Financial Planning: Income Tax Planning

Income Tax Planning
WHAT IS IT?

As the old saying goes, "Nothing is certain but death and taxes." Financial planning cannot postpone or prevent the first inevitable (death), but, in some instances, planning can postpone, reduce, or even eliminate the impact of the second, (taxes). Income tax planning encompasses several areas to include:

Understanding the structure and operation of our tax laws
Calculation and filing of federal income tax returns
Planning to minimize taxes
Other forms of personal taxation

The Federal Income Tax Code is very complex and detailed. Our discussion will be limited to a brief overview of its provisions and some of the more important applications to the financial planning process.

UNDERSTANDING OUR FEDERAL INCOME TAX LAWS

Federal Income Tax was authorized by the 16th Amendment and the Revenue Act in 1913. The Internal Revenue Code was created in 1939; was first modified in 1954, and has been modified numerous times since. Our tax laws are administered and enforced by the Internal Revenue Service (IRS).

Federal income tax provides the major source of revenue for our federal government. Individuals and businesses are taxed annually on “progressive rates” (the more you make, the more you pay). Currently these rate brackets range from 15% to 39.6% for individuals. When initiated, these rates were less than 5% upon inception, and have been as high as a 70% top marginal bracket in 1965-67.

The tax is paid on an “as you go” basis. Employers must withhold taxes from each paycheck and self-employed individuals must make quarterly estimated payments. Filing of an annual tax return (Form 1040) is required unless you fall below the minimum taxable income. There are numerous schedules, which may be required to accompany this 1040 Form, based on the individual’s personal situation. Individual tax returns are due by April 15, following the applicable tax year. Extensions are available, but this does not allow for additional time for the taxes to be paid.

The IRS audits about 1% of personal tax returns filed, with this percentage increasing to 5% of returns with income above $100,000. Some of the known “Audit Triggers” are as follows:

Tax returns reflecting use of tax shelters
Tax returns prepared by those on the “IRS Problem- Preparers List"
Tax returns reflecting significant deductions for travel and entertainment expenses
Tax returns reflecting significant business automobile expenses
Tax returns reflecting significant casualty losses
Tax returns reflecting significant income from barter
Tax returns reflecting deductions for in-home offices
Tax returns reflecting hobby losses.

Any disagreements will be resolved though the IRS Appeals Office; the U.S. Tax Court; the U.S. Claims Court, or the U.S. District Court.

CALCULATION AND FILING OF FEDERAL INCOME TAX RETURNS

There are several factors, which will determine the amount of federal income tax you will pay:

Filing Status
Taxable Income (Gross)
Allowable adjustments to income
Allowable deductions to income
Exemptions

Filing Status

The major categories are:

Married filing jointly (individuals who are married and jointly report their income and deductions). On a joint return, everything is considered to be combined, and both taxpayers must sign the return and are liable for tax payment.
Single (unmarried individuals who do not qualify as Head of Household)
Head of Household (unmarried individuals who qualify for the classification by means of maintaining a household for self and dependent relative(s) living in the household.)
Married filing separately (individuals who are married, but who choose to report their income and deductions separately)

Gross Income Defined

Income is defined very broadly by the IRS, and basically consists of any income regardless of the source (with a few noted exceptions). Gross income can fall into three categories:

Earned Income includes your wages, salaries, commissions, bonuses, tips, alimony, pension and annuity income; income from such sources as prizes, lotteries, gambling; and in under some circumstances a portion of Social Security income.
Portfolio Income includes dividends, interest, royalties and capital gains or losses from the sale of investment assets.
Passive Income includes income derived from limited partnerships, rental income and capital gains on passive activities (those activities in which you do not materially participate).

Sources of Income Excludable from Taxation

As previously stated, almost all sources of income constitute a part of your taxable income; however, there are some sources of income which are specifically excluded by the IRS. (Note: These exclusions contain restrictions and limitations, so your personal tax adviser can provide advice as to the applicability to your personal circumstances.) Some of the most important of these exclusions are:

Life insurance proceeds
Gifts and inheritances
Interest on certain investments such as some government obligations
Compensation received for injuries or sickness
Proceeds of accident or health plans
Premiums paid on your behalf by your employer for certain employee benefits such as medical, dental, and disability insurance
Various non-cash fringe benefits provided by your employer (such as employee discounts, parking, subsidized eating facilities, etc.)
Certain qualified scholarship and fellowship proceeds (not including benefits for room and board)
Social Security Benefits (for taxpayers below certain income levels)

