2004 Tax-smart strategies guide. Keep more of what you earn

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1 2004 Tax-smart strategies guide Keep more of what you earn

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3 2004 Tax-smart strategies guide Keep more of what you earn As a taxpayer, you currently have some of the largest tax cuts in history working to your advantage, including the new Working Families Tax Relief Act of 2004 that extends several popular tax breaks. Even so, taxes continue to take a big bite out of most people s earnings. And even with the recent extensions, many of these tax-saving provisions will apply for only a limited number of years. To fully realize their advantages and continue to minimize your tax burden in the future, you need to have a plan. Are you limiting your exposure to capital gains tax? Considering your alternative minimum tax (AMT) liability? Effectively managing your stock options? Planning adequately for your retirement and the transfer of your estate? Tax-smart strategies can help ensure a secure future for you and your heirs and help you keep your financial journey on course. Become familiar with the latest tax cuts and other tax-smart strategies outlined in this guide and discuss them with your Piper Jaffray financial advisor. While Piper Jaffray does not provide tax or legal advice, we welcome the opportunity to work with you and your tax or legal advisors to help you identify the tax-smart strategies most valuable to you. 1

4 Table of contents 3 Overview of the Working Families Tax Relief Act Family tax relief Extension of AMT relief Tax rate schedules and deductions for Tax rate changes Individual income tax rates Capital gains tax rates Taxation of dividends 2 10 Tax-efficient investment strategies Tax guidelines for investors Consequences of a wash sale Exclusion on sale of residence 12 Stock options Incentive stock options Nonqualified stock options Restricted stock 14 Alternative minimum tax Computing AMT Causes of AMT 15 Education Transferring assets Tax credits Tuition and fees deduction Coverdell education savings account The 529 plan 17 Retirement planning Employer sponsored plans Traditional IRAs Roth IRAs Traditional IRA versus Roth IRA 20 Estate planning Credit shelter trust Annual exclusion gift Inherited property Kiddie tax Life insurance trust Business succession plan Advanced estate planning strategies 23 Charitable giving Charitable trusts Which assets to donate

5 Overview of the Working Families Tax Relief Act In September 2004, Congress passed the 2004 Working Families Tax Relief Act, which provides a package of tax cuts that will affect an estimated 94 million Americans. The Act extends three tax breaks popular with working families and more than 20 expired business-related tax provisions. As a result of the new law, the $1,000 child tax credit, marriage penalty relief and the 10 percent income tax bracket will now be extended through Dec. 31, The Act also extends relief from the alternative minimum tax through The new law s provisions amount to a $132 billion tax cut for individuals. Many taxpayers were anticipating a higher tax liability in 2005 due to the expiration of these provisions. However, with the right tax strategy, the Working Families Tax Relief Act provides a renewed opportunity for tax savings. (See Charts A, B and C for 2005 standard deductions, exemption amounts and individual tax rates, which reflect changes made by this new legislation.) 3 Family tax relief Child credit The child credit, which is $1,000 per child for 2004, will stay at $1,000 through It was previously scheduled to drop to $700 for 2005 through 2008 and to rise to $800 for Marriage penalty relief The Act extends two provisions that provide a measure of relief from the marriage penalty. The provision setting the basic standard deduction for joint filers at twice that of single taxpayers and the provision that increases the size of the 15 percent rate bracket for married couples filing joint returns are extended through Both were previously due to expire at the end of percent bracket The new law repeals the scheduled reduction in the amount of income subject to the 10 percent bracket. (See Chart C.) Under the new law, through 2010, the 10 percent bracket applies to: the first $7,000 of taxable income, adjusted for inflation, for single individuals and married taxpayers filing separately, the first $14,000 of taxable income, adjusted for inflation, for married joint return filers and surviving spouses, the first $10,000 of taxable income, adjusted for inflation, for heads of households.

6 Extension of AMT relief The alternative minimum tax is a parallel tax system designed to ensure that all taxpayers with substantial income pay a reasonable amount of tax. To accomplish this, various deductions allowed for regular tax purposes are disallowed for AMT purposes. (See page 14 for more information on AMT.) Originally enacted to make sure that wealthy Americans did not escape paying taxes, the AMT has started to affect more middle-income taxpayers due to the fact that the AMT parameters are not indexed for inflation. Two key provisions of the Working Families Tax Relief Act extend partial relief to individual taxpayers from the AMT. 4 Higher exemption amount extended In recent years, Congress has provided a measure of relief from the AMT by raising the AMT s exemption amounts, thereby reducing the likelihood of an AMT liability. However, this partial relief was set to expire for tax years beginning after 2004, and the exemption amounts were scheduled to revert to the lower amounts allowed under prior law. The Act preserves this partial relief from the AMT by extending the higher exemption amounts to Nonrefundable personal credits Also, the Act extends the availability of nonrefundable personal credits to offset AMT through 2005 (instead of expiring after the 2003 tax year). Tax rate schedules and deductions for 2005 Chart A: Standard Deductions The basic standard deduction for 2005 will be: Joint return or surviving spouse $10,000 (up from $9,700 in 2004) Single $5,000 (up from $4,850 in 2004) (other than head of household or surviving spouse) Head of household $7,300 (up from $7,150 in 2004) Married filing separate returns $5,000 (up from $4,850 in 2004) Chart B: Phase-out of personal exemption The personal exemption amount for 2005 will rise to $3,200 (up from $3,100 in 2004). The phase-out of the personal exemption for 2005 will begin at adjusted gross incomes of: Joint return or surviving spouse $218,950 (up from $214,050 in 2004) Head of household $182,450 (up from $178,350 in 2004) Single individual $145,950 (up from $142,700 in 2004) (other than surviving spouse or head of household) Married filing separately $109,475 (up from $107,025 in 2004)

