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For Sale by Owner Articles • Owners.com - Money and Credit

Tax Planning

As you make your way through another tax filing season, don't overlook the potential value of thoroughly reviewing your tax return: It may highlight areas where some maneuvering can lead to significant tax savings. While "tax time" can be a headache for many, it forces you to gather and organize key financial data early in the year. Why not use this opportunity to uncover tax-saving strategies and techniques you may have been missing?
Your Adjusted Gross Income Looms Large
Your adjusted gross income (AGI) - which is calculated as your total income minus certain deductions - is used in determining your eligibility for a number of tax breaks (e.g., deductible IRAs or deductible medical expenses), as well as in the calculation of itemized deduction and personal exemption phaseouts for high-income taxpayers. So, while we're not suggesting that you give up your paycheck, you should consider ways of reducing your current tax exposure on the income received from employment, investment of other activities.
Voluntarily Defer Earned Income
Deferring a portion of your compensation through qualified and nonqualified retirement plans is a great way of saving current taxes while providing for your financial future. Participating fully - at least to the extent of any employer "matching" contribution - in a 401(k), 403(b) or 457 plan allows you to reduce your AGI and accumulate retirement funds on a tax-favored basis. If you're self-employed, a Keogh, SEP-IRA or SIMPLE plan can provide similar benefits.
In addition to qualified plans, a nonqualified deferred compensation arrangement between you and your employer may allow you to forgo a portion of your current pay in exchange for your employer's promise to pay you the deferred amount in a future year - typically after you've retired, when you might be in a lower tax bracket - plus interest (or the equivalent). The popularity and availability of nonqualified plans has grown tremendously in recent years due to the increased restrictions of qualified plans, especially for highly compensated individuals. The election to defer compensation must generally be made prior to the period in which it will be earned. This means that elections made in 1998 would generally cover 1999 compensation. However, you may be able to defer your 1998-year-end bonus if you make an election before it has been earned.
Compensatory stock options are another valuable benefit, allowing the holder to control the timing and amount of income recognition. Coming in two "flavors," nonqualified stock options (NQSOs) and incentive stock options (ISOs), these vehicles give the holder the right to purchase shares of the underlying property at a fixed price within a stated period. By delaying exercise as long as possible (e.g., until just prior to expiration), you can defer taxation of the bargain element, or "spread," and ride the growth in the underlying shares without increasing your current AGI.
Although the exercise of ISOs does not increase your AGI for regular tax purposes, the ISO spread is considered income for alternative minimum for tax (AMT) purposes. Thus, planning for ISO exercises requires careful monitoring; if you intend to exercise ISOs in 1998, consult with your tax advisor beforehand to determine the number of options you can exercise before running into the AMT. Note: So long as the stock acquired through the exercise of an ISO is not sold within two years of the date of the option grant or within 18 months of exercise, any gain realized on sale will be taxed at 20 percent (or 10 percent for individuals in the 15 percent tax bracket).
Restructure Your Portfolio to Shelter Investment Income
Schedule B of your tax return is where you report taxable interest and dividend income, all of which is taxed at ordinary income rates. How much of this income are you currently using? If you're in a "savings mode," funding future financial goals, consider emphasizing growth-oriented investments (e.g., certain stocks and stock-owning mutual funds) that produce long-term capital gains, which are taxed more favorably. In addition, by owning stocks directly, rather than indirectly through mutual funds, you'll generally have more control over the timing of capital gain (or loss) recognition in your investment portfolio.
If you're in the 28 percent tax bracket or higher, tax-free municipal bonds and/or bond funds may allow you to increase your after-tax return on the fixed-income portion of your portfolio. In addition, keeping higher-yielding taxable fixed-income investments (e.g., corporate bonds or bond funds) inside your tax-deferred accounts will defer taxation of you investment returns until the funds are withdrawn.
Variable annuities offer yet another way of sheltering investment income from current taxation. The lead article in this issue provides some interesting insights regarding these vehicles.
Delay Retirement Plan Distributions
Retirement plan distributions are treated as ordinary income. Thus, consider depleting nonretirement-plan assets before taking distributions that you are not required to receive from retirement plans in order to cover living expenses or other expenditures. Even if you have to sell appreciated property to raise cash, recall that capital gains are taxed more favorably than ordinary income. In addition, by selling assets that have depreciated in value, you could generate capital losses that could shelter current year capital gains. Note that up to $3,000 of net capital losses can also be used to offset ordinary income each year.
If your "required beginning date" for making "minimum required distributions" from your retirement plans is April 1, 1998, make sure to review our November/December 1997 article covering this topic so you don't get tripped up by the complex rules. The right decisions could help you lower your required distributions and reduce your current taxes.
Utilize Suspended Losses
Perhaps you own rental real estate that generates tax losses you cannot use currently due to the passive loss rules and an AGI that is over $100,000 (i.e., the losses are "suspended"). These losses are probably produced at least partly by the interest paid on a loan secured by the property. Other than selling the property to trigger the recognition of those losses, what can you do? By using the proceeds of a home equity loan on your residence to pay off (or down) the loan on the rental property (or by borrowing more than your outstanding balance on a pending refinancing of your residence), you could (a) convert your annual rental losses to net rental income, thereby "soaking up" your suspended losses, and (b) generate a current interest deduction for the home equity interest (limited to $100,000 of home equity indebtedness). Alternatively, you could use "excess cash that currently produces taxable investment income to pay off (or down) the rental loan, freeing up those suspended losses while reducing your AGI.
The New Roth IRA Makes Its Grand Entrance
If you've got existing IRAs (deductible or nondeductible), employing techniques that keep your 1998 AGI at $100,000 or below can really add juice to your financial plans this year. That's because 1998 is the inaugural year for the new Roth IRA. Existing IRAs can be "converted" penalty-free to Roth IRAs in 1998 by including the taxable value of the existing IRAs in gross income ratably over four years. (Taxes attributable to post-1998 conversions will be due in the year of conversion.) As we discussed in our September/October 1997 issue, the Roth IRA is a great way to (a) create tax-free income during retirement, and/or (b) accumulate significant income tax-free funds that can be transferred to heirs after your death. The biggest benefit from converting occurs if you can pay the income taxes out of non-IRA assets.
Be Creative
These are just a few ideas to help you lower Uncle Sam's (and you home state's) tax bite out of your 1998 income. Remember, it's never too early to start planning for tax time in 1999.

Because the materials covered in this article are complicated, this article should not be regarded as offering a complete explanation and should not be used for making decisions. Any suggestion should be reviewed with your personal financial and tax advisor.

© Copyright 1998 by Ernst & Young. All Rights Reserved.

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