No one likes to pay more than their fair share of income taxes. But in order to minimize your income tax bill, you need to plan for that result. To help, we have included several articles on the topic:

Tax Planning Tips Investment Tax Strategies The Basics of UTMAs Be Aware of the AMT Tax Planning Is a Year-Round Process

If you have any questions or would like to discuss tax planning in more detail, please contact us at (281) 277-6400 or service@DearbornCreggs.com.

Tax Planning Tips

Contribute the maximum amount to your 401(k) plan. Your contributions, up to a maximum of $11,000 in 2002, are deducted from your gross pay, so you don't pay current income taxes on the contributions (although you still pay Social Security and Medicare taxes). In addition, earnings and capital gains on your investments grow tax deferred until withdrawal. When you make withdrawals, you'll have to pay ordinary income taxes on the contributions and earnings (and possibly a 10% federal income tax penalty if withdrawals are made before age 59 1/2), but this tax-deferred growth typically means that you could have a larger nest egg than if you had been paying taxes currently during the years.

Decide which type of individual retirement account (IRA) to contribute to and then do so early in the year. Find out whether you're eligible to contribute to a traditional deductible or Roth IRA and then decide which is the better alternative for you. Make your contribution early in the year to allow your funds to compound tax deferred or tax free for a longer time.

Consider investing in municipal bonds if bonds comprise a portion of your investment portfolio. Interest income from municipal bonds is generally exempt from federal, and sometimes state and local, income taxes. (Income for some investors may be subject to the federal alternative minimum tax (AMT) and are subject to the bond premium and market discount rules.) In general, the higher your marginal tax rate, the more advantageous you'll find investing in municipal bonds. Before investing, compare the yield on the municipal bond to the after-tax yield of other types of bonds.

Investigate investments that generate capital gains, such as growth stocks. Capital gains on investments held over one year are subject to the 20% capital gains tax rate (10% if you are in the 15% tax bracket), compared to the top ordinary income tax rate of 38.6% in 2002. Also, you do not pay the tax until the investment is sold, allowing you to plan when to recognize the gain.

Replace loans that generate personal interest with mortgage loans or home-equity loans. Personal interest cannot be deducted on your tax return, while mortgage interest and home-equity loan interest typically can, as long as the mortgage does not exceed $1,000,000 and the home-equity loan does not exceed $100,000.

Make gifts of income-producing assets, up to $11,000 in 2002 ($22,000 if you split the gift with your spouse), to your children tax free. Doing so shifts the income from the assets to your children, who may be in a lower tax bracket. If your child is under age 14, be aware that the "kiddie tax" rules apply. In 2002, the first $750 of investment income is tax free, the second $750 is taxed at the child's tax rate, and any remaining interest income is taxed at the parents' marginal tax rate. Thus, you may want to utilize tax-free or tax-deferred investments for at least a portion of the child's investments until the child turns 14. All investment income of children aged 14 or older is taxed at the child's marginal tax rate.

Take advantage of education tax breaks. If eligible, make sure to document and claim the Hope Scholarship or Lifetime Learning credits or the above-the-line deduction for qualified higher-education expenses. Be aware that you may be able to deduct a portion of the interest paid on student loans if you meet certain of the eligibility requirements. Also, decide whether you want to save for college with an Education Savings Account or Section 529 Plan.

Obtain a receipt for any household goods donated to a charity. You may be able to deduct those contributions on your tax return. Also, keep track of any out-of-pocket expenses incurred while you are performing charitable work; those may also be deducted.

Keep track of your expenses if you are looking for a new job. Items like resume preparation, mileage, air fare, and hotels may be deducted as miscellaneous itemized deductions. If you get a new job in the same field and relocate more than 50 miles from your current home, you can deduct all your unreimbursed moving expenses. You don't even have to itemize to do so.

Start planning now. This gives you time to consider various tax planning strategies and ensure that you have adequate time to implement those strategies this year.

