2002 Year-End Tax Planning for Individuals

As 2002 draws to a close, there is still time to reduce your 2002 tax bill and plan ahead for 2003. This web page highlights several potential tax-saving opportunities for you to consider.

Basic Numbers You Need To Know

Because many tax benefits are tied to or limited by adjusted gross income (AGI)—IRA deductions, for example—a key aspect of tax planning is to estimate both your 2002 and 2003 AGI. Also, when considering whether to accelerate or defer income or deductions, you should be aware of the impact this action may have on your AGI and your ability to maximize itemized deductions that are tied to AGI. Your 2001 tax return and your 2002 pay stubs and other income- and deduction-related materials are a good starting point for estimating your AGI.

Another important number is your "tax bracket," i.e., the rate at which your last dollar of income is taxed. The middle and upper tax rates for 2002 and 2003 are 27%, 30%, 35%, and 38.6%—reduced by half a percentage point from 2001. Although tax brackets are indexed for inflation, if your income increases faster than the inflation adjustment, you may be pushed into a higher bracket. If so, your potential benefit from any tax-saving opportunity is increased (as is the cost of overlooking that opportunity).

More Generous IRA, Retirement Savings Rules in 2002

More tax-saving opportunities exist for retirement planning in 2002 than in previous years due to the availability of Roth IRAs, changes that make regular IRAs more attractive, and other retirement savings incentives.

Traditional IRAs: Individuals who are not active participants in an employer pension plan may make deductible contributions to an IRA. The annual deductible contribution limit for an IRA for 2002 is $3,000 (up from $2,000 in 2001). Depending on AGI, individuals who are active participants in a plan may make deductible contributions to an IRA. For 2002, the AGI phase-out range for deductibility of IRA contributions is between $34,000 and $44,000 of modified AGI for single persons (including heads of households), and between $54,000 and $64,000 of modified AGI for married filing jointly. Above these ranges, no deduction is allowed.

For 2002, a $500 "catch-up" contribution deduction is allowed for taxpayers age 50 or older by the close of the taxable year who meet the other qualifications for IRA deductions. Thus the total deductible limit for these individuals may be as high as $3,500.

In addition, an individual will not be considered an "active participant" in an employer plan simply because the individual's spouse is an active participant for part of a plan year. Thus, you may be able to take a full $3,000 deduction for an IRA contribution regardless of whether your spouse is covered by a plan at work, subject to a phase-out if your joint modified AGI is $150,000 to $160,000. Above this range, no deduction is allowed.

Roth IRA: This type of IRA permits nondeductible contributions of up to $3,000 a year (increased from $2,000 in 2001). Earnings grow tax-free, and distributions are tax-free provided no distributions are made until more than five years after the first contribution and the individual has reached age 591/2. Distributions may be made earlier on account of the individual's disability or death. The maximum contribution is phased out for persons with AGI above certain amounts: $150,000 to $160,000 for joint filers, and $95,000 to $110,000 for single filers (including heads of households). For 2002, a $500 "catch-up" contribution is allowed for taxpayers age 50 or older by the close of the taxable year, making the total limit $3,500 for these individuals.

Roth IRA Conversion Rule: Funds in a traditional IRA may be rolled over into a Roth IRA. Such a rollover, however, is treated as a taxable event, and you will pay tax on the amount converted. No penalties will apply if all the requirements for such a transfer are satisfied.

401(k) Contribution: The 401(k) elective deferral limit is $11,000 for 2002, up from $10,500 in 2001. If your 401(k) plan has been amended to allow for catch-up contributions for 2002 and you will be 50 years old by December 31, 2002, you may contribute an additional $1,000 to your 401(k) account, for a total maximum contribution of $12,000 ($11,000 in regular contributions plus $1,000 in catch-up contributions).

SIMPLE Plan Contribution: The SIMPLE plan deferral limit is $7,000 for 2002, up from $6,500 in 2001. If your SIMPLE plan has been amended to allow for catch-up contributions for 2002 and you will be 50 years old by December 31, 2002, you may contribute an additional $500.

Catch-Up Contributions for Other Plans: If you will be 50 years old by December 31, 2002, you may also contribute an additional $1,000 to your 403(b) plan or SEP.

