax pur-poses if the spouses are still in the same household. It is also impor-tant to note that large decreases in the amount of alimony in thesecond and third years following a divorce trigger IRS concern thatproperty settlement amounts, which are nondeductible, are beingtreated as alimony. There are guidelines on what payments under adivorce or separation agreement qualify as alimony for tax purposes.For example, making rent or mortgage payments for a spouse or ex-spouse may be deductible alimony, but the value of rent-free ac-commodations (for example, allowing a spouse or former spouse tolive without paying rent in a house you own) is not deductible.

Observation

A nonaccountable plan is not as good as it may at first sound,because miscellaneous itemized deductions can be claimedonly to the extent that they total more than 2 percent of yourAGI. So if your AGI is $100,000, your first $2,000 of miscella-neous expenses is nondeductible. In addition, you would re-ceive no tax benefits from the deduction of unreimbursedbusiness expenses if you are subject to the Alternative Mini-mum Tax. The AMT is described in detail later in this chapter.

Observation

Alimony is deducted “above the line” in arriving at AGI. There-fore, it can be claimed whether you itemize your deductions ortake the standard deduction.

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Social Security Taxes for Domestic Employees

You must pay and withhold Social Security tax for domestic employ-ees earning more than $1,300 during 2002. This figure will be in-creased for future inflation. You report this tax liability each year asa balance due on your Form 1040, Schedule H. Be sure to increaseyour wage withholding or make quarterly estimated payments topay the tax associated with these employees and avoid an esti-mated tax underpayment penalty.

Estimated Tax Payments

The government requires estimated payments because they preferreceiving tax payments throughout the year. Individuals can haveonly a $1,000 or lower balance due on their tax returns to avoid anestimated tax underpayment penalty, unless certain standards aremet. An interest-based underpayment of estimated tax penalty ischarged if no exception applies.

In general, there are three methods that can be used to avoid an un-derpayment penalty:

1. Estimated tax payments and/or withholding are equal to atleast 100 percent of last year ’s tax liability. However, if your2001 AGI exceeded $150,000, your 2002 estimated taxesmust be 112 percent of your 2001 tax liability to fall within thissafe harbor. And for 2003, estimated tax payments must be atleast 110 percent of your 2002 tax liability to fall within it.

2. 90 percent of your current-year tax liability is paid through es-timated tax payments and/or withholding.

3. 90 percent of annualized income (determined each quarterbased on actual income) is paid through estimated tax pay-ments and/or withholding.

These methods are applied to each quarter using one-fourth of theamounts shown earlier. A different method can be applied eachquarter.

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You can make additional payments at any time during the year to reduceor, in some cases, eliminate potential estimated tax underpayments. Be

Observation

The annualization method is generally best if a large part ofyour income is received in the latter part of the year.

Caution

If you use the “90 percent of current year ’s tax liability”method to calculate your estimated tax payments and recog-nize a large gain at year-end, you could be saddled with esti-mated tax penalties from a shortfall in earlier payments. If youhave a choice as to when you recognize the gain, remember toconsider estimated taxes.

Observation

If you fall behind in estimated tax installments at the beginningof a year, you may avoid or reduce an estimated tax penalty byhaving additional tax withheld from your wages during the lat-ter part of the year. Wage withholding is treated as occurringevenly over the course of the year, so one-quarter of each dol-lar withheld is treated as having been withheld in each quarterof the year.

Dates on Which You Must Pay Your Estimated Taxes

April 15: Based on actual income through March 31.

June 15: Based on actual income through May 31.

September 15: Based on actual income through August 31.

January 15: Based on actual income through December 31.

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careful not to overpay, though, because the excess payment is essen-tially an interest-free loan to the government.

Alternative Minimum Tax

The Alternative Minimum Tax (AMT) was designed to ensure thatevery individual and corporation pays at least some tax every year.In practice, the AMT is a separate tax system that runs alongside theregular tax system. It includes a broader base of income and asmaller range of allowable deductions and credits. If you have manyso-called preference items or adjustments (certain deductions andtax credits), you may have to figure and pay your tax under the AMTsystem. If the AMT applies and your regular taxable income is fairlysmall, consider gearing year-end planning toward reducing the AMTrather than regular tax.

The AMT is a two-tier system. Individuals with AMT income (AMTI)up to $175,000 (or $87,500 for married filing separately) over the ex-emption amount are subject to a 26 percent tax rate. A 28 percenttax rate applies to AMTI above these amounts.

