By Lee C. McGowan, CFP, Senior Client Advisor, TFC Financial Management

In an equity market that has dropped by double-digits, investors may look forward to closing out the year and beginning anew. Equity markets have declined at a rapid pace and  economic conditions have deteriorated considerably.  Stalwart investments have lost significant value and home prices suffered a record annual decline through the third quarter. Despite turbulent market conditions, planning for  year-end and preparing for the years ahead must go on.  In fact, there are strategies that can be implemented prior to year-end that may increase future after-tax returns.

This article focuses on timely, tax-related strategies. The strategies pertain to a diverse group of high net worth individuals across multiple generations. Strategies could be suitable for you, your children, your grandchildren, and/or your parents.

Tax-Loss Harvesting

Tax-loss harvesting can be an effective strategy for reducing tax liability as investors are able to net realized losses against capital gains earned during the year. Additional losses of up to $3,000 can also be deducted against ordinary income with any remaining losses carried forward indefinitely. Tax-loss harvesting seems straightforward, but the intricacies must be understood and carefully managed in order to not disrupt a disciplined investment strategy.

In order to successfully implement a tax-loss harvesting strategy, investors must be aware of the wash sale rule. The rule prohibits an investor from claiming a loss if he/she sells a security and buys a substantially identical security thirty days before or after the sale (also applies to transactions in a spouse's account). Investors should be aware of a recent ruling, effective December 2007, which goes beyond the traditional wash sale rules. Revenue Ruling 2008-5 expands the interpretation of the wash sale rule by disallowing a loss if an investor sells a security in his/her taxable account and buys a substantially identical security in his/her IRA. The ruling forces investors to scrutinize transactions in their IRAs if they have sold a security for a loss in their taxable account.

Investors should be particularly mindful of running afoul of the wash sale rule if they follow a disciplined investment strategy including systematic investing, portfolio rebalancing and/or capital gains and dividend reinvestments. Investors are cautioned to be attentive to transactions executed as part of the previously mentioned disciplined investment strategies, both in their taxable accounts and IRAs. Each of the strategies increases the risk of triggering the wash sale rule if not managed properly.

Generally, when investors take advantage of a tax-loss, they would like to remain in the same economic position. In other words, the investor would like to replace the security sold for a loss with a security that offers similar risk/reward characteristics. While the IRS has not provided a clear definition of "substantially identical securities" for each type of security, there are several reasonable assumptions that can be made. IRS Publication 550 provides some clarity with respect to individual stocks. It seems clear that GM can be sold and replaced with Ford. Transactions pertaining to mutual funds and exchange-traded funds are less clear, but the investment community has generally accepted that one actively managed fund can be replaced with another actively managed fund and an index fund can be replaced with another index fund (if the indexes are not identical). In addition, it has been accepted that an index fund can be replaced with an actively managed fund and vice-versa.

Capital Gains

The 15% long-term capital gains rate lowered in 2003, extended to December 31, 2010 by the Tax Increase Prevention and Reconciliation Act of 2005, is unlikely to be extended by the new administration. The current political landscape points to higher capital gains rates in the near future.

Planning Idea - Consider accelerating diversification plans and realizing gains in 2008 prior to the anticipated long-term capital gains rate increase.

IRA Charitable Rollovers

Enacted on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the rescue bill) contains several key provisions affecting individuals. One such provision, allowing for direct contributions from IRAs to charities, a popular charitable giving strategy initially included in the Pension Protection Act of 2006, has been revived in the rescue bill. The provision allows an individual age 70½ or older to donate a maximum of $100,000 per year for 2008 and 2009 directly from an IRA to a qualified charity.

Under the IRA charitable rollover provision, individuals do not receive a charitable deduction. Rather, they benefit by excluding the distribution from income. Traditionally, when individuals receive a distribution from their IRA and make a corresponding charitable contribution, they must include the distribution in adjusted gross income. The donation is then included as a charitable deduction on the federal tax return. For higher income taxpayers, the charitable deduction they receive will not completely offset the income taxes paid due to the IRA distribution (see below example).

The following example illustrates the benefits of making a charitable donation directly from an IRA.

Facts:

Taxpayer A and Taxpayer B each:

Taxpayer A and spouse take a distribution of $100,000 each from their IRAs to satisfy the RMD and make a charitable donation totaling $200,000 from his/her taxable account.

Taxpayer B and spouse elect to make a direct contribution from each of their IRAs of $100,000 to a qualified charity (total donation of $200,000).

