It's Tax Time. But There's Still Some Shelter LeftDick Janssen
`Will I ever see the day my tax rate will be lower than it is now?" That's what many taxpayers are wondering as they finish their 1040 forms. With Congress focusing on ways to raise revenue from upscale taxpayers, tax pros are steering clients toward some type of shelter.
That doesn't mean the limited partnerships of yesteryear, with the red-hot write-offs that the 1986 Tax Reform Act pretty well extinguished in its attack on "passive losses." Instead, the emphasis now is on more prosaic--and often neglected--ways to shelter income legally.
The stars these days are "retirement plans that allow tax-deductible contributions," says John Erb, a principal of De Teffe Capital Management in Alexandria, Va. "There's not a lot else left." They will be even more important on the grounds that Congress is likely to hit higher-income taxpayers harder once this election year is history.
CLEAR INCENTIVES. Even if tax rates are steeper when people withdraw funds from retirement plans, the tax-free compounding of interest over the years may be "powerful enough to make the plans worthwhile," says Donald Levy, senior consultant for the Research Institute of America in Englewood Cliffs, N.J.
At a big company, the savings vehicle of choice is apt to be a 401(k) "salary reduction" plan. A slice of your salary stays out of your paycheck and out of your taxable income. Your take-home pay doesn't drop by the full amount, however, because your income tax withholding goes down accordingly.
When your employer matches part of your contributions, a 401(k) is an excellent way to save on current taxes, says Gary Claus, partner in Price Waterhouse's Pittsburgh office. An employee can shelter up to $8,728 for 1992. When the employer contributes, too, the overall ceiling is $30,000 a year.
For small-business owners and employees, the Simplified Employee Pension deserves more attention than it usually gets. Although the money goes into an ordinary IRA, the tax-deductible limit is 15 times larger than usual--up to $30,000 a year, or 15% of earnings, whichever is less. The ceiling matches that of the better-known Keogh plans for the self-employed, but SEPs involve less paperwork.
An arrangement with your company to defer some compensation until a future year remains a possibility for top executives. But, Research Institute of America's Levy cautions: "Deferred comp is more questionable than it was." Corporate bankruptcies and takeovers have made collecting chancier, and tax rates could be considerably higher by the time you collect.
The advice about sinking all you can into tax-deferred retirement plans should be tempered in harder times. If you fear that your job--if not your company--is in danger of going down the tubes, just keep your income outside of any retirement plan, De Teffe's Erb advises. Otherwise, you could find that you can't get at your nest egg in an emergency without paying income tax plus a 10% penalty for withdrawing funds before you reach age 59 1/2.
`KIDDIE TAX.' There are still some old-fashioned tax shelters left, although planners urge caution before taking the plunge. "Working interests" in oil and gas partnerships still enjoy some tax breaks. The crackdown on real estate limited partnerships spares many active landlords and those who invest in low-income housing, notes Lee O'Connor of Grant Thornton. And some financial advisers recommend buying a deferred annuity from an insurance company. Earnings pile up tax-deferred until you start getting a regular payout. But make sure the deal equals other savings choices.
For some families, Price Waterhouse's Claus suggests "simple gift-giving to a kid." A person can give $10,000 annually to a child (or anyone else) without any gift or estate tax impact. Put in a savings account at current low interest rates, that sum would earn the child around $400 in a year, tax-free. "As long as you keep the kid's taxable income under the $600 threshold, there's no return to file," Claus says.
The next $600 of investment or "unearned" income during 1992 would be taxed at the child's 15% rate--still a bargain for parents in the 28% or 31% brackets. Under the dreaded "kiddie tax" rule applying to a child under 14, investment income of more than $1,200 this year will get taxed at the parents' top rate.
However, "there's a way to deal with that," points out Alan Klein, an Arthur Andersen tax partner in Dallas. Instead of banking the gift, he suggests putting it into municipal bonds that pay tax-exempt interest. Then, "by no means does the kiddie tax have a chilling effect on giving." Switching some of your own portfolio into munis often makes sense, too: in the 31% bracket, 6.5% on a muni is equal to 9.42% in taxable interest on Treasuries or corporate bonds.
But when your gifts are for tuition 15 years or so down the road, "don't worry about munis--put the money into growth stocks," suggests Klein. They pay small dividends, if any, that get taxed along the way, and history indicates that "there's probably no better investment on a long-term basis in this country than the stock market."
Major gifts to charities are part of many an upper-income taxpayer's strategy. But they can be complex, and an early start helps. For instance, if you have a much-appreciated painting that you'd like to see in a museum, Congress has extended the "one-year window" of relief from the Alternative Minimum Tax--but only to June 30. The AMT works by adding back certain deductions from regular tax. So after June 30, you could be hit with the 24% AMT rate on the difference between the price you paid and the current value of the donation.
SPECIAL TRUSTS. When you consider a major gift to a charity, allow ample time to get professional advice and explore all the deals. Instead of giving cash or securities outright, you can place them in a special trust (typically $50,000 and up). You get lifetime income plus an up-front deduction for part of the value, and the college, environmental group, or other nonprofit organization gets the money when you die.
If borrowing is more your thing at the moment, advisers stress that interest on home-equity loans is still deductible, while credit-card and other personal interest isn't. And a margin loan from your broker is "probably the most inexpensive way to borrow," suggests John Steffens, executive vice-president of Merrill Lynch's private client group. The annual interest on a loan to buy securities costs around 7% or 8% now, and it's deductible to the extent of investment income.
A money-waster that's all too common is paying too much tax too soon. If you're due for a big refund on 1991 taxes, chances are you've been withholding too much or have set your estimated quarterly payments for 1992 too high. "The idea is to come as close to zero as possible" when you file your return, says Jim Velten of Coopers & Lybrand in New York. That way, it isn't the government that's "gotten the use of your money" in the meantime--it's you.