Kiddie Tax Loophole Soon to Disappear (2007-10-29)

Kiddie Tax Loophole Soon to Disappear

(2007-10-29) by David John Marotta and Beth Anderson Nedelisky

Income-shifting is one of several tax planning tools families have used to lower their tax bill. Historically, parents could save a bundle by transferring highly appreciated investments to their children who are in lower tax brackets. However, this year, Congress has made income-shifting a dream of the past, trapping more kids in the dreaded "kiddie tax." Beginning January 1, 2008, children under 24 will owe taxes on unearned income at their parents' higher tax rates.

The "kiddie tax," or so it has been affectionately named, is a tax on children's unearned investment income or capital gains. Instead of taxing income and capital gains based on the child's tax bracket, the kiddie tax requires unearned income to be taxed at the parents' income and capital gains rates.

Before the expansion of the kiddie tax, parents turned to Uniform Transfer to Minors Accounts (UTMAs) or Uniform Gift to Minors Accounts (UGMAs) to move appreciated investments out of their estate. Once in the child's name, the assets were taxable at the child's - typically much lower - tax rates.

Shifting appreciated assets to a child could save a family 10% in capital gains taxes. Since most children earn little income, they usually fall into the lowest marginal tax brackets of 10% or 15%. Capital gains in these lowest two brackets are taxed at just 5%, compared to the typical 15% rate paid by many parents.

Savings could be even greater on short-term gains and investment income which are taxable at ordinary income tax rates. A child in the 10% bracket would pay 10% tax, instead of rates as high as 35% if mom and dad own the asset.

A once-in-a-lifetime kiddie tax loophole made intergenerational transfers even more appealing. In 2008, 2009, and 2010, capital gains rates are set to drop from 5% to 0% for individuals in 10% and 15% tax brackets. In other words, before the recent changes to the kiddie tax law, children 18 and over in the lowest two tax brackets could expect to pay no capital gains taxes in the next three years.

The new kiddie tax rule closes this loophole forever. If you were waiting for the days of 0% capital gains tax, you can kiss that dream good-bye.

Through 2005, the kiddie tax was limited to kids under 14. Last year, Congress cast the tax net wider, requiring children under age 18 to pay the kiddie tax. And this year, with the passage of the Small Business and Work Opportunity Tax Act of 2007, children under 19, or full-time students up to 24, will be subject to the kiddie tax. The good news is the new kiddie tax law doesn't take effect until January 1, 2008. If your child is between the ages of 18 to 23 this year you can still realize gains at your child's lower rate, if you act now.

After January 1st, children under 19, or full-time students under 24 will be stuck paying income and capital gains at their parents' tax rates. The kiddie tax applies as follows: No tax on the first $850 of earnings. Income between $851 and $1,700 is taxed at your child's tax rate. Any unearned income over $1,700 is taxable at the parents' marginal tax rate. However, children who provide for more than half of their own support will not be subject to the new law.

The expanded kiddie tax law now makes UGMA and UTMA a poor choice for college savings. Instead, 529 college savings accounts provide tax-free growth on contributions, allowing families to reduce their exposure to income and capital gains taxes. Qualified expenses such as college tuition, books, room and board can be withdrawn tax-free. And unlike UGMA and UTMA accounts, the college savings accounts are owned by the parent.

For more information about year-end tax planning, you are invited to attend the November NAPFA Consumer Education Foundation presentation. John G. Bowen, CPA, CFP®, AIF®, of Bowen Financial Services, LLC, will be speaking on the topic of year-end tax planning.

The seminar will be held on Saturday, November 10th from 12:00pm to 1:30pm at the Northside Library in the Albemarle Square shopping center. For more information call (434) 244-0000, or send an email to . To learn more about the NAPFA Foundation visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm.

