GTT RESOURCES: STRATEGIES:
YEAR-END TAX PLANNING
See our Updated Trader
Tax Center pages.
We cover these topics in Green's
2012 Trader Tax Guide.
In the 2012 guide, we cover special strategies for 2011 and 2012 year-end
tax planning, especially considering that the Bush-era tax cuts are scheduled
to expire at year-end 2012.
Each year, we update our year-end tax planning strategies and write new
articles about it for our blog, magazines and newsletters we contribute
to. An edited version of the below articles are published on our blog,
in Active Trader, Forbes
blog, and Fidelity Active Trader e-Newsletter.
2010 year-end tax tips for this uncertain time. Click
here for blog article.
2009 year-end tax planning, part 1. Click
here for blog article.
2009 year-end tax planning, part 2. Click
here for blog article.
2009 year-end tax planning, part 3. Click
here for blog article.
Fidelity version of the 2009 articles. Tax
Tips for Traders. The 2010 version is published in late November or
early December 2010.
Prior Years: are still useful too.
An edited version of the below article was published in the November 2008
edition of Fidelity's Active Trader E-news (as it was for 2007). See lot's
of other articles in prior years below this article and they are still
helpful this year.
Read our blog
for Green's articles on expected tax law changes coming in 2009 from our
new President-elect Obama together with a Democratic-controlled Congress.
Plus, about how the IRS is getting tougher on trader tax status and MTM
ordinary loss treatment.
- If Obama and Congress agree on tax rate increases on upper-income
taxpayers for 2009 and later years, it may be a wise 2008 year-end tax
strategy to take more income into 2008, instead of 2009. Securities
traders can sell short-term, and long-term profitable positions in 2008
(for a 15 percent long-term gains tax rate, versus a 20 percent rate
maybe coming in 2009). Plus, give themselves a better chance to qualify
for middle-class tax benefits coming in 2009.
- Try not to trigger AMT tax in 2008, because if AMT is repealed in
2009, you will lose a chance to get back an AMT credit (your AMT taxes
back). If your income is high enough, you usually fall out of the AMT
zone; since so much income is taxed at 35 percent versus the AMT rate
of 28 percent.
- If you are a "close call" on trader tax status in 2008,
and are counting on that business status to file for a large tax refund
in 2008 - and possibly in the past two years too with a NOL carryback
return - consider a change of course.
For example, you can soak up your 2008 ordinary trading losses (from
IRC 475 MTM on securities, or IRC 988 on forex) by converting from a
traditional retirement plan to a Roth IRA. Rather than ask the IRS for
a large tax refund, which can trigger an exam in this difficult environment,
wind up being a small taxpayer for 2008. You can then trade your Roth
IRA aggressively for permanent tax savings.
Alternatively, plan to carry forward your NOL rather than carry it back.
Fulltime traders with a strong case for trader tax status and use of
ordinary loss treatment should file for their NOL carryback refunds
and hopefully all states will honor them.
- Futures traders should think twice about joining a futures or options
exchange, because their trading gains are subject to self-employment
taxes (social security and Medicare) per Section 1402i. Obama campaigned
on resubjecting earned incomes over $250,000 to 12.4 percent social
security tax. The Medicare 2.9 percent tax already applies to all earned
income without limits. We believe that Electronic Corporate Memberships
on the CME are not full fledged memberships and they don't trigger the
- Republicans proposed raising the capital loss limitation to $20,000
from the paltry $3,000 limit used for almost half a century; and it's
never been indexed for inflation. Hopefully, Democrats will consider
this tax change too, as it will help the entire investor-class.
Section: See our third-party content provider for plain vanilla
strategies. "Year End Tax Savings Ideas for Individuals" and
"Year End Tax Savings Ideas for Businesses" (Nov. 2008 Newsletters).
As pointed out above and below, some upper-income taxpayers may want to
reverse normal year-end tax strategies; with a goal of accelerating income,
deferring deductions and avoiding AMT more than ever before.
Update of annual year-end tax planning article geared to traders:
Year-end tax planning can be more challenging for traders than other taxpayers.
Traders have widely fluctuating incomes and there are complex rules for
wash sales, capital-loss restrictions, trader tax status and more. Plus,
this year there are several proposed tax changes to consider, particularly
the potential repeal of the Alternative Minimum Tax.
By Robert A. Green, CPA
Most year-end tax planning articles in the mainstream media focus on tried-and-true
strategies – what I call “plain vanilla.”
This writer’s Web site also features plain vanilla year-end tax
planning at http://www.greencompany.com/Tools/Newsletters.shtml
(November, 2007 issue). An update of this article with appear in Fidelity's
same newsletter for November 2008, along with another article from Green
on Tips for Dealing with the IRS.
However, active traders should also focus on tax planning opportunities
unique to their industry; this is especially true of traders rising to
the level of business tax status.
Plain vanilla year-end tax planning strategies suggest that all taxpayers,
including active traders, should generally defer income and accelerate
expenses in order to reduce current-year taxable income and tax liabilities.
But the AMT (Alternative Minimum Tax) is becoming an increasingly big
problem, turning most tax planning logic upside-down. AMT is a huge concern
for 2008, since it is snagging more taxpayers this year and may be repealed
in 2009. Taxpayers should therefore make AMT planning job No. 1 in their
year-end tax planning.
Plain vanilla doesn’t cut it for active traders. Active traders
need better and more customized tax planning suggestions.
Here are a few nifty 2008 year-end tax planning tips for active traders.
First, though, a little more perspective on AMT.
AMT planning should dictate overall tax planning
If the Democratic-controlled Congress succeeds in repealing the AMT tax
(in 2009), most taxpayers should avoid paying any AMT taxes in 2008. Congress
is also proposing to raise tax rates on upper-income taxpayers by increasing
their top marginal tax rate to 44 percent from 35 percent. Paying for
AMT relief is the excuse for the tax hike.
See our blog for current articles on Obama's tax initiatives and the Democratic
tax initiatives in 2008 tax bills (not passed), like HR 3970 (Jan.
2008 blog article)
By accelerating income into 2008 and deferring AMT tax deductions into
2009, a taxpayer can save taxes in two ways. First, they can reduce AMT
taxes for 2008 (hopefully permanently), and second, they can subject more
income to 35-percent tax rates in 2008 rather than (possibly) 44-percent
tax rates in 2009.
For “married filing joint” incomes under $200,000, the regular
tax rates are 28 percent, which matches the AMT tax rate.
That means these taxpayers will surely trigger AMT and be disenfranchised
on many of their itemized deductions (state taxes, investment interest
and expenses, miscellaneous deductions, portion of municipal bond interest
and much more).
Futures and (electing) forex traders also trigger AMT way too easily.
With 60/40 tax treatment on IRC 1256 contracts (60 percent of profits
are taxed at the lower, long-term tax rate and 40 percent at the short-term
rate, regardless of how long the position has been held), their maximum
tax rate is 23 percent – far below the AMT rate.
Traders have unique opportunities and pitfalls
Again, the mainstream financial media often publicizes plain strategies
for investors. However, business traders should sometimes follow the reverse
For the past decade or more, it’s generally not been possible to
initiate offsetting positions to defer capital gains on one leg of a position
and take capital losses before year-end on the other leg.
In the 1980s, Congress enacted IRC 1256 mark-to-market accounting for
futures traders in order to prevent the above types of deferral abuse.
Congress and the IRS have also prevented this type of deferral abuse for
securities traders by enacting special rules for wash-sale loss deferrals,
straddle losses, constructive receipts, and selling positions against
Qualifying securities business traders often elect IRC 475 mark-to-market
(MTM) accounting (for ordinary loss treatment rather than restricted capital
losses), and this requires imputed sales for all open positions at year-end.
With MTM, a trader does not have to sell open positions for tax-loss selling
at year-end. Rather, they can simply mark their open positions to market
prices at year end.
Are wash sales always bad?
Wash-sale loss deferrals are generally a bad thing, since they increase
your capital gains income in the current year. Sometimes, though, wash
sales can be a good thing.
If a trader already has exceeded the $3,000 capital-loss limitation, it’s
better to have wash sales rather than excess capital-loss carryovers.
The qualifying business trader will probably want to elect IRC 475 MTM
in the following tax year, and their wash sales are converted to ordinary
tax losses in that following year. They are part of the IRC 481(a) adjustment,
which also includes year-end unrealized gains and losses (which are also
preferable to carryover realized capital losses).
Conversely, capital-loss carryovers can never be converted into ordinary
losses. A large capital-loss carryover may dissuade a trader from electing
IRC 475 MTM, since capital-loss carryovers can’t be applied against
MTM ordinary trading gains.
Business “trader tax status” unlocks significant
With trader tax status and MTM, a trader can unlock all sorts of tax breaks,
including business expenses, ordinary trading losses, NOL carry-back refunds,
and retirement-plan and health-insurance (AGI) deductions.
IRC 475 MTM exempts traders from the onerous wash-sale rules and capital-loss
Trader tax status converts restricted investment interest and expenses
(not deductible for AMT) into unrestricted business expenses (all deductible
If an active trader doesn’t qualify for trader tax status in 2008,
but expects to in 2009, they should consider deferring trading expenses
It's important to note that the IRS is beefing up it's attacks on business
traders, so it's wise to be more conservative on trader tax status qualification
determinations. Read our blog
article "IRS denies trader tax status and MTM."
A conservative strategy may be to capitalize 2008“startup”
expenses (IRC 195) and amortize those costs when they achieve trader tax
status in 2009. The first $5,000 of startup costs may be expensed in the
first business year, with the balance amortized on a straight-line basis
over 15 years.
Taxpayers need to establish a mini 401(k) plan (also called an individual
or solo 401[k]) or defined-benefit (DB) plan before year-end; otherwise
it’s too late to benefit. Full funding can wait until the extended
tax return due date. Roth IRAs and Mini Roth IRAs are also attractive
plans for traders.
Leading brokers (such as Fidelity) offer excellent retirement plan packages.
Mini 401(k) plans are among the best retirement plan types for traders.