7 Chart C: Tax rate schedules The tax rate schedules for 2005 will be as follows: For married individuals filing joint returns and surviving spouses, the 2005 rate brackets are: If taxable income is: The tax rate is: Not over $14,600 10% of taxable income Over $14,600 but not over $59,400 $1,460 plus 15% of the excess over $14,600 Over $59,400 but not over $119,950 $8,180 plus 25% of the excess over $59,400 Over $119,950 but not over $182,800 $23, plus 28% of the excess over $119,950 Over $182,800 but not over $326,450 $40, plus 33% of the excess over $182,800 Over $326,450 $88,320 plus 35% of the excess over $326,450 For single individuals (other than heads of households and surviving spouses), the 2005 rate brackets are: 5 If taxable income is: The tax is: Not over $7,300 10% of taxable income Over $7,300 but not over $29,700 $730 plus 15% of the excess over $7,300 Over $29,700 but not over $71,950 $4,090 plus 25% of the excess over $29,700 Over $71,950 but not over $150,150 $14, plus 28% of the excess over $71,950 Over $150,150 but not over $326,450 $36, plus 33% of the excess over $150,150 Over $326,450 $94, plus 35% of the excess over $326,450 For heads of households, the 2005 rate brackets are: If taxable income is: The tax is: Not over $10,450 10% of taxable income Over $10,450 but not over $39,800 $1,045 plus 15% of the excess over $10,450 Over $39,800 but not over $102,800 $5, plus 25% of the excess over $39,800 Over $102,800 but not over $166,450 $21, plus 28% of the excess over $102,800 Over $166,450 but not over $326,450 $39, plus 33% of the excess over $166,450 Over $326,450 $91, plus 35% of the excess over $326,450

8 For marrieds filing separate returns, the 2005 rate brackets are: If taxable income is: The tax is: Not over $7,300 10% of taxable income Over $7,300 but not over $29,700 $730 plus 15% of the excess over $7,300 Over $29,700 but not over $59,975 $4,140 plus 25% of the excess over $29,700 Over $59,975 but not over $91,400 $11, plus 28% of the excess over $59,975 Over $91,400 but not over $163,225 $20, plus 33% of the excess over $91,400 Over $163,225 $44,160 plus 35% of the excess over $163,225 For estates and trusts, the 2005 rate brackets are: 6 If taxable income is: The tax is: Not over $2,000 15% of taxable income Over $2,000 but not over $4,700 $300 plus 25% of the excess over $2,000 Over $4,700 but not over $7,150 $975 plus 28% of the excess over $4,700 Over $7,150 but not over $9,750 $1,661 plus 33% of the excess over $7,150 Over $9,750 $2,519 plus 35% of the excess over $9,750 Chart D: Reduction of itemized deductions The allowable amount of itemized deductions will be reduced if adjusted gross income in 2005 is more than: All returns other than married filing separately $145,950 (up from $142,700 in 2004) Married filing separately $72,975 (up from $71,350 in 2004)

9 Tax rate changes The 2004 Working Families Tax Relief Act was the fourth tax relief package passed in four years. Whether you are an individual or a business owner, the laws that came from these combined tax relief packages may enable you to reduce your taxes for years to come. Specifically, Congress has reduced the individual income tax rate, as well as the tax rate on capital gains and dividends. Individual income tax rates As stipulated in the Economic Growth and Tax Relief Reconciliation Act of 2001, Congress reduced individual income tax rates across the board. However, the tax rates will return to pre-2001 rates after 2010, resulting in increases, unless Congress takes further action. After 2010, the 10 percent tax bracket, which was implemented as part of the 2001 Act, also will be eliminated. (See Chart E.) Chart E: Individual income tax rate changes % 35% 39.6% 35% 33% 36% 30% 28% 31% 27% 25% 28% 15% 15% 15% 10% 10% No 10% bracket Capital gains tax rates If you are above the 15 percent ordinary income tax bracket, you now pay a 15 percent tax rate on capital gains. If you are in the 10 percent or 15 percent income tax brackets, you now pay a 5 percent tax rate on capital gains, and the rate drops to 0 for Rates will return to previous levels beginning Jan. 1, (See Chart F.) These rates apply to assets you have held longer than one year. If you sell capital assets that you have held one year or less, they are subject to ordinary income tax rates. Chart F: Capital gains tax rate changes Rate if you are above the 15% bracket 20% 15% 15% 15% 15% 15% 15% 20% 20% 20% Rate if you are in the 10% or 15% bracket 10% 5% 5% 5% 5% 5% 0% 10% 10% 10%

