A Year of Uncertainty?
Officially, year-end tax planning is
fairly straightforward in 2011. At year-end 2010, Congress extended
many of the income tax laws that were in place at the time. Some laws
were changed, especially in the estate planning area. For the most
part, the tax law passed at the end of last year is effective for two
years: 2011 and 2012. Therefore, you may expect to plan for year-end
2011 and for 2012 with some certainty.
As this issue is
written, however, the news from Washington is far from certain.
President Obama and Congressional leaders are attempting to resolve
federal budget and debt issues. Tax changes are possible, and such
changes may affect year-end planning in 2011. Our office will keep you
informed about any changes that become law and how they might impact
your year-end tax planning. In the meantime, here is an overview of the
In 2011, federal
income tax rates range from 10% to 35%. The same tax rates will be in
effect for 2012. Therefore, standard tax planning calls for deferring
income to 2012, where possible, and accelerating tax deductions to
2011. With this strategy, you'll defer tax payments and benefit by
having more use of your own money. You might reverse such planning,
though, if you expect your income to be significantly higher next year,
pushing you into a higher tax bracket.
For 2011 and 2012, the federal estate tax exemption is set
at $5 million. Similarly, the gift tax and generation skipping transfer
tax exemptions are set at $5 million through next year. Those exemptions
might be reduced in the future. Consequently, you may want to make large
taxable gifts now, while the gift tax exemption is so substantial. Our
office can review the tax consequences with you and make sure your
estate plan conforms with current law.
Did You Know?
2000 to 2011, IRAs increased from 22% of U.S. retirement savings to 27%
of the total, passing government plans and defined contribution plans,
such as 401(k)s.
Year-End Tax Planning for Investors
performed reasonably well for much of 2011 but fell precipitously after
the downgrading of the United State's credit rating. As of this
writing, the investment outlook for 2011 is quite uncertain. Despite
that fact, there are things you can do with your portfolio by year-end
to reduce the tax you'll owe for 2011. Start by reviewing Schedule
D of the federal income tax return you filed for 2010. See if you are
carrying over any net capital losses from previous years. The next step
is to tally your trading activity for 2011 so far. You can determine if
you are in a net capital gain or loss position for the year to date.
Example 1: Jane Collins is carrying over $10,000
worth of net capital losses from prior years. So far this year, her
securities trades have generated a net gain of $18,000. If Jane takes
no further action, she can use her loss carryover to offset part of
this year's gain and wind up with an $8,000 net capital gain. If
those gains are all long term, meaning that Jane held the securities
for more than a year before selling them, she will owe $1,200 in tax,
at a 15% rate.
Learning to love
To reduce her tax bill, Jane can take capital losses before
year end. If she takes $8,000 worth of losses, for example, Jane will
have a $10,000 net gain for 2011: her previous $18,000 net gain minus
$8,000 in year-end losses. With a $10,000 net gain for 2011 and a
$10,000 loss carryover from her 2010 tax return, Jane will have neither
net gains nor net losses. Therefore, she'll owe no tax on her trades
for her 2011 tax return. If Jane takes $11,000 worth of losses by year
end, she will have a $3,000 net capital loss to report for 2011. That
amount is the largest capital loss you can deduct on your tax return
If Jane is in a 25% federal income tax bracket and reports
a $3,000 capital loss, she will save $750 in tax -25% of $3,000. On the
other hand, if Jane takes no year-end losses she will owe $1,200 in tax,
as explained in example 1. Altogether, Jane improves her tax position by
$1,950 (going from a $1,200 tax obligation to a $750 tax savings) by
taking $11,000 in capital losses by year end. Reducing her adjusted
gross income (AGI) by going from a net capital gain to a net loss also
might help her use other tax deductions and tax
When you do your year-end tax planning for capital gains
and losses, remember to include capital gains distributions from mutual
funds. If you hold the funds in a taxable account, you'll owe tax on
those distributions, even if you reinvest the distributions in the same
fund. Your fund's website should post 2011 distribution information
by November or December. If you have 1,000 shares of ABC Fund, for
instance, and the fund announces a $1 per share capital gains
distribution, you'll know that you'll be reporting $1,000 of
If you sell securities to generate capital losses,
you'll receive cash. You may want to maintain the shape of your
portfolio; however, you can't immediately purchase the same
security you've just sold. Such a transaction, called a "wash
sale," disallows your capital loss.
