Maxwell Shmerler Certified Public Accountants CPA


For 2005 and Beyond

The changes in the US tax laws provide opportunities for individuals and corporations to reduce their tax bill. In order to take advantage of these opportunities, proper analysis and planning are required. The following are some tips and advice on how to ease your tax burden.

Homeowners, investors, savers and business owners can all benefit from making changes to their financial strategies to take advantage of the new laws. Select a topic from the listing below for planning tips on specific tax saving strategies.

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Many of the new tax laws were oriented around savings for education. Two new tax credits, the Hope Credit and Lifetime Learning Credit can provide up to $1,500 per year in tax credits for higher education. Other changes are advantageous only if taken advantage of by the individual or their family.

Education IRA (Renamed Coverdell Account in 2001)

In 2001, these plans were renamed the Coverdell Education Savings Account in honor of the late U.S. Sen. Paul Coverdell. Individuals can make annual contributions of up to $2,000 per child into an account that's exclusively for helping to pay higher education costs. The money contributed to a Coverdell account doesn't count against the $3,000 ($3,500 if 50 and older) annual total individuals may contribute to their combined individual IRAs. The earnings and withdrawals from a Coverdell account are tax-free, but you can't deduct the contributions from your income tax.

Of course, there are some drawbacks to the Education IRA. First, if a child has an education IRA funded in a given year, no one can put money into a prepaid-tuition plan for the same child in the same year. A prepaid tuition-plan provides tax-favored treatment to qualified state tuition programs that allow parents to save for their children’s college costs on a prepaid basis. Although both methods allow for tax deferral of savings gains, the Education IRA is far more flexible and would be favored under many circumstances.

Second, there is also the possibility that the existence of an Education IRA may reduce the financial aid eligibility of the student. The Department of Education has not yet ruled on this issue. If you are deciding between a normal IRA and an Education IRA, keep in mind that withdrawals from a normal IRA are allowed for higher education, and the existence of such an IRA will not affect financial aid eligibility, unless the funds are used for such a purpose. If financial aid requirements and eligibility are in questions, a normal IRA is a safer alternative.

Finally, the Hope and Lifetime Learning Credit are not available for any student during a year in which a withdrawal from an Education IRA takes place. Thus, if you foresee that your AGI will be below the threshold for these credits, an Education IRA becomes less attractive.

Should I Invest in My Child’s Name?

There are advantages and disadvantages in investing in a child’s name as a means for education savings.

On the negative, financial aid departments will often look at children’s investments when gauging their eligibility. Also, children usually gain control of their custodial accounts at either age 18 or 21, and may not use the funds for their original purpose.

On the positive, the lower long-term capital gains rates make custodial accounts more attractive. If your child is in the 15% tax bracket, than long-term capital gains are taxed at only 10%. Even more importantly, gains on assets held more than five years as of the year 2001 will be taxed at an even lower rate of 8%. Children under 14 are taxed at their parent’s rate for investment income over $1300 until the age of 14, so your children will have to be at least 14 to take advantage of these capital gains rates.

Can I Use My Roth IRA for Education?

At age 59 , you can withdrawal funds from a Roth IRA tax-free. The purpose of this withdrawal is irrelevant. But if you need money for a child’s education, and are not yet 59 , you can still make withdrawals from you Roth IRA tax free, but only up until the amount of your taxable contributions.


Retirement Savings Alternatives (IRA, Roth IRA)

Previously, the main advantage of an IRA was tax deferral. Reducing your tax burden when you are working and are thus in a high bracket, and transferring that burden to retirement when you will be in a lower bracket. If your tax rate at the time of withdrawal is the same or higher than when you made the deposit, there is no overall advantage. As a regular savings vehicle, an IRA had many shortcomings, the greatest being the penalty for premature withdrawal before the age of 59 . The new tax laws change all of that.

IRAs become more attractive as a retirement vehicle and as a savings vehicle. First, a new IRA, called the Roth IRA allows nondeductible contributions to be withdrawn tax free at age 59 . Although no tax benefit is received when invested, all gains when withdrawn are tax free. Second, normal IRAs now contain provisions for withdrawal before age 59 without penalty under certain circumstances. Up to $10,000 can be withdrawn for purchase of a first time home and for higher education expenses.

In determining how and where to place your savings, consider IRAs, if you qualify, as an alternative. And remember, under the new tax law, more people qualify for IRAs.


Tax Avoidance and Multiple Homes

An exclusion of up to $500,000 of profit on the sale of primary residence is now available. For many, this eliminates the hassle of record keeping, as long as their gain is below the maximum exclusion amount. It also eliminates the need to purchase a home at greater value to defer taxes. Does this mean you should run out and sell your home? – Hardly. But it does open up opportunities for real estate investment professionals.

The exclusion of up to $500,000 is available every two years. Owners of multiple properties can avoid tax on gains simply by living in each home for two years. An investor could purchase run down property, fix it up, and exclude any gain at sale simply by living in the home for two years. People who can afford to move from house to house will have an opportunity at the biggest benefit.