Taxpayers can contribute the elective deferral maximum ($15,500 for 2008),
plus there is a 20-percent net profit-sharing plan included, too (for
a maximum contribution of $46,000). For taxpayers age 50 or older, there
is another $5,000 amount allowed under a "catch up" provision.
With a mini 401(k) plan, a taxpayer can enjoy maximum income tax savings
in exchange for self-employment (SE) tax costs. Structured in the right
manner, the active trader usually saves more in income taxes than they
pay in SE taxes.
A mini 401(k) plan requires an annual 5500 or 5500-EZ filing.
With a DB plan, higher income traders can contribute much higher amounts
than the limit on defined contribution or profit-sharing plans (including
the Mini 401[k] plan).
Note that trading gains are not earned income, unless a trader is a member
of an options or futures exchange. So, non-exchange traders often need
to form entities to create (financially engineer) earned income for retirement-plan
deductions, unless they have another source of earned income.
See 2008 contribution limits for various types of retirement plans on
our tools' tax
rates page, towards the bottom of the page.
Consult us on these strategies.
A Roth IRA conversion may be a good strategy
Because traders have fluctuating income from year-to-year, they may fall
under the Roth IRA income threshold in 2008 ($100,000 specially calculated
AGI limit). That can be a good time to do a Roth IRA conversion.
Pay taxes at 2008 tax rates on the conversion amounts, before tax rates
possibly go up in 2009 (for the two most upper-income marginal tax brackets),
and then trade the account (permanently) tax-free through retirement.
Permanently tax free means a taxpayer can take distributions in retirement
If you exceed the income thresholds, build up a regular retirement plan
and consider a special break currently on the books for 2010 only. The
Bush Tax Cuts relaxed the income threshold for all taxpayers in 2010 only
in connection with Roth IRA conversions.
Try to qualify for “middle-class tax breaks”
Almost every middle-class tax break including deductions and credits (such
as retirement, education, and child care) have preset phase ins-and phase-outs
based on varying levels of Adjusted Gross Income (AGI).
Democrats plan even more tax breaks for the middle class along these lines
for 2009; see the Obama middle-class tax benefits mentioned on our blog
and his own Web site.
Active traders can qualify for these breaks in some years and not in other
years (when they make their bigger gains). Only good tax planning and
preparation software can figure it all out in your favor and on time before
Our progressive tax code was historically based on progressive income
tax rates (graduated marginal tax rates), and now tax writers are using
complex specialized income formulas to control access to other tax breaks,
Prepare a proforma year-end tax return using 2008 tax software. If you
trigger AMT, try to figure a way to prevent it. Assess your trader tax
status and capital gains and losses year-to-date along with all unrealized
gains and losses on open positions. Develop the right strategy to reduce
capital gains and maximize the $3,000 capital-loss limitation, but don’t
exceed that limitation if possible. Develop the right tax strategy for
2009 to complement your 2008 tax planning and save even more in 2009.
It’s probably best to engage a trader tax expert for more help.
Year-End 2006: ( The 2007 year end article was modified
for 2008 above)
"Year-end tax planning may
be important for all taxpayers, but it's paramount for traders. Jobs with
steady income lead to steady tax planning, as only a few tax strategies
may apply each year. However, trading for a living is anything but steady,
and valuable tax planning is almost impossible to achieve without “crunching
the numbers” before year-end to evaluate every available tax break
and pitfall." Read this article
by Robert A. Green, CPA, on year-end tax planning for traders. It was
written for the 2005 year-end, but it still applies for the 2006 year-end,
as the tax code is basically the same this year-end.
The tax code is generally indexed for inflation and threshold amounts
change each tax year. For a full run down on all the changes for the 2006
and 2007 tax years, click here for a Client
Letter from a leading tax publisher.
Hedge funds should also do year-end tax planning in order to maximize
tax benefits for their investors and themselves. Click
here to learn more about special GreenTrader hedge fund tax strategies.
Click here for other good
year end tax planning articles by Robert A. Green, CPA. "Here are
some nifty tax tips to put in your holiday basket. Some require action
before year-end, such as tax-loss selling, converting capital losses into
ordinary losses, establishing mini 401(k) retirement plans and paying
some of your taxes on time. Otherwise, start in January to enjoy tax savings
for all of next year."
We also have some excellent newsletters on general year-end tax planning
for all taxpayers (not just traders) in our Tools
here for our newsletter archive. See November and December.
Retirement plan strategies:
Establish a mini 401(k) plan or defined benefit (DB) plan before year-end;
otherwise it’s too late to benefit. You just need to form the plan
with a few dollars and you can do the contribution up until the due date
of your tax return including the extension.
Mini 401k plans are among the best retirement plan types for traders.
For lower contribution amounts, nothing beats a mini 401(k) plan. You
can contribute the elective deferral maximum ($15,000 for 2006). Enjoy
maximum income tax savings for very low self-employment (SE) tax cost
with a net savings of thousands of dollars.
With a DB plan, higher income traders can contribute much higher amounts
than the limit on defined contribution or profit sharing plans (including
the Mini 401(k) plan).
here to learn more about the best retirement plans for traders and
our related services. You need to jump through some hoops, including the
formation of an entity. We can do it all fast and at a low cost before
year-end. Just don’t come calling on us just before the year end
holidays there won’t be sufficient time.
Feel free to post questions on our message
board, attend our
conference calls, e-mail us at email@example.com
or call us.
We are standing by ready to help you plan and save before year-end. Please
sign up for a consultation
with Robert A. Green, CPA/CEO or another CPA with GreenTraderTax. CPA.
Customer service will schedule you right away.
You also may want to sign up for annual tax
preparation and planning before year-end. If you have trader tax status
in the current year, our retainer is another year-end tax deduction. Otherwise,
you are welcome to sign up whenever you like.
One important year-end tax strategy is to pay 100% of your state income
taxes owed by December 31st, rather than Q4 estimated tax due date of
January 15th of the following year. If you satisfy the "safe harbor"
exception on estimated taxes, you can defer the balance of your taxes
owed until April 15th.
But watch out for the nasty AMT tax - that second tax regime that is catching
many middle class taxpayers this year. State income taxes are an AMT tax
preference; meaning they are not deductible for AMT. For clients who ask
for our help, we plan this all correctly before year-end.
Ready for a consultation
tax planning may be important for all taxpayers, but it's paramount for
traders. Jobs with a steady income can count on steady tax planning, as
only a few tax strategies may apply each year. However, trading for a
living is anything but steady, and valuable tax planning is almost impossible
to achieve without “crunching the numbers” before year-end
to evaluate every available tax break and pitfall.
An article by Robert A. Green, CPA
(Written for Active Trader magazine in 2005.
The tax code is generally indexed for inflation and threshold amounts
change each tax year. For a full run down on all the changes for the 2006
and 2007 tax years, click here for a Client
Letter from a leading tax publisher.)
U.S. and state income tax codes are much too complicated. For almost 100
years, dueling politicians have used a weapon of fiscal (tax) policy to
reward their constituents, encourage or discourage certain behaviors (tax
incentives and penalties), and spread the wealth (progressive rates and
now many formulas, too).
Many in Congress and the White House are pushing for significant tax
reform. For our take on tax reform, visit our GTT
Alliance for Traders and Tax Reform section, specifically Tax
Reform and Fair
Tax. The best laid tax plans need to be flexible, reactive, and visionary,
and we cover all these needs.
Back in the "old" days (the early 1990s), before powerful,
easy-to-use computers, most taxpayers and professionals prepared income
tax returns by hand, so the tax code writers were forced to keep things
fairly simple (relatively speaking, compared to today).
Now with the proliferation of computerized tax return preparation (e.g.,
TurboTax and others), tax code makers and writers have enjoyed unlimited
ability to monkey around with the tax code. Call it pork barrel politics
on steroids. Almost every new tax break is written with all sorts of income
phase-outs, which only a computer could figure out. In the past decade,
many taxpayers used computers for preparation and consultations only.
Now you need computer number crunching for year-end planning too!
Here are some examples:
AMT: There are now two tax calculations that apply to many millions
of taxpayers. The second tax calculation is the nasty and now infamous
Alternative Minimum Tax (AMT). AMT was conceived for a small group of
millionaires who abused tax-shelter schemes, but now AMT is sneaking up
on many unsuspecting taxpayers. It's a real shame to be surprised by AMT
with your tax return bill after year-end, when you can do several things
to avoid AMT before year-end. You can't blame your accountant (the messenger)
about AMT anymore; we are trying to educate you. Congress is promising
to fix AMT, but it might take several more years. Yes, tax reform may
repeal AMT, but when you look closely, it's AMT that is the one tax scheme
that is surviving. After all, repealing all itemized deductions is just
like AMT in the first place. Learn more about AMT tax planning in this
article from BNA. Our tax professionals can crunch your numbers, see
if you get snagged by AMT and try to figure out a way to limit the damage
(there are lots of options to consider).
Middle-class tax breaks: As another example, almost every middle-class
tax break including retirement savings, education-related payments and
savings, child care payments and savings, and more are phased in-and-out
based on varying levels of Adjusted Gross Income (AGI). Read the rules
in the BNA article above and your head will spin. Only good tax planning
and preparation software can figure it all out in your favor and on time
before year-end. Our progressive tax code was historically based on progressive
income tax rates (graduated marginal tax rates), and now tax writers are
using complex specialized income formulas to control access to other tax
breaks, too. Fine tune your year-end tax planning to get into the right
tax bracket with the right formula for maximum savings.
Here are some tax saving tips:
Upper-income: If you are an upper-income taxpayer on a steady
basis, you can safely assume that most middle class AGI-dependent tax
breaks won't apply to you. That's too bad, but there are some other powerful
savings opportunities. Focus on high-end tax planning strategies for wealthy
individuals such as using trusts, family planning, charitable contribution
plans, and defined benefit retirement plans.
Middle-class income: If your income is between $50,000 and $160,000,
you should consider every possible (AGI-dependent) tax break. Tax writers
want the middle class to save for retirement, education, children and
more, and know they need some help hence these breaks.