There are three
ways to keep your portfolio on track yet avoid a wash
1. Double up. To use this tactic, you must begin the
process before the end of November. You buy an additional amount of the
securities you wish to sell, wait more than 30 days, then sell the
original holding for a capital loss.
Ken Larsen bought 200 shares of XYZ Bank Corp. a few years ago at
$80 a share. XYZ now trades at $50 a share. On November 23, 2011, Ken
buys another 200 shares of XYZ. On December 27, 2011, which is more
than 30 days later, Ken instructs his broker to sell the original 200
shares at $50 apiece. He takes a capital loss of $30 a share, or $6,000
on the 200 shares.
With this tactic, Ken avoids a wash sale.
He also maintains his position in XYZ Bank Corp., which Ken believes is
undervalued at $50 a share. As you can see, Ken has invested another
$10,000 in XYZ, so he stands to gain more if the stock price moves up
or lose more if it keeps falling while he is holding the additional 200
shares. If this approach appeals to you, double up before the end of
November so you can wait more than 30 days and still claim a capital
loss for 2011 with a year-end sale.
2. Hold your
cash. You also can avoid a wash sale by holding onto the sales
proceeds for more than 30 days before reinvesting. If Ken sells his
original lot of XYZ Bank Corp. for a $6,000 capital loss on November
23, he can park the money he receives in a bank or brokerage liquid
account for more than 30 days. Then Ken can repurchase 200 shares of
XYZ without losing his capital loss. In this scenario, Ken takes the
risk that the trading price of XYZ will move sharply higher while he
sits on the sidelines.
3. Buy something similar but not
identical. If Ken does not want to be out of the market for more
than a month, he can take the $10,000 he receives for selling 200 shares
of XYZ on November 23 and immediately buy another bank stock or a fund
that holds many bank stocks. Such investments may rise or fall with the
industry outlook, just as XYZ would, but they won't jeopardize a
capital loss. After more than 30 days, Ken can repurchase XYZ if he
wishes. In the interim, Ken takes the risk that the replacement holding
might not perform as well as XYZ.
Did You Know?
spring of 2011, the Standard & Poor's/Case-Shiller Home Price
Indices had dropped nearly 33% from the peak levels of mid-2006. They
were back to the price levels of the summer of 2003. Source: Standard
Year-End Family Tax Planning
turn your attention to year-end tax planning, you probably focus on
your own situation as a single taxpayer or as a married individual who
will file a joint tax return. Broadening your horizons, though, may pay
off. If you have relatives in a low tax bracket, some strategies can
permit you to take advantage of their low tax rates. The outcome might
be lower taxes and more money for you and your loved ones to spend or
Coping with the kiddie tax
You may believe
that shifting income from parent to student is a tax efficient way to
build an education fund. You might, for instance, give taxable bonds to
your children so they can receive interest in a low tax bracket.
Similarly, you might give appreciated assets to youngsters, who can
sell them and owe little or no tax on the gains.
Such tactics can
be useful, but they are limited by the so-called "kiddie tax."
This tax code provision caps the amounts of unearned income that can be
taxed at a youngster's rate. Excess amounts are taxed at the
parents' rate, so there may be no family tax
Recent legislation has changed the kiddie
tax rules. In 2011
- everyone under age 18 is considered a
- the same is true for full-time
students under age 24, if their earned income is less than half of
their support. Here, support is the total spent on a student's
behalf during the year.
- 18-year-olds are still considered
kiddies even if they are not fulltime students, as long as their earned
income is less than half of their support.
individuals subject to those rules owe no tax on unearned income up to
$950. The next $950 of unearned income will be taxed at the child's
rate, which will be no more than 10%. Over $1,900, all unearned income
will be taxed at the parents' rate. The kiddie tax limits change
periodically to keep up with inflation, so the $1,900 limit might move
up to $2,000, $2,100, and so forth in the future.
Even with the kiddie tax limits in place,
some families might find tax benefits in income
Example 1: John and Karen Jackson hold $35,000 in a
taxable bond fund yielding 5%. When their daughter Sarah is born, they
transfer their shares in that fund to the newborn. If Sarah receives
$1,750 (5% of $35,000) this year, she will owe no tax on the first $950
and $80 on the next $800, at a 10% rate. This can go on every year,
permitting Sarah to build up an education fund at a very low tax
Example 2: Brett and Caroline Morgan hold large
amounts of stock in the company for which Caroline has worked for many
years. This stock has appreciated sharply, so they would owe capital
gains tax on a sale.