First Time Homebuyers (IRA withdraw)

Many individuals now have access to a new source of funds for purchase of a first-time home. These funds are from an IRA. Under the new tax law, first-time homebuyers can withdraw funds for down-payment from their IRA, their parents IRA, and even their grandparents IRA, without penalty.

Many individuals who have considered buying versus renting, including the ensuing tax advantages, but did not have the down-payment may now be able to purchase a first time home.


Wait Until 2004

The maximum estate exemption increases in 2004 from $700,000 to $850,000, an increase of over 21%. Keep this in mind when planning your estate.

Family-Owned Businesses Win

Family-owned businesses qualify for an exemption of $1.3 million. This is an additional $300,000 over that allowed by current law in 2003.


To Sell or Not to Sell

Many investors held onto appreciated stocks in anticipation of the lowering in the long-term capital gains rate. If you are one of those investors, make sure alternate investments provide an equal or better risk/reward ratio. Also, keep in mind that many tax law provisions, including those changed for 1997 and 1998, are tied to Adjusted Gross Income. Sale of capital investments will increase AGI. Overall tax planning can help you determine any advantages or disadvantages to selling or holding investments in 1997.

Asset Placement and Your Portfolio

Lower long-term capital gains rates make growth oriented investments superior to income producing investments tax wise. When structuring, or modifying, your investment portfolio, certain guidelines should be considered.

Consider keeping or purchasing income-producing investments such as bonds in tax-favored accounts (IRAs, 401 (K)s) while keeping (or purchasing) growth oriented investments, such as stocks, outside to take advantage of lower capital gains rates.

Small Vs Large-Cap Stocks – Do Dividends Matter

Large Capitalization Stocks often pay dividends higher than their Small-Cap counterparts. Dividends are taxed at normal rates, whereas appreciation of stock may be taxed at the substantially lower long-term capital gains rates.

Should investors flock from Large-Cap stocks into Small-Cap stocks? According to Charles Kadlec, Chief Economic Strategist at J&W Seligman & Co., "Every time capital gains taxes have been cut since 1978, small-cap stocks have drastically outperformed the S&P 500."

Of course, there are other aspects to consider. Dividend yields, averaging over 5% for large-cap stocks in 1978, averaged a little over 2% in 1996. More and more large companies are distributing less and less dividends to their stockholders, deciding on reinvestment instead. Although the dividends on small-cap stocks have also declined, from 2.59% in 1978 to 1.37% in 1996, their decline is much less steep. Thus, the difference between small and large-cap stock yields has decreased, making the likelihood of small-cap out-performance lower. Changes in portfolio composition based on the capital gains tax cut should be taken judiciously.

Variable Annuities versus Mutual Funds

Variable Annuities are mutual funds that accumulate assets tax free until withdrawal, when regular income-tax rates of up to 39.6% apply. Regular Mutual Funds typical distribute income that is taxed at both the regular rate and the long-term capital gains rate. Thus, the break even holding period for Variable Annuities compared to mutual funds has increased.

When comparing variable annuities with mutual funds, determine the long-term capital gains characteristics of the mutual fund before determining which investment yields the greatest net gain over the time period in question. There may be other criteria to consider when looking at variable annuities, This includes any insurance features such as death benefit features.



The new tax laws provide a benefit for holders of stock options. Stock options give the holder the opportunity to buy shares of an employer’s stock at a bargain price. These options come in two varieties, ISOs (Incentive Stock Options) and NSO (Nonqualified Stock Options). Only ISOs gain any benefit under the new laws.

If you hold the ISO for two years after the grant, and at least one year after its exercise, any gain from the time of the grant to the time of the sale is taxed at the long-term capital gains rate. With NSOs, any appreciation above the option-grant price is taxed as ordinary income, payable at the time of exercise. Only gains subsequent to the sale of stock acquired through a NSO may qualify as long-term capital gains.

If you can, request ISOs as part of your pay.


Home Office Deduction (may now be available)

If you perform much of your work at home and you did not deduct your home office expenses because you either failed to meet the stringent requirements or were fearful of an audit, the new tax laws make such a deduction easier. Effective January 1, 1999, home office deductions are available if work at home includes substantial administrative or management services. Please see your tax planner or Maxwell Shmerler & Co., CPAs for details.

2003 Planning

Certain Moves that Save Taxes for 2005 and Beyond

Revise Withholdings on Payroll. The Tax Cuts Enacted in 2004 change both the tax brackets for individuals and other tax-related determinants. By reducing your withholding (by increasing your allowances) you can reduce your tax burden immediately, versus waiting until you file your returns in 2005 through a refund.

Make year-end gifts. Each year a person can give any other person up to $11,000 without incurring any gift tax. The annual exclusion amount increases to $20,000 per donee if the donor's spouse consents to gift-splitting. Anyone who expects eventually to have estate tax liability and who can afford to make gifts to family members should do so. Besides avoiding transfer tax, annual exclusion gifts take future appreciation in the value of the gift property out of the donor's estate, and shift the income tax obligation on the property's earnings to the donee who may be in a lower tax bracket (if not subject to the kiddie tax).