Observation

Use of either the annualization method or the 90 percent ofcurrent year ’s tax liability method is a good idea if your year-over-year income decreases or increases from one year to thenext by only a small amount. But if you have a sizable increasein income (for instance, if 100 percent [or 110 percent or 112percent for those with an AGI over $150,000] of your prioryear ’s tax will be less than 90 percent of the tax due on yourcurrent year ’s income), using the “percentage of the prioryear ’s tax liability” method allows the payment of lower esti-mated tax; this method is also far simpler, because you areusing actual numbers, not estimates.

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The exemption amounts are:

• $49,000. Married filing jointly or surviving spouses.

• $35,750. Single or head of household.

• $24,500. Married filing separately.

The AMT exemption amount phases out for high-income individuals.For married individuals filing jointly or surviving spouses, the phase-out begins at AMTI of $150,000 and ends at $346,000. For single orhead of household, the phase-out range is $112,500 to $255,500.For married filing separately, the phase-out range is $75,000 to$173,000. Married persons who file separate returns not only losetheir exemptions when AMTI reaches $173,000, but must increaseAMTI by 25 percent of the amount by which it exceeds $173,000up to an overall increase of $24,500 to bring them in parity withmarried individuals filing jointly.

Caution

The 2001 Tax Act increased the AMT exemption amounts tothe above levels, but only through 2004. If Congress doesn’ttake additional action, the exemption amounts will drop backto the 2000 level in 2005. That would subject many more peo-ple to the AMT.

Observation

Because the regular tax brackets are indexed for inflation, butthe AMT tax brackets are not, many more individuals will besubject to the AMT unless Congress adjusts the AMT brackets.

Observation

Don’t think that the AMT hits only wealthy tax-shelter in-vestors. Some of the items that lower your regular taxes but not

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If possible, consider spreading preference items over two or moreyears to take advantage of AMT exemption amounts and the 26percent first-tier AMT rate.

Calculating AMT

In general, the AMT is calculated as follows:

1. Begin with regular taxable income.

2. Add any personal exemption amounts claimed.

3. Add any net operating loss.

4. Subtract itemized deductions that cannot be claimed on Sched-ule A because of certain limits for high income individuals.

5. Adjust taxable income for certain deductions and preferenceitems, including any AMT net operating losses to arrive atAMTI.

6. Subtract the AMT exemption amount.

7. Multiply by the AMT rate.

8. Subtract AMT credits.

9. Compare with regular tax and pay AMT to the extent it ex-ceeds regular tax.

The AMT may increase your tax bill if you have one or more of thefollowing items and they are sizable in relation to your total taxableincome:

• Itemized deductions, especially state and local income taxes, realproperty taxes (for example, the taxes you pay on your home andother real estate you own), certain interest, and miscellaneousitemized deductions.

your AMT might surprise you: State and local income taxes,property taxes, personal exemptions, home-equity-debt inter-est, some medical expenses, and even the standard deductionare not allowed for AMT purposes. If you’re from a high-taxstate and have a large family, you may be subject to the AMT.

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• A large number of dependents.

• Accelerated depreciation.

• Interest income on certain tax-exempt private activity bonds is-sued after August 7, 1986.

• Large bargain elements (spread between the option price and thefair market value of the stock at the time of exercise) on exerciseof incentive stock options.

• Certain deductions generated in oil, gas, or other natural re-sources business operations.

• Large long-term capital gains.

The following example provides some of the more common adjust-ments and preferences that may subject a typical married coupleto AMT:

Alternative Minimum Tax Calculation

Part I: Adjustments and PreferencesMedical and dental expenses allowed onSchedule A (lesser of medical and dentalexpenses allowed on Schedule A or21⁄2 percent of AGI) $ 0

Taxes (state and local income tax, realestate, personal property, other taxes) 287,000

Miscellaneous itemized deductions(after 2 percent floor) 5,000

Incentive stock options 50,000

Passive activities 95,000

Total adjustments and preferences $1,437,000

Part II: Alternative Minimum Taxable Income

Taxable Income(after itemized deductions but before exemptions) $1,000,000

Phased-out portion of itemized deductions (38,000)

Total alternative minimum taxable income $1,399,000

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The couple in the example is subject to the AMT, primarily as a resultof a large estimated state tax payment made on January 15, 2002,for the sale of property in December 2001. Year-end tax planningcould have avoided the imposition of the AMT. The couple couldhave made the estimated tax payment on or before December 31,2001, and thus in the same year the gain was included in income.

If the AMT is triggered because you include in AMTI certain item-ized deductions and other “exclusion items,” such as personal ex-emptions, state taxes, tax-exempt interest, and depletion, you maywant to defer prepayment of state taxes so that you receive morebenefit from the deductions in a regular tax year.