All presentations are free and open to the public. You are encouraged to attend and to bring your financial questions.

from http://www.emarotta.com/article.php?ID=254

IRAs Offer Big Tax Savings for Charitable Gifts (2007-10-22)

IRAs Offer Big Tax Savings for Charitable Gifts

(2007-10-22) by David John Marotta and Beth Anderson Nedelisky

For a few more days this year, the tax law will allow you to give to charity directly from your IRA and count that gift toward your required minimum distribution. Giving to charity from your IRA will also provide you with additional tax savings. But, to qualify, you must make your donations before 2008.

Unlike the typical deduction you may be taking to offset your charitable giving, the Pension Protection Act of 2006 offers you tax savings opportunities which a charitable contribution deduction will not.

The Pension Protection Act provisions allow you to make so called "qualified charitable distributions" from your IRA and to exclude the gift from your gross income. Furthermore, such gifts can be used to fulfill required minimum distributions. But you must give before 2008, when the provision sunsets.

If you are an IRA account owner over 70½, you are required to take withdrawals, known as "required minimum distributions" (RMDs), from your IRA account. You must take your RMD each year, regardless of whether you need the money or not. What's more, IRA withdrawals must be reported as income and are taxed at ordinary income rates. After all, Uncle Sam won't let your money go tax-free forever.

The Pension Protection Act offers a unique tax benefit with these so called, "qualified charitable distributions." Here's how: Gifts you make to charity from your IRA bypass your taxes altogether. Since your gift is not counted as income, it does not increase your adjusted gross income (AGI).

Your adjusted gross income determines your tax bracket and your eligibility for a number of other tax benefits. By reducing this number, you may avoid the phase-out rules which may limit your itemized deductions or personal exemption amounts. You may even be able to drop to a lower income tax bracket.

If your IRA contains both before-tax and after-tax dollars, you can save even more by giving. Qualified charitable distributions made from an IRA containing both before-tax and after-tax dollars are taken from the portion of untaxed dollars. This is a radical departure from the typical IRA model which requires you to withdraw the pre-tax and after-tax dollars proportionately. Under the Act, you'll be able to give away the dollars which carry the highest tax liability. At the end of the day, you'll have a higher percentage of after-tax dollars left in your IRA.

To be considered a "qualified charitable distribution," your donations must meet a few criteria. First, only IRA account holders age 70½ or older are eligible to participate.

Next, your donation must be made directly from your IRA to the charity. Contact your IRA trustee for more instructions on how to initiate the transfer. Any distribution made payable to you won't qualify.

Finally, be sure the receiving organization is a qualified public charity or private foundation which can receive donations. Contributions to donor advised funds aren't considered qualified charitable distributions. And, as with any gift to charity, don't forget to obtain a receipt acknowledging your gift.

Qualified charitable distributions will help to fulfill your annual required minimum distributions. But, your donation can be greater than your required minimum distribution amount. You can exclude up to $100,000 in qualified charitable gifts each year. A gift amount over $100,000 must be recognized as income and deducted according to the standard charitable deduction rules.

Above all, keep in mind that you cannot double-dip and take a deduction for your IRA qualified charitable contribution. No deduction is permitted for charitable distributions which are not recognized as income.

Finally, be sure you act soon. Only contributions made to charity before January 1, 2008 can be characterized as qualified charitable distributions.

Qualified charitable distributions are just one tax planning tool which may save you money. We advise our clients to meet with their tax professional in November or December to review their tax plan before year's end. Tax planning is complex and time consuming. So, make an appointment with your tax professional before the real tax season hits.

For more information about year-end tax planning, you are invited to attend the November NAPFA Consumer Education Foundation presentation. John G. Bowen, CPA, CFP®, AIF®, of Bowen Financial Services, LLC, will be speaking on year-end tax planning.

The seminar will be held on Saturday, November 10th from 12:00pm to 1:30pm at the Northside Library in the Albemarle Square shopping center. For more information call (434) 244-0000, or send an email to . To learn more about the NAPFA Foundation visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm.