At the end of each year, Brett and
Caroline transfer shares to their three young children, who can sell
the shares and report the long-term capital gain. The Morgans monitor
the transfer and sale of shares so that their children do not report
gains over the kiddie tax limit each year. This strategy allows the
Morgans to cash in appreciated stock while the family pays little or no
capital gains tax.
Do these maneuvers make sense? Any tax
savings can help families bear expenses such as the increasing costs of
There are drawbacks, however. Some asset transfers may have
to be reported on a gift tax return. Holding assets in a student's
name might reduce eligibility for needbased financial aid. Perhaps most
important, assets transferred to a youngster eventually will be
controlled by that youngster, who may spend the money on things other
than higher education. Our office can help you quantify the tax savings
available through income shifting so you can decide whether these
tactics are worthwhile.
Income tax and estate planning with
Although the kiddie tax limits the impact
of shifting income to children, shifting income to retired parents who
are in a low tax bracket may be much more effective. Moreover, such
income shifts can be profitably paired with participation in a
parent's estate plan. The kiddie tax does not apply to retired
parents. Your parents may have relatively low income and substantial
tax deductions, perhaps from unreimbursed medical expenses. In such a
situation, you may be able to take advantage of their low tax bracket.
Some examples can
illustrate incomeshifting to low-bracket parents.
Roger and Kate Donovan are in the top 35% federal income tax
bracket. Kate's parents are in their late 70s and have taxable
income (after all deductions) of around $40,000 a year. Kate's
father has $200,000 in a traditional IRA, all in pretax money. Because
Kate's parents live comfortably on their current income, her father
has been taking only the required minimum distribution from his
In 2011, married couples who file joint tax returns can
have up to $69,000 of taxable income and remain in the 15% federal
income tax bracket. Therefore, Kate's father can convert an
additional $29,000 of his traditional IRA to a Roth IRA in late 2011
and owe only 15% on the taxable income generated by the conversion.
Kate's father executes this conversion and names Kate, his only
child, as the Roth IRA beneficiary.
The Roth IRA
conversion will add $4,350 to the federal income tax bill owed by
Kate's parents. To ease that burden, Roger and Kate might increase
the year-end holiday presents they give to her parents. In 2011, each
individual generally can give up to $13,000 each, to any number of
people, without incurring gift tax.
Pretax money in a
traditional IRA eventually will be subject to income tax, paid either
by the account owner or by the beneficiary after the owner's death.
In this example, Kate might take some withdrawals, in a high tax
bracket, after her father dies and she inherits his IRA.
By facilitating a Roth IRA conversion, this family is able
to take money from the traditional IRA at a low 15% tax rate. Similar
partial conversions can be executed each year until all the money has
been moved from the traditional IRA to a Roth IRA at a low tax
Roth IRA owners never have to take required distributions.
Moreover, all distributions from a Roth IRA are tax free after five
years and after age 59 1/2 . (The age requirement does not apply to
Roth beneficiaries.) The five-year calculation begins at the start of
the year, so a December 2011 Roth IRA conversion starts the five-year
clock at January 1, 2011; after January 1, 2016, just over four years
from now, all distributions from that Roth IRA will be tax free because
Kate's father is older than 59 1/2 .
father has a pressing need for money before the five-year mark, he can
withdraw the converted amount without owing income tax because he will
already have paid income tax on the Roth IRA conversion. Otherwise, the
money can keep growing inside the Roth IRA until it passes to Kate, who
can take tax-free withdrawals.
Other families may benefit by transferring assets from
middle-aged children to elderly parents, with the understanding that
those assets eventually will pass back to the
Example 2: Brian and Jean Russell are in the top 35%
federal income tax bracket. They have been helping to support
Brian's widowed mother, who has scant income beyond Social Security
checks. Instead of making periodic cash gifts to Brian's mother,
Brian and Jean transfer $100,000 worth of dividend paying stock to her
by year-end 2011 and another $100,000 in 2012. The Russells bought that
stock many years ago for $50,000. In 2011, each individual has a $5
million gift tax exemption, so Brian and Jean can make this gift
without paying gift tax. By spreading their gifts over two calendar
years, the Russells get more use of the annual gift tax exclusion, set
at $13,000 in 2011. (Gifts over $13,000 a year reduce the giver's
estate tax exemption, now set at $5 million.)