AMT taxes rarely snag very high income taxpayers (isn't that ironic)?
Note that commodities/futures traders have lower "60/40 split"
income tax rates (maximum blended rate is 23 percent), which is less than
the AMT tax rates (maximum rate of 28 percent), so they may be snagged
with AMT even with higher income.
If your income is between $160,000 and $600,000, and you live in a high-taxing
state, it's very likely AMT will snag you. So plan ahead! Why pay state
taxes in December in order to increase your regular income tax deductions
if you get snagged by AMT, which does not allow state tax deductions?
Lower income: If you have little to no income, tax planning
and savings may not be your main focus anyway and it's unlikely you need
to do year-end tax planning except if you are a trader! Then you
need to consider lots of tax-savings strategies including trader tax status,
wash sales, mark-to-market accounting (MTM), start-up expenses, net operating
losses, and more.
There are all sorts of special tax strategies for traders across the
income spectrum (high, middle, and low).
Defined benefit plans: If in 2005 you had another stellar year
and you are confident about the future being the same, consider a defined
benefit retirement plan for huge tax savings. An actuary may calculate
that you must contribute very large amounts to the plan over the next
several years, but this can save you a fortune in taxes. Plus, you can
trade the account for further tax deferral savings. DB plans must be established
before year-end and there is much customized paperwork. We need to start
Trading: Perhaps you can buy or sell certain trading and/or
investment positions before year-end to fall into the middle class tax
savings zone and unlock plenty of breaks. You need to know how close you
are to know what is possible. The educated tax consumer gets the most
breaks! We suggest you get GTT
TradeLog now to figure your gains and losses so we don't build a plan
on incorrect information. Click
here to read the other year-end tax planning articles by Robert Green.
Roth IRA conversions: If you are having a bad year in the markets,
consider the following special strategy: If your AGI is less than $100,000,
it might be an excellent time to convert your retirement savings accounts
(with tax deferral only) into a Roth IRA (for permanent tax deferral).
Also consider that traders can actively trade their Roth IRAs. Click
here to learn more about retirement plans and strategies for trading
the funds in those plans.
Business trader tax status: With trader tax status and mark-to-market
accounting, you unlock all sorts of business tax breaks. You escape the
onerous wash sale rules, capital loss limitations, and phased out itemized
and miscellaneous deductions. You also don't have to worry about AMT preferences.
Both winning and losing traders benefit. Winning traders get many ordinary
business deductions, and AGI deductions (also ordinary and above the line)
for retirement-plan contributions and health-insurance premiums. Losing
traders generate net operating losses (NOLs) that generate immediate tax
refunds from two-year carrybacks. It's win-win on all levels!
However, it's paramount to review trader tax status in advance of year-end.
See Robert Green's year-end tax
planning articles for traders below. There are several clever strategies
on converting capital losses into ordinary losses and much more. You won't
find that content anywhere else.
Why be surprised next April 15 to learn you don't have trader tax status?
It's wiser to assess your situation now (with Green's
help in a consultation if you like) and help yourself gain trader
tax status before year-end. If necessary, you can make a few changes,
such as trading more frequently.
Finally, like other small businesses taxpayers, business traders have
opportunities to manage their income and expenses. If you don't have MTM,
you can do tax-loss selling before year-end, and create or prevent wash
sales depending on your needs. It cuts both way, so read those trader
articles below from Green. The same applies to expenses; in some cases
you should accelerate them and in others defer them.
But again, there are so many scenarios that may apply, what seems to
be prudent may not be. You may be better off accelerating income and expenses
or deferring them, bunching deductions or not. Let us help you figure
it all out to your greatest tax advantage.
The moral of this story is that tax breaks are highly complex and vary
significantly by income level. The only way to tell for sure if you can
claim a tax break is with good tax software and actual numbers (or good
estimates). Almost all taxpayers prepare their tax returns with tax software
after year-end and good programs point out tax savings ideas for the future.
Why not cash in on good program tools for savings before year-end
when it counts the most?
Our firm uses the best tax software programs on the market (Lacerte and
BNA). Our CPA professionals can automatically input your 2004 tax information
(from your 2004 tax return files which we prepared already), then update
the information with 2005 actual numbers and/or estimates and then crunch
your numbers. Our software and professionals spot every possible savings
Here's the bottom line: There is no way you can get every tax benefit
you are entitled to without crunching the actual or estimated numbers
in an excellent year-end tax planning program. And with our top-flight
trader tax CPAs and attorneys, we can deliver the trader and general tax
savings you deserve. Yes, it would be fairer for tax savings to flow from
the spigot and for money to grow on trees, but it doesn't. You need to
engage an expert using the right tools to mine our current income tax
code. Vote for tax change tomorrow, but keep playing today's tax game
Remember, there are lots of good general tax content sites, publishers,
and services around and they are very helpful. But traders are a special
breed of taxpayer and we have built our practice researching, conceiving,
writing, and delivering on traders’ special tax needs. For almost
every tax break, there is a special twist or spin for traders. We bring
it all to the table.
Here is how we suggest you proceed before year-end:
Read all the tax planning content and articles on this page. .
Next, consider signing up for
tax planning and preparation or just a one-hour
consultation. We get you started with specific steps immediately by
We aim to please!
Tax Planning Strategies for Traders
Active Trader magazine. Click here.
SFO magazine. Click here.
Robert A. Green, CPA,
wrote the below article for the December 2003 issue of Active
(Written for Active Trader magazine in a prior year.
The tax code is generally indexed for inflation and threshold amounts
change each tax year. For a full run down on all the changes for the 2006
and 2007 tax years, click here for a Client
Letter from a leading tax publisher.)
Year-End Tax Planning Tips: Although the tax year isn't over yet, it's
never too early to begin your tax planning. Tax-loss selling, converting
capital losses into ordinary losses and establishing a mini 401(k) retirement
plan are just some of the things you can do to ease your tax burden before
the calendar turns.
Here is the original article submitted, before editing by the magazine.
Here are some nifty tax tips to put in your holiday basket. Some require
action before year-end, such as tax-loss selling, converting capital losses
into ordinary losses, establishing mini 401(k) retirement plans and paying
some of your taxes on time. Otherwise, start in January to enjoy tax savings
for all of next year.
By Robert A. Green, CPA
Investors and active traders have tax-savings opportunities at year-end.
Many investors sell losing positions towards the end of the year to lower
their capital gains income and capital gains taxes (known as “tax
Business traders with mark-to-market accounting
(MTM) report unrealized gains and losses at year-end, so it's not
necessary for them to exit their positions to gain tax savings. There
are plenty of things you can do just before year-end to improve your tax
situation, but it all depends on your tax status.
Investors and active traders use the default “cash method”
of accounting, which means they report realized gains and losses, and
not open positions (unrealized gains and losses), at year-end. Cash method
accounting also includes the dreaded wash-sale
and straddle-loss deferral rules. This means certain realized losses are
not allowed to be deducted on your current year’s tax return; instead,
they are carried over (deferred) to the following tax year, potentially
raising your tax bill for the current year.
The most dreaded part of cash method accounting is the onerous excess
capital-loss limitation rules. Congress allows taxpayers to deduct a maximum
loss of $3,000 per year, and the balance may be carried forward to future
tax years (commodities losses may also be carried back three tax
years, although they can only be applied against commodities gains).
Many business traders elected MTM (Internal Revenue Code 475) for securities
only (because MTM is not beneficial for commodities) and thereby get around
the dreaded aspects of “cash method” accounting. MTM business
traders are exempt from the onerous wash-sale and straddle-loss deferral
rules, and all losses are deductible as ordinary losses without any capital-loss
Many traders use the cash method for the current year and want to elect
MTM in the following year. This raises further complications and requires
Find your tax status and act accordingly
Your first order of business in late November or early December is to
determine what your tax status is for the current tax year. Did you rise
to the level of business status (trader
tax status) for the entire year, or a portion of the year? Will that
portion of the year include the year-end?
Did you elect MTM IRC 475 on time in the current tax year, or carry over
that election from the prior tax year? Existing taxpayers must elect MTM
by April 15 of the current tax year by attaching an election statement
to their prior year tax return or extension. New taxpayers don’t
have a prior tax return, so they can elect “internally” (in
their own books and records).
Some taxpayers miss the MTM election filing and later realize they qualify
as a “defacto”
husband/wife general partnership because they have joint trading accounts
and both worked as traders. Perhaps their defacto partnership made the
necessary “new taxpayer” internal election with a verbal resolution.
If you think you may qualify for a defacto partnership and need to use
MTM accounting to deduct large losses in the current year, consult with
a proven trader tax expert. For more information, see "I promise
to love, honor and save you tax money" in the July 2003 issue of
Active Trader. The article explains how husband-wife partnerships
require no formal agreement or paperwork, and they can save you a bundle
on your tax returns. You can also click
here to learn more.
If you elected MTM but don’t qualify for trader tax status at year-end,
you must use the cash method at year-end (and for any other portion of
the year you did not qualify for trader tax status). If you are a business
trader without MTM, you must use the cash method like any other investor.
You can still take advantage of many business tax breaks, some of which
require action before year-end.
”Cash method” accounting trading strategies to lower
your taxes at year-end
If you are an active trader but don’t qualify for business treatment
(trader tax status) or, if you do qualify but did not elect MTM
IRC 475 you must use the default “cash method” of accounting.
Here are some tips for lowering your taxes at year-end:
Manage your portfolio at year-end to defer unrealized capital gains and
realize capital losses, which lowers your capital gains and capital gains
Hold securities positions for 12 months to avoid short-term capital gains
(which are taxed at ordinary tax rates up to 35 percent) using hedges
in order to benefit from long-term capital gains (which are capped at
a 15-percent tax rate). The 2003 tax act lowered both rates, but it also
widened the difference, making this strategy more beneficial than in prior
Avoid wash-sale and straddle-loss deferrals by re-entering similar, rather
than identical, positions within 30 days.
Avoid purchasing mutual funds just after dividend declaration dates, which
usually occur around the end of the year. Price often drops after dividends.
