Looking for the silver lining Times are tough all over. Real estate prices are depressed, credit is tight and the ups and downs of the stock market are enough to induce motion sickness. Fortunately, the cloud hanging over the economy has a silver lining: It’s an ideal time for tax and estate planning. Let’s look at several strategies you can use to slash your income tax bill and minimize gift and estate taxes. Maximizing retirement contributions If possible, maximize your contributions to IRAs, 401(k) plans and other tax-deferred retirement saving vehicles. Contributions reduce your adjusted gross income (AGI), which not only lowers your taxable income but may also increase deductions that are phased out above certain AGI levels. For 2009, you can contribute up to $16,500 to your 401(k) plan ($22,000 if you are age 50 or older), and, depending on factors such as your AGI and whether you participate in an employer-sponsored retirement plan, $5,000 to your traditional or Roth IRA ($6,000 if you are age 50 or older). Converting to a Roth IRA If you have a large balance in a traditional IRA, it’s a good time to consider converting to a Roth IRA. Why? Traditional IRAs offer current tax deductions and tax-deferred growth, but when you or your heirs take distributions, the funds are subject to ordinary income taxes. Contributions to a Roth IRA, on the other hand, are nondeductible, but qualified distributions of contributions and earnings are tax free. Determining which type of IRA is right for you depends on your expected investment returns and whether you’re better off paying the tax now or later — your tax advisor can help you do the math. If you would benefit from a Roth IRA, converting an existing traditional IRA may be a good strategy, especially now while many asset values are depressed. When you do a Roth conversion, you have to pay taxes on the amount you convert. However, if your IRA assets have depreciated in value in recent months, you’ll minimize the tax cost while maximizing potential tax-free growth when the economy rebounds. Keep in mind that Roth IRA conversions are currently available only to taxpayers with a modified adjusted gross income (MAGI) of $100,000 or less. This income limit is scheduled to disappear beginning in 2010, making this strategy available to all taxpayers. If you believe your MAGI will be under the limit this year, it may be a good idea to lock in current asset values by doing the conversion now. Even if your income ends up being more than $100,000, you can always undo the conversion (known as “recharacterization”) and reconvert in 2010. In addition, if the value of your IRA declines further after you do the conversion, you can reduce your tax bill by undoing the conversion and then reconverting next year. Putting RMDs on hold When you reach age 70½, you have to take annual required minimum distributions (RMDs) from IRAs, 401(k)s and other retirement accounts. Failure to do so results in a tax penalty equal to 50% of the amount you should have withdrawn. In an effort to provide retirees with relief from the stock market downturn, Congress suspended the RMD requirement for 2009. Unless you need the money for living expenses, consider skipping RMDs this year, leaving more money in your retirement accounts to continue growing tax free. Harvesting losses If you’re holding poor-performing investments, consider selling them to “harvest” the losses. You can use these losses to offset up to $3,000 in ordinary income plus any capital gains you recognize this year. In addition, unused losses can be carried forward to future tax years. Plus, unloading losers also gives you an opportunity to replace them with investments that are expected to yield greater returns. Giving it away The struggling economy creates some attractive estate planning opportunities. By leveraging depressed asset values and rock-bottom interest rates, you can transfer substantial amounts of wealth to your children or other heirs at a minimal tax cost. A simple strategy is to give assets away. You can minimize gift taxes, for instance, by transferring real estate, stocks or other assets whose values have declined. Also, there are several estate planning strategies that thrive in a low-interest-rate environment. One of the most effective is the intrafamily loan. To avoid gift taxes on a loan to a family member, you must charge interest at or above the applicable federal rate (AFR). Recently, AFRs dropped to their lowest levels in decades. If your borrower places the funds in investments that outperform the AFR, the money left over after repaying the loan will essentially be a tax-free gift. For example, Alex loans his daughter, Ruby, $1 million, during a month when the AFR for midterm loans (more than three years, up to nine years) is only 2%. The loan agreement provides for interest-only payments for four years, with a balloon payment (interest + principal) at the end of the fifth year. Ruby invests the money in assets that yield a 6% return. As the chart “Advantage of an intrafamily loan” above illustrates, after repaying the loan, Ruby ends up receiving more than $225,000 gift-tax free. Other tools, such as grantor retained annuity trusts, charitable lead annuity trusts and intentionally defective grantor trusts, also take advantage of low asset values and interest rates, allowing you to transfer substantial amounts of wealth while minimizing or even eliminating gift taxes. Seize the opportunity Your tax advisor can help you determine whether these or other tax strategies can help you ease the pain of the recession, but it’s important to act quickly. Although these strategies will remain effective even after the economy begins to recover, they may never be as powerful as they are right now. • |
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