Planning Now Can Make April Less Taxing

The Republicans are brewing up some tantalizing tax breaks, but for most taxpayers, it's going to be yearend planning as usual. If the GOP wish list gets enacted--and that's a big if--that's all the more reason you should defer income to 1995 and accelerate deductions into this year as you normally would. That way, you delay paying taxes while keeping as much current income as possible--and take advantage of any tax cuts that get enacted. There are two exceptions: If you'll earn a lot more money next year or you're subject to the alternative minimum tax (AMT), consider the reverse strategy of shifting income into this year and delaying deductions until next. Either way, base your decisions on financial--not tax--considerations first.

APPRECIATION. The biggest proposed change is a 50% cut in the capital-gains tax. Whether this passes or not, you would want to avoid realizing gains on the sale of stocks, real estate, or interest income. If you have an appreciated stock that you want to sell, you can cash out and offset the gains with any capital losses you have. Or you can use tactics that let you lock in stock appreciation but defer the gains. For example, buy a put option to sell your stock at a fixed price in January. If the stock drops in the meantime, you'll still be able to sell at the current price. But if the stock rises, you'll enjoy the added appreciation minus the cost of the put--say, $3 per share. Either way, you defer the sale until next year.

Another strategy: Sell short against the box. This way, you lock in your price by holding a long and short position in the same stock so price fluctuations are canceled out. You do this by borrowing shares of an appreciated stock you already own and shorting them. But you don't close the deal and get the gain until you repay the broker in the future. "We've been telling clients to put off selling stocks that peaked by selling short and not closing until next year," says Tom Ochsenschlager, a tax partner at accountant Grant & Thornton in Washington.

If you've already realized gains in 1994 and, like most hapless bondholders, have big losses, sell the losers to offset the gains. You can write off those losses dollar for dollar against your gains if you sell this year. And, if the losses exceed your gains, you can deduct up to $3,000 against ordinary income. If you want to take the bond losses without changing the composition of your portfolio, do a swap. Sell the offending securities to realize the loss, and use the money to buy similar ones. If they vary in interest, maturity, or issuer, you can avoid the wash-sale rule. That rule disallows the tax break if you sell and buy "substantially similar" securities within a 30-day period.

To avoid capital gains from real estate, you could put off the sale until next year. If you must sell this year, arrange to get paid in installments, most of which will be received next year, says Rick Taylor, a partner at KPMG Peat Marwick in Washington. To avoid gains from interest on bank deposits, consider investing that cash in Treasury bills or short-term certificates of deposit that don't mature until next year.

The Republicans are also offering to boost "family values" by reducing the marriage penalty, giving families a $500 tax credit per child, a one-time credit of up to $5,000 to cover the expenses of adopting a child, and a $500 credit for elder care. The most significant change would be the marriage penalty. Taxes currently penalize two-income couples because together they get less of a break than each would singly. Any penalty reduction would be gradually phased in because it represents a huge loss of federal revenue, says KPMG's Taylor. The only way to avoid the marriage penalty is to put off the wedding until next year, but for most people matters mf the heart come before taxes.

NEW IRA. Republican leaders also propose to roll back the 1993 tax increase on Social Security benefits to high-income people, from 85% to 50%. And they want to increase the amount beneficiaries aged 65 to 69 could earn to $30,000 from $11,160 before their benefits get reduced. Even if this isn't passed, those currently taxed on Social Security should try to defer income to preserve as much of the benefit as possible. One way is to take less out of your individual retirement account or 401(k) plan without running afoul of the distribution rules.

Self-employed taxpayers and business owners would also catch a break under the GOP regime. Home-office deductions would be liberalized, letting you deduct costs as long as the office was essential to your business--even if it wasn't your principal place of work. The proposal would also increase depreciation for business equipment purchased in a given year from $17,500 to $25,000. So "if your equipment purchases are going to exceed $17,500, wait to buy until next year," suggests Ochsenschlager.