Saver's Credit: Beginning in 2002, a nonrefundable tax credit is available based on the qualified retirement savings contributions to an employer plan made by an eligible individual. Only taxpayers filing joint returns with AGI of $50,000 or less, head of household returns with AGI of $37,500 or less, or single returns (or separate returns filed by married taxpayers) with AGI of $25,000 or less, are eligible for the credit. The amount of the credit is equal to the applicable percentage (10% to 50%, based on filing status and AGI) of qualified retirement savings contributions up to $2,000.

Maximize Retirement Savings: In many cases, employers will require you to set your 2003 retirement contribution levels before January 2003. You may want to increase your contribution to lower your AGI in order to take advantage of some of the tax breaks described above. In addition, maximizing your contribution is generally a good tax-saving move.

Deferring Income to 2003

If you expect your AGI to be higher in 2002 than in 2003, or if you anticipate being in the same or a higher tax bracket in 2002, you may benefit by deferring income into 2003. Deferring income will be advantageous so long as the deferral does not bump your income to the next bracket. Some ways to defer income include:

Delay Billing: If you are self-employed, delay year-end billing to clients so that payments will not be received until 2003.

Interest and Dividends: Interest income earned on Treasury securities and bank certificates of deposit with maturities of one year or less is not includible in income until received. To defer interest income, consider buying short-term bonds or certificates that will not mature until next year. If you have control as to when dividends are paid, arrange to have them paid to you after the end of the year.

Accelerating Income Into 2002

In limited circumstances, you may benefit by accelerating income into 2002. For example, you may anticipate being in a higher tax bracket in 2003, or perhaps you will need additional income in order to take advantage of an offsetting deduction or credit that will not be available to you in future tax years. Note however that accelerating income into 2002 will be disadvantageous if you expect to be in the same or lower tax bracket for 2003. In any event, before you decide to implement this strategy, we should "crunch the numbers."

If accelerating income will be beneficial, here are some ways to accomplish this:

Accelerate Collection of Accounts Receivable: If you are self-employed and report income and expenses on a cash basis, issue bills and attempt collection before the end of 2002. Also see if some of your clients or customers might be willing to pay for January 2003 goods or services in advance. Any income received using these steps will shift income from 2003 to 2002.

Year-End Bonuses: If your employer generally pays year-end bonuses after the end of the current year, ask to have your bonus paid to you before the beginning of 2003.

Retirement Plan Distributions: If you are over age 591/2 and you participate in an employer retirement plan or have an IRA, consider making any taxable withdrawals before 2003.

You may also want to consider making a Roth IRA rollover distribution, as discussed above.

Deduction Planning

Deduction timing is also an important element of year-end tax planning. Deduction planning is complex, however, due to factors such as AGI levels and filing status. If you are a cash-method taxpayer, remember to keep the following in mind:

• Deduction In Year Paid: An expense is only deductible in the year in which it is actually paid.

• Payment By Check: Date checks before the end of the year and mail them before January 1, 2003.

• Promise To Pay: A promise to pay or providing a note does not permit you to deduct the expense. But you can take a deduction if you pay with money borrowed from a third party. Hence, if you pay by credit card in 2002, you can take the deduction even though you won't pay your credit card bill until 2003.

AGI Limits: The AGI limits on itemized deductions affect deduction planning. For 2002 returns, overall itemized deductions are reduced by 3% of the AGI exceeding $137,300 ($68,650 if married filing separately). Similarly, certain deductions may be claimed only if they exceed a percentage of AGI: 7.5% for medical expenses, 2% for miscellaneous itemized deductions, and 10% for casualty losses.

Standard Deduction Planning: Deduction planning is also affected by the standard deduction. For 2002 returns, the standard deduction is $7,850 for married taxpayers filing jointly, $4,700 for single taxpayers, $6,900 for heads of households, and $3,925 for married taxpayers filing separately. If your itemized deductions are relatively constant and are close to the standard deduction amount, you will obtain little or no benefit from itemizing your deductions each year. But simply taking the standard deduction each year means you lose the benefit of your itemized deductions. To maximize the benefits of both the standard deduction and itemized deductions, consider adjusting the timing of your deductible expenses so that they are higher in one year and lower in the following year.

