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Clients and Friends:
When we meet with a prospective client, the first document we ask to see is the last tax return that was filed. In reviewing these returns, it is more common than not, that we find areas that could have been handled differently, which would have resulted in a smaller tax bill. The preparer of the last tax return most often did nothing wrong, in that they were in compliance with the Internal Revenue Code. However, certain options weren't chosen to keep the tax bill to a minimum.
The most likely candidates for reducing taxes are an individual who has a small business, or is doing consulting work. So if you know someone in that situation, give them my name. If we can help reduce their tax bill, you might just make a friend for life.
This month's e-newsletter has the following articles:
- Getting ready for next year's liberalized IRA-to-Roth IRA conversion rules - this change in the law (allowing those whose adjusted gross income exceeds $100,000 convert traditional IRA's to Roth IRA's) which will take effect 1/1/10 may provide tax savings opportunities for those with the right situation.
- Hell Week, One Year On - an article written by Nick Murray - I always find his writing about the financial climate insightful - I think you will to.
- Tax Savings Techniques for Security Gains - many of you may find yourself in the opposite situation that existed a year ago - you've got securities that have appreciated in value - here's some thoughts on reducing the tax burden upon sale of appreciated investments
As always, please contact us if you have any questions about these issues, or any concerns you have about taxes or finances.
Bob Rounsfull
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Getting ready for next year's liberalized IRA-to-Roth-IRA conversion rules
Next year will be a pivotal one for retirement planning, as it will be the first year in which taxpayers will be able to convert funds in regular IRAs (as well as qualified plan funds) to Roth IRAs regardless of their income level. This new conversion option poses significant tax planning challenges and opportunities for 2009, 2010 and2011. This Practice Alert takes a look at the new conversion option, and explains how to prepare for it.
Conversions to Roth IRAs. For 2009, taxpayers (other than married persons filing separately) with modified adjusted gross income (AGI) of $100,000 or less may convert amounts in a traditional IRA to amounts in a Roth IRA. (Code Sec. 408A(c)(3)(B)) Amounts from a SEP-IRA or a SIMPLE IRA also may be converted to a Roth IRA, but a conversion from a SIMPLE IRA may be made only after the 2-year period beginning on the date on which the taxpayer first participated in any SIMPLE IRA maintained by the taxpayer's employer. (Reg. § 1.408A-4)
For purposes of conversions to Roth IRAs, AGI is defined as it is for traditional IRA purposes except that it does not include income resulting from the conversion from a traditional IRA to a Roth IRA. (Code Sec. 408A(c)(3)(C)(i) ; Reg. § 1.408A-3) AGI-for purposes of determining conversion eligibility only-does not include any required minimum distribution from an IRA under Code Sec. 408(a)(6) and Code Sec. 408(b)(3). (Reg. § 1.408A-3)
A conversion from a regular IRA to a Roth IRA is subject to tax as if it were distributed from the traditional IRA and not recontributed to another IRA (Code Sec. 408A(d)(3)(A)(i)), but isn't subject to the 10% premature distribution tax. (Code Sec. 408A(d)(3)(A)(ii); Reg. § 1.408A-4 , Q&A 7)
After Dec. 31, 2007, distributions from a Code Sec. 401(a) qualified plan also may be rolled over to a Roth IRA. (Code Sec. 408A(d)(3))
Major change coming next year. For tax years beginning after 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing a separate return will be able to convert amounts in a traditional IRA into a Roth IRA (currently they are barred from doing so). (Code Sec. 408A(c)(3))
Why make a IRA-to-Roth IRA conversion? Roth IRAs have two major advantages over regular IRAs:
(1) Distributions from regular IRAs are taxed as ordinary income (except to the extent they represent nondeductible contributions). By contrast, Roth IRA distributions are tax-free if they are "qualified distributions," that is, if they are made (1) after the 5-tax-year period that begins with the first tax year for which the taxpayer made a contribution to a Roth IRA, and (2) when the account owner is 59 1/2 years of age or older, or on account of death, disability, or the purchase of a home by a qualified first-time homebuyer (limited to $10,000). (Code Sec. 408A(d)(2))
(2) Regular IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions to be made commencing in the year following the year in which the IRA owner attains age 70 1/2. By contrast, Roth IRAs aren't subject to the lifetime RMD rules that apply to regular IRAs (as well as individual account qualified plans). (Code Sec. 408A(c)(5))
A similar comparison could be made between distributions from qualified retirement plans and Roth IRAs.
