Well, believe it or not, it’s that time of the year again. Time to consider all of the tax law changes that may impact on your 2002 federal income tax return.  It is important to remember that while there are many traditional year-end planning strategies, each year offers new ones as well, due to changes in your own tax and financial situation, as well as changes to the tax laws.  In this Fall 2002 Tax Client Newsletter we will bring you up-to-date on what’s going on in Washington these days and talk about some tax planning ideas that you might want to consider and/or implement before the year-end.

As a response to the savage attacks on America on September 11, 2001 and the negative impact on the U.S. economy, Congress and President Bush reached an agreement in March 2002 and enacted the Job Creation and Worker Assistance Act of 2002. This, combined with the phase-in of many of the tax changes from the 2001 Tax Act, presents new tax saving opportunities for 2002. The 2001 Economic Growth and Tax Relief Reconciliation Act significantly impacts on the 2002 tax year as well as future years. There are a number of opportunities available to a variety of (but not all) taxpayers.

Effective year-end tax planning typically means looking at your tax situation over a two-year period—the current year (2002) and next year (2003). This enables you to see whether it’s advantageous, for example, to shift income and deductions from one year to the other and whether the dreaded alternative minimum tax (AMT) is a factor to consider. Please keep in mind that we are here to assist you and answer any questions that you might have. Feel free to contact us if you have any questions regarding any of the items in this newsletter or any other tax related questions.

Goal: Planning for YOUR Personal Income Taxes

Item 1: Deferring Income and Accelerating Deductions

The most common year-end tax planning strategies are those that defer income from the current year to later years and those that move deductions from later years into the current year. The underlying reason is that it’s better to pay taxes later rather than sooner due to the time value of money. This concept is even more relevant now since tax rates are scheduled to go down in the future. Rates are the same for 2002 and 2003, but they decline 1% in 2004 and again in 2006. The 2006 tax rates are scheduled as follows:  25%, 28%, 33% and 35%.

Shifting taxes from 2002 to later years not only benefits from the time value of money, but you might also pay less due to lower future rates. You should know that the issue of future tax rate reductions continues to be debated in Congress and no one can predict with any certainty just what the future will hold.  A one or two year “look forward” seems appropriate and practical. It probably makes no sense to look too far into the future.

So, how do taxpayers shift income and deductions between tax years? The most common techniques are using income or deductions that you have control over. For example, if a taxpayer is due a year-end bonus and can get their employer to agree, receiving the bonus in January 2003 rather than 2002 might make sense. Before anyone would take this step they certainly would want to be certain that the bonus would be there in early January. A self-employed taxpayer might consider delaying sending out invoices in order that the income is received in early 2003 rather than in 2002.

On the deduction side, some taxpayers could move charitable donations they would normally make in early 2003 to the end of 2002. You can do the same with real estate taxes or state income taxes. If you own a cash-basis business, delay billings so payments aren’t received until 2003 or accelerate paying off certain business related expenses, such as office supplies and repairs and maintenance, to 2002. Here’s a practical tip: Always remember that before deferring any income - you must assess the inherent risk of doing so.

Item 2: AGI: One of the Most Important Numbers You Need to Know

Many tax deductions and credits are subject to a single AGI amount or AGI-based phase-outs. The result: only taxpayers with AGI below certain levels benefit. [AGI is the amount at the bottom of page 1 of your Form 1040—basically your gross income less certain adjustments (i.e., deductions), but before itemized deductions and the deduction for personal exemptions.]

One of the areas of confusion inherent in the tax laws is the lack of uniformity among the numerous AGI tests. The applicable AGI amounts differ depending on the particular deduction or credit. The following table shows a few of the more common deductions and credits and the applicable AGI phase-out ranges for 2002:

Keep in mind that this is just a sample of some of the important AGI tests that may affect your tax situation. Knowing and, to the extent possible, managing your AGI can be the difference between claiming all or part of a deduction or credit, or none of it. Therefore, being aware of the deductions and credits you are eligible for, but which are subject to AGI limits, can help you plan to ensure you can claim them. Managing your AGI can be somewhat difficult since it is not affected by many deductions you can control, such as deductions for charitable contributions and real estate and state income taxes. However, to the extent you can claim additional “above-the-line” deductions, such as those for IRA or self-employed retirement plan contributions, or reduce or shift taxable income to a later year, you can effectively reduce your AGI and, in turn, claim more deductions or credits that might otherwise phase-out.