Adjustments to Income

Certain allowable adjustments may be made to gross income. These are sometimes referred to as “above the line deductions”, due to their location on the Tax Return. Some of these adjustments are:

Qualifying contributions to IRA accounts (limited) See Retirement Section.
Penalty on early withdrawal of savings (limited)
Alimony paid (limited)
Moving expenses (limited)
Losses from sale or exchange of property (limited)
Student Loan Interest (limited)
Certain adjustments for self-employed individuals
50% of self-employment tax paid
A portion of health insurance premium paid (45% in 1999)
Qualifying contributions to Keough Retirement Plan (limited) See Retirement Section
Trade and business deductions

Deductions From Adjusted Gross Income

You may either elect the Standard Deductions or you may choose to Itemize Deductions. These deductions are known as “below the line” deductions. Only about one-third of all tax returns use the Itemized Deduction method.

Standard Deductions for 1999 are:

The following are the most common allowable deductions for those who itemize:

Medical and dental expenses (in excess of 7.5% of AGI)
Some state, local, and foreign income, property and personal, and property taxes
Interest payments on home loans and some investment interest (limited)
Charitable contributions (limited)
Moving expenses (limited)
Some job-related and other miscellaneous expenses (in excess of 2% of AGI)
Un-reimbursed casualty and theft losses (limited)

Exemptions

A taxpayer may claim exemptions for him/herself, a spouse, and any dependents (including children under age 24 who are full time students). Certain limitations and restrictions apply.

Example

	Gross Income
Less:	Adjustments to Gross Income
Equals:	Adjusted Gross Income (AGI)
Less	Larger of Itemized or Standard Deductions
Less	Exemptions
Equals	Taxable Income

Once Taxable Income has been determined, the applicable tax table/schedule is applied. Ninety percent of all taxpayers fall into the first two brackets (15% and 28%). The rate which will apply to each successively higher tax bracket is called “marginal income bracket”. It should also be noted that a taxpayer’s “effective rate” may be higher or lower than the actual scheduled rate. For example, an individual in the upper tax brackets may lose a portion of his/her itemized deductions or exemptions as the income increases, so the actual effective rate will actually be higher than the 39.6% top bracket.

Some taxpayers may be subject to an additional tax calculation, the Alternative Minimum Tax (AMT). This is a separate calculation which may eliminate some of the deductions available under the regular method of calculation such as net losses from some passive business activities; charitable contributions of appreciated capital gain property; etc. If the calculation of AMT results in a higher amount than the regular method of calculation, the taxpayer will be responsible for the higher payment.

Tax Credits

Once the amount of taxes due has been determined, there may be tax credits available to offset payment due. A tax credit is a dollar-for-dollar reduction in the actual tax bill, and as such, is of more value than a deduction for an equal amount, which simply reduces the amount of taxable income. Limitations and exclusion apply to all of these credits and their use should be co-ordinated through your tax adviser. The most common of these are:

Child and dependent care expense credit
Earned Income Credit
Credit for Elderly or Disabled (Scroll down in the link for information)
Foreign Tax Credit
Lifetime Learning Credit
Hope Scholarship Credit

So, we now complete our tax calculation as follows:

Example

	Gross Income
Less:	Adjustments to Gross Income
Equals:	Adjusted Gross Income (AGI)
Less	Larger of Itemized or Standard Deductions
Less	Exemptions
Equals	Taxable Income
Times:	Applicable Tax Rate
Equals	Tax Liability
Less	Tax Credits and Prepayments
Equals	Tax or Refund Due

Special Tax Treatment Items

* Capital Gains
A capital gain occurs when an asset (stock, bond, real estate, etc.) is sold for more than its initial purchase price. The tax rate is determined by the holding period of the asset. For holding periods of more than 12 months, the rate is now 10% for those in the 15% bracket and 20% for those in the other brackets. For an asset held less than 12 months, the capital gain is the same as ordinary income.

* Capital Losses
A capital loss occurs when an asset (stock bond, real estate, etc.) is sold for a loss. Both long-term and short-term losses can be written off dollar-for-dollar against any capital gain. Beyond that, capital losses can be written off against ordinary income up to $3,000 per year. (Any excess loss may be carried forward to future years.)