An AMT credit, which you can claim against your regular tax liabil-ity in future years, is available to the extent that your AMT is the re-sult of certain adjustments and preferences, including incentivestock options, accelerated depreciation, intangible drilling costs,and mining and exploration costs (the so-called deferral items). NoAMT credit is available for so-called exclusion preferences that per-manently avoid the payment of tax, such as certain tax-exempt in-terest and state and local income taxes.

Planning for the AMT is extremely complex. Decisions aboutwhether you should accelerate or defer income or deductions de-pend on the mix of items that give rise to the AMT. In most cases,

Part III: Exemption Amount and AlternativeMinimum Tax

Exemption amount for married filing jointly(phased out completely at $346,000) $ 0

Alternative minimum tax base 1,399,000

Tentative minimum tax (up to $175,000 multiplyby 26 percent; over $175,000 multiply by 28percent and subtract $3,500) 388,220

Regular tax liability 356,759

Total alternative minimum tax $ 31,461

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AMT planning seeks to accelerate your income and defer your de-ductions. In deciding the right strategy for you, it is essential to “runthe numbers” under the regular tax and the AMT for the currentyear as well as for future years.

Conclusion

Rumor has it that although some people like tax planning, most peo-ple would prefer to do almost anything else. But what most of usconsider a burden needn’t be a nightmare or a mystery. People canunderstand their tax options and intelligently choose those optionsbest suited to their needs. This book is intended to be a liberatingguide, grounded in our belief that every tax problem has a solution,if accurate and accessible information is available.

We have given you much to think about. The first chapter laid out the tax changes that have taken place in 2002 and that wereintroduced by the 2001 Tax Act that will take effect over the next10 years. The rest of the book provides a wide range of informa-tion and strategies and covers diverse areas, such as investments,retirement planning, home ownership, education savings, estateplanning, and year-end tax planning for individuals, business own-ers and their companies. It also explains many basic tax concepts.The tax laws are incredibly complex. The Internal Revenue Code,along with its regulations and related cases, procedures, and rul-ings, can fill whole library rooms. As difficult as the law is, specific financial, family, and business situations can complicatethings further, making tax planning a highly personal and individu-alized undertaking.

This book offers you a foundation—information and strategies thatwill make most individuals aware of ideas that may work for themand help them avoid costly tax mistakes. You should supplement thisnew foundation in taxes by considering how your personal situationplays into tax decisions. Tax planning never occurs in a vacuum, but

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Appendix A 237

is just a part, albeit an important part, of an overall financial plan-ning process.

The tax strategies described in this book have been developed fromthe combined experience of many PricewaterhouseCoopers profes-sionals. However, because every individual has unique circum-stances, it is important that you consult a tax professional beforeimplementing any tax strategy described in this book or elsewhere.

Appendix A: January TaxStrategy Idea Checklist

Most tax help books present year-end planning ideas. We have de-cided to go one step further and suggest strategies that make senseto implement as early in the year as possible. Early adoption of theideas presented in the list below may make sense to maximize youropportunities to defer tax, generate income that is tax-free, and/orshift assets or income out of your estate.

� Contribute to an IRA (see page 87).

� Contribute to a Coverdell Education Savings Account (seepage 126).

� Contribute to a Section 529 plan to the amount of the state taxdeduction (if available) (see page 120).

� Make a contribution to your Keogh (see page 85).

� Consider a Roth IRA conversion (see page 90).

� Think about making additional gifts if you have not fully usedyour unified credit equivalent of $1 million (see page 149).

� Make payments that were due in 2002 that you deferred to2003 because of the AMT (see page 231).

� Purchase the annual maximum of Series I bonds (see page 198).

� Make $11,000 ($22,000 for married couples) annual exclusiongifts (see page 142).

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238 Appendix B

Appendix B: PricewaterhouseCoopers’ Personal Financial Services

About PricewaterhouseCoopers’ PersonalFinancial Services

PricewaterhouseCoopers’ Personal Financial Services practice pro-vides comprehensive financial planning services designed to helpbuild, preserve and maximize the wealth of high-net-worth individu-als, corporate executives and business owners. We work with theseindividuals to develop financial strategies that are integrated andconsider the numerous aspects of wealth accumulation and its rami-fications on their businesses and families.

PricewaterhouseCoopers’ assets in the area of personal financial ser-vices include over 400 full-time financial planning advisers in the USand another 200 advisers in locations throughout the world. Withextensive experience and knowledge, we bring a broad perspectiveto assessing and planning wealth goals.