All presentations are free and open to the public. You are encouraged to attend and to bring your financial questions.

from http://www.emarotta.com/article.php?ID=253

Employee Retirement Options - Part 2 (2007-10-15)

Employee Retirement Options - Part 2

(2007-10-15) by David John Marotta

Most employees have all their retirement eggs in one basket --their employer's retirement plan. The plans usually offer less than two dozen fund choices to cover all your hopes of maintaining your lifestyle, independence, and dignity in your later years. As discussed in the previous article, the more baskets (and eggs) you have, the better. If most of your retirement assets are with your employer, here's how to make the most of what you've got.

First, there are some mistakes to avoid. Probably the most common mistake made by employees is to allocate an equal amount of money to each of the fund choices. Studies have shown that given ten choices, employees tend to put 10% in each choice. Given five choices they put 20% in each choice. If four of the choices represent one type of asset and the fifth is unique the asset allocation is split 80/20. If the funds happen to be the other way round then the asset allocation is 20/80.

The equal proportions methodology builds very poor portfolios. You can't afford to make these types of mistakes with your future livelihood. The only thing worse than the equal proportions strategy is allocating all of your money to just one fund. You need an investment philosophy that integrates all of your asset holdings. Only then can you evaluate which of your company's fund options are right and determine what percentage to allocate to each.

Many employer sponsored retirement plans are just mediocre. Neither the fund company nor plan provider has much incentive to fill your selections with stellar choices. Plan sponsors have a fiduciary responsibility, but few take that responsibility seriously. Procedures may or may not be in place even to meet minimum guidelines. Still, you should be able to find a few funds worth selecting in order to gain your employer's match.

Your own company or plan provider usually isn't the best place to turn for advice. After all, they are the ones that picked the options in the first place. You should get the outside opinion of a professional financial planner on where to invest.

Another common mistake is to invest in whatever funds have done the best over the past 1, 3, or 5-year period. None of these measures is long enough to produce a balanced asset allocation. Every financial disclaimer states that "past performance is no indication of future returns," and yet, past performance remains the primary selection criteria for many investors. Too many employees pick the asset category that has done the best over the past three years. However, these higher-than-average returns often represent a peak. Going forward, they are the fund choices most likely to under-perform for the next three years.

While three year average returns is a poor way to select a fund, thirty year average returns is a good way to select an asset category for including in your asset allocation. If small cap value is a good asset category to include for the long term, see if your plan includes any small value funds. Then judge them against other outside funds within their asset class and not against other funds within your plan.

You should be looking for funds which are the best funds within their asset class regardless of how well the asset class has done over the short term of just the last few years. Funds that are the best in their category can often be found through index funds that have very low expense ratios.

Remember also that you are looking for a team of funds and not just a few hot shots. Your retirement portfolio consists of more than just your employer's plan. Even if your employer's plan only has a couple of good choices, you can use your other investments to create a balanced asset allocation. While the choices in your employer's plan may be limited, investments in your IRA or taxable account will have an unlimited number of choices from which to craft a balanced allocation.

It is important to start with an over all asset allocation plan and then see what asset classes your employer's plan offers that would integrate well with your investment philosophy. Since your employer's plan usually has the most limited number of choices, pick the best it has to offer that fits with in your over all plan.

The NAPFA Consumer Education Foundation is holding a free seminar on how to build a well diversified retirement portfolio using your employer's retirement plan choices. I will be presenting how to build retirement portfolios using the choices available at the University of Virginia. The talk will be held on Saturday, October 20th from noon to 2pm at the Northside Library. For more information call (434) 244-0000, or send an email to charlottesville at NAPFAfoundation.org
To learn more about the NAPFA Foundation visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm.

from http://www.emarotta.com/article.php?ID=252

Employee Retirement Options - Part 1 (2007-10-08)

Employee Retirement Options - Part 1

by David John Marotta

Putting all of your retirement eggs in one basket is easy to carry, but risky. Most workers are putting all their retirement assets in the basket of their employer's retirement plan. They are depending on one employer and two dozen eggs (funds) to hatch and maintain their lifestyle, independence and dignity in their later years. Don't trip.

Just one generation ago employers provided their employees with defined benefit plans for retirement. The employee could plan on a benefit that the employer had contractually promised. The employer was responsible to insure that a defined amount would be payable to each employee when they retired. Such security today is obsolete.