transferred stock pays a 4% dividend. If so, Brian's mother will
receive $8,000 per year in extra income: 4% of $200,000. Assuming the
dividends are "qualified," which is the case for most
investment income dividends, low-bracket taxpayers owe 0% tax. As long
as Brian's mother keeps her taxable income at $34,500 or less this
year, she will owe no tax on the dividends. Brian and Jean would have
owed 15% tax on the dividends if they had kept the
In this example, Brian's mother revises her will so
that Brian will inherit the shares she now owns. Suppose Brian's
mother dies when those shares are worth $215,000. If Brian's mother
has lived for more than one year after the gift, Brian will have a
$215,000 basis (cost for tax purposes) in the inherited shares. He can
sell them for $215,000 and owe no tax. Therefore, no one will ever owe
capital gains tax on the shares' appreciation from $50,000.
However, if Brian's mother dies before a year has passed since the
gift, he will not get a step up in basis.
FICA Wage Base
wage base has increased to $110,100 for 2012, up $3,300 from $106,800
Year-End Estate Tax Planning
mentioned previously in this issue, decedents have a $5 million
exemption from the federal estate tax for deaths in 2011 and 2012. Many
states also impose tax on estates or estate beneficiaries. Depending on
the state, people with a net worth of $1 million or more may leave
their heirs with tax to pay. In addition, future legislation might
reduce the federal estate tax exemption. As a result, you may want to
take some actions by year-end 2011 that can reduce your heirs'
exposure to future estate tax.
Do you have more wealth than the amount
you're likely to need for yourself and perhaps for a surviving
spouse? If that's the case, use your annual gift tax exclusion for
2011 before year end. Once the calendar flips to January, you can use
your gift tax exclusion for 2012, but you can't go back and use any
leftover exclusion from 2011.
In 2011, the exclusion amount is $13,000
per recipient, and no limit exists on the number of recipients for
which you can use the exclusion. Thus, married couples effectively have
annual exclusions up to $26,000 per recipient to an unlimited number of
recipients this year.
Gifts in excess of $13,000 this year will
be sheltered from gift tax by a $5 million lifetime gift tax exemption,
per giver. Gifts in excess of the annual exclusion and the lifetime
exemption are taxed at 35% in 2011 and 2012, the same rate that applies
to estate assets over $5 million.
Grantor retained annuity trusts (GRATs) may help reduce
your taxable estate, if you anticipate having a large estate - and a
potentially large estate tax obligation. If you act in 2011, you can
take advantage of low interest rates, some relatively low asset values,
and current tax law. The Obama administration has proposed tightening
the rules on GRATs. Moreover, some Congressional leaders have expressed
a desire to rein in the tax advantages of GRATs.
You can take
advantage of the current GRAT rules by creating a GRAT before any
legislation takes effect. With a GRAT, you create a trust (so
you're the grantor) and contribute assets to it. You set the term
of the trust and the annuity you'll retain; that's the payout
you'll receive during the life of the GRAT. After the trust term,
the assets will pass to the trust beneficiaries you've named,
perhaps your children.
Example 1: Sheila Simmons
transfers stock worth $500,000 to a GRAT. She sets a trust term of four
years and agrees to receive an annuity of $135,000 a year from the
trust. Suppose that the current IRS interest rate table sets the
present value of receiving $540,000 over the next four years at
$500,000. If so, Sheila has not made a gift and owes no gift tax. This
transaction gives Sheila a return on her money of around 3% a year.
In this example, Sheila transfers stock that has lost value
in recent years. She thinks the shares will appreciate by more than 3% a
year over the next four years. If that happens, assets will be left in
the trust when the GRAT terminates. Sheila's beneficiaries might
receive shares worth $50,000, $100,000, or more when the trust
terminates, free of any gift tax.
If you create a
GRAT, you'll use the "Section 7520 interest rate" published
monthly by the IRS, to put a value on the annuity you retain. The lower
the interest rate, the greater the chance that the appreciation of the
trust assets will result in a transfer of wealth to the trust
beneficiaries with little or no gift tax.