Personal Financial Services Partner Resources

Central Region

IllinoisChicago Larry D. Brown 312-298-2214

MichiganDetroit Bernard S. Kent 313-394-6537

MissouriSt. Louis Rebecca S. Weaver 314.206-8490

TexasDallas Kevin F. Roach 214-754-7261Houston Bruce J. Belman 713-356-4680

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Appendix B 239

New York Metro Region

New JerseyFlorham Park Steven A. Calvelli 973-236-5595

New YorkNew York Vincent D. Vaccaro 646-394-2545New York Kent E. Allison 646-394-4259New York Evelyn M. Capassakis 646-394-2363

Northeast Region

MassachusettsBoston Richard L. Kohan 617-439-7461Boston Mark J. Bonner 617-428-8140Boston Douglas A. Theobald 617-439-7444

Southeast Region

District of ColumbiaWashington D.C. Arnold H. Koonin 202-414-1049

FloridaMiami Allison P. Shipley 305-375-6303Miami Richard S. Wagman 305-381-7650

GeorgiaAtlanta Bernard E. Palmer 678-419-7335

North CarolinaCharlotte Robert D. Lyerly 704-344-7521

PennsylvaniaPhiladelphia Michael B. Kennedy 267-330-6075Philadelphia Karl Weger 267-330-2496

West Region

CaliforniaLos Angeles David D. Green 213-236-3329San Francisco Dennis G. Whipp 415-498-7995San Francisco Alfred Peguero 415-498-7830San Francisco Scott A. Torgan 415-498-7955

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ABOUT THE AUTHORS

Richard J. Berry Jr. is PricewaterhouseCoopers’ U.S. Tax Leader andis also a member of the firm’s U.S. Management Committee andGlobal Tax and Legal Services Executive Committee. Richard joinedthe firm in 1974 and was admitted to the partnership in 1983. He isa CPA and holds a Doctorate of Business Administration fromGeorge Washington University, and MBA from Rutgers Universityand a BA from Catholic University.

Michael B. Kennedy is a partner of PricewaterhouseCoopers andthe National Director of the firm’s Personal Financial Services prac-tice, which provides comprehensive financial planning services tohigh-net-worth individuals, corporate executives, business owners,and entrepreneurs. Michael has been with the firm for more thantwenty-eight years. Michael is a CPA and member of the American,Pennsylvania, New Jersey, and Delaware Institutes of Certified Pub-lic Accountants and holds the Personal Financial Specialist designat-tion. He has both a BS in economics and an MBA from RiderUniversity. He is a member of the board of trustees of Rider Univer-sity and was most recently honored by his alma mater with a life-time achievement award from the school of business.

Bernard S. Kent is a personal financial services partner for Price-waterhouseCoopers LLP. He has more than twenty-eight years ofexperience encompassing all phases of tax planning and personal fi-nancial counseling. He has been quoted in numerous national peri-odicals, including the Wall Street Journal, Forbes, Fortune, U.S.News and World Report, Investor ’s Business Daily, Business Week,Kiplinger ’s, and Inc., and has been chosen three times by Worthmagazine as one of the best financial advisors in the country. He isthe past chairman of the personal financial planning committee ofthe Michigan Association of Certified Public Accountants. Bernie re-ceived his BA in economics from Oakland University and his JDfrom the University of Michigan Law School.

240

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241

Accelerating deductions, 8,173–192. See alsoDeduction(s)

casualty losses, 187–188charitable contributions,

182–187deferred giving, 186–187property donations, 183–184substantiation requirements,

184–185idea checklist, 191–192interest:

business, 176investment, 177passive activity, 177–179personal, 181student loan, 179–180

medical expenses, 181–182miscellaneous itemized

deductions, 188–190moving expenses, 190–191overview/introduction, 173–175state and local taxes, 175–176

Accountable plan, 227–228Adjusted gross income (AGI), 218Adoption credit, 14Alimony, tax effects of, 228Alternative minimum tax (AMT),

15–16accelerating deductions and, 8,

175, 176, 181, 182, 189adoption credit and, 14calculating, 233–236child credit and, 14defined, 231–233incentive stock options (ISOs)

and, 67–70market gains and, 51Tax Acts (2001/2002) and, 15–16tax-exempt bonds, 64–65year-end diagnosis, 170–171year-end planning for business

owners, 209Annuity(ies):

income deferral and, 198tax-deferred, 93–94

INDEX

frie_z02bindex.qxd 10/9/02 2:04 PM Page 241

242 Index

Annuity trust, grantor retained, 156Assets:

ownership review, 150–151transferring (shifting income to

family members), 199–202Automobiles, business (bigger tax

advantages for), 206–207

Bank certificates (deferring income),196

Bonds:original issue discount (OID),

65–66premium or discount, 65–66private activity, 64taxable/tax-exempt, 64–65U.S. savings, 131–132, 139,