Avoid capital-loss carryovers. Don’t exceed the $3,000 capital-loss
carryover. This creates “tax baggage” for business traders
When planning for capital-loss limitations and estimated taxes, anticipate
mutual fund capital-gain distributions.
Avoid investment-interest carryovers and investment-expense limitations.
Both require investment income for these deductions. Figure out your investment
income (portfolio income and capital gains).
Find out if your hedge fund or investment company Form K-1s will report
trading gains and losses using the cash or MTM methods of accounting (trader
tax status and this accounting election is on the entity level).
Consider allocating some of your “taxable portfolio” to tax-free
investments and tax-free retirement accounts (with tax-deductible or non-deductible
Consider shifting income to other family members. Children younger than
14 are subject to the “kiddie tax” rules, which allow lower
tax rates on the first $1,500 of “unearned” income (the excess
is taxed at the parents’ tax rates). Children 14 or older are not
eligible for the “kiddie tax” rules. Consider paying your
children wages to help in your trading business; you both are exempt from
payroll taxes and can benefit from the child’s lower tax bracket
Contribute appreciated securities to charity. You get a tax-deductible
contribution at the higher fair market value (FMV). You are exempt from
capital-gains taxes on the increase of FMV over purchase price. This is
wiser then paying capital-gains taxes and then contributing cash to the
Commodities and futures traders (with or without trader tax status) are
automatically subject to another type of mark-to-market accounting, IRC
Section 1256. They report “economic” gains and losses and
can’t manage their income with the above strategies. Commodities
losses can be carried back three tax years against commodities gains,
so plan accordingly.
If you are in low tax brackets in 2003 and expect to be in high tax brackets
for 2004, you may want to reverse some of these strategies.
There are lower 2003 Act tax rates on qualifying dividends and
long-term capital gains.
Arrange your investments to take advantage of the new lower tax rates
on “qualifying” dividends, paid by domestic and qualifying
foreign corporations. Pay careful attention to the detailed rules; most
traders won’t get these benefits, except on their “segregated”
“Dividends” from money market funds, life insurance policies,
real estate investment trusts (REITS – 90-percent portion) and some
mutual funds do not qualify. Many mutual funds invest in bonds, currencies
and other instruments that do not have qualifying corporate earnings and
The “holding period” for qualifying dividends is 60 of 120
days before the ex-dividend date, which will ruin this benefit for many
traders (those that don't hold positions that long).
The “effective date” for lower long-term capital-gains rates
is May 5, 2003.
Carefully plan to offset capital gains and losses to maximize post-May
5, 2003 long-term capital gains.
Shift investment income to children (with annual gift limits) to take
advantage of the two lowest tax brackets (5 percent) on long-term capital
Click here for more information
on the 2003 Tax Act changes.
MTM traders can’t manage income, but they have many other
tax-saving opportunities, including net operating losses (NOL).
Unlike traders who use the default cash method of accounting, MTM business
traders (and all commodities and futures traders) report both realized
and “unrealized” gains and losses at year-end.
MTM business traders may not defer capital gains on trading positions,
but can on “segregated” investment positions.
MTM business traders are not penalized with the onerous wash-sale and
straddle-loss deferral rules and capital-loss limitations; all realized
and unrealized trading losses are deducible in the current tax year in
full as ordinary losses (not capital losses).
MTM business traders can have negative taxable income and carry back “net
operating losses” (the business portion of trading expenses
and trading losses) two tax years (or five years for 2001 and 2002 only).
Carefully plan your NOLs in advance in order to receive immediate tax
refund relief for prior years in which you have taxable income taxed at
higher marginal rates. For example, if you have significant taxable income
in 2001 but losses in 2002, try to increase your 2003 NOL so you can carry
the NOL back to 2001. You won’t be able to carry back a 2004 NOL
for any benefit in 2002 and 2003, two losing years (since you have losses
in those carryback years). Instead, you can carry forward your 2004 NOL
to 2005 and beyond (up to 15 years).
Traders without MTM can still generate a NOL with their trading-business
MTM traders don’t need to worry about tax-loss selling. They can
take profits early and not worry about trying to defer capital gains.
They also don't have to worry about rushing to sell a losing position
to lock in the tax loss; it is already locked in with MTM.
Switching to MTM from cash method accounting is difficult if
you have tax baggage.
Business traders face complex issues when they consider switching to MTM
from the default cash method (capital gains and losses). The most important
issue concerns capital loss carryovers.
Capital loss carryovers are the main culprit for putting traders
out of business.
Not being able to deduct your trading losses because of capital-loss limitation
and wash-sale rules is sort of like paying full-service brokerage commissions.
It can accelerate your exit from a trading business.
It’s foolish to pay full-service brokerage commissions if you trade
on your own with an online or direct-access brokerage firm. It’s
also foolish to not get exempt from the capital-loss limitation rules
on securities if you are a business trader. All that is necessary is a
little free education about how and when to elect MTM. You can’t
tell a full service broker to give you a refund because you later learned
about better offerings, and you also can’t tell the IRS later on
to allow you to use MTM. The IRS is very strict about denying late MTM
Many traders skip the MTM election when they start their trading business
because they don’t know about it, get the wrong advice and/or make
the wrong decision about it. The latter is certainly the case if they
get stuck with capital loss carryovers.
You can carry back MTM losses for immediate tax refunds to replenish
your trading accounts rather than having carried-over "capital losses"
suspended to future years. Many traders never cash in on those capital-loss
carryovers after having to exit a trading business. They simply have no
or little money left to invest for capital gains.
These non-MTM traders fall into the following tax trap, because you can’t
have it both ways. If you have trading gains in the following year, you
want to keep the cash method to offset new trading capital gains with
capital loss carryovers. If you have trading losses, you want to have
MTM for ordinary loss treatment, as it's adding fuel to your fire to add
to your capital-loss carryovers.
If you have large trading losses by April 15, it’s probably safer
to elect MTM to insure ordinary loss treatment. Conversely, if you have
large trading gains, it may be OK to skip the MTM election and gamble
on having net trading gains for the year (and using your capital-loss
carryovers). If you have small gains or losses, your MTM election decision
is a gamble.
Consider electing MTM on securities only (not commodities) and utilizing
other ways to generate capital gains to use up your capital-loss carryovers.
Start trading commodities such as the E-Minis, which may be similar to
securities products you trade. E-Minis and other commodities will not
be subject to MTM treatment (unless you also elect MTM on commodities)
and will instead generate capital gains and losses. Your first set of
commodities gains will be tax-free because you will offset them with your
capital loss carryovers. Afterwards, you will benefit from the lower tax
rates on commodities. 60 percent is long-term capital gains (capped at
a 15-percent tax rates) and 40 percent is short-term capital gains (which
are taxed at up to 35 percent). That translates to a maximum blended rate
of 23 percent on commodities vs. a maximum rate of 35 percent on short-term
securities trading. Instead of trading the QQQQ, an exchange traded fund
(ETF) taxed as a “security,” trade the E-Mini, a similar market
risk instrument taxed as a “commodity.”
Traders have a large variety of new financial products to trade: ETFs,
E-Minis, single-stock futures, plenty of new indices, and options and
futures on almost everything. Learn how all these new products are taxed
– as securities or commodities – and consider that commodities
have lower tax rates. Click here.
Another way to use up capital-loss carryovers is to “segregate”
some securities as “investment positions,” not subject to
MTM. For starters, their capital gains are tax-free. And, if you hold
them for 12 months, the capital gains are taxed at the lower long-term
capital gains rates. If you believe the markets have turned the corner
from bear to bull, this may be a timely strategy.
Limit capital losses and then covert some into wash sales for ordinary
loss treatment next year.
The higher your capital-loss carryovers; the harder it is for you to make
the switch to MTM.
First, try to limit the amount of your capital-loss carryovers.
If you already reached the capital-loss limitation, sell profitable positions
and keep open losing positions. Hedge accordingly. Don’t sell any
additional losing positions. More losses won’t benefit your current
year’s taxes, and they will make your MTM election in the following
year a tougher decision to make.
If you do sell losing positions that generate a capital-loss carryover,
consider re-entering the position within 30 days to create a beneficial
wash-sale condition (in all other cases, wash sales are not beneficial).
If you elect MTM in the following year, wash-sale loss deferrals are better
than capital-loss carryovers because wash sales can be converted into
ordinary losses, whereas capital-loss carryovers may never be converted
into ordinary losses (and remain as your tax baggage).
Pay your bills early for additional tax savings, providing you
don’t trigger AMT taxes and AGI limitations.
All taxpayers should consider paying more bills early before year-end
to maximize current year tax deductions.
Taxpayers and most sole proprietor business traders use the cash method
of accounting rather than the accrual method of accounting. This is different
from the cash vs. MTM methods of accounting as they apply to trading gains
and losses. Cash accounting is when bills are paid; accrual accounting
is when expenses are incurred. Credit card purchases are cash items on
the date purchased, not when the credit card bill is paid.
Normal taxpayers and investors may want to consider “bunching”
their itemized deductions into the current year and then taking a standard
deduction in the following year. There is no sense coming up short on
the standard deduction every year and wasting some itemized deductions
such as charitable contributions.
Again, watch out for that dreaded Alternative Minimum Tax, because many
itemized deductions are not deductible for AMT (including investment interest,
all taxes and miscellaneous itemized deductions).
Calculate if your Adjusted Gross Income (AGI) will be significantly lower
in the following tax year. Many itemized deductions and other tax breaks
(see below) are limited by AGI levels. Medical expenses are deductible
in excess of 7.5 percent of your AGI. Miscellaneous itemized deductions,
including non-reimbursed employee business expenses, job-hunting expenses,
education expenses (except for business traders) and investment expenses
are only deductible in excess of 2 percent of AGI. You also need to beware
of casualty losses.
Business expenses are not added back for AMT tax calculations.
Business traders should lower their AGI to unlock “middle-class”
Business traders should accelerate expenses for two good reasons:
First, additional business expenses lower your taxable income, which lowers
your tax bill. If you have a net operating loss, additional expenses increase
your NOL and related NOL tax refunds. The sooner the better when it comes
to NOLs, as you can only go back two tax years.
