Dudugjian & Maxey

A Law Corporation

Telephone (916) 786-7272 Facsimile (916) 786-7306

What Do You Really Know About Tax Planning?

Tax planning undertaken early in the year is more effective than last-minute attempts to reduce taxes. More options and more opportunities are available to save taxes not only in the upcoming tax year, but in the years to come. Tax planning has become a long-term project.

As those in Washington (but let's not forget the state) struggle with the annual budget, the federal deficit, and government spending cuts, there will be much talk about taxes. Whether the politicians tinker with the tax code ( http://www.law.cornell.edu/uscode ) or throw it out altogether in favor of a national sales tax, a tax on consumed rather than earned income, or a flat tax, the same dollars are required.

It's impossible to predict what new tax legislation we will actually have and how long it will last before the next revision. One thing is certain, you need to stay informed. We are here to help you do just that and to work with you so that you pay the lowest tax allowed under the law.

Planning Cuts Taxes at All Stages of Life

Starting Out

Participate in a retirement plan.

If you recently started your first job, a retirement plan might seem like the last thing you need; but a 401(k) or SEP retirement plan is often the best tax-cutting strategy at any age. That's because retirement plan contributions generally are excluded from income, and plan earnings grow tax-deferred. If you are eligible, you also should consider making a deductible contribution to an individual retirement account (IRA or Roth IRA). If you're self-employed, look into setting up your own Keogh plan.

Pay the tax now or pay it later? The Tax Reform Act of 1997 (for more information regarding the Tax Reform Act of 1997, go to http://speakernews.house.gov/taxfull2.htm ) provided additional planning opportunities by providing for a new IRA (the "Roth IRA"). Under the Roth IRA, you do not deduct your contribution to an IRA; earnings within the IRA are not taxable (just like a regular IRA); but unlike a regular IRA, when you withdraw the funds at retirement, you also do not owe taxes. Roth IRAs are effective for 1998 and thereafter; however, if a Roth IRA is suitable for you, you can establish a regular or non-deductible IRA and roll that IRA (or any other IRA) into a Roth IRA in 1998 (spreading the taxes over four years).

Whether or not a Roth IRA is advantageous to you depends upon your current tax rate, length of time until you retire, your tax rate at retirement and the tax laws at retirement. Generally speaking, a Roth IRA makes the most sense for young taxpayers who have a long time until retirement and are currently in a very low tax bracket or for older taxpayers considering estate planning.

Here's how they compare:

Traditional IRA

Roth IRA

(begins for tax year 1998)

Education IRA

(begins for tax year 1998)

Annual contribution limit* $2,000 $2,000 $500 per child
Age limit on contributions 70 1/2 No 18
Income limit for making a contribution Varies, see your tax advisor AGI Individual $95,000; joint $150,000 Contributor's AGI individual $95,000; joint $150,000
Contribution tax deductible? Depends, see your tax advisor No No
Distribution taxable? Yes No No
Can convert to Roth IRA Yes, but will have tax consequences No, but can be transferred from another Roth IRA at another company No
Can convert to Education IRA? No No Can be transferred from another Education IRA at another company (for same child)

Can be redesignated to another eligible family member

When is disbursement penalized? 10% penalty for withdrawals under age 59 1/2, unless for qualified expenses 10% penalty for withdrawals under age 59 1/2 or on assets held in account less than 5 years, unless for qualified expenses 10% penalty if not used for college or if not used by age 30
When is disbursement mandatory? After age 70 1/2 No mandatory disbursement Before age 30


*The maximum annual IRA contribution (except for Education IRA is $2,000 per person. In other words, you cannot contribute $2,000 to a traditional IRA and $2,000 to a Roth IRA. This $2,000 restriction applies only to annual contributions. There are no dollar limits on IRA transfers and rollovers.

Watch out for the marriage penalty.

If wedding bells are in your future, beware of the marriage penalty. This is a feature in the tax law that causes some married couples to pay more tax than two singles earning the same amount of income. In some cases the marriage penalty is unavoidable (short of not getting married), but in other cases, a little advance planning can save a sizable amount of tax. This year Congress claims they will be examining this "marriage penalty."

Plan your deductions.

Don't rush into buying a home just to save taxes. But if purchasing a home otherwise makes sense, mortgage interest is still a valuable tax deduction.