Investment Tax Strategies

With marginal income tax rates of up to 38.6% in 2002, taxes can seriously erode your investments' total return. Consider these strategies:

Consider your holding period before selling. Gains on investments held for one year or longer are taxed at the capital gains tax rate of 20% (10% if you are in the 15% tax bracket), rather than ordinary income tax rates. Thus, before selling an investment, you should review your holding period. If the one year holding period will be reached in a short time, you might want to wait to sell the investment. On the other hand, you might want to sell immediately if you're concerned that the investment's value could drop during that period.

Review your realized gains and losses before year end. If you have realized gains but are holding investments with losses, you might want to sell them before year end to offset the gains. You can offset all of your capital gains plus take an additional $3,000 of loss against ordinary income. This strategy may be particularly useful if your adjusted gross income is close to the eligibility limits for various tax benefits.

If you still want to hold the investments with losses, you can sell them to deduct the loss and later repurchase them, as long as you avoid the wash sale rules. These rules state that you must repurchase the investment at least 31 days before or after you sell the original investment to recognize the loss for tax purposes.

Specifically identify which shares you are selling. If you purchased an investment over time, you may have varying basis amounts for different shares. Your gain or loss will be determined by which shares you sell. Thus, you should assess your overall tax situation, decide whether you want a higher or lower gain or loss, and then designate which shares you want to sell. Also consider your holding period. If you don't specifically identify which shares you are selling, the Internal Revenue Service will assume you sold the first shares purchased.

Donate investments with large capital gains to charitable organizations. Of course, this strategy only makes sense if you were planning to make a charitable contribution anyway. You can deduct the fair market value of the investment (provided you held it for over a year) as a charitable contribution, subject to limitations based on your adjusted gross income. By donating the investment, you do not pay capital gains taxes on the gain. For instance, assume you donate stock with a fair market value of $10,000 and a basis of $2,500. You receive a charitable contribution deduction of $10,000 and you avoid capital gains taxes of $1,500 (20% of your gain of $7,500).

Keep track of your investments' basis so that you don't overpay taxes. For instance, reinvested dividends are part of your cost basis, since income taxes were paid when the dividends were received. For inherited assets, the cost basis is typically the value on the date of the previous owner's death.

Consider tax-deferred or tax-exempt investments. The interest income from municipal bonds is typically exempt from federal income taxes and possibly state and local income taxes. (There may be alternative minimum tax consequences and an impact on taxation of Social Security benefits.) Contributions to 401(k) plans and IRAs can grow on a tax-deferred or tax-free (for Roth IRAs) basis. This deferral of income taxes can make a significant difference in the ultimate size of your portfolio.

The Basics of UTMAs

Custodial accounts under the Uniform Transfers to Minor Act (UTMA) are often used to save for a child's college education or to help parents reduce their income taxes. Basically, you set up an account for your child, naming yourself or someone else as custodian. Under current tax laws, you can transfer a certain amount each year, $11,000 in 2002 ($22,000 if the gift is split with your spouse), with no gift tax implications. Any income generated on those gifts is your child's income, taxable as follows:

• For children under age 14, the first $750 of income in 2002 is tax free, the next $750 of income is taxed at the child's tax rate, and the remaining income is taxed as the parents' marginal tax rate.
• For children over age 14, all income is taxed at the child's tax rate.

Once assets are transferred to the account, they become the child's assets and cannot be taken back. The custodian manages the property for the child's benefit until control passes to the child (typically 18 or 21, depending on your residence state). When the child reaches that age, the account terminates and the assets transfer to the child's control.