198Bonuses, year-end:

planning for business owners,207–208

year-end (deferring income), 194Business(es). See also Employer;

Employer retirement plans:family:

continuation planning, 210–213repeal of estate tax break for,

48interest (accelerating deductions

for), 176small:

credit for plan start-up costs,36

defined contributionretirement plans, 81

succession/continuation planning,210–213

buy-sell agreements, 210–211covenant not to compete, 211

deferred compensation, 211earn-out (contingent sale price),

211importance of early planning,

212–213year-end planning for, 203–213

alternative minimum tax(AMT) planning, 209

bigger tax advantages forbusiness automobiles,206–207

bonuses and deferredcompensation, 207–208

depreciation allowance(year-end edge for new),204–206

income deferral oracceleration, 208–209

overview/introduction,203–204

personal holding company(PHC) tax, 209–210

retirement plans, 207Buy-sell agreements (year-end

planning for business owners),210–211

Bypass or credit-shelter trusts, 41,154–155

Capital expenditures: year-endedge for new depreciationallowance, 204–206

Capital gains, 52–56better rates for five-year gains,

54–56exceptions to 20 percent rate,

53–54favorable rates, 52–53year-end checkup, 169–170


Index 243

Capital losses, 59–60Casualty losses (accelerating

deductions for), 187–188Charitable contributions:

accelerating deductions for,182–187

deferred giving, 186–187property donations, 183–184quid pro quo contributions, 186retirement assets and, 45substantiation requirements,

184–185tax brackets and, 8

Charitable remainder trusts, 93, 158Children:

kiddie tax, 9, 168, 201, 223, 224moving income to, 9, 134–135,

199–202 (see also Incomeshifting)

Child tax credit, 13–14Citizenship and QDOT (noncitizen

surviving spouse), 159College savings. See Education

fundingCommunity property states, 150Compensation, deferred, 195,

207–208, 211Conservation easements, 46Contingent sale price, 211Continuation planning for

businesses, 210Corporate insider (and option

stock), 196Covenant not to compete, 211Coverdell Education Savings

Accounts, 17–18. See alsoEducation funding

converting investments to, 52,126–127, 139

highlights/overview, 22, 52Hope scholarship credit, 17improvements, 17–18Lifetime Learning credit, 17renamed (were “education

IRAs”), 17, 22Credit-shelter trusts, 41,

154–155Custodial account, 199

Death. See Estate planningDeduction(s). See also Accelerating

deductions:basic tax concept, 219education expenses, 20–21,

133, 135–136, 139, 140home office, 110–112individual retirement account

(IRA), for employer planparticipants, 88

itemized (phase-out of limits on),4, 10–13, 222–224, 225

married taxpayers (increase instandard deduction),11–12

retirement plans (increasedlimits), 37–39

standard, 11–12, 223student loan interest, 20–21,

133, 139upper income individuals and,

10Deemed-sale election, 56–57Defective trust, intentionally,

158–159Deferred compensation, 195,

207–208, 211Deferred giving (accelerating

deductions for), 186–187


244 Index

Deferring income, 8, 193–202,208–209

annuities, 198business owners, 208–209compensation, deferred, 195,

207–208, 211dividends, 196–197401(k) plans, 199individual retirement accounts

(IRAs), 199installment sales, 197–198introduction, 193–194shifting income to family

members, 199–202stock options or stock

appreciation rights, 196Treasury bills and bank

certificates, 196U.S. savings bonds, 198year-end bonuses, 194

Defined benefit plans:Keogh, 85pension, 82–84

increase in benefit limit,82–83

nonqualified deferredcompensation plans,83–84

Defined contribution plans, 77–81401(k) plans, 78–81larger contributions allowed,

77–78profit-sharing plans, 78for small employers, 81

Dependent care credit, 15Depreciation allowance, 204–206Dividends (deferring income),

196–197Dynasty trust, 157–158

Earn-out (contingent sale price), 211Economic Growth and Tax Relief

Reconciliation Act of 2001(2001 Tax Act), 3. See also TaxActs of 2001 and 2002(overview of changes)

Education funding, 4–5, 17–22, 52,119–140, 152

arrangements (overview of mainfeatures/income limits),139–140

Coverdell Education SavingsAccounts, 17–18

converting investments to, 52,126–127, 139

highlights/overview, 22, 52Hope scholarship credit, 17improvements, 17–18Lifetime Learning credit, 17renamed (were “education