10 Taxation of dividends Since the 2003 Tax Act granted certain types of dividends favorable tax treatment, dividends have become a widely discussed topic. That Act s provisions reduce the tax rate on dividend income received in tax years 2003 through Previously, dividends were taxed as ordinary income, as high as 38.6 percent. Now, if you are above the 15 percent ordinary income tax bracket, you will pay a 15 percent tax rate on qualified dividends. If you are in the 10 percent and 15 percent ordinary income tax brackets, you will pay a rate of 5 percent, which drops to 0 in Rates will return to previous levels beginning Jan. 1, (See Chart G.) Chart G: Tax rate changes for qualified dividends Rate if you Regular income 15% 15% Regular income tax rate are above the tax rate 15% bracket Rate if you are Regular income 5% 0% Regular income tax rate in the 10% or tax rate 15% bracket Under the law, some dividends are not qualified to receive the lower tax rate. Dividends paid by most U.S. companies and most foreign companies whose stock trades in the United States are qualified, however. To qualify for the lower dividend rate, you must have held the stock for more than 60 days out of the 120-day period beginning 60 days before the stock s ex-dividend date, which marks when the stock begins trading without the dividend. Non-qualified dividends will continue to be taxed as ordinary income, as high as 35 percent. A few dividends are still subject to the higher rate. Specifically: Payments in lieu of dividends The dividends paid on shares of stock that are lent out in a margin account running a debit balance go to the person or institution that borrowed the stock. You still will receive payment in lieu of dividends, which is equal to the dividend payout, but it is not eligible for the tax cut. Real Estate Investment Trusts (REITs) REITs must pass on at least 90 percent of their profits to shareholders. By doing this, the profits are left mostly untaxed at the corporate level. As a result, most REIT dividends will be taxed at the higher rate.

11 Interest income You may think earnings are dividends when in fact they are interest or another form of payment that is not eligible for the lower tax rate. These include interest from corporate and treasury bonds, certificates of deposit and money market funds, which will continue to be taxed as ordinary income. (See Chart H.) Preferred securities If the preferred security is equity, the dividend qualifies for the tax cut. However, if the preferred security is a debt instrument for tax purposes, which many are, the income is really interest and will be taxed as ordinary income. Chart H: Comparison of dividend vs. interest tax treatment Type Amount Maximum tax rate* Tax After-tax income Dividend income $10,000 15% $1,500 $8,500 Interest income $10,000 35% $3,500 $6,500 Before-tax and after-tax comparisons Before-tax rate After-tax yield Interest** Dividend*** 6% 3.90% 5.10% 5% 3.25% 4.25% 4% 2.60% 3.40% 3% 1.95% 2.55% 2% 1.30% 1.70% 9 *2003 federal rates **2003 top bracket (35%) ***2003 top bracket (15%)

12 Tax-efficient investment strategies A large part of tax-efficient investing revolves around minimizing capital gains taxes the taxes you pay on your profit when you sell an asset for more than the cost to you. As shown in Charts E and F, you pay a different tax on capital gains, depending on your tax bracket and how long you have held the investment. If you keep the investment more than 12 months, your capital gains tax is reduced. Here are some strategies that may help you limit your exposure to capital gains taxes: Buy and hold Consider holding your appreciated stocks for at least 12 months, so you earn the lower capital gains rate. Sell your most expensive shares first By selling the shares for which you initially paid the highest price, you incur a smaller capital gain on the sale. 10 Take losses to offset gains Consider selling assets that have lost value at the same time you re selling those that have appreciated. You can deduct capital losses from capital gains dollar for dollar. You may also deduct up to $3,000 in capital losses from non-capital income in one year. If you have a capital loss that is greater than $3,000, you can carry over the unused portion to later years. Tax guidelines for investors Several tax-efficient investments and techniques allow you to maximize the benefits of individual investments while minimizing the corresponding tax burden. Consider dividend-paying stocks With the introduction of the lower 15 percent maximum federal tax rate on dividends, dividend-paying stocks have become more valuable. However, while this law change makes it more appealing to hold dividend-paying stocks in your portfolio, you shouldn t let tax considerations dictate your portfolio allocations. Invest in growth stocks Growth stocks often pay few, if any, dividends, choosing instead to reinvest their profits back in the company to encourage further growth. Therefore, the majority of taxes you pay on them will be in the form of capital gains. Reduce turnover Holding on to stocks for the long-term could save you more tax dollars than ever. Selling stocks frequently creates capital gains. Long-term gains are taxed at a lower rate than regular income, as long as you ve held the stock for more than one year. Consider active tax management in a unified managed account If you use a money manager for some or all of your investment portfolio, you may benefit from switching to a program that offers active tax management services. Your financial advisor can help you evaluate the pros and cons of various programs. Swap your bonds In a bond swap, you sell a bond, take a loss and then buy another bond of similar quality from a different issuer. The wash sale rule (see below) does not apply to a transaction like this because the bonds are not identical. Thus, you can achieve a tax loss with little change in economic position.

