Year-End Tax Tips

By Daniel Kadlec

The most celebrated date in the year when it comes to taxes is, of course, April 15--the first and most widely observed deadline for filing your tax return. But from a planning point of view, year-end is the more critical moment, and it's bearing down like an IRS agent with Leona Helmsley's diary. You can still cut your tax bill for 1999 and beyond. Don't panic. But put down the holiday shopping list, for a while anyway, and consider some steps that will pay off all year, not just for a few sparkling moments in December.

The good news is that the sweeping reforms approved in 1997 have for the most part been phased in. While there isn't a lot that's new this year, lawmakers have plenty of big new ideas. They always do. Some want to lower the capital-gains tax rate, now 20% at the federal level for most people who hold an asset longer than one year. That's down from 28% a few years ago, and it could be pushed to 15%. Another hot topic is the so-called death tax. Republicans want to eliminate the tax on estates, which can reach rates as high as 55%.

Also in the taxman's sights is the marriage penalty, a quirky tax that means two-earner couples often pay more than single-earner couples, even though their household income may be the same--and way more than if the two-earner couple lived together unmarried.

Don't expect any of these things to kick in soon, though. Since next year is an election year and much of the rhetoric in Washington will be centered on how to save Social Security, tax experts say it's unlikely there will be any major tax changes before 2001. So plan around what's known--not what might happen. On these pages, we look at six ways to cut your taxes before Dec. 31. Generally, you'll want to reduce your taxable estate and income while maximizing your tax-deferred savings. Here's how:

THE JOY OF GIFTING

If generosity is its own reward, it's doubly gratifying to whittle down your taxable estate each year. The amount you can shelter from tax at death through the lifetime exclusion is rising, and will reach $2 million for a married couple ($1 million for an individual) in 2006, up from $1.3 million ($650,000 for an individual) in 1999. Sound tax planning can leave your estate at or just below those levels, minimizing the estate tax. Give $10,000 ($20,000 as a couple) to each heir. Such gifts can be made, tax-free, annually. If your estate is $3 million, you save $5,500 in estate tax every time you give away $10,000.

If you have a large estate, consider setting up a family limited partnership to accelerate gifting. By placing securities in such a partnership and naming yourself the general partner, you may be able to give away more, faster, notes Kevin Flatley, director of estate planning at BankBoston. Courts have consistently found that assets in such a partnership have less value because they are not liquid. Only the general partner can sell. So you may be able to gift up to $14,000 of stock this way and value it at only $10,000.

Consider charitable donations of assets that have greatly appreciated. You can take a full deduction for the market value of the asset, yet skip the capital-gains tax. If you aren't sure which charity you want to favor and you're giving cash, consider establishing a gift fund to reduce your estate. You can choose where to send the money next year. A number of mutual-fund companies have such funds, though they give you less freedom in choosing where to ultimately direct the money.

Don't forget that as the lifetime exclusion rises in coming years, you benefit even if you used it up at a lower level. You can shelter from estate tax the difference between the old limit that you've exhausted and the new limit. You can also donate, tax-free, virtually unlimited amounts for certain medical and education expenses beyond the normal gift limitations.

HURRY UP AND WAIT

As always, you'll want to defer income where possible and accelerate deductions. That might mean taking a bonus in January rather than December, if you have a choice, or paying your last estimated quarterly state income tax in December instead of January. Other ways to pull deductions forward: prepay health-insurance premiums, student-loan and mortgage interest and some college tuition.

If you expect to be in a much higher tax bracket next year, however, you should do the opposite. Ditto if you'll get hit with the alternative minimum tax in 1999. Before making any move, in fact, you should consult a tax pro to figure out if the amt applies. Once only the superrich were vulnerable, but now many upper-middle-class taxpayers get hit. Warning signs include a very large mortgage, stock options that you've exercised or large business-related deductions.