There are other tax advantages: Because distributions from Roth IRAs are tax-free (if they are qualified distributions), they may keep a taxpayer from being taxed in a higher tax bracket that would otherwise apply if he were withdrawing taxable distributions, don't enter into the calculation of tax owed on Social Security payments, and have no effect on AGI-based deductions. What is more, the benefits flow through to beneficiaries of Roth IRA accounts, who also can make tax-free withdrawals from such accounts (they are, however, subject to the same annual post-death minimum distribution rules that apply to beneficiaries of regular IRAs).
Who should make IRA-to-Roth IRA conversions? The consensus view is that the conversion route should be considered by taxpayers who:
... have a number of years to go before retirement (and are therefore able to recoup the dollars that are lost to taxes on account of the conversion);
... anticipate being taxed in a higher bracket in the future than they are now; and
... can pay the tax on the conversion from non-retirement-account assets (otherwise, there will be a smaller buildup of tax-free earnings in the depleted retirement account).
Complicating factor for 2010 conversions. A unique income inclusion rule will apply for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. (Code Sec. 408A(d)(3)(A))
A major wild card in making this choice is the tax-rate picture after 2010. Absent Congressional action, after 2010 the tax brackets above the 15% bracket will revert to their pre-2001 levels. That means the top four brackets will be 39.6%, 36%, 31%, and 28%, instead of the current top four brackets of 35%, 33%, 28%, and 25%. The Administration has proposed to increase taxes only for those making $250,000, but it is difficult, at this point in time, to predict who will get hit by higher rates. What's more, there are proposals on the table to help finance health reform with a surtax on higher-income taxpayers.
What do to this year. Taxpayers who intend to take advantage of the new conversion option next year should consider the following strategies:
... Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They'll reduce their 2009 tax bill and, if they make the conversion to Roth IRA next year, they won't have to pay back the tax savings until 2011 and 2012.
... High income taxpayers should consider making nondeductible IRA contributions this year. They can then roll over the accounts into Roth IRAs next year at no tax cost.
... Some high-income taxpayers plan to make large conversions in 2010 but to opt out of the deferral of tax until 2011 and 2012 because they fear they will be in a higher tax bracket in those years than in 2010. These taxpayers should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income but should, rather, do the reverse in an effort to avoid being pushed into the highest brackets by a large IRA-to-Roth-IRA conversion. These taxpayers should be considering ways to defer deductions to 2010, and accelerate income from next year into 2009.
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Hell Week, One Year On
We recently observed the first anniversary of the most shocking and terrifying week in most of our financial lives: the economic cataclysm of September 15-19, 2008.
Even the greatest one-day stock market crash in history on October 19, 1987 did not shake us the way this Hell Week did, inasmuch as it was almost entirely contained in the equity market: the economy, the banking system, and the world at large, aided by a tsunami of liquidity from the Federal Reserve, rolled merrily along. The epicenter of the earthquake-at the corner of Broad and Wall Streets-turned out to be the whole earthquake.
And the terrorist atrocities of September 11, 2001, even as they forced us to confront a whole new global geopolitics-and our position in the world as the target of an unfathomable crypto-religious hatred-had, after the initial shock, no lasting economic effect.
But Hell Week 2008 shook the global financial system to its foundations. The previous week, the federal government had taken over the two government-sponsored mortgage enterprises Fannie Mae and Freddie Mac as they teetered on the edge of the abyss. On Monday, September 15, Lehman Brothers failed. It was (and remains) the largest corporate bankruptcy in American history, but on that day, this datum seemed almost beside the point. The issue was how much damage Lehman's failure would do to financial institutions all over the world which were exposed to Lehman through complex derivatives-in the jargon, Lehman's counterparty risk. No one seemed to be able to get a handle on this, and that uncertainty struck terror in the heart of the financial system. That same day, Merrill Lynch-one of the last great, independent investment banking and brokerage houses-was forced to merge with Bank of America in order to stave off its own imminent failure.
The next day, the government had to bail out one of the world's largest insurance companies, AIG, whose counterparty risk threatened to be even greater than Lehman's. And indeed, on that day-having written off its exposure to Lehman-the Reserve Primary Fund, a $62 billion money market fund, "broke the buck." That is, its net asset value fell below a dollar a share. Suddenly, no one knew what three trillion dollars of nominal money market fund assets were really worth, and panic liquidation set in on a hitherto unimaginable scale.
And so the week went on, with the government desperately injecting unprecedented amounts of liquidity into the financial system, in an attempt to prevent the credit markets from going into anaphylactic shock. All in vain: by week's end, it was becoming clear that the global market for credit was shutting down. And as it did, the world economy-to which credit functions as oxygen does to the human body-would fall off a cliff. Never in our lifetimes has economic activity in our country fallen so far so fast as it did in the fourth quarter of 2008 and the early months of 2009. Hell Week had been the detonator of a global thermonuclear financial implosion.