Secondly, a business trader should know about many special tax breaks
which are based on AGI levels. These breaks are “phased out”
at different levels of AGI, hence their common name: “middle-class
Business traders often go from rags to riches and vice versa in any given
year. One year their AGI may be very high and most tax breaks are phased
out. In other years, they have low AGI and their window opens to put in
place many of these middle-class tax breaks.
For example, if your AGI is less than $100,000, you can convert a taxable
retirement plan into a Roth IRA, which can convert “timing”
tax-free build up into “permanent” tax-free build up (every
trader's dream scenario). See more details on this strategy below.
Here are some other tax breaks limited to certain AGI levels: IRA contributions,
Roth IRA conversions, education credits, Coverdell education savings accounts,
interest on student loans, exemptions for children, earned income credit,
real estate passive activity losses and social security income exclusions,
to name a few.
Read about them and the phase out amounts at www.irs.gov.
Business traders should buy more equipment before year-end for
their home office
If you have trading gains in excess of your trading-business expenses,
accelerate fixed asset purchases before year-end to maximize section 179
(100 percent) depreciation and home-office deductions. Both deductions
require income; otherwise you must carry them over to the following year.
Section 179 depreciation limits were raised to $100,000 for 2003 from
$24,000 in 2002. If you don’t have income, opt for accelerated “bonus”
Don’t shy away from home-office deductions. They are no longer a
red flag and they won’t interfere with your home-sale gain exclusion.
Deduct health-insurance premiums and retirement plans to lower
AGI deductions for sole proprietor businesses (Schedule C) include, but
are not limited to, retirement-plan deductions, health-insurance premiums
and 50 percent of self-employment taxes.
The problem for traders is that, unlike other sole proprietor businesses,
they may not take these AGI deductions unless they create some “earned
income.” Trading gains with or without MTM are not earned income.
Traders can form an entity for their trading business and have their entity
pay them, as owner/manager, a fee. This management fee is reported on
a second Schedule C, which is earned income subject to self-employment
taxes and which can drive a health-insurance premium deduction and contribution
to a tax-deductible retirement plan.
Alternatively, a trader can pay their spouse a fee for helping them manage
their trading business, with the requirement that the spouse not be an
owner of the trading business. A Schedule C owner may not pay his or herself
a fee or salary. If the husband and wife are both owners, then they cannot
file a Schedule C. Instead, they are a “defacto” general partnership
and must file a partnership tax return. A guaranteed payment can then
be declared in lieu of a fee to accomplish the same earned income result.
If you paid your spouse money during the year and he or she did help you
in your trading business, you may be able to structure this all at year-end
or early in the following year. Consult with a trader tax expert if you
have further questions. It can be well worth it. Click
here for more information on husband/wife general partnerships.
Paying fees to your children older than 14 also lowers your AGI.
Favorable Mini 401(k) retirement plans must be established before
Establish a Mini 401(k) retirement plan for you and/or your spouse before
year-end with nominal funds. The balance of your tax-deductible contribution
can be calculated and paid after year-end.
All “qualified” retirement plans must be established before
year-end, including 401(k) plans, Mini 401(k) plans, profit-sharing plans
and defined benefit plans.
Qualified plans must be fully funded for annual contributions by the due
date of your tax return, including extensions (up to Oct. 15 of the following
IRA and Roth IRA plans must be established and contributions must be made
by April 15 of the following year. SEP IRA plans, another type of profit-sharing
plan for business owners, may be both established and funded up until
the due date of your tax return, including extensions. If you miss the
Mini 401(k) plan setup before year end, use a SEP IRA instead.
Otherwise, Mini 401(k) plans are the most attractive for traders. You
need fee income rather than trading income to fund a retirement plan.
Therefore, owners/managers need a trading or investment entity such as
a general partnership, LLC or S-Corp to pay them a fee before year-end.
Recent tax law changes increased the annual profit-sharing contribution
limit from $25,000 in 2002 to $40,000 for 2003 and $41,000 for 2004.
here to learn more about retirement plans.
Roth IRAs are also attractive for traders.
Roth IRAs are especially attractive for traders. Their main tax features
are “permanent” tax-free savings on portfolio income, and
traders know how to maximize portfolio savings.
Roth IRA contributions (limited to $3,000 per year) are not tax deductible,
but the corresponding good news is that distributions in retirement are
Traditional IRA contributions (limited to $3,000 per year) are tax deductible
(up to certain AGI levels), but the corresponding bad news is that distributions
in retirement are taxable at the higher ordinary income tax rates (up
to 35 percent).
Roth IRAs provide for “permanent” tax savings on the portfolio
income buildup, whereas traditional IRAs (and qualified retirement plans)
only provide “temporary” tax savings. Traditional IRAs are
not attractive for traders. It might be a better idea to “buy and
hold” securities for the long term no tax is due until sale
of the securities and lower long-term capital gains tax rates (up to 15
A note of caution: If you operate a business (trading or otherwise) in
a retirement account, the IRS may classify it as a “prohibited transaction”
which makes you subject to penalties. Play it safe and only trade 25 percent
Note: All retirement plan contributions require “earned income.”
Get more bang for your buck with a Roth IRA conversion
Roth IRAs are great for traders, but many traders can’t get much
bang for their buck out of that puny $3,000 non-deductible contribution
per year (which you can make even if you have other retirement plans).
There is a better solution. You may “convert” an existing
retirement plan into a Roth IRA. The one caveat is that you must pay all
income taxes on the ordinary income portion of the conversion in the year
of conversion. The requirement is that your “modified AGI”
is less than $100,000 in the year of conversion, before the converted
income is added in.
The conversion rules are complex, so visit www.irs.gov
to learn more. You may only convert from an IRA to a Roth IRA, so
if you have a qualified retirement plan, do a Rollover IRA direct transfer
The IRS treats the Roth converted amount as ordinary income (an “early
withdrawal”), but you are exempt from the additional normal “early
withdrawal” excise tax penalties of 10 percent.
Not included in ordinary income are non-deductible contributions (and
certain employer matched contributions in 401(k) plans).
If your existing retirement plans have been battered by the recent bear
markets, it’s an ideal time to consider this conversion. You will
have lower conversion income taxed at ordinary rates and the recovery
of these assets will be tax-free.
So if you had a bad year in 2003, it can be worth your while to do this
conversion. Rather than carry back a NOL, which can cause an IRS exam
(which you don't want if you are a close call on trader tax status), do
a Roth conversion to use up your losses. Don’t just stop at zero
taxable income consider taking advantage of the lower tax brackets
with some positive taxable income.
You can stop wherever you like by only converting a portion of your retirement
plans to the Roth IRA.
Fringe Benefits Plans and Flexible Spending Accounts
If you are interested in opportunities to convert more of your non-deductible
family expenses into deductible business expenses, you should learn about
“fringe benefit" plans.
Most small businesses, including trading businesses, overlook fringe
benefit plans; many larger companies rely on fringe benefit plans to attract
and retain employees.
Fringe benefits, commonly known as “perks,” include: retirement
plans; health, life and disability insurance; education, dependent care
and adoption assistance; meals, lodging and parking; and many other types
Self-employed individuals (and pass-through entity owner/employees) who
want to benefit from fringe benefit plans can do so if their spouses work
for the business. By covering employees and spouses, they become entitled
to benefits by virtue of being the spouse of an employee.
Click here to learn more
about fringe benefit plans.
Choose the right entity early.
You still may have time before year-end to choose the right entity for
your trading business to provide the tax benefits you need (retirement
plans, health insurance premiums and fringe benefit plans among them).
If you want to use your entity for the following year, it’s beneficial
to form the entity just before year-end and to commence its operations
on Jan. 1 of the following year. It may take a few weeks to form the entity
and open the trading accounts. Starting in November or early December
If you commence your business operations after the start of the tax year,
you will have a more complex tax filing for the following year; with sole
proprietor operations for the first part of the year and the entity operations
for the balance of the tax year.
Traders prefer “pass-through” entities to avoid double taxation
in a C-Corp, on both the entity level (up to a 34-percent tax rate) and
again on the individual level (up to 15 percent, if there are qualifying
dividends). Pass-through entities have single taxation on only the individual
level (rates up to 35 percent).
Traders also prefer pass-through entities to utilize ordinary losses on
their individual tax returns. This allows them to offset other types of
income and get NOL carrybacks. Losses are often trapped in C-Corps for
many years to come.
here to learn more about entities for traders.
Plan your business start-up, suspension and exit well.
There are many important tax-planning issues to consider when you start
up your trading business, when you suspend it and when you exit it.
The key in all cases is to maximize your business expenses and to use
MTM accounting during the period of business activity (not before or after
Business expenses paid outside the period of business activity may be
“start-up expenses,”“investment expenses” (restricted
and limited) or non-deductible expenses.
Trading losses outside the period of business activity may not utilize
MTM accounting, meaning those capital losses will be subject to the capital-loss
limitation. If the business activity stops before year-end, the trader
must deal with the onerous wash-sale and straddle-loss deferral rules
at year-end. Before year-end, if you believe you are falling short of
qualification, try to increase your trading activity by trading tiny amounts
or taking very small risks. Commissions are low enough these days to make
this strategy worthwhile.
If you know you are exiting your trading business, make sure to pay all
your business expenses before you close your trading accounts (or slow
the activity to a point you no longer qualify).
If you use MTM, you can mark all open positions to market on the date
of exit and start with that market value for cash accounting going forward.
Play it safer and sell all open positions before you exit the trading
business. However, most traders don’t know they exited until after
If you exit your trading business and have an open section 481 adjustment,
you will have to report the remaining deferred income in the year of exit
(and it may trigger estimated taxes in the quarter you exit). It may pay
to try to continue to qualify through year-end to defer a 481 adjustment
one more year.
Click here to learn more about Section 481
If you stop trading for a while but plan to resume soon, you are in a
complex situation without much guidance from the IRS. It’s wise
to re-elect MTM in the following year in case the IRS considers you to
have exited and then re-entered a trading business. You should consult
with a proven trader tax expert.