Medical Expenses: Medical expenses, including amounts paid as health insurance premiums, are deductible only to the extent that they exceed 7.5% of AGI. Consider bunching medical expenses into years when your AGI is lower.

State Taxes: If you anticipate a state income tax liability for 2002 and plan to make an estimated payment, consider making the payment before the end of 2002.

Charitable Contributions: Consider making your charitable contributions at the end of the year. This will give you use of the money during the year and simultaneously permit you to claim a deduction for that year. You can use a credit card to charge donations in 2002 even though you will not pay the bill until 2003. A mere pledge to make a donation is not deductible, however, unless it is paid by the end of the year.

To avoid capital gains, you may want to consider giving appreciated property to charity.

Business Deductions:

• Self-Employed Health Insurance Premiums: Self-employed individuals are allowed to claim 70% (up from 60% in 2001) of the amount paid during the taxable year for insurance that constitutes medical care for themselves, their spouses and dependents as an above-the-line deduction, without regard to the 7.5% of AGI floor.

• Equipment Purchases: If you are in business and purchase equipment, you may make a "Section 179 Election," which allows you to expense (i.e. currently deduct) otherwise depreciable business property. In general, you may elect to expense up to $24,000 of equipment costs (with a phase-out for purchases in excess of $200,000) if the asset was placed in service during 2002. In addition, careful timing of equipment purchases can result in favorable depreciation deductions in 2002. In general, under the "half-year convention," you may deduct six months worth of depreciation for equipment that is placed in service on or before the last day of the tax year. (If more than 40% of the cost of all personal property placed in service occurs during the last quarter of the year, however, a "mid-quarter convention" applies.)

• First-Year Bonus Depreciation: For qualified property placed in service in 2002, you may take an additional depreciation allowance of 30% of the adjusted basis of the property. The adjusted basis of the qualified property is reduced by this additional allowance before computing any other depreciation. (However, the first-year §179 expensing amount described above is computed before this additional allowance is computed.) The 30% additional allowance also applies to qualified New York Liberty Zone property—property meeting certain requirements and located in the vicinity of the 9/11 tragedy in New York City.

• NOL Carryback Period Extension: If your business suffers net operating losses in 2002, you may apply those losses against taxable income as far back as five tax years instead of the general two-year "carryback" period. Thus, for example, the loss could be used to reduce taxable income—and thus generate tax refunds—for tax years as far back as 1997.

Education and Child Tax Benefits

Child Tax Credit: A tax credit of $600 per qualifying child under the age of 17 is available on this year's return. The credit is phased out at a rate of $50 for each $1,000 (or fraction of $1,000) of modified AGI exceeding the following amounts: $110,000 for married filing jointly; $55,000 for married filing separately; and $75,000 for all other taxpayers. For lower-income taxpayers, a portion of the credit may be refundable to offset payroll taxes.

Credit for Adoption Expenses: Beginning in 2002, the adoption credit limitation is increased to $10,000 of aggregate expenditures for each child.

HOPE Credit and Lifetime Learning Credit: The maximum HOPE credit is $1,500 (100% on the first $1,000, plus 50% of the next $1,000) for qualified tuition and fees paid on behalf of a student (i.e., the taxpayer, the taxpayer's spouse, or a dependent) who is enrolled on at least a half-time basis. The credit is available for only the first two years of the student's post-secondary education.

The Lifetime Learning credit maximum in 2002 is $1,000 (20% of qualified tuition and fees up to $5,000). A student need not be enrolled on at least a half-time basis so long as he or she is taking post-secondary classes to acquire or improve job skills. As with the HOPE credit, eligible students include the taxpayer, the taxpayer's spouse, or a dependent.

For 2002, both the HOPE credit and the Lifetime Learning credit are phased out at modified AGI levels between $82,000 and $102,000 for joint filers, and between $41,000 and $51,000 for single taxpayers.

Coverdell Education Savings Account: Beginning in 2002, the aggregate annual contribution limit to a Coverdell education savings account (formerly called an education IRA) is increased to $2,000 (from $500) per designated beneficiary of the account. This limit is phased out for individual contributors with modified AGI between $95,000 and $110,000 and joint filers with modified AGI between $190,000 and $220,000. The contributions to the account are nondeductible but the earnings grow tax-free and the uses for the accounts have been expanded.