The new model moves the outcome responsibility from the employer to the employee through what are called defined contribution plans. The employer is helping with the input (the contribution), but no longer guaranteeing the output (the benefit).

An employee's retirement income is now contingent on four variables: how much the employee puts in, how much the employer matches, the performance of the underlying funds and of course, time.

In a typical defined contribution plan the employer will match dollar for dollar the first 3% of your salary, and fifty cents per dollar on the next 2% of your salary. That means if you contribute 5% of your salary, your employer will give you an additional 4% of your salary in retirement contributions.

Getting the maximum amount possible of this free money should be your first priority in saving for retirement. Even if your 401k or 403b defined contribution choices are not stellar, you still get an automatic 80% return on your money the very day you contribute. Strangely, many employees neglect to pick up this free money. The 80% automatic return is an offer you should not refuse.

After saving enough to get the full match from your employer, don't necessarily continue to use your employer's plan as your only retirement basket. After getting the full match, we recommend funding your Roth IRA, your spouse's Roth IRA and your taxable account. Only after adequately funding these individual account choices should you consider putting more money into your employer's plan than is necessary to get the full match.

Retirement plans through work are laden with fees and expenses that are not on individual investment accounts. The difference in fees is often 1% or more. The longer you leave your money in a defined contribution plan, the more the excessive fees will erode its value. There are plans so laden with fees that they are not even worth the match. Where the fee differential is 2%, after 30 years the fees will have eaten up the entire 80% match.

In other words, if you had the same amount of money in a traditional IRA account earning 2% more because of lower fees after 30 years you would have 81% more money in your account. For this reason alone, make sure that you don't leave money in an employer's retirement plan any longer than you have to. After terminating employment with one employer you should always roll that money into an individual IRA Rollover account where you can invest with lower fees and better choices.

It is a mistake to move money from a pervious employer's plan into your current employer's plan. This mistake, however, can often be undone. Money that has its source from another employer is usually allowed to be rolled out of an employer's plan and into an IRA Rollover account. If you are in this situation you should see if you can rescue some of your investments from the higher fees and limited choices of your current employer's plan.

There's another important tax reason not to put all of your retirement assets in your employer's plan. If you take a deduction while you are in a low tax bracket and in retirement when you are taking withdrawals you are in a higher tax bracket then your contributions work against you. You would have done better to have put your extra non-match retirement savings into a Roth or taxable account. Your tax rates are likely to be higher during your retirement. Currently, top marginal tax rates are only 35%. Before the Bush tax cuts the top marginal rate was 39.6%. Before the Regan tax cuts the top marginal rate was 70%. Before the Kennedy tax cuts the top marginal rate was 90%. Tax rates are at historic lows.

When you take the money out of an employer's plan or a traditional IRA account you will have to pay taxes at whatever tax rate is currently in effect. And after age 70 ½ you will have to start taking required minimum distributions in order for the government to ensure that they will get their tax. Historically speaking, the odds are your withdrawals during your retirement will be charged at a higher income tax rate than the deduction you received when you put the money in.

It may be better for you to pay your current tax rate and get your money into a Roth IRA where it won't be taxed again or a taxable investment account where the growth is only taxed at capital gains rates.

If you are just starting out in your career you are probably in the lowest tax bracket you will ever be in. Therefore it is more important to carry your retirement savings in more than one basket. Fund your employer's plan with no more than is necessary to get the match and then fund your Roth IRA and build your taxable savings.

The NAPFA Consumer Education Foundation is holding a free seminar on how to build a well diversified retirement portfolio using your employer's retirement plan choices. I will be the speaker this month presenting how to build retirement portfolios using the choices available at the University of Virginia. The talk will be held on Saturday, October 20th from noon to 1:30pm at the Northside Library. For more information call (434) 244-0000, or send an email to Charlottesville@NAPFAFoundation.org. To learn more about the NAPFA Foundation visit http://www.napfafoundation.org/NAPFAfoundation_Charlottesville.htm.

from http://www.emarotta.com/article.php?ID=251

Dorothy in Taxland: Below the Line Deductions (2007-10-01)

Dorothy in Taxland: Below the Line Deductions

(2007-10-01) by David John Marotta

Not all deductions are created equal. Some deductions are more valuable than others. What matters is whether or not the deduction is "above the line" or "below the line". The line in this case is your adjusted gross income (AGI).