Item 3: Strategies Involving Your Securities

Claiming Capital Losses

There are a number of year-end investment-related strategies that can help lower your tax bill. Perhaps the simplest is reviewing your securities portfolio for any losers that can be sold before year-end to offset gains you have already recognized this year or to get you to the $3,000 ($1,500 married filing separate) net capital loss that’s deductible each year. If your net loss for the year exceeds $3,000 the excess can be carried over indefinitely to future tax years. Be mindful, however, of the wash sale rules. Under this rule, your loss is deferred if you purchase substantially identical stock or securities within the period beginning 30 days before and ending 30 days after the date of sale. This is certainly a year in which many taxpayers will have no difficulty in finding a $3,000 capital loss. Recognizing a loss on your tax return serves to reduce your Adjusted Gross Income (AGI) and therefore your Taxable Income.

What Investments to Sell?

Be choosy when selling securities. When selling stocks or mutual fund shares, the general rule is that the shares you acquired first are the ones you sell first. However, if you choose, you can specifically identify the shares you’re selling when you sell less than your entire holding of a stock or mutual fund. By notifying your broker of the shares you want sold at the time of the sale, your gain or loss from the sale is based on the identified shares. This sales strategy gives you better control over the amount of your gain or loss and whether it’s long-term or short-term.

Item 4:  Strategies for Your Business

2002 Tax Law Changes Offers Bonus Depreciation

Take Advantage of Bonus Depreciation. In an effort to spur the economy by motivating businesses to purchase new assets, the 2002 Job Creation and Worker Assistance Act enacted this year includes some very favorable deprecation rules. New (not used) business assets acquired after September 11, 2001 and before September 11, 2004 are generally eligible for a special 30% first-year bonus depreciation deduction that is in addition to normal first-year depreciation. That’s an immediate deduction equal to 30% of the cost of the asset.

All business property, other than buildings and structural components, normally qualifies. This includes certain leasehold improvements, which can be a real boon for some lessors and lessees. One of the particularly attractive features of this new rule is that the additional 30% bonus depreciation is available regardless of when the property is placed in service during the year. Thus, property acquired and placed in service on the last day of the tax year is eligible for the special “bonus.”

Along the same lines as bonus depreciation, the 2002 Tax Act also raised the first-year depreciation limit on so-called luxury automobiles acquired before September 11, 2004. Again, only new property qualifies, but for 2002, the depreciation limit for qualifying vehicles is increased from $3,060 to $7,660. Thus, new vehicles placed in service before the end of the year qualify for the higher first-year depreciation limit.

Tax Tip: If you’re thinking about purchasing new business property, it might make sense to go ahead and do so before the end of 2002. That way, you can enjoy not only the benefits related to using the new asset, but also a higher tax write-off for 2002.

Employing Your Children or Grandchildren

 If you are self-employed, don’t miss one last opportunity to employ your child (or grandchild) before the end of the year. Doing so has tax benefits in that it shifts income from you to your child or grandchild, who normally is in a lower tax bracket or may avoid tax entirely due to the standard deduction. There can also be payroll tax savings since wages paid by sole proprietors to their children under the age of 18 are exempt from both social security and unemployment taxes. Employing your children has the added benefit of providing them with earned income, based on which they can then make an IRA contribution (hopefully a ROTH IRA) for 2002.Children with IRAs, particularly ROTH IRAs, have a great head start on retirement savings since these funds can grow significantly over a long period of time.

Remember a couple of things, though, when employing your child or grandchild. First, the wages paid must be reasonable given the child’s age and work skills. Second, if the child is in college, or entering college soon, and if financial aid is a factor in the child’s college attendance, having too much earned income can have a detrimental impact on the amount of aid the child might be eligible to receive.

Item 5: Other Tax Strategies to Consider

Retirement Plan Distributions

Everyone needs to understand the rules affecting retirement plan distributions.  If you’re age 70½ or older, you’re normally subject to the so-called minimum distribution rules with regard to your retirement plans (other than Roth IRAs). Under these rules, you must receive at least a certain amount each year from your retirement accounts. You can always take out more than the required amount, but anything less is subject to a 50% penalty on the shortfall amount. The tables for determining your required minimum distributions (RMD) each year are based on your (and, in some cases, your beneficiary’s) life expectancy. The IRS recently revised these rules and tables, generally resulting in smaller required distributions for most taxpayers. Thus, if you haven’t taken your required distribution for 2002, do so before year–end to avoid a hefty penalty. Also, if you’re not basing your required distribution on the new IRS tables, it’s probably to your advantage to do so.

If you turned age 70½ in 2002, you can delay your 2002 required distribution to 2003 if you choose (until April 1, 2003). But, waiting until 2003 will result in two distributions in 2003—the amount required for 2002 plus the amount required for 2003. You will need to take your next RMD by December 31, 2003. While deferring income is normally a sound tax strategy, here it results in bunching income into 2003. Thus, think twice before delaying your 2002 distribution to 2003 because the bunching of income in 2003 might throw you into a higher tax bracket or have a detrimental impact on other tax deductions you normally claim.