In general, your costs for acquiring a capital asset, including the start
of a business, are added to the cost basis of your asset and not deducted
until the business is sold or closed.
There is a special rule for “start-up” expenses (IRC Section
195). Start-up expenses may be amortized (expensed) over not less than
60 months on a straight-line basis. Start-up expenses must meet three
requirements: expenses must be paid in connection with “investigating”
the creation of your trading business (easy for traders); they must be
a normal expense of the business (also easy for traders); and they must
not be interest, taxes, or research and development, each of which has
its own tax treatment.
Many traders spend considerable funds before entering a trading business.
They attend seminars, educational programs, buy computers and start using
trading tools for mock trading. Later, when they see success from simulated
trading, they open a brokerage account and start their actual trading
It’s wise to open your trading account early and trade very small
sums with very small risk before you pay for many business expenses.
Pay education expenses after you start trading
Education expenses are only deductible after you start your trading business,
with one exception. If you are already in a trading-related profession
or business, such as a stock broker, then it's deductible for "maintaining
and improving your job or business skills."
Education expenses may not be lumped in with start-up expenses. Investors
can't deduct education expenses, even after trading (because they don’t
have business status).
Education expenses for qualifying institutions (undergraduate or post-graduate
school) can be utilized for education credits. Trading schools are not
There may be room for interpretation. Aggressively considering trading
schools as a way to “investigate” a trading business and then
including these expenses as amortizable start-up expenses is a possible
Learn more about education expense benefits in our article on fringe benefit
plans. Click here.
Trading gains require timely tax payments to avoid penalties
Trading and investment income is subject to the estimated tax payment
This income is not part of an employee W-2; therefore there is no employer
to withhold your taxes. If you are late with estimated tax payments, consider
asking your employer to withhold additional amounts from your paycheck
at year-end. A tax loophole treats all W-2 tax withholding as being ratably
done throughout the tax year.
Estimated tax payment rules call for paying your tax obligations on a
quarterly basis. Read about these rules at www.irs.gov.
Read about the “safe harbor” rules, which provide for paying
a lower amount based on your prior year’s taxes.
Estimated tax payment rules are not a good match for trading businesses
and provide headaches for many traders who face the following problem:
They may make a fortune in the first quarter only to lose it all in the
later quarters. They then must wait until the following tax year to file
their tax returns and get these refunds back. One could argue, though,
that if you lost money in the later quarters, it was safer to leave some
capital with Uncle Sam rather than in your trading account.
Some traders consider the underestimated non-deductible tax penalty of
4 percent per annum an attractive “margin loan” rate. The
IRS changes the rate often, and the current rate is fairly low.
Even if you want to borrow from Uncle Sam as long as possible (until April
15, when you have to pay 90 percent of your taxes for the prior year or
be subject to additional penalties and interest), it’s a good idea
to pay some or all of your state taxes before year-end to maximize your
itemized deductions for additional tax savings.
Note: State taxes are not deductible for alternative minimum tax (AMT),
so there's no sense paying early if you don’t get a tax benefit.
Learn more about AMT taxes at www.irs.gov.
Click here to learn more about this tax
payment strategy below.
The tax code is very complex for all taxpayers. For traders it’s
even more complex, with myriad investment rules and complexities of trader
tax status. To make things even more difficult, the tax code has different
breaks for different income levels, and traders move quickly between these
levels. How can a trader keep one eye on the markets and another on mastering
the tax code? The answer is they can't, so they need a trader tax expert
to help. This once a year “general checkup” is most effective
just before the end of the year. We suggest you consider a consultation
with our firm or sign up for 2003
tax preparation and planning soon.
This article by Robert A. Green, CPA,
appeared in the February 2004 issue of SFO
magazine: What tax rate does your future hold? Securities and futures
exchanges are competing for your business with many new products. When
choosing which ones look most attractive, add taxation to the mix; it
could help reduce your tax rate by 12 percent.
Here is the original article submitted, before editing by the magazine.
(Written for the magazine in a prior year. The tax
code is generally indexed for inflation and threshold amounts change each
tax year. For a full run down on all the changes for the 2006 and 2007
tax years, click here for a Client Letter from
a leading tax publisher.)
Wise taxpayers should do their tax planning before year-end. Traders
have special circumstances that make year-end tax planning even more paramount.
Certain moves can save you a fortune come April 15.
By Robert A. Green, CPA
Self-employed business traders have more tax responsibilities than employees
(who have their taxes withheld and paid by their employers). For example,
self-employed persons must pay their own estimated income taxes (on a
quarterly basis) and they must file business tax returns (Schedule C for
individuals). These responsibilities can be burdensome.
The good news for self-employed persons is that with added responsibilities
come many opportunities for tax benefits. Self-employed persons also have
many options for different accounting treatment, and they control their
own tax destiny. However, much of that tax destiny expires at year-end,
meaning you must make certain moves before year-end to improve your tax
Traders are a special breed of self-employed persons. They have all the
same rules and opportunities that regular self-employed businesses have,
plus additional headaches or opportunities when it comes to dealing with
trader tax status, wash sales, straddle rules, constructive receipts,
mark-to-market (MTM) accounting and Section 481(a) adjustments.
For all these reasons, it is paramount that business traders deal with
these tax issues before year-end, come up with a good year-end tax planning
strategy and execute that strategy on time.
“Cash method” business traders (such as investors) in securities
are stuck with the onerous application of various tax-loss deferral rules
including: wash-sale and loss-deferral rules; year-end tax straddles and
constructive receipt transactions; and annual net capital-loss limitation
($3,000 per year for individuals, zero for C-corporations).
It is important to see ahead of time how these “capital-loss treatment”
limitation rules might affect your trading around the year-end period.
Many traders find it advantageous to make minor changes to their trading
programs to result in better results tax-wise.
MTM business traders are able to avoid the above “capital-loss treatment”
headaches. MTM traders report their “economic” trading gains
and losses (realized and unrealized gains and losses). MTM traders do
not have to sell securities at year-end for “tax selling,”
which can save them commissions. Wash sales and straddles rules are both
irrelevant, as MTM traders are specifically exempt from them.
MTM traders have ordinary gain or loss treatment on their trading positions
and cash method treatment on their “segregated” investment
positions. It is important to seek all this out before year-end to see
where you stand.
By planning ahead, a cash method securities trader planning to elect MTM
for the following tax year may convert unutilized “unrealized”
capital losses into ordinary tax losses for the following tax year (see
Like other self-employed taxpayers, business traders may accelerate business
deductions and estimated state income tax payments into the current tax
year. That can save you significant income taxes, even though it’s
just a “timing” benefit.
First, figure out your general gameplan before year-end.
A first step in year-end tax planning for a trader is to assess whether
or not the trader qualifies for trader tax status for all or part of the
current tax year.
If you do not qualify for trader tax status as of year-end, you may not
use mark-to-market accounting, even if you elected it on time or carried
over that accounting method from the prior tax year. In this case, though,
you may qualify for trader tax status for the earlier part of the tax
year and use MTM accounting (ordinary loss treatment) for that period
only. You will be stuck with the onerous “capital-loss treatment”
limitations at year-end.
Don’t wait until tax time in the following year to make this determination
of “trader tax status;” it may be too late if you want to
take advantage of year-end tax strategies.
If you don’t qualify for trader tax status at year-end, but plan
to qualify starting in January of the following year, don’t accelerate
your business expenses per the above tax strategy. You will be accelerating
“investment expenses,” which may not generate tax benefits.
It would be better to defer investment expenses and turn them into business
expenses in the following tax year.
Calculate your trading and investment gains and losses before
Traders need to have a good handle on their trade accounting well before
year-end if they want the opportunity to plan around wash sales, straddles,
constructive receipts and conversion to MTM in the following year.
It is also important to have separate accountings for trading gains and
losses vs. “segregated” investment gains and losses. MTM traders
use MTM for trading gains and losses, but they still must use cash method
accounting for “segregated” investment positions.
Segregation is supposed to be done “contemporaneously” on
the date you acquire a position. All positions in a trading account are
by default a trading position unless you label it an investment position
and then hold it accordingly for a certain period of time. The segregation
rules are complex and beyond the scope of this discussion.
Traders should have all these accounting components in place before they
embark on year-end tax planning.
Many brokerage firms have profit and loss reports available online. Take
caution that many of them have “unmatched trades” and/or they
do not account for wash sales, straddles, constructive receipts or MTM
if you are a MTM trader.
You can use a good trade accounting software program such as our “GTT
TradeLog” to import all your trades for the entire year. For
cash method traders, the program calculates wash sales, and makes the
Section 481 adjustment for the following tax year. For MTM traders, the
program calculates year-end MTM imputed sales using year-end prices downloaded
off the Internet.
Cash method traders have many tax opportunities and pitfalls at year-end.
Without proper tax planning, profitable and losing traders may be stuck
with “capital-loss treatment” limitations including wash sales,
straddle rules and constructive receipts. Losing traders are also limited
by the capital-loss limitation each year.
Wash-sale conditions exist when a trader re-enters a losing trade within
30 days or exiting the losing trade (i.e., closing the position). Straddle
rules and constructive receipt rules apply when a trader has an “offsetting
position” he or she takes a loss on one part of the position
but holds the offsetting gain position open at year-end. The IRS seeks
to prevent cash method traders from playing games by taking losses in
one year and deferring offsetting positions with gains into the next tax
year. This makes sense by design, but it is a nightmare for most traders
and they are not trying to play games with the IRS.
Wash sales, straddle rules and constructive receipts are beyond the scope
of this article. Click here for more
information on wash sales.
MTM method traders are exempt from “capital-loss limitation”
MTM business traders have it much easier at year-end than cash method
traders. MTM traders don’t have to worry about year-end “tax
selling” of trading positions. They are exempt from wash sales,
straddles and constructive receipt rules on their trading positions. They
are subject to these rules on their “segregated” investment
Cash method traders electing MTM for the next tax year have excellent
opportunities for tax benefits. The flip side is tax pitfalls.