Student Loan Interest: You may be eligible for an above-the-line deduction for student loan interest paid on any "qualified education loan." The maximum deduction is $2,500 in 2002. The deduction is phased out at a modified AGI level between $100,000 and $130,000 for joint filers in 2002, and between $50,000 and $65,000 for individual taxpayers.

Qualified Higher Education Expenses: Beginning in 2002, you also may be eligible to deduct qualified tuition and related expenses as an above-the-line deduction. In 2002, a taxpayer with modified AGI of not more than $65,000 ($130,000 for a married couple filing jointly) who is not claimed as a dependent on another person's return is entitled to a maximum deduction of $3,000.

Rules are in effect to coordinate education provisions, such as the qualified higher education expense deduction, the Hope and Lifetime Learning credits, Coverdell education savings accounts, and qualified tuition plans, to prevent double benefits.

Business Credits

Small Employer Pension Plan Startup Cost Credit: Beginning in 2002, certain small business employers that did not have a pension plan for the preceding three years may claim a nonrefundable income tax credit for expenses of establishing and administering a new retirement plan for employees. The credit applies to 50% of the first $1,000 in administrative and retirement-education expenses for each of the first three plan years.

Employer-Provided Child Care Credit: Beginning in 2002, employers may claim a credit of up to $150,000 for supporting employee childcare or childcare resource and referral services. The credit is allowed for a percentage of "qualified child care expenditures" including for property to be used as part of a qualified child care facility, for operating costs of a qualified child care facility and for resource and referral expenditures.

Investment Planning and Gift Planning

The following rules apply for most capital assets in 2002:

• Capital gains on property held one year or less are taxed at an individual's ordinary income tax rate.

• Capital gains on property held for more than one year are taxed at a maximum rate of 20% (10% if an individual is in the 10% or 15% marginal tax bracket).

• Capital gains on property held for more than five years are taxed at a maximum rate of 18% (8% for individuals in the 10% or 15% marginal tax bracket). For this special lower rate to apply, individuals in a marginal tax bracket above 15% must have acquired the property after December 31, 2000, or have elected to treat property purchased before January 1, 2001, as acquired on January 1, 2001. (The election, made on the 2001 return, required the recognition of gain as if the property were sold.) Individuals in a marginal tax bracket of 15% or below need not have acquired the property after December 31, 2000, for the special lower rate to apply.

Timing of Sales: You may want to time the sale of assets so as to have offsetting capital losses and gains. Capital losses may be fully deducted against capital gains and also may offset up to $3,000 of ordinary income ($1,500 for married filing separately). In general, when you take losses, you must first match your long-term losses against your long-term gains, and short-term losses against short-term gains. If there are any remaining losses, you may use them to offset any remaining long-term or short-term gains, or up to $3,000 (or $1,500) of ordinary income. When and whether to recognize such losses should be analyzed in light of the changes in the capital gains rates applicable to your specific investments.

Gifts: To avoid capital gains, you may want to consider giving appreciated property to children or grandchildren if they are in a lower tax bracket than your own. For 2002, each person is entitled each year to give gifts of $11,000 to an unlimited number of donees without incurring any gift tax. For example, you can annually give $11,000 to each of your children, their spouses, and your grandchildren without utilizing any of your applicable credit amount. Your spouse can agree to "gift-split" thus doubling the amount of these gifts. (The applicable credit available against the gift tax is $1.0 million in 2002.)

Social Security

Depending on the recipient's modified AGI and the amount of Social Security benefits, a percentage—up to 85%—of Social Security benefits may be taxed. To reduce that percentage, it may be beneficial to defer receipt of other retirement income. One way to do so is to elect to receive a lump sum distribution from a retirement plan and to rollover that distribution into an IRA. Alternatively, it may be beneficial to accelerate income so as to reduce the percentage of Social Security taxed in 2003 and later years.

Other Tax Planning Opportunities

We also can discuss the potential benefits to you or your family members of other changes made for 2002, including §529 qualified tuition programs and the above-the-line deduction for teachers for classroom-related expenses.

Alternative Minimum Tax

Some of the standard year-end planning ideas will not reduce tax liability if you are subject to the alternative minimum tax (AMT) because different rules apply. Because of the complexity of the AMT, it would be wise for us to analyze your AMT exposure.