* Sale of Personal Residence
Single taxpayers may exclude up to $250,000 of gain from the sale of a personal residence. Married taxpayers filing jointly may exclude up to $500,000. This exclusion is available every two years. Any loss on the sale of a personal residence is not deductible.

TAX PLANNING AND ITS ROLE IN THE FINANCIAL PLANNING PROCESS

Taxpayers are always seeking ways to eliminate or at least reduce their income tax burden. There are some strategies, when used in conjunction with the overall financial plan, which can accomplish these goals.

Some popular tax-savings strategies are:

Taking Maximum Advantage of Tax Filing Options

This technique involves the maximization of available tax deductions, exemptions and credits (thereby reducing the amount of taxable income). These issues will vary by individual and should generally be discussed with a tax professional; however, some of the more important considerations are:

Are you aware of all available exemptions, deductions and credits to which you are entitled?
Is your present taxpayer status (joint return, separate return, Head of Household, etc.) best for you?
Will your AMT calculation exceed your regular tax calculation; and if so, what planning steps should you consider?
If self-employed, have you considered which form of business structure (Sole Proprietorship, Sub-S Corporation, C-Corporation, Partnership, etc) is most advantageous from a tax perspective?

Acceleration and Deferral Techniques

Income tax liability can frequently be reduced though the techniques of deferral or acceleration.

Acceleration: Income may be accelerated (taken early) so as to include it for a taxable period in which taxable income is less than in the next taxable period; thereby reducing taxes. Expenses may also be accelerated. One reason this strategy would be used would be to take maximum advantage of deductions and exemptions. For example, if a taxpayer has already had medical deductions of 7.5% of AGI, this would mean that any additional qualifying medical expenses incurred during that tax year, would be eligible for a deduction. Another instance in which this acceleration technique would work would be if current year taxable income was considerably less than anticipated income for the upcoming tax period; and thus, deductions would be of more value in the future to offset the higher income.
Deferral: Deferring or postponing income may also result in tax savings. If taxable income is anticipated to be less in the next taxable period, deferring income into that period could result in lower taxes. Conversely, deferring expenses into the next taxable period would make sense if taxable income was anticipated to be higher than in the current income period.

Utilization of Non-Taxable Employee Benefits

You may have access to certain employer-sponsored benefits through your job, which may provide great economic benefit to your family without creating any taxable income. These may be at no cost to you; or may require that you share in the cost. Some of the most popular benefits, which result in no taxable income, are

Group medical and dental insurance (benefits received are not considered taxable income.)
Group term life insurance (death benefits of up to $50,000 in most cases, are exempt from taxation.)
Group accidental death and dismemberment, travel accident and related plans

Income/Deduction Shifting

The taxpayer shifts a portion of his/her income (and therefore taxes) to a family member or entity, which is in a lower tax bracket. Some useful techniques are:

Making a gift of income–producing property (such as stock, savings bonds, certain real estate, etc.) In this case, all future income will be taxed to the recipient, not the donor. It is important to note that this action may have Gift Tax implications, which should be discussed with your personal tax advisor.
Also, the property itself must be given away; since gifts of only the income will not shift the income tax burden to the recipient. Also, the Tax Reform Act of 1986 limited the usefulness of this technique between parents and children by taxing unearned income over $1,400 per year for children who are under age 14 at their parents’ top tax rate.
The opposite of income shifting is deduction shifting. This is accomplished by shifting allowable tax deductions to a taxpayer who is in a higher bracket than the taxpayer who would otherwise be claiming this deduction.

Tax-Managing Your Investment Portfolio

As an investor, you may be able to time investment sales in order to maximize your tax advantage. If you have capital gains on securities or other investment property, these gains may be offset by selling another security you own for a loss. This involves the planning in terms of the timing of the purchase and sale of these securities so that they fall within the same tax calculation period.
"Tax exchanges" are available which will permit the sale of a security for a loss, and yet maintain a similar investment position. (For example, if you originally purchased a technology stock at $10 per share, but the stock had now declined to $5 per share, you could sell this stock, taking advantage of the loss for income tax purposes and immediately purchase a different technology stock; thereby keeping your position in a technology investment. (Note: tax laws concerning this type transaction are somewhat complicated, so you should consult with your tax professional for personal advice before undertaking this strategy.)

Tax laws permit a taxpayer to select which stock/fund shares they want to sell if they are selling only a part of their holdings.