Cash method traders first have a headache in dealing with the “capital-loss
limitation” rules at year end (discussed above).
If that cash method trader also wants to elect mark-to-market accounting
for the following tax year, their level of tax planning complexity raises
a notch. When a cash basis trader elects MTM for the following tax year
there are many new tax planning opportunities as well as pitfalls. All
of these must be factored into the general tax planning for capital-loss
When a cash method trader makes a change in accounting method to MTM,
they are required to make a Section 481(a) adjustment on the first date
of the year of change. With MTM, the trader starts the year with all prior-year
open positions valued on opening prices the first trading day of the year.
The trader ended the prior year without having to report “unrealized”
gains and losses on open positions at year-end. Therefore, the Section
481(a) adjustment is meant to account for this disconnect. The Section
481(a) adjustment equals the prior year-end “unrealized” gains
or losses on trading positions only (not segregated investment positions).
The gold in this article is a strategy to convert unutilized capital
losses into ordinary losses.
A cash method trader who already exceeds the capital-loss limitation should
not sell additional losing positions before year-end (in December); instead,
that trader should try to hold those losing positions open until January
(using indices to hedge risk if necessary).
The idea is that a carryover capital loss is not useful in the current
tax year and it may not be useful in the following tax year. By holding
the position open at year-end, the loss becomes a Section 481(a) adjustment,
which is a full ordinary loss deduction in the following tax year.
Negative Section 481(a) adjustments are reported in full in the year of
change. Positive Section 481(a) adjustments greater than $25,000 are prorated
over four years.
It may even make sense to convert large unrealized gain positions to MTM
trading positions in the next tax year (with a MTM election) and then
prorate those gains over four tax years.
Caution You are stuck with "built-in"
Please note that when a partner contributes an asset to a partnership
where the asset has a "built-in" capital loss in the hands of
the partner (i.e., the cost basis of the asset is more than the fair market
value at the date of the contribution to the partnership), the loss from
sale of the asset is still treated as a capital loss by the partnership
if the asset is sold within five years of the date it was contributed
to the partnership. This is true even if the partnership has trader status
and has properly elected MTM. Internal Revenue Code Section 724(c) specifically
prevents the conversion of “built-in” capital losses on security
transactions to ordinary losses by contributions from a cash basis trader/investor
to a trading entity that has properly elected MTM. This applies also to
a limited liability corporation (LLC), including a single-member LLC.
However, it does not apply to S-corporations
Joe Trader converts “unutilized” unrealized capital
losses from the current year into fully deductible ordinary losses in
the following year.
Joe Trader is a cash method (non-MTM) securities trader. On Dec. 1 of
the current tax year, Joe calculates current year-to-date net capital
losses in the amount of $25,000. On the same day, Joe also calculates
net “unrealized” trading losses on his open trading positions
in the amount of $50,000. As a cash method trader, he is limited to a
net capital loss deduction of $3,000 for the current tax year.
Joe plans to elect MTM for the following year, by April 15, so his following
year trading gains and losses will be “ordinary” and not “capital.”
Joe is happy to avoid the prospect of increasing his already unutilized
capital loss carryovers.
Joe does not have GTT TradeLog and he is not certain of his wash sales
and straddles. He figures he can skip this headache since he can’t
imagine that his deductible capital loss would end up being less than
his capital-loss limitation of $3,000.
Joe should know that a wash-sale or straddle-loss deferral may be better
tax-wise than a capital-loss carryover, because he is electing MTM for
the following year. In most cases, wash-sale and straddle-loss deferrals
become part of a Section 481(a) ordinary loss adjustment. However, a capital-loss
carryover can never be recovered as an ordinary loss. Joe should calculate
his proper wash-sale and straddle-loss deferrals to take advantage of
this tax benefit.
When thinking about his open positions in December, Joe figures his current
year-to-date capital losses already far surpass the $3,000 capital-loss
limitation, so why take more capital losses before year-end? They won’t
help lower his current year tax liability.
Joe further figures that capital-loss carryovers are harder to utilize
in the following year because he will be generating ordinary rather than
capital gains from trading, and he will have few segregated investment
positions to generate capital gains.
The smart move for Joe in December is to not sell his open positions and
instead try to hold them through year-end. If the market risk is too great,
Joe can hedge the open positions with indices.
By doing this, Joe will convert unutilized current year “unrealized”
capital-loss carryovers into a negative Section 481(a) adjustment that
is an ordinary loss in the following year.
Joe killed two birds with one stone. He lowered his capital-loss carryover
and he also increased his ordinary tax loss in the following year.
Joe can be even more clever by tax-loss selling before year-end on his
open unrealized gain positions. That will reduce his capital-loss carryover
and increase his Section 481(a) adjustments, respectively.
Note: If Joe had the reverse fact pattern and had unrealized capital
gains instead of unrealized capital losses, it would be imperative for
Joe to sell all those unrealized capital gains before year-end to offset
his $25,000 of realized capital losses to date.
Business traders accelerate following-year expenses to lower current-year
The cardinal rule of year-end tax planning is to accelerate business deductions
and losses into the current tax year and defer income and gains into the
following tax year.
The idea is to defer income taxes until the following tax years, thereby
benefiting from the use of this tax money during the current and following
tax year. These are referred to as “timing” rather than “permanent”
As a default method of accounting, business traders use the “cash
method” of accounting for both business expenses and trading gains
and losses. This means that business expenses are deductible when “paid”,
as opposed to when “incurred.”
Note: When a business trader elects MTM, it only changes how gains
and losses are treated, not how “cash basis” expenses are
For example, if a cash method business trader attends a seminar at year-end,
but pays the bill in January, it is a business expense for the following
A business trader may also elect to use the “accrual method”
of accounting, which means that expenses are deductible when incurred,
not when paid.
A business trader may also elect to use MTM accounting for their trading
gains and losses. This MTM election must be filed with the IRS by April
15 of the current tax year; otherwise the cash method of “capital
gains and losses” applies for the entire tax year. See below for
tax planning moves related to trading gains and losses.
Since trading gains and losses are treated separately from expenses and
business traders don’t have other forms of income, for most business
traders it may be better tax-wise to use the accrual method of accounting
for business expenses. This also may be more trouble accounting-wise.
For cash method business traders, the easiest way to accelerate deductions
is to pay all bills before year-end. Note, however, that a prepayment
of following-year expenses will not give rise to a current-year tax deduction.
Credit card charges are treated like payments of cash or check. It does
not matter when you pay the credit card bill. For example, if you charge
your credit card for a new computer on Dec. 31, that is a current-year
tax deduction under the cash method. It does not matter that the computer
is listed on your January credit card statement.
Maximize your 100-percent depreciation for the current tax year.
If you plan to upgrade your computers, equipment and/or furniture/fixtures
soon, why not do it before year-end rather than in early 2003?
Each tax year, a taxpayer is allowed IRC Section 179 depreciation (100
percent) up to the first $100,000 (increased from $24,000 for 2002) of
depreciable assets. Excess amounts are subject to the normal rules of
depreciation and amortization (over the useful life of the asset).
Figure out whether to pay the minimum or maximum state estimated
income taxes before year-end for a tax-savings deduction.
Self-employed taxpayers, like business traders, are responsible for paying
their own estimated income taxes during the current tax year. This is
more complex than it is for employees who have their federal and state
income tax withheld by their employers and reported on their W-2s.
For most traders, if they wait until April 15 of the following year (the
tax deadline) to pay their current year federal and state income taxes,
they will be subject to federal and state “underestimated tax penalties.”
The current federal rate is 4 percent.
In general, these rules work as follows: You may owe this penalty for
the current year if the total of your withholding and estimated tax payments
did not equal at least the smaller of 90 percent of your current year
tax liability, or 100 percent of your prior year tax liability (the “safe
harbor rule”). If your adjusted gross income (AGI) for the prior
year was more than $150,000 ($75,000 if your filing status is married
filing a separate return), substitute 110 percent for 100 percent above.
Some traders make a business decision to not pay estimated income tax
payments for their first three quarters in order to use that tax money
for additional trading capital. In the event they lose money in Q4 and
end the year with loses or lower gains, they can catch up with a Q4 estimated
If they have trading gains in Q4, they are willing to pay the underestimated
tax penalties for Q1, Q2 and Q3, charged on a quarterly basis. They consider
this another form of a margin loan at 4-percent rates.
The important tax planning question is whether to pay the minimum or maximum
state income tax payment by Dec. 31, or on the due date of Jan. 15 the
Assume a trader’s current-year taxable income is significantly higher
than their prior year's taxable income. Using the safe harbor rule, this
trader can pay a good portion of their current-year income taxes by April
15 of the following year, thereby paying less with Q4 estimated income
In many cases, it is tax beneficial for the above trader to pay their
entire current-year state tax due by Dec. 31 rather than the required
amount on Jan. 15 and the balance on April 15. A current-year itemized
deduction for state taxes will reduce the trader’s federal tax liability
at their highest federal marginal rates, up to 35 percent.
A note of caution about alternative minimum tax (AMT): Make sure the Q4
estimated income tax payment does not give rise to an AMT, since state
income taxes are not a deduction for AMT taxable income. Only pay enough
state taxes before year-end until AMT is triggered. Pay the rest in the
following year (some may be owed by Q4 Jan. 15 and the rest by April 15).
Another note of caution about forgoing estimated tax payments to increase
trading capital as long as possible: Many traders played this game for
tax year 1999 and lost what they owed by April 15, 2000. Many of them
are still in hot water with the IRS and state tax authorities. Every year
just before April 15, many traders must liquidate positions to raise capital
to pay taxes. Watch out for this annual musical chairs.
from a leading tax publisher:
2006 Year-End Tax Planning for Individuals
As 2006 draws to a close, there is still time to reduce your 2006 tax
bill and plan ahead for 2007. This letter highlights several potential
tax-saving opportunities for you to consider. I would be happy to meet
with you to discuss specific strategies.