It is a minor irony of Hell Week that the stock market, as measured by the S&P 500, closed that Friday at its high for the week: 1255. The rally, such as it was, was propelled by the hope against hope that the government's apparent willingness to intervene without limit-to do, in Fed Chairman Bernanke's phrase, "whatever it takes"-would stem the tide. Reality would overtake us soon enough: driven relentlessly lower by massive home foreclosures, a cascade of bank failures, the bankruptcy of two of Detroit's Big Three and soaring unemployment, the equity market would in the next six months decline by nearly half from its Hell Week close, to 676 on March 9. (And this, of course, was the continuation of an already significant bear market which had begun when the market topped out at 1565 in October 2007.)
It was the nearest thing we had ever seen to the end of the world. Investors fled equities in a wave of panic which has few if any antecedents in our lifetimes. As 2009 began, deposits in passbook savings accounts and money market funds (the latter now guaranteed, in desperation, by the government) were greater than the market capitalization of the entire U.S. stock market, as denominated in the Wilshire 5000 stock index. Think of it, dear reader: for months on end-on any given day-the holders of cash equivalents earning less than one percent per year could have reached out and bought the American stock market in its entirety by nightfall. Yet they did not. And indeed, why would they? It was the end of the world. Everyone said so.
As I write, a year almost to the day since the end of Hell Week, the S&P 500 stands at 1070-about fifteen percent below its close on the Friday, and less than six percent below the week's low at 1134.
How can that be? Why, Hell Week was the beginning of the end of the world. Look what unfolded over the next six months: inarguably, the onset of the end of the world. Everyone said so.
Yet six months further on-the best six months in the American stock market since 1933, if anyone's counting-we're within a whisker of where we were in the middle of Hell Week. And will-sooner than later, if one may hazard a pure guess-surpass those levels. This eventuality will, when and if it happens, wipe out all the market's "losses" since the morning of Lehman's failure. Far more to the point of this essay, it will leave everyone who panicked out of the market during and after Hell Week-and who is still out-under water. Again: how can this be? What on earth can have happened?
What happened, dear reader, is that once again, seemingly against all reason and logic, the world did not end.
A detailed recitation of all the economic phenomena which have turned importantly positive-manufacturing (up eight months in a row), retail sales, productivity, the national savings rate, household net worth (the first uptick in two years), and even housing starts-is probably not necessary here. Indeed, even the last, lingering negative economic indicator, unemployment, seems to be in the process of topping out. The major banks have begun repaying their TARP money, and are recapitalizing. Merger and acquisition activity has restarted from a dead stop. And in a final irony, the Treasury just in the last few days quietly ended its guarantee program for money market funds, stating quite correctly that it was no longer necessary. We are by no means out of the economic woods-now, all that excess liquidity has to get mopped up before inflation ignites-but (a) we'll cross that bridge when we come to it, and (b) that's way beyond the scope of this essay.
One wishes simply to point out, here, that the world did not end-as indeed, historically, it has always failed to end in all the crises of yesteryear-and that everyone who predicated his portfolio on the end of the world has once again, at this writing, thrown snake-eyes. This is neither economic nor market commentary. Still less is it a prediction of the economy, nor of next year's market. It is purely an inquiry into the tragedy of panic.
Even more seductive than the siren song of a fad near its top-the Internet in 1999, real estate in 2005, oil in the spring of 2008-is the hypnotic spell of catastrophism near a bottom. This is a psychological much more than it is an economic phenomenon, since it is well documented in the literature of behavioral finance that we fear loss far more acutely than we hope for gain. The peaceful and even blissful illusion of "the safety of cash"-bringing with it surcease from the pain of watching our investments lose value every day-becomes at such times well-nigh irresistible. And to justify giving in to the lure of cash, we latch on to whatever apocalyptic theory comes most readily to hand in the mainstream media.
And invariably-at least throughout history so far-we come bitterly to regret it.
This is, finally, the lesson of Hell Week one year on: that however horrific this particular turn of the cycle was, it was just that: a turn of the cycle. But that the cycle itself had not been repealed. And that if history was any guide-and it remains the only guide we have-however much the rubber band was stretched in one direction, even so would it snap back when released.
It was not necessary to know how or when the cycle would reassert itself, and in fact no one did, because no one consistently can. (And even if a lonely voice or two had spoken up for the imminence of the cyclical turn, the cacophony of catastrophism last winter would surely have drowned them out.) It was merely necessary to maintain one's faith that the cycle would turn. But that faith was and is much more a temperamental than an intellectual quality. And one nurtures it not by studying the economy at any given moment, but by studying history all the time.
