Knowledgeable advisors can cut their clients' tax bills.
The nefarious alternative minimum tax is top-of-mind
for advisors this tax-planning season. An estimated 3.5 million filers
will pay it for 2005, rising to nearly 19 million next year, according
to a May estimate by the Washington, D.C.-based Tax Policy Center. With
that train wreck on the horizon, speculation is rampant that Congress
might change the alt min rules-and others too-after Labor Day.
Uncertainty only amplifies the complexity of planning, particularly in the case of AMT, because being able to forecast whether a client will pay it this year but not next, or vice versa, presents opportunities for shifting income and deductions to the optimal year-or for abandoning strategies altogether if the client is a perennial AMT victim. "You do different things depending on whether the client's in AMT or not," says planner Norm Boone, president and founder of Mosaic Financial Partners in San Francisco.
To avoid making recommendations whose benefits are quashed by AMT, advisors need to be familiar with the deductions disallowed by the alternative tax system. One that gets less attention than most is interest on a mortgage used for something besides buying or improving the home-equity debt, in Internal Revenue Service parlance. A March ruling clarified how the rules apply when multiple refinancings are involved, says Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md.
Suppose a client borrowed $300,000 to purchase a home several years ago. After paying off $50,000, he refinanced the balance to get a lower interest rate and paid the closing costs out-of-pocket. The new loan simply replaced the original acquisition debt. Later, when the principal had fallen to $200,000, he pulled out equity by refinancing $300,000. Per the recent ruling, the first $200,000 obtained in the re-refinancing retains its character as acquisition indebtedness, Kitces says. But the client took the family on a luxury cruise with the remaining loan proceeds, rendering it home-equity debt. So one-third of the interest on the loan ($100,000 home-equity debt, divided by $300,000 loan total) is nondeductible if the client is an AMT taxpayer. In contrast, the regular tax rules permit writing off the interest on up to $100,000 of home-equity debt.
It may be wise to coach staff about discussing alt min with clients, says Mitchell Freedman, president of MFAC Financial Advisors in Sherman Oaks, Calif. Last year, one of Freedman's employees, in counseling a client victimized by AMT for the first time, said, "Bad news. You're in the AMT, and you're not going to get the benefit of your itemized deductions." The associate's approach was so negative, Freedman says, "it got the client crazy. So I've educated my people to explain the AMT to clients in an educational way and not as a good-news/bad-news scenario."
1. Enhance tax efficiency when rebalancing portfolios. With qualified dividends taxed at a modest 15% through 2008, Freedman sees rebalancing as an opportunity to get dividend-paying stocks into taxable accounts and out of tax-deferred portfolios, where the income is likely to be taxed at a higher rate upon withdrawal. "When we can, we're using rebalancing to tweak portfolios to optimize the tax consequences for our clients," he says.
2. Consider hybrid automobiles. Clients who buy a new alternative-fuel car this year not only get a $2,000 above-the-line federal deduction, their states may offer a break, too, significantly lowering the vehicle's cost. Colorado, for instance, offers a generous income tax credit.
The federal deduction changes to a tax credit for 2006, thanks to recent energy legislation. But calculating the credit requires several computations and begins to phase out-get this-after the manufacturer has sold more than 60,000 qualifying vehicles. The credit for buying a Toyota, the most popular line, could begin phasing out by late 2006, some predict. Lexus, Honda and Ford also make clean-fuel models.
3. Use casualty losses to get tax refunds. Clients with a loss from a disaster in a presidentially declared disaster area can deduct it from last year's income by amending their returns. "That could put some cash back in their pocket and cushion the blow a little," says Freedman. See IRS Publication 547 for more details.
4. Remind charitable clients to give appreciated securities. The typical client forgets he can get a market-value deduction for gifts of securities and avoid capital gains tax on the appreciation, says Curt Weil, principal of Weil Capital Management in Palo Alto, Calif. "It's remarkable how often a client tells us, 'Boy, I'm glad you reminded me about that (rule),'" he says.
5. Recommend interest-free loans to family. The IRS-required interest rate on intrafamily loans remains low. If interest for the year is less than the $11,000 annual exclusion from gift tax, the client can forego the interest (which makes it a gift to the borrower) without tax consequence, says Weil. "Just be sure the proper loan documentation is in place," he cautions.
6. Get a jump on next year. On January 1, the Roth 401(k) finally arrives, a product of the 2001 tax act. (Yes, the one that sunsets.) After-tax contributions to this new type of retirement plan are permitted regardless of income, while investment earnings can be withdrawn tax-free after age 59 1/2, assuming the participant began contributing to the plan at least five years ago, says Robert S. Keebler, a CPA and partner with Virchow, Krause & Company LLP, in Green Bay, Wis. Although minimum distributions must begin at age 70 1/2, Roth-k assets can be rolled to a Roth IRA, which does not require withdrawals.
The primary issue for advisors is whether clients should allocate their 401(k) contributions to a traditional plan or the new species, if their company happens to offer both. In 2006, an individual's total 401(k) contributions are limited to $15,000, plus an additional $5,000 for those age 50 or older.
The type of 401(k) to fund depends on the relationship between the client's current tax bracket and the rate he expects to pay when withdrawing money from the account in retirement, says Kitces, the Maryland planner. "With a higher tax bracket in the future, you're better served by paying today's lower rates and putting after-tax dollars in a Roth. If you think the client's rate will be the same or lower in the future, lean toward a traditional, deductible 401(k)," Kitces says.
You also have to consider potential taxation of the client's Social Security benefits, Keebler points out. Under current rules for couples, for each dollar of their modified adjusted gross income that's between $32,000 and $44,000, 50 cents of their government benefits are taxed. Above that range, it's 85 cents. In other words, the client adds $1.85 to taxable income for each dollar earned until 85% of his Social Security is taxed. Those who expect to be affected by these rules should choose a Roth, Keebler says. The tax-free withdrawals from a Roth don't count as income that triggers tax on government benefits, whereas distributions from a traditional 401(k) do.
Oh, that pesky sunset provision scheduled to annihilate every provision of the 2001 tax act? Roth-k plans in existence at the end of 2010 won't have to be terminated, goes the thinking. They just won't be able to accept more contributions. Unless, of course, Congress changes the rules.