UTMA accounts are fairly easy to set up, but you should consider several factors before doing so:

• Assets in the UTMA are considered your child's when applying for college financial aid. Under present financial aid formulas, 35% of your child's assets must be used for college education costs, while only 5.6% of your assets must be used.
• Since you can't take the assets back, make sure you won't need those funds in the future.
• Once control passes to your child, you can't control how the money is spent. While you may hope that your child uses the funds for things like funding college or buying a home, at age 18 or 21, your child may have different ideas for the money.
• There are other ways to save for your child. If the amounts being transferred are substantial, you might want to consider a trust, which gives you more control over when and for what reasons funds are distributed to your child. If you are saving for college, perhaps a Section 529 plan or education savings account would be a better alternative.
  

Be Aware of the AMT

The alternative minimum tax (AMT) was originally designed to ensure that wealthy taxpayers paid at least a minimum amount of income taxes. But more and more taxpayers are becoming subject to the AMT, with that number expected to grow from 1.7 million taxpayers in 2002 to 35 million by 2010 (Source: United States Department of Treasury, 2002).

How is the AMT calculated? As its name implies, the AMT is an alternative way to calculate your income tax bill. You start with your taxable income and add back several items, including personal exemption deductions; the standard deduction if you don't itemize; state, local, and property tax deductions; medical expenses, unless they exceed 10%, rather than 7.5% of AGI; municipal interest income from certain private-activity bonds; certain business-related items if you own a business, rental property, or interest in a partnership or S corporation; and the difference between the market price and exercise price of incentive stock options.

From this calculation, you subtract the AMT exemption amount, which increased in 2002 to $49,000 (up from $45,000) for married taxpayers filing jointly and $35,750 (up from $33,75) for single taxpayers. However, the exemption is phased out by 25 cents for every dollar of AMT taxable income over $150,000 for married taxpayers filing jointly and $112,500 for single taxpayers.

The result is then subject to the AMT rates - 26% on the first $175,000 of income and 28% on amounts over that. If the AMT exceeds your regular income tax, the difference must be paid as the AMT. If you pay the AMT, some portion of that tax may be refunded in future years through an AMT credit that offsets your regular tax liability. However, the credit can only be used in years when you don't pay the AMT.

How can you plan for the AMT? Since so many items affect the AMT calculation, it's difficult to determine who will be subject to the tax. If you're concerned that you may be subject to the AMT, consider these strategies:

• Accelerate income and postpone deductions. This is just the opposite of the conventional advice of deferring income and accelerating deductions. But in years when you are subject to the AMT, you will typically pay less tax by postponing deductions (many of which are added back in the AMT calculation) and accelerating income (so income is taxed at a maximum rate of 28% instead of a maximum income tax rate of 38.6%). Income that could be accelerated includes selling investments at a gain, taking prepayments of bonuses, and withdrawing money from individual retirement accounts (IRAs) and other retirement plans.
• Plan stock option exercises carefully. For AMT purposes, the difference between your exercise price and the market price on the date of exercise is considered income, even if you don't sell the stock or the value decreases after exercise. You might want to exercise stock options early in the year. Then, near the end of the year, you can sell the stock if the price goes down so you won't be subject to the AMT on the option exercise.
  

Tax Planning Is a Year-Round Process

Tax planning is often confused with tax preparation, with thought given to the subject only when preparing your annual tax return. However, little can be done to actually lower your tax bill at that point. If your goal is to reduce taxes, you need to be aware of tax planning opportunities throughout the year.

Take time early in the year, perhaps as part of the tax preparation process, to assess your tax situation, looking for ways to reduce your tax bill. Consider a host of items, such as what kinds of debt you owe, how you're saving for retirement and education expenses, which investments you own, and what tax-deductible expenses you incur. It often helps to discuss these items with a professional who can review strategies you might not have considered.

During the year, consider the tax consequences before making important financial decisions. This will prevent you from finding out later that there was a better way to handle the transaction.

Look at your tax situation again in the fall, which gives you plenty of time before year end to implement any additional tax planning strategies. At that point, you'll also have a better idea of your expected income and expenses for the year. You may then want to use strategies you hadn't considered earlier in the year, such as selling investments at a loss to offset capital gains.

FR2000-0110-0012