13 Consequences of wash sale The wash sale rule prevents you from taking a loss on a security when you are essentially in the same position before the sale as after. According to the rule, you cannot sell shares of a security at a loss and then, within 30 days, buy (or enter a contract or option to buy) substantially identical securities. When you have a wash sale, the holding period of the new securities includes the period you held the securities on which the loss was not deductible. When a loss is disallowed because of the wash sale rule, you must add the loss to the cost of the new securities you purchase. Exclusion on sale of residence Selling a residence and moving into a smaller home or condominium is seldom an easy decision. However, an exclusion that may eliminate your federal tax liability on the gain from the sale or exchange of your home may make the decision a little easier. If you are a single person selling your principal residence, up to $250,000 of the gain from the sale is tax-exempt. In most cases, if you are a married couple filing a joint return, the tax-exempt gain doubles to $500, Since you will not owe any tax on the gain from the sale of your principal residence, this rule alleviates the hassle of trying to document costs, expenses and prices involving various residences over the years. Like most tax laws, however, you must meet qualification rules to claim the exclusion. In addition to the $250,000/$500,000 limitation, you must have owned and used the home as your principal residence for at least two of the five years before the sale or exchange, and in most cases you can only take advantage of the provision once during a two-year period.

14 Stock options Companies often provide stock options as a benefit to employees. A stock option gives you the right to purchase shares of your company s stock at a specified price for a certain period of time. Often, the price to purchase the stock is less than the stock s current market value. The two most common types of stock options are incentive stock options (ISOs) and nonqualified stock options (NQSOs), which is the more common of the two. ISOs are more restrictive than NQSOs. They can only be given to employees and may not be transferred, except in the event of death. NQSOs offer greater flexibility and can be granted to employees or non-employees. There is no required holding period and they may be transferred. The most significant difference between the two options, however, is their tax implications. Only ISOs enjoy special tax treatment. 12 Incentive stock options With ISOs, you do not recognize income at the time the option is granted, at the time the option vests or at the time the option is exercised. Instead, you recognize capital gain on the subsequent sale of the stock. If you hold the stock longer than one year after exercise and two years after the grant date, the gain is taxed as a long-term capital gain. However, if you violate this one- or two-year rule, the gain is taxed as ordinary income. Although you are not subject to ordinary income tax on the spread between the exercise price and the market value at the time an ISO is exercised, provided you meet the restrictions described above, you may be subject to the alternative minimum tax (AMT). (See page 14.) Nonqualified stock options Nonqualified stock options are more flexible than ISOs, yet they do not enjoy the same tax advantages. NQSOs are not taxable at the date the options are granted unless the option has a readily ascertainable fair market value, which is usually not the case. Instead, NQSOs are subject to ordinary income tax on the spread between exercise price and market price at the time of exercise. Once NQSOs are exercised, you own the stock. The cost basis on the stock is the market value on the exercise date. If you hold an NQSO for a period of time after exercise and then sell the stock, you are subject to tax on any appreciation that occurs after the date of exercise. If you hold the stock longer than one year, the gain will be taxed as a long-term capital gain. However, if you hold the stock for one year or less, the gain after exercise is taxed as a short-term capital gain at your ordinary income tax rate. It is critical to monitor stock option expiration dates. You may want to sell an option when the value of the stock is high and the expiration date is soon, since the value at risk is high. As an expiration date approaches, your leverage declines and your planning alternatives diminish. If you wait until the last minute and your stock declines before you take action, you may lose the opportunity for substantial wealth accumulation. It may be wise to consider a phased diversification strategy several years prior to expiration.

15 Restricted stock While stock options give you the right to purchase shares of your company s stock at a preset price, restricted stock is awarded at no cost or for only a nominal payment, provided you meet the vesting requirements. A company often issues the stock, which has restrictions on when it can be sold, as partial compensation. The restriction usually lifts in three to five years when the stock is vested. You are not taxed on restricted stock when it is granted. When your shares are vested, they are taxed as ordinary income according to their fair market value on that date, not their value on the grant date. You may also elect to pay taxes on restricted stock within 30 days of the grant. If you make this election, you do not pay taxes later when the shares vest. However, when you finally sell the shares, you will pay a capital gains tax on the appreciation over the grant price. There may be disadvantages to paying the tax early: You must prepay the tax in the current year. You will not receive a refund on the tax if you leave the company prior to vesting. You gain no tax benefit if the stock does not appreciate. 13