IRAs”), 17, 22deductions, 21, 135–136, 140employer education assistance,

20, 136–137, 140estate planning and tuition

payments, 152home equity loans, 132HOPE scholarship credit, 17, 19,

21, 124, 127, 130–131, 135idea checklist, 137–138income shifting and capital gains,

134–135individual retirement account

(IRA) distributions for, 140investment planning and, 120qualified Section 529 tuition

programs, 18–19, 120–122,139

expenses that qualify, 122–123


Index 245

gift and estate tax breaks,125–126

prepaid tuition plans, 120–121tuition savings plans, 121

relatives, 19, 120–121, 127,133–134

ROTH IRAs, 128–129savings bonds, 131–132, 139student loans, 20–21, 133, 139tax credits, 130–133, 140traditional IRAs, 129–130

Employer:education-assistance plans, 20,

136–137, 140professional retirement services/

planning (nontaxable fringebenefit), 34, 96

Employer retirement plans, 75–84defined benefit pension plans,

82–84increase in benefit limit, 82–83nonqualified deferred

compensation plans, 83–84defined contribution plans, 77–81

401(k) plans, 78–81larger contributions allowed,


phase-out of IRA deductions forparticipants, 88

two basic kinds, 77Estate planning, 5, 39–48, 141–161

asset ownership review, 150–151catch-22 clause, 52conservation easements, 46exemption allowances, 142–144family businesses (repeal of

estate tax break for), 48

gift-giving program, 152giving a Roth IRA, 160how estate and gift tax works,

142idea checklist, 161installment payment of estate

taxes, 47–48loss of full-basis step-up, 43–45overview/introduction, 141–142paying gift taxes (now) vs. estate

taxes (after death), 160phase-down of estate tax,

40–42exemption increases, 40planning for, 148–150rate reduction, 41–42year-by-year transfer tax rates

and exemptions, 42qualified domestic trusts

(QDOTs), 46–47state death taxes, 42–43,

151–152tax rates (gift /estate), 144–148trusts, 154–160valuation discounts, 153–154wills, 150

Estimated tax payments, 9,229–231

Exemptions, personal, 11, 223,224

Family:business:

continuation planning, 210–213repeal of estate tax break for,

48education expenses (relatives

helping with), 19, 120–121,127, 133–134


246 Index

Family (Continued)members, shifting income to,

199–202trusts (see Credit-shelter trusts)

Florida Intangible Trust, 66401(k) plans, 25, 75, 78–81

annual elective deferral limits, 82catch-up, 26–27income deferral, 199

403(b)/457 changes, 21, 23–24,27–28

Gift(s)/gift tax. See also Estateplanning:

annual exclusion, 41education funding, 125–126estate tax and (how they work),

142exemption allowances, 142–144intentionally defective trusts,

158–159paying gift taxes (now) vs. paying

estate taxes (after death),160

planning technique (personalresidence trust), 112

regular program of gift giving, 152tax rates, 144–148

Grantor retained annuity trust, 156Gross income (basic tax concept),

217

Half-year convention, 205Home-equity loans:

education funding, 132refinancing nondeductible

personal expenditures,107–108

Home office deduction, 110–112exclusive/regular use, 110principal place of business,

110–112Home ownership, 105–118

idea checklist, 118mortgage interest, 106–107personal residence trust, 112rental properties, 109–110tax benefits, 106–112vacation/second homes, 106,

107, 108–109Home purchases, 115–118

mortgage points, 116–118real estate taxes, 115–116

Home sales, 113–115partial exclusion, 113–114partial exclusion rule for joint

filers, 114–115principal residence gains

exclusion, 113–115qualifying for the $500,000

exclusion, 113HOPE scholarship credit, 17,

19, 21, 124, 127, 130–131,135

Incentive stock options (ISOs),68–70

Income deferral. See Deferringincome

Income shifting, 168–169capital gains tax rate and,

134–135to children, 9, 134–135,

199–202methods, 200–202timing, 199–200


Index 247

Individual retirement accounts(IRAs), 86–92

deductions for employer planparticipants (phase-out), 88

education funding, 128–130,140

employer plan combination, 29higher contribution limits,

28–29, 87income deferral, 199Roth:

conversions to, 89–92deferring income, 199education funding, 128–129giving, 160new employer plan

combination (“QualifiedRoth Contribution”program), 29

vs. traditional, 86traditional, 86, 88–89

Installment payment of estatetaxes, 47–48

Installment sales (deferringincome), 197–198

Intentionally defective trust,158–159

Interest (accelerating deductionsfor):

business, 176investment, 177passive activity, 177–179personal, 181student loan, 179–180