If you're on the fence about taking the standard deduction or itemizing, you might consider a strategy, known as bunching, in which you defer deductions one year, accelerate them the next, and so on. That allows you to benefit from itemizing every other year while taking the standard deduction in between.

SELL THOSE LOSERS

Now is the time to take stock of your investment portfolio. If you've sold securities at a gain, consider weeding out some losers--offsetting taxable gains with an equal amount of losses and taking an additional $3,000 in losses against ordinary income. The first to sell are those you've held longer than a year. Long-term losses must first be applied against long-term gains. But once those have been offset, you may apply remaining long-term losses against short-term gains, allowing you to cancel a gain taxed at as much as 39.6% with a loss that should save only 20%.

Selling for just tax reasons doesn't make sense if your losers are still worth holding. If you do sell and generate the tax loss, you can't hold onto that loss if you repurchase the stock within 30 days. So buy another stock in the same industry. "This is especially simple in the mutual-fund world," observes Tom Ochsenschlager, tax partner at Grant Thornton. Sell a losing fund, realize the loss for tax reasons, and immediately buy another fund just like it.

THE ROTH CONVERSION

Created two years ago, the Roth IRA eliminates many of the headaches in dealing with retirement savings in your retirement years. There are no mandatory distributions, and because the Roth is funded with after-tax dollars, there is no tax upon withdrawal. It's all yours--even the part that grew tax-free. Not everyone qualifies for a Roth. You must have an annual household income under $100,000 to convert an old IRA to a Roth, and under $160,000 ($110,000 for singles) to start one with new money.

If you converted an old IRA into a Roth in 1998, you have until Dec. 31 to undo it. The deadline was recently extended to allow those who converted without knowing whether they qualified for the Roth the opportunity to correct their error. Many rushed to convert in 1998 because of a one-time grant to spread the resulting tax over four years. The effect, though, was to extend the period in which you can unconvert and then reconvert to the Roth. You'd want to do that if your IRA's value is much lower now than when you originally converted. It can save a bundle in taxes. You lose the ability to spread the tax over four years, but you can approximate that benefit by converting a fourth of your portfolio each of the next four years.

OPEN A KEOGH

You have until April 15, or the date you file your return, to open a tax-advantaged IRA, assuming you qualify. But it's increasingly likely that you'll qualify for a Keogh, which must be established by year-end. A Keogh is a tax-deferred savings vehicle, like a 401(k), for the self-employed. If you have left your job and now derive income from consulting or serving as a board member, for example, you are eligible to open a Keogh by contributing, on a pretax basis, 25% of your earnings up to $30,000. Once the account is activated, you have until you pay your taxes next year to fund it.

In general, you should max out on any tax-deferred savings opportunity. This has been especially true since Congress two years ago rolled back a punishing 15% excise tax on withdrawals from retirement accounts deemed, through a complicated formula, to be too large. Be careful, though, if your tax bracket will rise in retirement. Withdrawals from tax-deferred accounts get taxed as income. If you'll be retiring soon, new contributions might not have enough time to grow tax-deferred. You might be better served putting new savings into a tax-efficient mutual fund, like an index fund. When you cash that in after one year, you pay the capital-gains rate on your earnings, typically lower than the income-tax rate you pay on IRA withdrawals.

MANDATORY DISTRIBUTIONS

You've saved dutifully for years, and your 401(k) is bulging with tax-deferred savings. Don't blow it when it's time to start taking money out. Unless you still work, you must begin taking distributions from IRAs and 401(k) accounts the year you turn 70 1/2. The penalty is a 15% hit on the shortfall between what you withdrew during the year and the minimum withdrawal that was required. The first year only, you get a grace period. You have until April 1 the following year to take money out of the account. But from then on, the deadline is Dec. 31. It's probably a mistake to put off the distribution that first year, even though you may not need the money and want to keep it invested. By delaying, you're forced to take two distributions the following year, and that may push you into a higher tax bracket. Mandatory distributions are one reason Roth IRAs have become popular since their creation two years ago.