“Like sweet and sour pork” was the term Philadelphia Eagles coach Andy Reid used to describe a pivotal fourth-quarter play against the New York Giants on which Jason Avant made a drive-saving catch and Evan Mathis was hurt. Quite fittingly, that is my feeling when assessing year end tax planning options. Some choices can be quite beneficial; others, not so sweet.
First of all, tax planning should not be a year end event. It should be an activity practiced year round. Below are strategies that can make a difference in reducing your tax obligations, flavored with rules that, if not followed, will cost you more money with the Internal Revenue Service and quite possibly State and Local as well.
Hire Your Child–Since your offspring already possess talents unique to their generation, why not employ them in your business. If you’re a sole proprietor or have a husband/wife partnership, the first $5,000 in wages can possibly reduce your tax obligations up to $2,500.
Use Those Wages for Roth IRA–Like a College 529 Plan, your money grows tax free. Unlike a 529 Plan, funds do not have to be used for school. Should you need those funds for school, the 10% penalty withdrawal is waived and the income may be taxed at your child’s tax rate.
Implement Section 127 Plan–Deduct college tuition! If your child is age 21 or older and has been employed by you (see above), you can institute a Sec. 127 Plan for tuition reimbursement up to $5,250. You cannot discriminate on this, but you can limit by job classification. For example, if your child is a part time worker, then this benefit needs to be offered to all part time workers.
IRA Distributions When you’re 70 ½–Many are aware that mandatory IRA distributions can be deferred in the year one turns 70 ½. Thus, if you’re 70 ½ in 2011, you do not have to begin distributions until April 2012. This is a bad idea.
In 2012, in addition to the 2011 IRA distribution, you need to take your 2012 distribution. The result of taking both distributions in one year could be to push you into a higher tax bracket and, worse, could cause your social security benefits to become taxable as well. Bottom line–take your IRA distributions in the year when you turn age 70.
Capital Gains Planning–Let’s say you’re sitting with a large gain on an investment and you’re planning to sell. Doing so in a high tax state like New Jersey will result in nearly a 25% tax obligation between the IRS and the state. Further, if your gain is significant enough, it may result in the gain being subject to the Alternative Minimum Tax, which would push your IRS rate to 22-23% before throwing in the state tax rate.
One approach to reducing those taxes would be to gift the investment to working children whose tax bracket is lower and/or who live in a state that is not as confiscatory as New Jersey. The result could be a much lower tax bill.
Buying Mutual Funds in December–Beware of this, as capital gains and dividends are distributed then, leaving a tax obligation that could have easily been avoided. Wait until after distribution date to purchase.
Avoiding Tax Penalties–There are a variety of ways to incur the wrath of the IRS, state and local tax agencies. Where in the past these benevolent institutions would lightly tap you on the hand should you cross them, today they can bring the fear of the Almighty upon you.
Filing timely–Always a good thing to do. Not filing your taxes on time can bring about substantial penalties. Particularly, corporate and partnership returns, despite not owing any money, are now targeted for penalties if sent in late.
Avoiding Underpayment Penalties–Either pay 100% of 2010 tax liability (110% if your adjusted gross income exceeded $150k), or 90 percent of 2011 tax liability, to avoid these penalties.
Extensions–These are not worth the paper they’re printed on, if money is owed to the IRS. Better to over-estimate taxes owed and generate a refund.