In addition to Traditional IRAs, the RMD rules apply to Rollover IRAs, as well as to certain employer-sponsored retirement plans, such as 401(k) or 403(b) plans. Participants in 401(k), 403(b) or other qualified retirement plans who are not 5% owners of a company may hold off on distributions until retirement. This exception does not apply to participants in SEPs, SARSEPs or SIMPLE IRAs.

ROTH IRAs are not subject to distribution requirements, except after the death of the account owner.

To get the most out of your retirement assets, it’s a good idea to map out your retirement plan distributions. Please note that we are available to assist you with this important matter.

IRA Contribution Amounts Increased

Effective for 2002, eligible taxpayers face an increase in the amount that they may contribute. The base increase from $2,000 a year to $3,000 is significant and taxpayers 50 or older may contribute an additional $500 to the accounts. Note that the increases affect both traditional IRAs as well as ROTH IRAs. Please keep in mind that there has been an increase in the amounts that can be contributed to any number of retirement savings accounts.

Saving for Education

The opportunity to save today for education tomorrow has been changed in a very positive way. Education IRAs have been renamed Coverdell Education Savings Accounts and the amount that may be contributed has been changed from $500 per beneficiary per year to $2,000 effective this year. Effective for 2002, the number of taxpayers eligible for a Coverdell Education Savings Account has been increased. The 2002 AGI test is $95,000-$110,000 for single taxpayers and $190,000-$220,000 for a married couple filing jointly. This is considered a very generous AGI test. In addition to increasing the amount that may be contributed to Coverdell Education Savings Accounts, the law now expands the list of “qualified” education expenses to include certain elementary and secondary education expenses in addition to college expenses.

The 2001 tax law changes provide even greater flexibility to the very popular 529 Savings Accounts. Effective for 2002, “qualified” distributions from these plans (pre-paid tuition and college savings plans) are tax-free (no longer taxed at the child’s tax rate). What makes the 529 plans so popular is the fact that there is no AGI test associated with the plans and the plans allow taxpayers to set aside a significant amount of money in these accounts.

While the HOPE Scholarship Credit and Lifetime Learning Credit are still in place (see AGI test in the above chart), Congress and the President agreed in 2001 to offer taxpayers a new choice effective for 2002-2005. The new choice is an above-the-line (line 26) deduction for college tuition and fees. The maximum deduction here is $3,000 for 2002 and 2003 and $4,000 for 2004 and 2005. Unfortunately, the new deduction comes with a rather limited AGI test (see the above chart) and the deduction is scheduled to expire after 2005. More taxpayers will be eligible for the new education deduction (line 26) than have been eligible for either the HOPE or Lifetime Learning tax credits.

Thanks to Congress and the President, employer-provided support for higher education has been made permanent (at least until 2010). Up to $5,250 of employer-provided education assistance can be offered tax-free to employees and a business deduction for the employer.

Do you know anyone who is an elementary or secondary school teacher? While Congress was considering expanding worker assistance this year, it passed and President Bush signed into law a new above-the-line deduction for teachers. Line 23 of the 2002 1040 (Educator Expenses) tax return will allow a deduction of up to $250 for the out-of-pocket cost of books, supplies, computer equipment, etc. To qualify, the teachers must work a minimum of 900 hours a year and keep appropriate receipts and records.

The Education Menu is so complicated and at the same time appealing that I would appreciate the opportunity to review the subject with you at a future date. Remember that its not just mom and dad that are saving for education.

Tips on Charitable Giving

Taxpayers might want to consider two charitable giving strategies that can help boost your 2002 charitable contributions deduction. First, donations charged to a credit card are deductible in the year charged, not when payment is made on the card. Thus, charging donations to your credit card before year-end enables you to increase your 2002 charitable donations deduction even if you’re temporarily short on cash or simply want to defer payment until next year. Note, however, that any interest paid with respect to the charge is not deductible.

Another charitable giving approach you might want to consider is the “donor-advised fund.” These funds essentially allow you to obtain an immediate tax deduction for setting aside funds that will be used for future charitable donations. With these arrangements, which are now available through various organizations including mutual funds such as Fidelity and Vanguard, you contribute money or securities to an account established in your name. You then choose among investment options and, on your own timetable, recommend grants to charities of your choice. The minimum for establishing a “donor-advised fund” is often $10,000 or more, but these funds can make sense if you want to obtain a tax deduction now but take your time in determining or making payments to the recipient charity or charities. These funds can also be a way to establish a family philanthropic legacy without incurring the administrative costs and headaches of establishing a private foundation.

Conclusion

Through careful planning, it’s possible that your 2002 tax liability can still be significantly reduced. Don’t delay considering this important matter and the opportunities available to you.

The ideas discussed in this letter are a good way to get started with 2002 year-end tax planning. However, the ideas presented in this Tax Client Newsletter are in no way intended to be a substitute for personal tax professional assistance. Please do not hesitate to call on our office with any questions that you have.