Investments and stock options,51–71

bond premium or discount, 65–66capital gains, 52–56

better rates for five-year gains,54–56

exceptions to 20 percent rate,53–54

favorable rates, 52–53capital losses, 59–60education funding and planning,

120Florida Intangible Trust, 66idea checklist, 70–71identification of securities, 63–64incentive stock options (ISOs),

68–70interest (accelerating deductions

for), 177introduction, 48–49, 51–52netting rules, 57–59nonqualified stock options,

66–67passive activity losses, 62–63protecting and postponing stock

gains, 61–62buying put options covering

stock you own, 61writing covered call options,

61–62qualifying current holdings for

18 percent rate, 56–57record keeping, 63–64taxable/tax-exempt bonds,

64–65wash sale rule, 60–61

Itemized deductions. SeeDeduction(s)

January:making gifts in, 153tax strategy idea checklist, 236


248 Index

Job Creation and WorkerAssistance Act of 2002 (2002Tax Act), 6. See also Tax Actsof 2001 and 2002 (overview ofchanges)

Joint ownership, 150

Keogh plans, 76, 84–85defined benefit plan, 85money purchase plan, 84profit sharing plan, 84

Kiddie tax, 9, 168, 201, 223, 224

Life insurance:split-dollar, 94–96, 187trust, 155–156universal variable, 96

Lifetime learning credit /HOPEscholarship credit, 17, 19, 21,124, 127, 130–131, 135

Losses, casualty (acceleratingdeductions for), 187–188

Marital status (basic tax concept),220

Marriage penalty:defined, 226–227relief, 11–12

Medical expenses (acceleratingdeductions for), 181–182

Medicare tax, 195Modified adjusted gross income

(MAGI), 218–219Money purchase plan (Keogh), 84Mortgage:

interest, 106–107points, 116–118

Moving expenses (acceleratingdeductions for), 190–191

Netting rules, 57–59Non-compete covenant, 211

Options, put /call:put options covering stock you

own, 61writing covered call options,

61–62Original issue discount (OID)

bonds, 65–66

Passive activity:interest (accelerating deductions

for), 177–179losses, 62–63

Pass-through entities, 10Personal exemption phase-out, 11,

223, 224Personal holding company (PHC),

209–210Personal interest, accelerating

deductions for, 181Personal residence trust, 112Phantom stock, 67Points, mortgage, 116–118Principal residence gains exclusion,

113–115partial exclusion, 113–114partial exclusion rule for joint

filers, 114–115qualifying for the $500,000

exclusion, 113Private activity bonds, 64Private elementary/secondary

schools:Education Savings Accounts,

128unlimited gift tax exclusion,

152


Index 249

Professional retirementservices/planning (nontaxablefringe benefit), 34, 96

Profit sharing plans:defined contribution plans, 78Keogh, 84

Property donations (acceleratingdeductions for), 183–184

Purchase of home, 115–118Put options covering stock you

own, 61

Qualified domestic trusts (QDOTs),46–47, 159

Qualified personal residence trust,157

Qualified retirement plans, 75–77,195

Qualified terminable interestproperty (QTIP), 45

Quid pro quo contributions,186

Rate reductions, tax credits, anddeductions (overview of effectof tax law changes), 4, 6–16

adoption credit, 14alternative minimum tax (AMT),

15–16bottom line, 12–13child tax credit, 13–14dependent care credit, 15marriage penalty relief, 11–12new ten percent income tax

bracket, 7personal exemptions, 11reduction in 28 percent and

higher tax rates, 7–10upper income individuals, 10

Real estate taxes:accelerating, 175statutory formula (buyer/seller),

115–116Record keeping: identification of

securities, 63–64Relatives: education funding, 19,

120–121, 127, 133–134Rental properties, 109–110Retirement, 5, 23–39, 73–104, 207

catch-up 401(k) and SIMPLE plandeferrals, 26–27

charitable remainder trusts, 93combined plan limit, 76defined benefit pension plans,

82–84increase in benefit limit, 23,

82–83nonqualified deferred

compensation plans,83–84

defined contribution plans, 77–81401(k) plans, 78–81larger contributions allowed,


employer plans, 75–84403(b)/457 changes, 23–24,

27–28idea checklist, 103–104increased 401(k) and SIMPLE

plan deferrals, 25increased compensation limit,

24–25increased deduction limits, 37–39individual retirement accounts

(see Individual retirementaccounts (IRAs))


