November 2006

Year-End Tax Strategies

By Larry Grogan

As we approach the end of 2006, we have a lot on our minds. There will be holidays, parties and family gatherings. Probably the last thing on your mind is financial planning. However, this is the time of year when financial planning should be done. As with any project, you need to plan your desired results and then implement the steps to make you successful.

This article will look at some ways you can maximize your tax benefits as 15 April approaches.

1) Maximize your Retirement

For 2006, you can contribute up to $15,000 to your 401k, 403b's, 457's or SEP retirement plans. If you are 50 or older, you can add an additional $5,000 for a total contribution of $20,000 for 2006. The same rule applies for SIMPLE retirement plans, but the contribution limit is $10,000, and $2,500 for the catch-up contribution.

Because contributions to workplace retirement accounts are done on a pre-tax basis, you automatically reduce taxes due from your salary.

Individual 401k's are relatively new retirement programs which allow the individual business owner to contribute the lesser of 25 percent of your compensation or a maximum of $44,000 per year. You, too, have the ability for catch-up contributions of $5,000. Additionally, if your spouse is an employee, they, too, can make contributions into the individual 401k.

Once you have maximized your workplace retirement and you can still afford to put more money into your retirement, you can invest in IRA's. If you are interested in having a tax deduction for yourself, you should select the Traditional IRA. Your contribution will then be used to lower your taxable income and reduce the amount of taxes due come April.

The Roth IRA allows your investments to grow tax free and be withdrawn tax free, but the Roth IRA does not allow for an immediate tax savings.

2) Evaluate your Investment Mix

Even though you may not receive an immediate tax benefit, you can receive a long-term benefit by investing in either tax-free bonds or annuities. Either of these investments will prevent or defer future taxation on your investment.

You can invest in a variety of tax-free bonds. The U.S. Government is the largest issuer of bonds, and investing in treasuries and other government-secured entities secures you a federal tax-free benefit from your investment.

Many states offer their residents tax-free bonds. New York and California are the largest issuers of state tax-free. However, some state bonds may be federally taxable, so evaluate this option carefully.

Puerto Rico issues many bonds as well, often referred to as triple tax-free bonds because they can be federally and state tax free.

When considering bonds, understand a basic principal with any bond purchase: All bonds have a price and an associated interest rate attached to them. And there is an inverse relationship with the price and interest rates — interest rates go up, bond prices go down, and vice versa.

Much like your 401k or IRA, as your money grows in an annuity, that growth is occurring tax deferred — a great benefit when you are trying to minimize your taxes.

A second unique component of annuities is that they are insurance products. And with any insurance product, you can purchase riders to add additional layers of protection for your investments or for specific needs.

One such rider is lifetime income. Many annuities now offer lifetime income and are being used in the same manner as a pension. You are guaranteed a monthly income regardless of market conditions. You can also design your annuity to include an inflation factor so that each year you will receive a higher distribution than the year before.

You can also provide higher insurance protection to your beneficiaries. Many annuities will set the death benefit at the highest investment amount reached, less any distributions. This feature is particularly popular if you have pre-existing health conditions which could be uninsurable.

3) Retirement Income

Did you know that anywhere from 50 to 85 percent of your Social Security benefits could be taxed, depending on how much other income you have, and where it comes from? Understanding what counts and what doesn't when it comes to calculating the tax you pay on your Social Security benefits can help you plan accordingly.

When you begin receiving Social Security benefits, your provisional income determines if — and how much — your benefits will be taxed. How do you know what your provisional income is? Your 1040 instruction booklet and your tax adviser are best able to answer this question, but to get a rough idea, first determine your total income. Add together wages, taxable interest, tax-exempt interest, ordinary dividends, taxable IRA distributions, your taxable pension and annuity distributions plus one half of your Social Security benefits. This total will be your provisional income.

If your provisional income exceeds a certain threshold ( $25,000 for singles and $32,000 for married people), a portion of your Social Security benefits will be taxable; the total you came up with determines how much. Don't forget: the IRS counts even your tax-exempt income in this calculation, too.

Since your Social Security benefit amount is fixed (you can't change it), you need to figure out if adapting your investment and income strategies can reduce the other amount in the equation – your total income.

4) Capital gains and Losses

If you know you will be paying taxes, you may be able to sell some investment losses to help offset any taxes due.

This strategy requires a careful review of your investments, but if you have experienced losses with your investments, you can use up to $3,000 per year to minimize your taxes due.

Just as a reminder, the end of the year is always a great time to review your investment mix and its performance, and rebalance if necessary. Grogan Advisory Services offers free portfolio reviews to IEEE members, so contact us if you have any questions or concerns.

5) 529 College Savings Plans

The tax benefits with 529's are plentiful. First, your investments grow tax deferred.

Secondly, withdrawals are tax free as long as they are used for qualified education expenses.

Thirdly, 26 states offer state tax incentives if, as a resident, you invest in your state's 529 plan.

The last major tax benefit that 529 plans offer is through gifting and can be used specifically for estate planning purposes. As you may know, you may gift up to $12,000 per year to as many individuals or institutions as you can afford. As a married couple, you may gift $24,000.

529 plans will allow you to take advantage of five years of gifting all in one year. Let's take a close look at the implications of this benefit.

Grandparents are the single largest contributor to 529 plans and often grandparents must manage potential estate taxes. Using the 5 year gift regulation allowed for 529 plans, grandparents can contribute as much as $120,000 per year into as many 529 accounts as they can afford.

In a scenario where the grandparents gift the maximum $120,000 to eight grandchildren in one year, the implications are this:

1. Grandparents are able to remove $960,000 from their estate to lower their potential estate taxes
    

2. Grandparents significantly reduce the financial burden that parents face to save enough to get their children through school
    

3. The grandparents give the greatest gift they could ever give their grandchildren – the opportunity for a fantastic education

So the 529 college saving plans are excellent vehicles to reduce your taxes in a variety of ways.

6) Philanthropic Gifting

We've covered some of the benefits of gifting, from both a personal perspective and as a means of reducing your tax burden. Philanthropic gifting is another way to help ease your tax burden. Charities, institutions and associations all rely on gifts to provide the many important services to support their communities.

Summary

We have explored just a few strategies for reducing your year-end tax burdens. These methods will help your retirement, education and improve your investment portfolios.

To summarize, you can maximize your retirement by: maximizing your contributions to your retirement retirement plans, which will automatically reduce the taxes you pay; review your investment mix to make sure you are taking advantage of tax-deferred and/or tax-free investments; evaluate your retirement income to reduce the amount paid on Social Security; use investment losses to minimize your taxes and then rebalance your portfolio for maximum performance; invest in 529 college savings plans to prepare for future college expenses; invest in tax-deferred shelters and possibly reduce potential estate taxes; and, finally, gift to charitable organizations.

Successful tax strategies take planning. You can't wait until the last minute. Now is the time to plan and prepare and we are here to assist you. If you have any questions, please feel free to contact us by visiting www.ieee.org/fap and clicking on the Grogan Advisory link..

A pre-recorded webinar of this article is available at https://efs529.on.raindance.com/confmgr/view_stored_doc.jsp?docId=9116177512811607103175132165&docType=recording

Larry N. Grogan is president of Grogan Advisory Services, an independent financial services firm in Malta, N.Y. Grogan Advisory Services is one of several programs offered to members as a benefit of their membership. For more information on this or other IEEE Financial Advantage products and services, please visit us online at www.ieee.org/fap. Comments may be submitted to todaysengineer@ieee.org.