Qualified personal residence trusts (QPRTs) are similar to
GRATs in some ways. You create a QPRT, transfer assets into it, set a
trust term, and name trust beneficiaries who eventually will receive
the assets from the trust. With a QPRT, however, the asset you transfer
must be a house, and instead of receiving a flow of assets from the
trust, as you do with a GRAT, you receive the right to use the house
during the trust term. The house can be a principal residence or a
The transfer of the house to the QPRT is
treated, for gift tax purposes, as a gift of the remainder interest in
the house that the trust beneficiaries will receive at the end of the
trust term. The value of the remainder interest is the value of the
house at the time of transfer less the value of the right to use the
house during the trust term. The value of the right to use the home is
determined according to the length of the trust, the grantor's life
expectancy, and the Section 7520 interest rate as determined by the IRS
for the month of the transfer.
At the end of the
trust term, you are allowed to live in or use the house if you wish.
However, you must pay a fair market rent to the new owners - the QPRT
beneficiaries. Such payments will move even more assets to your loved
ones, free of gift tax.
Example 2: Phil Matthews, age 50,
transfers a $1 million vacation home to a QPRT, setting the trust term
at 25 years. Using interest rates in effect at that time, the value of
Phil's retained interest is about $700,000. Thus, Phil has made a
gift of $300,000, which will be amply covered by his $5 million
lifetime gift tax exemption.
Phil can continue to use the vacation
home for the next 25 years. Assuming appreciation of less than 3% a
year, the home will be worth around $2 million when the QPRT expires.
At that point, the $2 million home will pass to the trust beneficiaries
with no gift or estate tax due. QPRTs might make sense now that real
estate values are depressed, if you assume the property will gain value
in the future.
With a QPRT, you can enlarge the gift tax
break by creating a trust with a long term. However, you must outlive
the trust term to get the estate tax exemption. If you die during the
QPRT term, the house will go back into your estate. Our office can
illustrate how various QPRT terms will result in smaller or greater
gift tax obligations.
401(k) Deferral Limits
maximum annual amount that can be deferred under the traditional 401(k)
is $17,000 for 2012, up $500 from $16,500 in 2011.
Persons at age 50
and over are entitled to an additional catch-up contribution of $5,500
in 2012, unchanged from 2011.
The SIMPLE 401(k) annual deferral limit
is $11,500 for 2012, unchanged from 2011.
Tax Implications of New Law on Homeowners Association Reserve Funds
Minnesota law requires only that a Homeowners Association (“HOA”)
reserve fund be “adequate” in the Board’s opinion, given future
A new Minnesota law effective January 1,
2012 places additional legal requirements on HOA’s. Key parts of the
amended statute are:
• HOA’s must reevaluate the
adequacy of their reserve fund at least once every three
• The HOA cannot borrow from the reserve fund to pay
operating expenses (but the replacement reserves can be pledged as
security for a loan to the association); and
fund allocations can be waived for components if the HOA decided to
fund those costs through future special assessments. However, this
waiver can last no longer than 4 years unless reaffirmed.
A qualified homeowners' association (that is, a
condominium management association, residential real estate
association, or timeshare association) generally may elect to be
treated as a tax-exempt organization. If the association elects to be
tax-exempt, it won't be taxed on “exempt function income.”
Assessments required to meet the Minnesota legal requirements of
maintaining an adequate reserve fund for future replacement needs are
not taxable income as this qualifies as exempt function income.
However, the association would pay tax on any nonexempt net income such
as income earned on amounts set aside in a fund for future improvements.
HSA Contribution Limits
maximum annual amount than can be contributed to an HSA is $3,100 for
an individual, up $50 from $3,050 in 2011.
The 2012 maximum
annual amount that can be contributed to an HSA is $6,250 for families,
up $100 from $6,150 in 2011.
Persons at age 55 and over are entitled
to an additional catch-up contribution of $1,000 in 2012, unchanged
For More Information.....
information on these topics or tax and tax-planning questions that you
may have, please contact your tax advisor at the Smith Schafer office
nearest you at one of the phone numbers listed
Segments of this newsletter are taken from The CPA
Client Tax Letter (ISSN 1066-1867) and are prepared by AICPA staff for
the clients of its members and other practitioners. The Tax Letter
carries no official authority, and its contents should not be acted
upon without professional advice. Copyright Â© 2011 by the American
Institute of Certified Public Accountants, Inc., New York, NY
10036-8775. Printed in the U.S.A. Sidney Kess, CPA, JD, Editor. For
AICPA customer service call 888.777.7077 or visit
In accordance with IRS Circular 230,
this newsletter is not to be considered a "covered opinion" or
other written tax advice and should not be relied upon for IRS audit,
tax dispute, or any other purpose.
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