250 Index

Retirement (Continued)Keogh plans, 84–85overview of changes, 23–39plan loans to owner-employees,

35professional retirement services/

planning (nontaxable fringebenefit), 34, 96

reasons for using plans or IRAsfor saving, 75

required distributions, 34–35,99–102

rollovers, 30–33simplified employee pension

plans (SEPs), 86–92small-business credit for plan

start-up costs, 36Social Security, 97–98sources of income for, 73–74split-dollar life insurance, 94–96state and local government

employees (457 plans),23–24, 27–28

tax credits, 33, 92–93tax-deferred annuities, 93–94tax-favored retirement plans,

73–74top-heavy rules, 37universal variable life insurance,

96vesting of employer

contributions, 24waiver of user fees, 36–37year-end planning for business

owners, 207Rollover(s), 30–33

of after-tax contributions,31–32

spousal, 33

Roth IRA:conversions to, 89–92deferring income, 199education funding, 128–129giving, 160new employer plan combination

(“Qualified RothContribution” program),29

vs. traditional, 86

Sale of home, 113–115Savings bonds, U.S.:

deferring income, 198education funding, 131–132,

139Savings incentive match plan for

employees (SIMPLE), 25,26–27, 76

Second homes, 106, 107, 108–109Section 529 qualified tuition

programs, 18–19, 120–122.See also Education funding

Securities, identification of,63–64

Shifting income. See Incomeshifting

SIMPLE (savings incentive matchplan for employees), 25,26–27, 76

Simplified employee pension (SEP)plans, 76, 86–92, 207

Social Security:domestic employees and, 229retirement planning, 97–98taxes on, 195, 225–226

Split-dollar life insurance, 94–96,187

Standard deductions, 11–12, 223


Index 251

State and local taxes:accelerating deductions for,

175–176loss of credit for state death

taxes, 42–43, 151–152Step-up, full-basis, 43–45Stock appreciation rights, 196Stock option(s). See also

Investments and stock options:incentive (ISOs), 68–70income deferral, 196nonqualified, 66–67trust, 160

Student loan interest deduction,20–21, 133, 139

accelerating, 179–180phase-out ranges, 133

Taxable income (computations/adjustment), 219–220

Tax Acts of 2001 and 2002(overview of changes), 3–49

education reforms, 4–5,17–22

estate tax changes, 5, 39–48rate reductions, tax credits, and

deductions, 4, 6–16retirement plan changes, 5,

23–39Tax brackets:

new ten percent income taxbracket, 7

reduction in 28 percent andhigher tax rates, 7–10

Tax concepts, basic, 217–237accountable plan, 227–228adjusted gross income (AGI),

218alimony, tax effects of, 228

alternative minimum tax (AMT):calculating, 233–236defined, 231–233

estimated tax payments,229–231

gross income, 217January tax strategy idea

checklist, 236marginal and effective tax rates,

221–224marital status, 220marriage penalty, 226–227modified adjusted gross income

(MAGI), 218–219social security taxes, 225–226social security taxes for domestic

employees, 229taxable income (computations/

adjustment), 219–220tax credit or deduction, 219

Tax credits:concept, 219education, 130–133, 140retirement contributions/savings,

33, 92–93Tax deferral planning, 166–167Tax-deferred annuities, 93–94Tax-exempt investments, 10Tax reduction planning, 165–166Treasury bills and bank certificates

(deferring income), 196Trusts, 154–160

bypass, 41, 154–155charitable remainder, 158credit shelter, 154–155dynasty trust, 157–158family, 154–155grantor retained annuity, 156intentionally defective, 158–159


252 Index

Trusts (Continued)life insurance, 155–156qualified domestic, 159qualified personal residence, 157stock option, 160

Tuition. See Education funding

Unified transfer tax system, 142.See also Estate planning

Uniform Gift to Minors Act(UGMA) account, 200

Uniform Transfers to Minors Act(UTMA) account, 200

Universal variable life insurance, 96U.S. savings bonds:

deferring income, 198education funding, 131–132,

139

Vacation/second homes, 106, 107,108–109

Valuation discounts, 153–154Vesting of employer contributions,

24

Wash sale rule, 60–61Will, drafting, 150Writing covered call options, 61–62

Year-end bonuses, 194Year-end tax planning strategies,

165–171. See alsoAccelerating deductions;Deferring income

alternative minimum tax (AMT)diagnosis, 170–171

business owners, year-endplanning for, 203–213

capital gains checkup, 169–170income shifting, 167, 168–169tax deferral, 166–167tax reduction, 165–166


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