Year-End Tax-Planning Tips.

Performing year-end tax planning now could be amply rewarded on April 15, 2001. Individual income in 2000 generally will be subject to Federal taxation at rates ranging from 15 to 39.6 percent. The applicable rate can be influenced by effective tax planning, which often involves deferring income

Deferring Income

Opportunities for deferring income and thus reducing tax liability in the current year may exist in connection with a year-end bonus, deferred compensation agreement, interest income, alimony payments, installment sales, and flexible-spending accounts.

Year-end bonus. A year-end bonus that is not paid until January 2001 will escape taxation in 2000. A taxpayer cannot obtain this benefit, however, by refusing to accept a bonus payment offered in 2000 until 2001.

Deferred compensation agreement. An employee may be able to obtain a written deferred compensation agreement from his or her employer. Under such a plan, the employee elects to defer a portion of income until a stated time, and is taxed on the deferred income only when it is received. To obtain the tax benefit, the employee must be willing to accept the risk that he or she may not receive the payments. Using an irrevocable trust to hold the deferred compensation can help minimize this risk.

Interest income. A taxpayer who expects to earn substantial interest income in late 2000 should consider purchasing a short-term certificate of deposit (CD) that matures in 2001. None of the interest earned will be subject to tax in 2000 provided interest on the CD is not payable without penalty until next year.

Alimony payments. Alimony payments, but not property settlements, are deductible. Alimony payments are income to the person who receives them, but if the recipient is in a lower tax bracket, there will be a net tax benefit that both the person paying the alimony and the recipient can share. Before finalizing a separation or divorce agreement, a tax adviser should be consulted regarding whether payments can be characterized as deductible alimony.

Installment sales. A taxpayer who is planning to sell in 2000 certain investment property, such as real estate or stock in a closely held business, can defer recognizing gain by structuring the sale on an installment basis.

Flexible-spending accounts. A flexible-spending account, which generally must be set up in 2000 to save on next year's taxes, permits a taxpayer to pay for eligible health and dependent care expenses with pretax wages. The amount contributed to the account also is not subject to FICA taxes.

Accelerating Income

If one's effective tax rate will be significantly lower in 2000 than in 2001, accelerating the recognition of income can ensure that more income is taxed at the lower 2000 rate. A taxpayer in this situation should consider individual retirement account (IRA) distributions, the exercise of stock options, installment note sales, or Series EE savings bonds redemption.

IRA distributions. A taxpayer who is over age 59 1/2 and has a traditional IRA may be able to increase his or her 2000 income without penalty by making withdrawals from the account.

Exercise of stock options. A taxpayer who owns nonqualified stock options should consider, from an investment perspective, whether this might be a good year to exercise those options. If so, exercising the options will generate taxable income.

Installment note sales. A taxpayer can accelerate income in 2000 from an installment sale made in a previous year if the buyer agrees to pay off the note before year end, the holder of the note sells the note to a third party or the note is used as collateral for a loan.

Series EE savings bond redemption. If a taxpayer has not reported the interest earned on Series EE savings bonds in prior years, he or she can redeem the bonds and report all of the accrued interest in 2000.

Itemizing Deductions

When itemizing, a taxpayer must make sure he or she qualifies to take the deductions. A taxpayer is entitled to take either actual itemized deductions or the appropriate standard deduction every year, but not both. A quick review of the prior year's tax returns can help determine which option would be most advantageous. If one's itemized deductions have been about the same as the allowable standard deduction, it may be possible to save taxes by "bunching" itemized deductions in alternate years.

If deductible expenses are paid by check, the checks should be delivered on or before December 31, 2000. Mailed checks will have met this deadline if mailed before January 1, 2001. For expenses paid by credit card, the charge date is the qualifying factor. A taxpayer need not pay the credit card bill before year-end to take a deduction for 2000.

Medical expenses. Only unreimbursed medical expenses in excess of 7.5 percent of a taxpayer's adjusted gross income (AGI) may be claimed as a deduction in 2000. If one can choose whether to incur medical expenses in 2000 or 2001, the deciding factor should be in which year the taxpayer will be able to surpass this threshold. If the threshold will be met in 2000, the taxpayer should consider making additional purchases of discretionary (but not purely cosmetic) medical products and services before year-end. Allowable expenditures include prescription drugs, insulin, eyeglasses, hearing aids, fees for smoking-cessation programs, annual physicals, certain payments related to long-term care, and insurance premiums.

State or local income taxes. To increase one's deduction for state or local income taxes in 2000, estimated tax payments should be made before December 31, 2000. Most real-estate taxes, state and local property taxes, and foreign income taxes also are deductible. One should consider paying these taxes before year-end.

Interest on residence. Interest on loans used to acquire, construct, or substantially improve a principal residence and one other residence is, within statutory limits, deductible if paid during the year. Interest on an additional $100,000 of home equity indebtedness also is deductible. A taxpayer may be able to accelerate deductions by making the January 2001 mortgage or home equity payment before December 31.