Gifts that qualify for annual exclusion. The gift tax exclusion generally is not available for gifts of future interests. However, transfers to minors under the Uniform Gifts to Minors Act or Uniform Transfers to Minors Act do qualify for the exclusion. Also, a gift made to or for the benefit of a minor qualifies for the exclusion if the gift property and its income will pass outright to the beneficiary on reaching age 21 (or to the minor's estate if he or she dies before age 21). Also, gifts to so-called Crummey trusts, which give the beneficiary a limited right of withdrawal, qualify for the annual exclusion. (Rev Rul 74-405, 1973-2 CB 321)

Gift checks. A gift by check to a noncharitable donee is considered to be a completed gift for gift and estate tax purposes on the earlier of:

… the date on which the donor has so parted with dominion and control under local law as to leave in the donor no power to change its disposition, or

… the date on which the donee deposits the check (or cashes the check against available funds of the donee) or presents the check for payment, if it is established that:

(1) the check was paid by the drawee bank when first presented to the drawee bank for payment;

(2) the donor was alive when the check was paid by the drawee bank;

(3) the donor intended to make a gift;

(4) delivery of the check by the donor was unconditional; and

(5) the check was deposited, cashed, or presented in the calendar year for which completed gift treatment is sought and within a reasonable time of issuance. (Rev Rul 96-56, 1996-2 CB 161)

Thus, for example, a $10,000 gift check given to and deposited by a grandson on Dec. 31, '05 is treated as a completed gift for '05 even though the check doesn't clear until '04 (assuming the donor is still alive when the check is paid by the drawee bank).

Recommendation: Annual exclusion gifts shouldn't be postponed until year-end. If such gifts are made at the beginning of each year, their appreciation in value inures to the donee that much sooner, and greater family income tax savings can be achieved. Additionally, if the donor dies or becomes incapacitated during the year, the exclusion already will have been secured.

Year-end-gifts of appreciated stock. A taxpayer may be holding appreciated stock that would yield gain taxed at 15% (if held for more than one year but not for more than 18 months) or at a higher bracket (if held for one year or less and the taxpayer is in one of the top three brackets). If the taxpayer has determined that the stock should be sold soon, tax dollars can be saved by gifting the stock to a low-bracket family member who can sell the stock and pay a 15% tax on all or part of the gain.

Increase withholding to help avoid estimated tax underpayment penalty. An employee may discover that his prepayments of tax for 2005 have been too small because his estimate of income or deductions was off and he underwithheld, or because he failed to make estimated tax payments for unanticipated income, such as sales of stock. To ward off or reduce an estimated tax underpayment penalty, the employee can ask his employer to increase withholding for his last paycheck or paychecks to make up or reduce the deficiency. He can file a new Form W-4 or simply request that the employer withhold a flat amount of additional income tax.

Increasing the final estimated tax payment for 2005 (due on Jan. 15, 2006) can cut or eliminate the penalty for a final-quarter underpayment only. It doesn't help with underpayments for preceding quarters. By contrast, tax withheld on wages can wipe out or reduce underpayments for previous quarters because, as a general rule, an equal part of the total withholding during the year is treated as having been paid on each quarterly estimated payment date. (Code Sec. 6654(g)(1))

Deplete health FSA accounts. Employees who participate in their employer's health flexible spending account (FSA) should keep in mind that medical expenses reimbursed under the account must be incurred during the participant's period of coverage (normally 12 months) under the FSA. Expenses are treated as having been incurred when the participant is provided with the medical care that gives rise to medical expenses, and not when the participant is formally billed or charged for, or pays for, the medical care. (Prop Reg 1.125-2, Q&A 7(b)(6)) An employee whose period of coverage ends on Dec. 31 should be sure to deplete his health FSA before year end (e.g., by getting new contact lenses) or he'll lose what's left in the account. Keep in mind that a health FSA can only reimburse medical expenses as defined in Code Sec. 213. (Prop Reg 1.125-2, Q&A 7(b)(4))

Observation: Thus, medical expenses that aren't deductible under Code Sec. 213, such as the cost of over-the-counter drugs or purely cosmetic surgery, can't be reimbursed under a health FSA.

Set up Keogh plans by year-end. A calendar-year self-employed individual who wants to contribute to a Keogh plan for 2005 can do so up to the due date of his return (including extensions), but only if the plan is set up before the end of 2005. (IRS Pub No. 560 (1996) p. 10) By contrast, a SEP plan can be established as late as the self-employed person's return due date (including extensions).

Year-end moves that protect next year's tax breaks. Before year-end, employees should be sure to tell their employers how much they'd like to set aside in 2001 in a Code Sec. 401(k) plan or flexible spending arrangement, where the plan year coincides with the calendar year. That's because an employee must elect in advance how much to set aside in the plan. Similar rules apply to nonqualified deferred compensation plans.

Defer equipment purchases to salvage expensing deduction. 

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Waiting until your tax return is due to determine your deductions and possible credits is too late. Planning, even for low and middle income individuals, can result in concrete tax savings. Some planning simply requires common sense. Other planning requires a thorough understanding of our tax laws. It is here that a tax advisor can help. Please contact your financial planner or Maxwell Shmerler & Co.