- Planning for the sale of appreciated assets within the next 2 or 3 years.
- Making annual exclusion gifts.
- Making contributions to Code Sec. 529 plans.
- Making contributions to IRAs.
- Doing Roth IRA conversions.
- Exercising incentive stock options (ISOs).
Planning for the sale of appreciated assets: California’s maximum capital gain tax rate is now 37.1% for passive income (Federal and California rates combined). That may drop to 33.3% or to 29.8% depending upon whose legislation, if any, is enacted. These high rates still warrant advance planning for the sale of an appreciated asset, including real estate or a business, is best begun 2 or even 3 years before the sale.
Making annual exclusion gifts: Annual exclusion gifts are the first strategy to consider if your client has a taxable estate. Annual gifts are simple, effective and expressly authorized by the Internal Revenue Code (“the Code”). If both spouses make gifts, they can effectively remove $28,000 per year from their estate for each beneficiary. Over time, these gifts can accumulate to a very considerable sum and provide substantial savings and enhance asset protection. This is true even if the taxpayers don’t have a large family. In addition, if gifts are made with discounted assets like family limited partnership interests or fractional interests in real estate, each annual exclusion gift and the amount that can be transferred over time can be increased substantially.
Annual exclusion gifts are typically made in November or December as part of your end of year tax planning. However, the amount that can be removed from the taxpayer’s gross estate and accumulated in the hands of heirs can be substantially increased if the gifts are made early in the year. An earlier gift gives the transferred assets the maximum period of time to grow in the hands of heirs instead of in the taxpayer’s estate. Income earned on the asset during the year is also shifted to a donee with a potentially lower marginal tax rate.
Making contributions to Code Sec. 529 plans: Contributions to Code Sec. 529 plans are subject to the federal gift tax and generation skipping transfer (GST) tax. Contributions qualify for the annual exclusion, which provide an opportunity for them to make large annual contributions without incurring any gift or GST tax or using up any gift or GST tax applicable exclusion amount. Code Sec. 529 even permits taxpayers to use five years of annual exclusion in the first year. Instead of making a $14,000 contribution each year for five years, taxpayers can actually contribute $70,000 in the first year. Although no further contributions can be made to the same beneficiary for the rest of the five-year period, money is removed from the gross estate faster and accumulates faster in the child’s account than if annual contributions of $14,000 were made.
Funding an IRA early in the year: The earlier in the year an IRA is funded, the greater the amount of money that can be accumulated in the account over a period of time. The closer the contributions are made to the beginning of the year, the larger these accumulations would be.
Doing Roth IRA conversions: Doing a Roth IRA conversion early in the year produces a different kind of tax benefit. Tax on the conversion isn’t due until April 15 of the following year so the taxpayer has more than 15 months to pay the tax. With a large IRA, the value of this deferral could be substantial.
Converting early in the year also gives the taxpayer more time to decide whether to re-characterize the transaction. The deadline for reversing a Roth IRA conversion is October 15th of the following year regardless of whether the taxpayer requested an extension to file the tax return or filed it before April 15th. The earlier in the year that a conversion is done, the longer that you have to see how the converted assets will perform and to determine whether a re-characterization would be favorable.
Exercising incentive stock options (ISOs): In the event of a qualifying disposition, ISOs are not subject to regular income tax at grant or at exercise. Taxation occurs when the underlying stock is sold. At that time, the taxpayer recognizes capital gain on the difference between the cost of the option and the sale price of the stock.
Sale of the stock is a qualifying disposition if it occurs more than 2 years after the grant date and more than one year after the stock was transferred to the employee (generally the exercise date). Note that the spread between the strike price and the stock’s FMV on the exercise date is a tax preference item for alternative minimum tax (AMT) purposes unless the taxpayer sells the stock in the same year the option was exercised. The exercise of an ISO often results in a large AMT preference item and significant AMT liability. Exercising ISOs early in the year may be more favorable than exercising the ISO later in the year.
Tax planning at the beginning of the year may never be as popular as year-end planning. Nevertheless, the earlier you plan, the better the result often providing for greater savings.