Results:

Taxpayer A and spouse report $275,000 as ordinary income on his/her federal and state tax returns. The $200,000 charitable donation is treated as an itemized deduction on his/her federal tax return. There is not a deduction for the charitable donation on the state income tax return (there is no taxable benefit from the charitable donation at the state level in many states). Taxpayer A and spouse have an AGI of $275,000 as a result of the RMD. The Taxpayer's itemized deductions, including the charitable deduction, are reduced (due to the AGI limitation for itemized deductions). Taxpayer A is not allowed to deduct the entire contribution in 2008 due to the 50% of AGI limitation on cash donations to a public charity.

Taxpayer B and spouse benefit by reducing their federal and state taxable income by $200,000, which reduces their state income tax liability by $10,000. In contrast to Taxpayer A, Taxpayer B's itemized deductions are not reduced; therefore, he/she does not lose a portion of the charitable deduction due to income limits.

In summary, taxpayers who may benefit from the IRA direct contribution to charity are those who:

As with most financial planning strategies, the potential benefits of the IRA charitable distribution must be compared with other charitable gifting strategies to assure optimal tax and gifting benefits.

Charitable Giving

Donations to qualifying charities and foundations are generally fully deductible as long as deductions are itemized and limits based on income are not exceeded (deduction is dependent on the nature of the gift, the type of charity and amount of adjusted gross income). In addition to the previously mentioned IRA charitable gifting technique, there are several other valuable charitable gifting vehicles including donor advised funds, charitable remainder trusts and private foundations.

Planning Idea - Donate appreciated securities - If a taxpayer donates appreciated securities, he/she may be able to take a charitable deduction equal to current fair market value of the security. The taxpayer will also avoid paying tax on the capital gain incurred if the security was sold.

Gifting

Taxpayers may want to take advantage of the annual gift-giving limits to reduce future income and estate tax liabilities. For 2008, the annual exclusion for gifts to individuals is $12,000 per donee, without paying gift tax on the amounts transferred. Married couples can gift $24,000 per donee, per year without gift tax consequences. The strategy not only removes the amount of the annual exclusion amount from an estate, but it removes future earnings on the gifts from an estate. The annual exclusion amount for individuals has been increased to $13,000 for 2009 ($26,000 for couples).

Planning Idea - Taxpayers are allowed substantial gifts to 529 education savings plans. A five-year forward election may be made to a 529 plan allowing a contribution to be made ratably over a five year period for gift tax purposes.  The five-year forward election allows for cash gifts of five times the available annual exclusion.

Kiddie Tax

The Kiddie Tax, originally enacted in 1986, treats most unearned income of children as taxable income at their parents' tax bracket. Before 2006, the Kiddie Tax applied to children under the age of 14. Effective in 2008, the tax applies to children who are age 18 and to full-time students who are age 19 to 23 (unless the children provide half of their own support).

Planning Idea - Due to recent changes, consider altering investment strategies in existing UTMA/UGMA accounts to include tax-efficient investments (e.g., municipal bonds). Consider transferring UTMA/UGMA accounts to a 529 education savings plans (UTMA/UGMA rules are maintained, but growth is tax-deferred and distributions for qualified higher education expenses are tax-free).

Retirement Planning

Under current law, beginning January 2010, the $100,000 modified adjusted gross income (MAGI) limitation for Roth IRA conversions will vanish.  As a result, individuals who previously were ineligible will be able to convert assets held in Traditional or Rollover IRAs, or qualified retirement plans, to a Roth IRA, regardless of how much they earn.  Investors who expect their marginal tax rates in retirement to be higher than current rates may benefit by converting to a Roth IRA.

Planning Idea - High-income investors who do not qualify for Roth IRA contributions might benefit from making non-deductible contributions to a Traditional IRA and converting to a Roth IRA in 2010. The non-deductible contributions to an IRA will not be taxed as a result of the Roth conversion (income tax may be due if there are existing pre-tax IRA assets and earnings on the non-deductible contributions).

Alternative Minimum Tax (AMT)

If a taxpayer's income tax under AMT calculations is higher than their regular income tax liability, he/she must pay the AMT. AMT rates are generally lower than the marginal income tax brackets (AMT rates of 26% as 28%), but many deductions allowed in calculating the regular tax liability are not allowed for the AMT calculation.  The deductions not allowed under AMT are state and local income tax, property taxes, and some miscellaneous itemized deductions.

Planning Idea - Taxpayers should project whether they may be subject to AMT and time their income and deductions accordingly (e.g., if they are subject to AMT in the current year, they should delay paying estimated state income tax in the fourth quarter as the deduction is not allowed under the AMT calculation).  Taxpayers may also want to avoid certain municipal bonds that are subject to AMT (i.e., various "private activity" municipal bonds).

Tax planning is unique to each family and should be viewed in the light of an overall financial plan. Vetting each strategy with your wealth management team is advised.