16 Alternative minimum tax The alternative minimum tax (AMT) is an extra tax some people pay in addition to their regular income tax. Many of today s tax breaks or benefits may be offset by a higher AMT. The intent of AMT is to prevent people with high incomes from using special tax benefits to pay little or no taxes. For various reasons, AMT is reaching more taxpayers each year, including some people who do not have high incomes, primarily because it has not been adjusted for inflation. The Urban-Brookings Tax Policy Center estimates that 2.4 million taxpayers will be subject to AMT in By 2005, that number increases to 12.7 million, and by 2010, it is estimated that 33 million taxpayers nearly one-third will pay AMT if rules are not changed. Additionally, Urban-Brookings estimates that by 2010, 95 percent of families and individuals with incomes from $100,000 to $500,000 will fall into the AMT zone. 14 Computing AMT AMT reduces or eliminates various tax benefits that are available under the regular income tax. There is a special AMT exemption designed to prevent AMT from applying to taxpayers with modest incomes; however, this deduction is phased out when incomes reach higher levels. AMT tax rates start at 26 percent and move to 28 percent at higher income levels. To determine whether you owe any AMT, compare your AMT liability with your regular income tax liability. If your regular income tax liability is higher, you do not owe any AMT. If your regular income tax liability is lower, the amount of AMT you have to pay is the difference between the two taxes. Causes of AMT Several events can cause or contribute to liability under AMT. Mortgage interest and charitable contributions are generally exempt from AMT consideration. Items that cause or contribute to AMT include: A large number of personal exemptions Standard deductions High state and local taxes Interest on certain home equity loans A substantial amount of miscellaneous itemized deductions Large deductible medical expenses Exercising generous incentive stock options Significant capital gains Tax-exempt interest from bonds not exempt under AMT Select tax shelters

17 Education Providing your children with quality higher education may be one of the greatest financial burdens you face. Only the cost of a home makes a greater dent in most family budgets. Congress has recognized this substantial cost and has provided a variety of taxsaving opportunities to mitigate college expenses, provided you meet the requirements. Transferring assets You can transfer up to $11,000 a year ($22,000 for married couples) in cash or assets to each of your children with no gift tax consequences. Tax credits There are two tax credits available that may help you offset higher education costs by reducing your income tax. Both are phased out for higher-income tax payers, however. Hope Scholarship credit For the first two years of post-secondary education, you may be able to claim a credit of up to $1,500 per year, per student, for qualified tuition and related expenses incurred by you, your spouse or eligible dependent. (Expenses paid by a dependent child are treated as if made by the parent.) The student must be enrolled at least half-time at an eligible institution for at least one academic period during the year. 15 Lifetime Learning credit A credit of up to $2,000 is available for an unlimited number of years for qualified tuition and related expenses. Qualified expenses include payments for undergraduate and graduate-level courses, certain professional degree courses and courses to acquire or improve job skills. The credit does not vary based on how many students are in the family. (Expenses made by a dependent child are treated as if made by the parent.) Tuition and fees deduction Beginning in 2004, if your modified adjusted gross income (MAGI) is not more than $65,000 ($130,000 if you re married filing jointly), the amount of qualified education expenses you can take into account in figuring your tuition and fees deduction has increased from $3,000 to $4,000. If your MAGI is larger than that but less than $80,000 ($160,000), your maximum tuition and fees deduction is $2,000. No deduction is allowed if your MAGI is over $80,000 ($160,000). Coverdell education savings account The Coverdell education savings account (ESA) is a tax-deferred financial planning vehicle that allows you to save money for future education-related expenses. The advantage of an ESA is that your investment grows tax-deferred over the years. While you pay taxes on the contributions you make, withdrawals are exempt from federal tax if they are used for qualifying expenses. You can invest up to $2,000 per year, per beneficiary, in an ESA. However, it s phased out for higher-income taxpayers.

18 The 529 plan The 529 plan is a flexible savings plan for college education that offers tax advantages as well as unique estate planning benefits. These state-sponsored plans allow families to invest more tax-deferred money toward education than previously allowed, generally more than $200,000 per student. Benefits of the 529 plan: Earnings grow tax-deferred, much like a 401(k) or IRA. Distributions are exempt from federal taxes if they are used for qualified education expenses. The account owner controls withdrawals, not the beneficiary. 16 Your income does not affect your eligibility. Anyone can contribute, and contributions are not included in a taxable estate, making it an attractive option for grandparents. Tax implications of the 529 plan: Contributions are not deductible; earnings are federally tax-exempt when used for qualified education expenses. Some plans may offer state and local tax benefits for state residents. The earnings portion of any nonqualified withdrawal is generally taxed at your tax rate and is subject to a 10 percent penalty. Estate planning benefits of the 529 plan The estate and gift tax treatment of 529 plans is an outstanding feature. When you own a 529 account, you retain control of all decisions regarding distributions and have the power to revoke the account, even though its value is shifted from your estate to the estate of your beneficiary. Contributions to a 529 plan qualify for the $11,000 annual gift tax exclusion. A special election allows you to contribute up to five years of gifts the first year, enabling you to contribute up to $55,000 to a beneficiary s account (subject to plan limits) and treat the contribution as though it were made over five years*. If the contributor dies within this five-year period, a prorated portion is included in the estate. *To avoid gift tax under this provision, no additional gifts to or for that child may be made during the following five years. Some tax provisions affecting 529 plans will expire Dec. 30, 2010, unless extended by Congress. Changes in the federal tax code could impact state tax treatment of 529 plans.