Example

Suppose, if over time, you had purchased shares of a particular stock as follows:

100 shares at $20 per share in 1985

50 shares at $70 per share in 1990

100 shares at $80 per share in 1995

The value of the stock is now $70 per share. If you wish to sell 50 shares, you may sell shares which would result in a gain (those purchased in 1985); no loss or gain (those purchased in 1990) or a loss (those purchased in 1995).

Since capital gains laws favor investments held for periods of at least 12 months, (See Capital Gains Above), investment sales may be timed to take advantage of this lower tax rate.

Making Charitable Contributions

Charitable contributions are considered itemized deductions, which reduce your taxable income. These charitable gifts may take various forms:

Gifts of cash
Gifts of appreciated property such as stock or real estate (These gifts would generally be deductible at fair market value on the date of the gift, with no capital gain consequences to the donor.) This may, however, trigger Alternative Minimum Tax consequences.
The establishment of Charitable Remainder Trusts in which property is transferred to the trust, with the donor receiving and income stream from the investment, and the charity receiving the property. The taxpayer receives a current tax deduction for the value of the “remainder” interest that the charity is receiving.

View the IRS site providing information from Publication 526, Charitable Contributions.

Tax Shelters

Some investments, such as certain types of real estate, oil and gas drilling, historical rehabilitation, etc. are structured to take advantage of certain tax write-offs, such as depreciation, amortization or depletion. It should be noted that the effectiveness and availability of these types of investments have been greatly diminished by the Tax Reform Act of 1986. This was intended to discourage taxpayers from investing in a particular activity strictly for tax purposes.

Tax-Free Investing

Interest paid on some investments is free from federal income tax; and often from state and local taxes, as well. One such investment category is public purpose municipal bonds (that is, bonds issued by some governmental entities). However, you should be aware that the interest from certain tax-exempt municipal securities might be subject to the Alternative Minimum Tax computation.) Note: this strategy is generally of interest only to the higher tax brackets, due to the fact that at lower brackets, these bonds would not have as high a return as the taxable bonds even after the payment of taxes.

Another investment potentially excludable from taxation is Series EE Bonds, when used for higher education purposes (Certain limitations apply.)

Tax Deferred Investing

Other investments do not eliminate tax, but simply postpone taxation until some future date. This may be advantageous if the taxpayer anticipates being in a lower tax bracket in the future. Another potential advantage of this technique is that investment return during the deferral period is enhanced, since the postponed amount of tax remains invested, earning interest, as well. Some of the most common vehicles for this deferral technique are:

Qualified employer-sponsored retirement plans
Employee Stock Purchase Plans
Non-Qualified deferred compensation Plans
Self-employed Retirement Plans (Keoughs, etc.)
Individual Retirement Accounts (IRAs)
Tax Sheltered Annuity Plans for employees of non-profit organizations and public school systems
Purchase of Series EE Savings bonds (bonds issued by the federal government on a discounted basis). Bond owners may elect when they want to be taxed on the increase in value of these funds; either yearly as interest accrues or upon maturity or when they are redeemed.
Life Insurance Cash Values and the interest/investment return they receive are not subject to current income taxation. If values remain in the policy until the death of the insured, they pass as a portion of the death benefit to the beneficiary with no income tax consequences ever! If values are withdrawn during the life of the insured, any gain over and above the initial investment of premium is taxed as ordinary income. (For more information, see Insurance Module.)
Deferred Annuity policies also feature the deferral of tax on investment growth until the policyholder withdraws these funds. (For more information, see Insurance and Retirement Modules.)

Tax Planning Wisdom

Tax planning is very important; however, it should never be over-emphasized at the expense overall financial goals and objectives. In some instances a strategy, which results in tax-savings also results in some loss of flexibility, control, or some other advantage. For example, tax-favored retirement plans offer deferral of taxes until retirement; however, they impose strict regulations and penalties which prevent the use of these funds prior to retirement age (59 ½ in most cases). In general, if a strategy to save taxes does not make sense, other than for tax purposes, it should not be implemented. Also, a tax adviser should generally be consulted concerning the overall implications of any tax-savings strategies.

OTHER FORMS OF PERSONAL TAXATION

Other Federal taxes include Social Security /Employment Taxes (7.65% of your income if you are employed, and 15.3% of your income if you are self-employed); Unemployment Insurance/Tax; and Transfer Taxes (including Gift and Estate Tax); and certain Excise Taxes.

State and local taxes include property taxes, income taxes (in all but 6 states) sales tax, licensing tax, excise tax, etc.