Above the line deductions are subtracted from your gross income in order to compute your AGI. Therefore, above the line deductions reduce your AGI which also reduces your taxable income. Reducing your AGI can lower many subsequent calculations which will lower other taxes you may have to pay. As a result, above the line deductions are more advantageous than those taken below the line. They are like Dorothy's ruby slippers, once you have them on the Wicked Witch of Taxland can't touch you.

Below the line deductions are more uncertain. Like many items in the tax code the correct answer to "Will they reduce my taxes?" is: "It depends." They are like Dorothy's first encounter with the Wizard. He promises to grant her requests if she would only bring him the witch's broomstick and she never thinks to challenge the man behind the curtain.

AGI minus your personal exemptions and deductions equals your taxable income. You can claim a personal exemption for you, your spouse, and your dependents. In 2007, you can reduce your AGI by $3,400 for each exemption you claim. These exemptions are subject to phase outs above $234,600 for joint filers ($156,400 for singles).

Below the line deductions are subtracted from your AGI to compute your taxable income. You can either itemize your deductions or you can take a standard deduction, whichever is greater. In order to gain from itemizing, your itemized deductions must exceed your standard deduction. Nearly two out of three taxpayers do not gain and choose to take the standard deduction instead.

Your standard deduction is a fixed dollar amount based on your filing status plus some specific adjustments. For 2007, your standard deductions is $5,350 if you are single, $7,850 if you are the head of household, or $10,700 if you are married filing jointly. You can take an additional standard deduction of up to $1,050 if you are age 65 or older.

Home ownership is the most common way to boost your deductions above the standard deduction. The IRS allows home owners to deduct their interest payments each year. If your home mortgage is at 6% and your payments are mostly interest, then most of your mortgage is tax deductible. If your marginal tax rate is near one third, the government is paying 2% of your interest, and you are only paying 4% of your interest. For most middle class families that results in a huge tax savings.

The benefits of a mortgage are greater when the majority of your payment is interest, not principle. There is no tax deduction for payment of principle. Therefore, you want as many years of interest payments as possible. As a result, 30-year mortgages have much greater tax savings than 15-year mortgages.

When it comes to maximizing your deductions, home owners can also deduct real estate taxes and points paid down on the loan. The cost of the points can be deducted over the price of the loan. So, If you paid $3,600 in points for a 30 year mortgage you can write off $10 a month, or $120 each year. If 10 years into the loan you refinance again, all the remaining points that haven't yet been deducted are deductible in the year you refinance anew. In our example that would be $2,400.

If home ownership alone doesn't make itemizing worthwhile, your state and local taxes (including personal property taxes) along with any charitable deductions may push you over the top. Alternately, if you have high medical expenses which exceed 7.5% of your AGI, you can deduct them as well.

Once you have ensured that your itemized deductions are over your standard deduction there are several smaller deductions that can increase your tax savings.

Miscellaneous itemized expenses can be deducted only when their total exceeds 2% of your AGI. For most people, their deductions are too low or their AGI is too high. But, if your income drops for a year, or you retire, you may qualify.

Deducting miscellaneous expenses is difficult unless you keep good records throughout the year. Qualifying expenses may include work related expenses, legal or accounting fees related to tax preparation, investment advisory fees, estate planning and investment expenses including your safety deposit box, professional dues, and newspaper subscriptions.

Overall, keeping good records is vital to determining whether you can itemize your deductions come tax time. Itemizing your deductions may provide you with some additional tax savings. With an overflowing bucket of deductions and exemptions, your tax burden will soon be melting.

from http://www.emarotta.com/article.php?ID=250