19 Retirement planning Today s longer life expectancies, as well as pressures on the Social Security system, have made planning for retirement more important than ever. There are several ways you can invest to ensure you will have income to finance your retirement. In addition, your earnings have the potential to grow faster in retirement plans and retirement accounts because of their tax advantages. The amount you can save is increasing as well. Employer-sponsored plans The government offers incentives for you to save for your retirement through employersponsored plans, such as a 401(k). If you are a business owner, consider establishing a qualified plan for you and your employees. While the details of these plans vary, they generally share two important characteristics: earnings growth is tax-deferred and contributions are made with pre-tax dollars. By investing pre-tax dollars into a retirement plan, you lower your annual taxable income. 17 It s almost always a good idea for you to contribute as much as you can to a companysponsored retirement plan, especially if your employer matches your contribution. If there is an employer match, you should contribute as much as you can to receive the full match. Some of the most common retirement plans include: 401(k) 403(b) Simplified Employee Pension (SEP) Savings Incentive Match Plan for Employees (SIMPLE IRA) Profit Sharing Plan Money Purchase Pension Plan Solo 401(k) Traditional IRAs Individual retirement accounts (IRAs) are an attractive option in addition to an employer plan or if you do not have access to an employer plan. An IRA can help your investments grow faster because you don t pay taxes on the earnings until you withdraw the money, usually in retirement when your tax bracket is lower. The contribution limit for an IRA is $3,000 per year in If you are age 50 or older at year-end, you can contribute an additional $500. These contribution limits will increase in future years. (See Chart J.) In addition to tax-deferred earnings, IRAs provide other benefits: Possible tax deductions Even if you are eligible to participate in a company retirement plan, you may be able to deduct contributions to your traditional IRA depending on your income. If your income is too high to let you benefit from the tax deduction, you can still make contributions that will grow tax-deferred.

20 Many investment options You can own an almost unlimited variety of investment options in your IRA, including stocks, bonds and mutual funds. Some penalty-free withdrawals You are allowed penalty-free special purchase withdrawals to buy a first home or pay for higher education expenses. Withdrawals will be taxed as ordinary income. No income limits There are no income limits to contribute to a traditional IRA. It is available to anyone with earned income. There are, however, some downsides to traditional IRAs. Mandatory distributions begin at age 701/2. If you take the funds as income before 591/2, you will have to pay a 10 percent penalty tax, except in penalty-free situations such as those listed above. In addition, at death, your heirs pay income taxes on distributions at their bracket. 18 Rollovers When you retire or change jobs, you may receive a lump-sum distribution from your employer s retirement plan. With a direct rollover, you can transfer your balance directly into an IRA, where your money can continue to grow tax-deferred. However, if you receive the distribution personally, you need to act fast. You have just 60 days to roll your retirement plan distribution into an IRA to retain its tax-deferred status. If you own several IRAs, you can consolidate all of them into one account, which will reduce your paperwork and provide you with more control over your retirement investments. Roth IRAs Roth IRAs were introduced in 1998 to encourage more people to save for retirement. Like traditional IRAs, you can make an annual contribution up to the limit set by Congress, and you pay no income tax on the earnings as they accumulate. The contribution limit for a Roth is the same as the limit for a traditional IRA, with similar increases in future years. (See Chart J.) However, there are differences in Roth IRAs that may make them more appealing for many investors. Benefits of Roth IRAs include: Tax exemptions With a Roth IRA, growth is tax-deferred. Withdrawals are tax-exempt provided your account has been open for at least five years and you are 591/2, purchasing your first home or have become disabled. They are also exempt when paid to your beneficiaries at your death. Greater flexibility Since you have already paid taxes up front, there are no minimum distribution requirements. (Your beneficiaries will be subject to minimum distributions, however.) That means your account can continue to compound as long as you wish. In addition, you can keep contributing to a Roth IRA as long as you continue to earn income. Heirs not taxed If you die and your account is at least five years old, your heirs inherit the assets income tax-free.

