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.