The great documentary filmmaker Ken Burns has said, "History is medicine. It has nothing whatever to do with the past. It has everything to do with the present."
A word to the wise: next time-and you may be sure there will be a next time-just keep taking your medicine.
© 2009 Nick Murray. All rights reserved. Used by permission.
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Tax Savings Techniques for Security Gains
Nobody can be very happy about the stock market's performance in the last year or so. That said, the market's recent rebound may actually have left you wondering whether it's time to capitalize on some of those newly realized gains on stocks you purchased during the downturn. While taxes should not be the main consideration in this decision, they certainly need to be considered as they can make a significant impact on your investment return.
With that in mind, here are a couple tax smart strategies to consider as you analyze your investment opportunities and decide what to do about recent gains.
Should You Wait to Sell Until the Stock Qualifies for Long-term Capital Gains Treatment?
If the stock sale qualifies for long-term capital gain treatment, it will be taxed at a maximum tax rate of 15%. Otherwise it will be taxed at your ordinary income tax rates, which can be as high as 35%. Clearly, you'll pay less taxes (and keep more of your gains) if the stock sale qualifies for long-term capital gain treatment. The amount of taxes you'll save depends on your ordinary income tax bracket.
To qualify for the preferential long-term capital gain rates, you must hold the stock for more than 12 months. The holding period generally begins the day after you purchase the stock and runs through (and includes) the date you sell it. These rules must be followed exactly, because missing the required holding period by even one day prevents you from using the preferential rates.
The question then becomes: Are the tax savings that would be realized by holding the asset for the long-term period worth the investment risk that the asset's value will fall during the same time period? If you think the value will fall significantly, liquidating quickly, regardless of tax consequences, may be the better option. Otherwise, the potential risk of holding an asset should be weighed against the tax benefit of qualifying for a reduced tax rate.
Comparing the risk of a price decline to the potential tax benefit of holding an investment for a certain time is not an exact science. However, the following should be considered:
1. Your expected ordinary income tax rate relative to the anticipated capital gains rate.
2. The amount of appreciation that will eventually be taxed.
3. How much longer the asset must be held to qualify for favorable capital gain rates.
4. Whether any existing capital losses could offset the gain (and the benefit of the lower rate).
We'd be glad to help you weigh your options.
Use "Specific ID Method" to Minimize Taxes
If you are considering selling less than your entire interest in a security that you purchased at various times for various prices, you have a couple options for identifying the particular shares sold-(1) the first-in, first-out (FIFO) method and (2) the specific ID method. FIFO is used if you do not (or cannot) specifically identify which shares of stock are sold, so the oldest securities are assumed to be sold first. Alternatively, you can use the specific ID method to select the particular shares you wish to sell. This is typically the preferred method as it allows you at least some level of control over the amount and character of the gain (or loss) realized on the sale, which can lead to tax savings opportunities.
For example, if you realized some capital losses earlier this year (or you have a capital loss carryover from last year), realizing a short-term (vs. long-term) gain may be advantageous. This can be accomplished by specifically identifying the newest shares of a particular security as sold. Then, the older shares can be sold (generating a long-term gain) later, when the gain will not be offset by capital losses.
Be careful, though, if your basis in the shares differs (and it usually does), the specific ID method affects the amount of the gain as well as the holding period. Sometimes, reducing the current taxable gain by selling the highest basis shares first is more beneficial than obtaining the lower long-term capital gain rate. Each case will depend on your specific facts, and will require comparative calculations.
The specific ID method requires that you adequately identify the specific stock to be sold. This can be accomplished by delivering the specific shares to be sold to the broker selling the stock. Alternatively, if the securities are held by your broker, IRS regulations say you must notify your broker regarding which shares you want to sell and identify them by reference to their purchase date and per-share price. The broker must then issue you a written confirmation of your instructions.
Unfortunately, discount and online brokers may be unwilling or unable to issue these confirmations. In this scenario, the Tax Court's 1994 Concord Instruments Corp. decision seems to say you can give oral instructions regarding which shares to sell and still use the specific ID method even though no confirmation is forthcoming. However, you should carefully document your instructions by making notations on the written transaction statements received from your broker (and it is still better to follow the requirements under the IRS regulations when possible).
Conclusion
We would like to help you develop a personal strategy for maximizing the benefit of one of the best tax breaks available. We will contact you in the near future to discuss your situation. If you have any questions in the meantime, please give us a call.
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