21 As with the traditional IRA, there are some downsides to the Roth IRA. Unlike a traditional IRA, you do not get a deduction when you contribute to a Roth IRA. That means you pay taxes while working rather than when retired, when your tax rate is likely to be lower. Roth IRA eligibility is also subject to income limits. If you are single and your AGI is less than $95,000, you can contribute the full amount to a Roth IRA; if your AGI is between $95,000 and $110,000, you are allowed to contribute less. If you are married and filing a joint return, you can contribute the full amount if your AGI is less than $150,000; you may contribute less if your AGI is between $150,000 and $160,000. Traditional IRA versus Roth IRA There are benefits to both a traditional IRA and Roth IRA. How do you determine which is right for you? Consider a traditional IRA if you: 19 don t participate in a retirement plan at work, expect to be in a lower tax bracket when you retire, are eligible to deduct your contributions, want to consolidate money from a former employer s plan into a single IRA. Consider a Roth IRA if you: don t qualify for a tax-deductible IRA, have earned income that meets the current guidelines, expect to be in a higher tax bracket when you retire, won t need the assets to cover your expenses in retirement. Chart J: Retirement plan contribution limit increases Year 401(k) 401(k)s Traditional Traditional SIMPLEs SIMPLEs 403(b)s 403(b)s and Roth and Roth IRAs for taxpayers 457s and 457s and SEPs IRA for taxpayers 50 and over SEPs for taxpayers 50 and over 50 and over 2004 $13,000 $16,000 $3,000 $3,500 $9,000 $10, $14,000 $18,000 $4,000 $4,500 $10,000 $12, $15,000 $20,000 $4,000 $5,000 $10,000 $12, $15,000 $20,000 $4,000 $5,000 $10,000 $12, $15,000 $20,000 $5,000 $6,000 $10,000 $12,500

22 Estate planning You don t have to burden your heirs with heavy estate taxes, which can drain up to 55 percent of your estate. Through careful planning, you can minimize your estate taxes, make sure your assets go where you intend, protect your family s interests and support charitable causes that are important to you. Almost all of your financial assets, including investments, real estate and insurance policies, are included in the value of your estate. If your estate is worth more than $1.5 million in 2004, you will be subject to federal estate taxes. (See Chart K.) Fortunately there are a variety of estate planning strategies you can use to reduce your estate tax and increase the amount you leave to your heirs. Chart K: Estate & gift tax schedule 20 Estate Lifetime gift Maximum estate/ Year exemption exemption gift tax rate 2003 $1,000,000 $1,000, percent 2004 $1,500,000 $1,000, percent 2005 $1,500,000 $1,000, percent 2006 $2,000,000 $1,000, percent 2007 $2,000,000 $1,000, percent 2008 $2,000,000 $1,000, percent 2009 $3,500,000 $1,000, percent 2010 No Estate Tax $1,000,000 0 percent 2011 $1,000,000 $1,000, percent Credit shelter trust Current estate and gift-tax laws allow every person for example, you and your spouse to transfer $1.5 million of property to heirs free of estate taxes. If this tax credit isn t used during your lifetime or at death, the credit is wasted. So, if you draw up a will or a living trust that transfers all assets to your spouse, then your total estate is protected to only $1.5 million. To ensure that both you and your spouse use your $1.5 million tax exclusion, you could establish a credit shelter trust provision in your will or living trust. This arrangement allows you and your spouse to transfer up to $3 million to your heirs, free of estate taxes, saving up to $705,000 in taxes over an all to spouse plan. You would need to divide assets between spouses as equally as possible so that the credit shelter trust could be properly funded. Keep in mind that property owned as joint tenants with rights of survivorship and beneficiary designations supersede instructions in the will. Pay careful attention to how accounts or assets are titled.

23 Annual exclusion gift Under the federal gift tax provision, you can make tax-free gifts of up to $11,000 ($22,000 for a married couple) to an unlimited number of recipients each year. The gifts can be in the form of cash, securities or other property, as long as the recipient has a present right to the property, rather than some right to use or receive the property in the future. By gifting assets to others, you can deduct their value from your estate. You can make a gift outright, to a custodial account (for minors) or in trust (for minors or adults), depending on what s best for your individual situation. There are times when it makes sense to gift in excess of the annual exclusion or to make special kinds of gifts, such as those for educational and medical expenses. Although the value of your gift is based on fair market value, the recipient will generally assume the cost basis of the asset with unrecognized appreciation. Therefore, the recipient will owe taxes on any gain when he or she sells the asset. In most cases, the recipient will assume your holding period for long-term capital gain purposes. 21 Inherited property The value of inherited property for your heirs is based on fair market value at the date of your death or fair market value on the alternative valuation date. The alternative valuation date is either the distribution date of the asset or six months after your death, whichever is earlier. The executor of your estate can elect to use the alternative date if it lowers your estate s tax liability. Inherited property is automatically considered to be long-term property, regardless of how long it has been held. Kiddie tax The kiddie tax was enacted by Congress to prevent parents from transferring income to their children to lower their tax rate. The tax applies only to the net unearned income (income other than wages) of children who are younger than 14 at the end of the tax year. Examples of this type of income include interest, dividends, net capital gains and rental income. For 2004, the kiddie tax is calculated as follows: The first $800 of net unearned income is free due to standard deductions applicable to individuals who are claimed as a personal exemption on their parent s return. The next $800 of net unearned income is taxed at the child s own tax rate, most likely 10 percent or 15 percent. Net unearned income above $1,600 is taxed at the parent s tax rate. Children 14 and older are taxed on their income at their own rate.

