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Opportunities in a Down Market |
If you are part of a close-knit family, you probably give generous gifts to each other during the holiday season. But in the next couple of months, you might decide to be extra-generous. Reason: Due to an upcoming change in the annual gift tax exclusion, you will be able to give away more in gifts without paying any federal
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Bear Market: Time for a Roth
IRA Conversion?
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When stock prices are down, there can be a chance to save on taxes using a Roth IRA.
Assuming you meet the income requirements, consider converting your regular IRA to a Roth IRA. Since you pay taxes based on what the account is currently worth, the tax cost to convert is lower when the value of your IRA is down.
The rules are complex, so let's start with the basics.
With a Roth IRA, contributions aren't tax deductible but withdrawals are tax-free after five years, as long as you're age 59 1/2 or older. In addition, you don't have to take required distributions from a Roth IRA after age 70 1/2, so your money can keep growing tax-free for decades.
In contrast, with a regular, deductible IRA, you get an upfront deduction for contributions but you must begin taking taxable mandatory withdrawals after you turn 70 1/2.
So converting a regular IRA to a Roth IRA can pay off in future tax-free income.
However, the conversion is considered a liquidation of your original IRA so you owe tax on the amount withdrawn and placed in a Roth account. The tax is due in the year of the conversion takes place.
Income requirements: Your adjusted gross income (AGI) can't exceed $100,000 in the year of the conversion. (Beginning in 2010, there will no longer be an income limit on Roth conversions.)
The Market Effect
After a stock market drop devalues your IRA, it might make sense to convert your IRA to a Roth IRA because the tax bill will be lower. Suppose, for example, you rolled over your $500,000 retirement plan account balance into an IRA. Now you want to convert to a Roth account. Assuming a combined federal and state tax bracket of 40 percent, converting your $500,000 IRA to a Roth IRA will trigger a $200,000 tax obligation (40 percent times $500,000).
But if the value of your IRA drops to $400,000, you only owe $160,000 on a conversion (40 percent times $400,000). In this example, you save $40,000 by converting after a market dip.
Keep in mind that the additional conversion income will increase your AGI. That could disqualify you for other tax-saving deductions, credits and exemptions or make more of your Social Security benefits taxable.
The rules are tricky so consult with your tax pro to ensure the best results. |
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There's an old saying among professional advisers: Don't let the tax tail wag the investment dog. In other words, you want to take advantage of the rules involving capital gains and losses when buying or selling stocks but taxes should never be the primary reason for a transaction. | gift tax. By doing so, you're able to reduce the size of your taxable estate that will be left to your heirs.
What's more, the recent downturn in the stock market may have diluted the value of some of your investment holdings. Giving away stocks, bonds, mutual funds and even real estate when they are valued on the low side may enable you to pass even more of your current net worth to other family members.
Basic information: Under the annual gift tax exclusion, you can give gifts of cash or property up to a specified value to as many recipients as you would like with no gift tax consequences. The annual threshold for the exclusion is $12,000 for 2008 and it has been that amount for several years. However, due to an inflation adjustment, the limit jumps to $13,000 for 2009.
This exclusion amount doubles for joint gifts made by a married couple. Let's say that you and your spouse have three adult children and seven grandchildren. For 2008, both of you can give each child and grandchild $12,000 to celebrate the holidays. Then in January, you can give each family member another $13,000. In a span of just two months, you and your spouse can reduce your estate by a total of $250,000 ($25,000 in gifts during 2008 and 2009 times ten recipients).
For recipients, the amount received as a gift doesn't count as income for tax purposes.
Note that you don't have to sell stock to give gifts to family members. Instead, you can transfer securities that have a lower value now than they did months ago, thereby decreasing the overall estate. (A similar strategy may work if the stock of your closely held company has recently declined in value.) If the securities eventually rebound, the family members can sell them at a profit --- and they may avoid paying capital gains tax on the sale.
That's because the federal income tax rate on long-term capital gains and qualified dividends is currently zero percent for people in the 10 percent or 15 percent federal income tax rate brackets.
So if you have children, grandchildren, elderly parents or other loved ones who are in the bottom two tax brackets for 2008, you might want to give them stock or mutual fund shares that you expect to rebound. Then, they can sell the investments and pay zero percent on any gains -- assuming the shares have been held for more than one year. For purposes of passing the more-than-one-year test, the recipient combines his or her holding period after the gift with your holding period before the gift.
Giving away stock that pays dividends can be another smart strategy. As long as the recipient is in the 10 or 15 percent rate bracket, the dividends will be free from federal income tax.
This profitable opportunity is available from 2008 through 2010 -- unless Congress changes the rules, which could easily happen. So you may want to take advantage of the zero percent rate on long-term gains and dividends as soon as possible.
There are a couple of important considerations if you are interested in gifting stock shares to take advantage of the zero percent tax break:
1. Consider the Kiddie Tax rules if your gift recipient is younger than age 24 on December 31, 2008.
2. As mentioned earlier, the zero percent rate only applies to long-term capital gains and dividends received by those in the 10 or 15 percent federal tax brackets. But your gift recipient can be doing well financially and still be in the 15 bracket.
For example, a married man files jointly, has two dependent kids, and claims the standard deduction for 2008. He and his spouse could have up to $90,000 of adjusted gross income (AGI), including long-term capital gains and dividends from securities received as gifts, and still be in the 15 percent bracket. Their taxable income would be $65,100, which is the top of the 15 percent bracket for joint filers.
Not All Gifts Count Toward the Exclusion
There are a couple ways you can give an individual more than $12,000 for 2008 or $13,000 for 2009. Gifts made directly to an educational institution to pay for tuition don't count toward the gift tax exclusion. The same is true for payments made directly to a health care provider, such as a doctor or hospital, to pay for medical expenses on behalf of someone else. Therefore, you can pay a grandchild's college tuition for the next semester in addition to giving the same grandchild $12,000 in December and $13,000 in January -- all free of gift tax.
Finally, you have one other gift tax break in your pocket. The lifetime gift tax exemption applies to gifts of up to $1 million after you've exceeded the annual gift tax exclusion. You don't use any of this amount unless the gifts you give an individual in one year exceed the annual exclusion. For example, say you give your son a $16,000 gift in 2008. You have used $4,000 of your lifetime limit.
However, using this exemption erodes the available tax shelter from the estate tax exclusion. This amount is $2 million for 2008 and increases to $3.5 million in 2009. Any amount you use of your lifetime gift tax exemption reduces the amount that can escape estate tax after your death. So it's generally a good idea to limit your lifetime gift giving to amounts covered by the annual gift tax exclusion and the exceptions for education and health care expenses -- unless your estate planner advises otherwise.
Consult with your estate planning adviser for more information.
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