Generally, only the portion of points that represents prepaid interest is deductible in the year paid. The entire amount paid as points might be deductible if the loan is used to buy or improve a principal residence and is secured by that home. Taxpayers who satisfy the requirements should try to close on any such loan before year-end so the points can be deducted on the 2000 return.

Interest on loans. If one has paid interest on loans taken out to buy investments (other than tax-exempt securities), the interest can be deducted to the extent of net investment income.

Charitable gifts. Charitable gifts should be made in the year in which the gifts will provide the most tax benefit. While gifts of clothing, books, furniture, and equipment qualify for the deduction, a person must obtain a written acknowledgement from the recipient organization for gifts valued at more than $250. The IRS has announced it will be particularly alert for valuation misstatements related to contributions of automobiles.

Donations of investment property, such as securities, to a charity should be made in the most tax-efficient manner possible. If the securities have appreciated and have been held for more than one year, donating the actual securities, not the proceeds, to the charitable organization will entitle the donor to a charitable deduction for the value of the securities without paying tax on the appreciation. If, on the other hand, the securities are worth less than the original cost, it is usually better to sell the property and donate the proceeds. The charity will receive the same value, and the donor will recognize a capital loss that may be used to offset other income.

Alternative minimum tax. The alternative minimum tax (AMY) was designed to ensure that those in the highest income-tax bracket paid at least a minimum amount of tax. As a result of changes in the tax law, however, many taxpayers may be subject to this alternative tax calculation. This is a complex area of the law. Therefore, a taxpayer who has been subject to the AMT in the past, or is concerned that it may apply in 2000, should consult with a tax adviser.

Retirement plans. Contributions to traditional IRA and Keogh plans do not have to be made by year-end to offset 2000 income. There are, however, a number of important year-end considerations related to contributions to a retirement plan.

Active participants in a qualified plan are not permitted to deduct contributions to a traditional IRA if their income exceeds certain amounts. In addition, a contribution to a Roth IRA may not be made by single filers with AGIs above $110,000, or taxpayers who are married filing jointly and with a 1999 AGI above $160,000. Taxpayers who are near these contribution limitations should consider deferring income as part of their yearend planning.

Qualified distributions received from a Roth IRA are tax-free. Most taxpayers with modified AGI of less than $100,000 in 2000 are eligible to convert existing traditional IRAs to Roth IRAs without paying the additional 10 percent excise tax for early withdrawal. However, income taxes must be paid in 2000 on the taxable amounts converted. Because being even one dollar above the income ceiling will eliminate the possibility of conversion, anyone who is planning to execute a conversion should estimate income carefully before year-end.

With a 401(k) or similar plan, a taxpayer can save a portion of salary earned on a before-tax basis. Unlike IRA contributions, 401(k) deferrals for 2000 may be made only in 2000. A person who has a 401(k) plan should make sure to defer the maximum affordable amount by year-end.

A taxpayer who is self-employed, owns a business, and has earned income from the business may be able to set up a Keogh plan. While contributions to a Keogh plan can be deducted if made by the tax-return due date, the plan must be established before the end of 2000.

Other Considerations

Taxpayers should review the amount of support they have provided to their dependents this year to ensure that they meet the support test that allows a person to claim an exemption for the dependents.

Anyone who has not remitted enough tax to cover anticipated tax liabilities may be subject to underpayment penalties. These penalties are assessed on the basis of payments throughout the year; thus, they may not be avoided by simply paying the amount due when the return is filed. Anyone who might have underpaid taxes to date should consider increasing Federal and state withholdings from wages for the remainder of the year. Taxes withheld are considered to have been paid evenly throughout the year. Therefore, increasing withholdings in the latter part of 2000 may make up for underpayment earlier in the year.

The end of the year also is a good time to review estate and gift-tax planning. Although gifts to individuals are not deductible against income tax, a person can give up to $10,000 annually ($20,000 with a spouse's consent) to as many individuals as desired without paying any gift tax. In addition, an unlimited gift-tax exclusion is available to pay medical or educational expenses, if payments are made directly to a medical or educational institution.

A taxpayer can help a child, grandchild, or other person save for higher education by making a gift through a state-sponsored tuition program. Gifts made through these programs are not deductible for Federal income-tax purposes, but do qualify for the annual gift-tax exclusion, and may be deductible for state income-tax purposes.

A taxpayer who turned 70 1/2 during 2000 and has not yet begun to take distributions from a qualified pension, profit-sharing, stock bonus, traditional IRA, or tax-sheltered annuity plan generally will need to take his or her first distribution no later than April 1, 2001. (A taxpayer who has not yet retired can defer distributions from qualified plans until retirement but still must begin taking distributions from traditional IRAs). Waiting until next year to take the first distribution, however, will bunch income into tax year 2001, because the taxpayer will be required to take two distributions next year.

By carefully projecting one's income through year-end and reviewing the related tax liability, a taxpayer still has time to do tax planning that can have a positive impact when it is time to file.

William G. Kistner, MM, CPA, is a tax partner, Ernst & Young LLP, chicago, Illinois, and a member of HFMA's First Illinois chapter. His address is Ernst & Young LLP, 233 South Wacker Drive, Chicago, Illinois 60606-6301.