If you don't have a mortgage, you may not have enough deductions to itemize every year. This is another way of saying that your "standard deduction" often will be higher than your actual deductions; but it still pays to keep track of the actual deductions. By bunching deductions in a particular year (for example, by making a charitable contribution in December rather than the following January), you may be able to exceed the standard deduction and itemize anyway.

Raising a Family

Stay the course with your retirement plan.

If you've been contributing to a SEP or 401(k) plan, keep up the good work. If you aren't contributing the maximum, consider boosting your contribution. If you aren't participating at all, this is the stage in life when you should give it some serious consideration.

Take advantage of flexible spending accounts.

While we're on the subject of employee benefits, be sure to find out if your employer offers a flexible spending account (FSA). If so, consider participating. An FSA allows you to set aside pre-tax dollars to cover two common types of family expenses: medical bills that aren't covered by insurance (for example, deductibles and co-payments), and certain child care expenses. Since the tax law requires that you forfeit any amount in your FSA that you don't use during the year, plan carefully.

Maximize your child care credit.

If you and your spouse are both employed at full or part-time jobs, make sure you get the maximum benefit from the child care credit. When calculating the credit, remember that you may be able to include the cost of day care, nursery school, babysitting, and summer camp.

Plan for the "kiddie tax."

According to the kiddie tax rules, every child is allowed to earn up to $650 of interest, dividends and other "investment income" free of tax. The next $650 of investment income is subject to tax at your child's tax rate. If your child is under 14, any investment income in excess of $1,300 generally will be taxed at your rate. Once your child turns 14, all of his or her investment income will be taxed at your child's rate.

To plan for the kiddie tax, consider putting enough assets in your child's name to earn at least $1,300 of investment income per year. If your child is under 14 and it appears that investment income will top $1,300, consider investing some of your child's assets in tax-free or tax-deferred investments, such as municipal bonds, Series EE U.S. savings bonds, growth stock mutual funds, or certain life insurance products.

Obviously if your children earn income which enables them to establish an IRA, you may want to consider a Roth IRA (see above).

The 1997 Tax Reform Act includes three new benefits for college education, including the "Dynasty" Education IRA.


Plan carefully when your home is involved.

As you head into retirement, your home is likely to be one of your most important assets. Don't make any financial moves that affect your home, such as selling or refinancing, until you've investigated all the tax angles.

Choose the best distribution strategy.

When you retire, you may have to decide what to do with the payout from your retirement plan--specifically, whether you want to roll it over into an IRA or use a favorable tax computation called forward averaging. This is a complex and important financial decision that you don't want to make without a careful review of your options.

Once you reach age 70, you must decide on the best strategy for taking money out of your IRA. These mandatory, minimum distributions can be based on your life expectancy at the beginning of the distribution period, your life expectancy as recalculated every year, or the joint life expectancy of you and another beneficiary (such as your spouse). Unless you need additional cash, you'll generally want to select the distribution formula that results in the smallest payout. That way, you leave the maximum amount possible to compound in your IRA tax-deferred.

Minimize the tax on your social security benefits.

As you know, as much as 50% to 85% of your social security benefits may be subject to income tax. If you're close to the taxable thresholds--$32,000 or $44,000 on a joint return and $25,000 or $34,000 for singles--several strategies can help reduce the tax bite. Be sure to review the options available in your situation.

Your Home and Taxes

Taxes often come into play for homeowners, and it's important to be aware of potential benefits and pitfalls. Are you buying or selling a home? Remodeling? Refinancing? As a homeowner, you should know that important tax consequences are often associated with some fairly common events.

Home Purchase.

When purchasing a home, for example, you may pay a portion of the mortgage interest in advance. This loan origination fee, or "points," is a percentage of the total amount borrowed.

If points are paid for a principal residence, you generally can deduct the full amount in the year paid, even if the points were paid by the seller. A word of caution: you must reduce your home's tax basis by the amount of seller-paid points, and this could affect your capital gain on resale.

Of course, one of the greatest tax benefits of home ownership kicks in during the early years of the mortgage, when most of your payments go towards tax-deductible interest.


What happens if you refinance? If you pay points, the general rule requires that you prorate deductions over the life of the loan. But if some of the refinance proceeds go toward home improvements, you may be able to take a current deduction for the portion of the points related to those improvements.