24 Life insurance trust Life insurance will be included in your taxable estate if: your estate is the beneficiary of the insurance proceeds, or you own the policy or otherwise possess incidents of ownership in the policy at your death or within three years of your death, regardless of who is the beneficiary. To keep life insurance proceeds from being included in your estate, you can transfer your policy, along with assets to pay future payments, to a life insurance trust. The trust then owns the insurance, paying premiums with the funds you contributed to keep it in force. As long as the agreement gives you no rights of ownership, the proceeds will not be included in your estate. Be aware, however, of the three-year rule. If you transfer a policy to a life insurance trust, you must live three years from the date of the transfer or the proceeds from that policy will be considered part of your estate. 22 Business succession plan If you own a small business, you can protect your family s financial and personal interests in the business by creating a succession plan. If you do not, taxes could greatly diminish the value of your business when you die and may even force its liquidation. You can preserve your business and accumulated wealth if you plan properly for the distribution of your business assets and payment of estate taxes. You may also benefit from other strategies such as buy-sell agreements or key employee coverage to help ensure that your business will stay afloat during any unexpected events such as a disability or the death of an owner or key employee. Advanced estate planning strategies It s crucial to plan ahead to protect your heirs from having to pay excessive capital gains or estate taxes. These are some advanced estate planning strategies to consider today, to provide for your family in the future. Qualified personal residence trust You can transfer a primary or secondary residence to a qualified personal trust and continue to hold the right to use the property for the term of the trust. When the trust term expires, the residence is passed to your heirs, with the potential for substantial estate tax savings. Family limited partnership Consider a family limited partnership if you own a family business or rental property or have a relatively large investment portfolio and want to make gifts to your children. It allows you to maintain control of your assets while gifting their value to your heirs. Grantor retained trusts With a grantor retained trust (GRT), you retain the right to receive payments, at least annually, for the term of the trust. At the end of the term, the assets in the trust go to your heirs.

25 Charitable giving By making charitable gifts during your lifetime or by bequeathing them, you ll benefit those organizations you care about and reduce your taxable estate. Charitable gifts provide you with three distinct tax advantages. Immediate income tax deductions When you make the gift, you can claim an income tax deduction for that year. Avoidance of capital gains tax on appreciated assets If you give an appreciated asset, such as a stock or a parcel of real estate, you won t be responsible for the capital gains tax when the asset is sold. Reduction of taxable estate By removing the asset from your taxable estate, you may be able to lower the estate taxes that your heirs will face. The amount you can claim as an income tax deduction depends primarily on the type of charity and the type of asset you contribute. (See Chart L.) 23 Chart L: Charitable contribution income tax deduction limits AGI limits Contribution recipient Cash & ordinary Appreciated capital income property property FMV Public charities 50% 30% Operating private foundations 50% 30% Nonoperating private foundations 30% 20% Disallowed deductions may be carried forward up to five years. Based on the guidelines provided in Chart L, if you donated $25,000 worth of appreciated stock to a charity and your adjusted gross income is $50,000, the maximum deduction you can claim for the contribution is $15,000 (or 30 percent of $50,000). You can carry over the remaining $10,000 and apply it as a deduction against income in future years. Charitable trusts If you are making particularly large gifts of securities to charities, you may benefit from the flexibility and tax advantages of a charitable lead trust or charitable remainder trust. Charitable lead trust With a charitable lead trust, you do not give away the securities themselves but instead donate the income they generate for a specific period of time. This may provide you with an immediate income tax deduction. When the period ends, the remaining trust assets pass back to you or your beneficiaries, usually with a gift or estate tax savings.

26 Charitable remainder trust When you place your securities in a charitable remainder trust, the trust makes the charitable donation. You get an immediate income tax deduction and you avoid capital gains taxes. Furthermore, a charitable remainder trust can sell your appreciated stock, purchase an income-producing vehicle with the proceeds and then pay you an income stream for life. (As a non-charitable beneficiary, you are taxed on this annual income payment.) Upon your death, the trust will pay out the remaining funds to the charity or charities you ve chosen. Which assets to donate Consider these guidelines when choosing which assets to donate: 24 Lifetime gifts For lifetime gifts, it is best to donate appreciated property with low dividend rates that you have held more than 12 months. This is because your income tax deduction is based on the higher fair market value, not the initial cost. Also, the trust can sell the asset without incurring capital gains tax, leaving the full asset value available to the trust for reinvestment. Typically, income payments from the trust exceed previous dividend payments. Gifts at death For gifts at death, it is best to donate assets on which you must continue to pay income taxes, such as IRAs, qualified retirement plans and annuities. The benefit in donating these types of assets is that the trust is treated as a tax-exempt entity, so you avoid both estate and income taxes. Why not sell the asset and donate the proceeds? You may wonder why you would not want to sell an asset and donate the proceeds. Doing this diminishes the benefit of avoiding an immediate capital gains tax. By selling the asset first, the value of the charitable contribution would be an after-tax amount, leaving less money to generate income in the future. Source for Charts A-L: U.S. Internal Revenue Code

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