The future may also bring a new kind of IRA. The Republicans are suggesting the "American Dream" IRA from which people could withdraw money for medical, educational, and homebuying purposes without a penalty. There would be no upfront deduction when you stash money in this IRA, but retirement funds would not be taxed when you start receiving them. It's not yet clear whether this IRA would replace or coexist with current IRAs, which allow deductions for people under certain income levels.

Irrespective of the GOP, some changes become effective next year that you should heed now. For one, this is your last chance to donate gifts of appreciated securities to private foundations and deduct the current market value instead of the purchase price. Private foundations are set up by individuals or families to support their charities. Don't confuse this with donations made to public organizations such as universities, churches, or hospitals. You can still deduct the full value of appreciated gifts to such public charities. "Wherever possible, instead of using cash, give away appreciated stocks or mutual funds that have been held more than one year," says Nadine Lee, a tax partner at Ernst & Young. "That way, you get a big deduction and avoid capital gains."

If you elected to pay the 1993 tax increase in installments, remember that payment No.2 is due in April over and above what you will owe for this year. "People have to make sure now that they will have the cash on hand to pay it," says Mark Kersting, tax manager at accountant Urbach, Kahn & Werlin in New York.

Now's the time to ensure that your withholding or estimated tax payments are high enough to avoid penalties--currently around 9% of the amount unpaid per month. The rules are complicated: You're safe if you withhold 90% of this year's bill or an amount equal to last year's. If you earn more than $150,000, however, you'll have to withhold 110% of what you owed last year. If you've withheld too little, it's not too late to get your employer to hold back more from your paycheck or pay extra estimated taxes.

RED FLAGS. Starting in 1995, a greater tax bite comes out of the paychecks of those making more than $135,000 and those who are self-employed. The former must pay a medicare tax equal to 1.45% of all earnings, and the latter must pay 2.9%. Self-employeds must also set up a Keough retirement plan by yearend.

When projecting your tax liability, calculate two years ahead. You don't want to catch a tax break this year only to be liable for the AMT next year. Many deductions, such as state and local taxes, don't apply under the AMT. Two red flags for falling into the AMT: if you live in a high-tax state and if you have lots of capital-gains income.

No matter what politics sweep into the tax code next year, always make your money moves for sound financial reasons, not just to save on taxes. "Analysis and projection are a required part of fiscal planning," says Lehman Brothers political analyst Kim Wallace. "Hoping and wishing often lead to disappointment."

                Yearend Tax-Planning Tips
         CAPITAL GAINS Republican leaders are making loud noises about cutting the capital-gains tax. That's all the more reason to stick with a yearend strategy of deferring stock sales until next year. Buying put options is a tactic that allows you to lock in the current stock price without realizing gains from the sales until 1995.
         ORDINARY INCOME Max out investments in retirement plans, pensions, 401(k)s, IRAs, and other tax-deferred vehicles. Defer bonuses and speed up deductions. Consider a short-term tax-deferred investment such as Treasury bills or three-month certificates of deposit to put off having to pay tax on the interest.
      CHARITABLE CONTRIBUTIONS This year is your last chance to deduct the fair-market value rather than the purchase price of appreciated property when you donate to private foundations. But it will still be legal with public charities, so use mutual funds and securities over cash in future years.
         WITHHOLDING Figure out if you've withheld enough because you will be subject to stiff penalties if you haven't set aside 100% to 110% of the prior year's tax (depending on income) or 90% of what you owe this year. It's not too late to get your employer to withhold more.
                   GOP Wish List
      REDUCE capital-gains taxes by 50%.
      CREATE the American Dream Individual Retirement Account that would allow withdrawals for certain purposes without a penalty.
      RAISE the depreciation on business equipment.
      LOOSEN restrictions on home-office deductions.
      INCREASE the amount retirees can earn before getting taxed on Social Security benefits.
      PHASE IN reduction of the marriage penalty.
      ESTABLISH a $500 tax credit per child, a one-time $5,000 credit for adopting a child, and a $500 credit for elder care.