If you take out a loan to make substantial improvements to your home, and the loan is secured by your principal residence, the interest is generally deductible. To the extent that remodeling increases the value of your property, the property's basis will increase, potentially reducing future capital gains.

Other home improvement costs generally are not deductible, but if you upgrade your home for medical reasons--say, to add a wheelchair ramp or stair lift--you may be able to deduct a portion of the cost as a medical expense.

Home office.

The home office deduction can be another tax break of home ownership. If you use part of your home regularly and exclusively as a principal place of business, you may be able to deduct costs associated with that part.

Home sale.

The general rule for the sale of a personal residence has been substantially modified. You may have the ability to sell a home every two years at no gain, provided the gain is less than $250,000 per single person or $500,000 for a married couple. In fact, Form 1099 should not be filed unless the gross sales price exceeds $250,000 or $500,000. If you exceed that amount, unlike prior law, you no longer have the ability to defer the taxes by rolling it over into a more expensive home. Obviously this modification needs to be considered in planning the sale of homes, which is usually the largest single asset owned by most families.

Tax Update

Tax Reform Discussed (for more information regarding the Tax Reform Act of 1997, go to http://speakernews.house.gov/taxfull2.htm or for information regarding the Internal Revenue Code, visit http://www.law.cornell.edu/uscode ).

Nothing has changed. As Congress struggles with the issues of government spending, budgets, and taxes, several proposals have emerged that would forego tinkering with the current tax code and change the tax system entirely. You'll be hearing a great deal about these alternative tax systems in the coming months.

Following is a quick summary of the different kinds of tax systems being discussed:

VAT. The value-added tax is a tax applied to goods and services at each stage of the production process. Businesses pay a tax based on the value they add to a product. Opponents consider the tax regressive, since it is virtually a hidden sales tax. Proponents like it because it could generate considerable revenue and because the VAT has already been used successfully by other countries.

National sales tax. One proposal would eliminate the federal income tax and the Internal Revenue Service and substitute a national retail sales tax of 17%. The states would collect and remit the national sales tax at the same time they collect state sales taxes. Employers would still be required to collect and pay social security taxes.

Consumed-income tax. The underlying concept in this tax is the taxation of consumption rather than income. One proposal would do this with a tax deduction for income saved or invested each year.

Flat tax. In its purest form, the flat tax is the simplest tax. Everyone pays the same single tax rate on all business and wage income. All credits, deductions, and special rules are eliminated. While very appealing for its simplicity, the flat tax presents some major problems. First, a flat tax probably would not raise as much revenue as the current income tax, causing the federal deficit to balloon. Second, the tax is regressive in nature.

Actual proposals currently in the news often combine concepts from more than one kind of tax in an attempt to produce needed revenue and fairness to taxpayers.

Dudugjian & Maxey is available to provide information so that you can confidently answer the question:

How Much Do I Really Know About Tax Planning?



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Dudugjian & Maxey

A Law Corporation

Telephone (916) 786-7272 Facsimile (916) 786-7306


A living trust is not a "tax-advantaged instrument", but it can be an effective tax planning tool. The Internal Revenue Service imposes federal estate and gift taxes on a decedent's estate in excess of $650,000. (The maximum amount of $650,000 may be reduced by certain lifetime gifts.) As you can see from the "Schedule of Federal Estate Taxes" included in this packet of information, this tax can be very high. The only good news is that estate taxes are calculated on the NET value of the estate, not the GROSS value.

Under the Unified Tax Credit, an estate valued at $675,000 or less is exempt from federal estate tax as well as gift tax. The Unlimited Marital Deduction allows the first spouse to die to pass his/her entire estate to the surviving spouse free from gift or estate taxes. For married persons, the exemption applies to estates with values up to $1,350,000. However, even though each person is allowed $675,000 tax free, unless adequate tax planning has occurred prior to the death of the first spouse, many couples lose one of those $675,000 exemptions. A living trust can help to avoid this occurrence.


Net Estate Value.......Estate Tax

$ 675,000.....................$0

$ 700,000.............$ 9,250

$ 750,000............$ 27,750

$ 800,000............$ 47,250

$ 850,000............$ 66,750

$ 900,000............$86,250

$ 950,000............$105,750






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