Basic Numbers You Need To Know
Because many tax benefits are tied to or limited by adjusted gross income
(AGI)—IRA deductions, for example—a key aspect of tax planning
is to estimate both your 2006 and 2007 AGI. Also, when considering whether
to accelerate or defer income or deductions, you should be aware of the
impact this action may have on your AGI and your ability to maximize itemized
deductions that are tied to AGI. Your 2005 tax return and your 2006 pay
stubs and other income- and deduction-related materials are a good starting
point for estimating your AGI.
Another important number is your "tax bracket," i.e., the rate
at which your last dollar of income is taxed. The tax rates for 2006 are
10%, 15%, 25%, 28%, 33%, and 35%. Although tax brackets are indexed for
inflation, if your income increases faster than the inflation adjustment,
you may be pushed into a higher bracket. If so, your potential benefit
from any tax-saving opportunity is increased (as is the cost of overlooking
IRA, Retirement Savings Rules for 2006
More tax-saving opportunities continue for retirement planning in 2006
than in previous years due to the availability of Roth IRAs, changes that
make regular IRAs more attractive, and other retirement savings incentives.
As discussed herein, even more changes will begin in 2007.
Traditional IRAs: Individuals who are not active participants in an employer
pension plan may make deductible contributions to an IRA. The annual deductible
contribution limit for an IRA for 2006 is $4,000. Individuals who are
active participants in a plan may also make deductible contributions to
an IRA, but limited in amount depending on their AGI. For 2006, the AGI
phase-out range for deductibility of IRA contributions is between $50,000
and $60,000 of modified AGI for single persons (including heads of households),
and between $75,000 and $85,000 of modified AGI for married filing jointly.
Above these ranges, no deduction is allowed.
For 2006, a $1,000 "catch-up" contribution deduction is allowed
for taxpayers age 50 or older by the close of the taxable year who meet
the other qualifications for IRA deductions. Thus, the total deductible
limit for these individuals may be as high as $5,000.
In addition, an individual will not be considered an "active participant"
in an employer plan simply because the individual's spouse is an active
participant for part of a plan year. Thus, you may be able to take the
full deduction for an IRA contribution regardless of whether your spouse
is covered by a plan at work, subject to a phase-out if your joint modified
AGI is $150,000 to $160,000. Above this range, no deduction is allowed.
Roth IRA: This type of IRA permits nondeductible contributions of up
to $4,000 a year. Earnings grow tax-free, and distributions are tax-free
provided no distributions are made until more than five years after the
first contribution and the individual has reached age 591/2. Distributions
may be made earlier on account of the individual's disability or death.
The maximum contribution is phased out for persons with AGI above certain
amounts: $150,000 to $160,000 for joint filers, and $95,000 to $110,000
for single filers (including heads of households). For 2006, a $1,000
"catch-up" contribution is allowed for taxpayers age 50 or older
by the close of the taxable year, making the total limit $5,000 for these
Roth IRA Conversion Rule: Funds in a traditional IRA may be rolled over
into a Roth IRA. Such a rollover, however, is treated as a taxable event,
and you will pay tax on the amount converted. No penalties will apply
if all the requirements for such a transfer are satisfied.
A taxpayer's AGI (whether married filing jointly or single) is limited
to $100,000 to make such a conversion and the taxpayer must not be a married
individual filing a separate return.
401(k) Contribution: The 401(k) elective deferral limit is $15,000 for
2006, up from $14,000 in 2005. If your 401(k) plan has been amended to
allow for catch-up contributions for 2006 and you will be 50 years old
by December 31, 2006, you may contribute an additional $5,000 to your
401(k) account, for a total maximum contribution of $20,000 ($15,000 in
regular contributions plus $5,000 in catch-up contributions).
SIMPLE Plan Contribution: The SIMPLE plan deferral limit is $10,000 for
2006, the same as in 2005. If your SIMPLE plan has been amended to allow
for catch-up contributions for 2006 and you will be 50 years old by December
31, 2006, you may contribute an additional $2,500.
Catch-Up Contributions for Other Plans: If you will be 50 years old by
December 31, 2006, you may also contribute an additional $5,000 to your
403(b) plan or SEP.
Saver's Credit: A nonrefundable tax credit is available based on the
qualified retirement savings contributions to an employer plan made by
an eligible individual. Only taxpayers filing joint returns with AGI of
$50,000 or less, head of household returns with AGI of $37,500 or less,
or single returns (or separate returns filed by married taxpayers) with
AGI of $25,000 or less, are eligible for the credit. The amount of the
credit is equal to the applicable percentage (10% to 50%, based on filing
status and AGI) of qualified retirement savings contributions up to $2,000.
Maximize Retirement Savings: In many cases, employers will require you
to set your 2007 retirement contribution levels before January 2007. You
may want to increase your contribution to lower your AGI in order to take
advantage of some of the tax breaks described above. In addition, maximizing
your contribution is generally a good tax-saving move.
Hurricane Relief: The 10% penalty on early distributions from qualified
retirement plans does not apply to qualified hurricane distributions of
up to $100,000 from a qualified retirement plan, a §403(b) annuity,
or an IRA. A qualified hurricane distribution covers distributions taken
after Hurricanes Katrina, Rita and Wilma. A qualified Hurricane Katrina
distribution is any distribution from an eligible retirement plan made
on or after August 25, 2005, and before January 1, 2007, to an individual
whose principal place of abode on August 28, 2005, is located in the Hurricane
Katrina disaster area and who has sustained an economic loss by reason
of Hurricane Katrina. A qualified Hurricane Rita distribution is any distribution
from an eligible retirement plan made on or after September 23, 2005,
and before January 1, 2007, to an individual whose principal place of
abode on September 23, 2005, is located in the Hurricane Rita disaster
area and who has sustained an economic loss by reason of Hurricane Rita.
A qualified Hurricane Wilma distribution is any distribution from an eligible
retirement plan made on or after October 23, 2005, and before January
1, 2007, to an individual whose principal place of abode on October 23,
2005, is located in the Hurricane Wilma disaster area and who has sustained
an economic loss by reason of Hurricane Wilma. Distributions from someone
affected by multiple hurricanes cannot overlap. Withdrawals are ratably
included in income over a three-year period, unless the taxpayer elects
to include the amount in the current year. Withdrawals can be recontributed
to a qualified plan during such three-year period to avoid the withdrawal
being included in income. Any tax paid prior to the recontribution can
be recovered through refund procedures.
Pension Act Relief: Effective for distributions made after 2006, nonspouse
beneficiaries may roll over to an IRA or other plan structured for that
purpose amounts inherited as a designated beneficiary. The inherited amounts
are subject to the annual minimum distribution rules requiring distributions
over the person's life expectancy (recalculated annually). Also, for taxable
years beginning after 2006, the IRS must make available a form for a taxpayer
to file with the IRS directing the IRS to send a refund directly to the
taxpayer's IRA. In addition, indexing the adjusted gross income levels
for the saver's credit (also made permanent) and IRAs will begin in taxable
years after 2006. Effective for distributions made after September 11,
2001, a reservist (called up between September 11, 2001, and before December
31, 2007, for more than 179 days) is excepted from the 10% premature distribution
tax for distributions before age 59 1/2 to a reservist, and allows the
money to be repaid within two years after the end of active service. Effective
for distributions made after August 17, 2006, public safety officers can
avoid the early 10% distribution penalty for distributions based on separation
from service if the officer is at least 50. Individuals who worked for
a bankrupt employer whose officers were indicted and whose employer had
at least a 50% match in the form of employer stock in its §401(k)
plan can make an additional IRA catch-up contribution (three times the
otherwise applicable catch-up amount). The contributions can be made for
2007, 2008, and 2009. For tax years beginning after 2006, after-tax contributions
from qualified plans may be rolled over into defined benefit plans and
§403(b) tax-sheltered annuities. Prior to the 2006 Pension Act, after-tax
contributions only could be rolled over into defined contribution plans
Deferring Income to 2007
If you expect your AGI to be higher in 2006 than in 2007, or if you anticipate
being in the same or a higher tax bracket in 2006, you may benefit by
deferring income into 2007. Deferring income will be advantageous so long
as the deferral does not bump your income to the next bracket. Some ways
to defer income include:
Delay Billing: If you are self-employed, delay year-end billing to clients
so that payments will not be received until 2007.
Interest and Dividends: Interest income earned on Treasury securities
and bank certificates of deposit with maturities of one year or less is
not includible in income until received. To defer interest income, consider
buying short-term bonds or certificates that will not mature until next
year. If you have control as to when dividends are paid, arrange to have
them paid to you after the end of the year.
Accelerating Income Into 2006
In limited circumstances, you may benefit by accelerating income into
2006. For example, you may anticipate being in a higher tax bracket in
2007, or perhaps you will need additional income in order to take advantage
of an offsetting deduction or credit that will not be available to you
in future tax years. Note however that accelerating income into 2006 will
be disadvantageous if you expect to be in the same or lower tax bracket
for 2007. In any event, before you decide to implement this strategy,
we should "crunch the numbers."
If accelerating income will be beneficial, here are some ways to accomplish
Accelerate Collection of Accounts Receivable: If you are self-employed
and report income and expenses on a cash basis, issue bills and attempt
collection before the end of 2006. Also see if some of your clients or
customers might be willing to pay for January 2007 goods or services in
advance. Any income received using these steps will shift income from
2007 to 2006.
Year-End Bonuses: If your employer generally pays year-end bonuses after
the end of the current year, ask to have your bonus paid to you before
the beginning of 2007.
Retirement Plan Distributions: If you are over age 59 1/2 and you participate
in an employer retirement plan or have an IRA, consider making any taxable
withdrawals before 2007.
You may also want to consider making a Roth IRA rollover distribution,
as discussed above.
Special rules for taxpayers affected by the late 2005 hurricanes have
special distribution rules, even into 2006, discussed above.
Deduction timing is also an important element of year-end tax planning.
Deduction planning is complex, however, due to factors such as AGI levels
and filing status. If you are a cash-method taxpayer, remember to keep
the following in mind:
Deduction In Year Paid: An expense is only deductible in the year in
which it is actually paid.
Payment By Check: Date checks before the end of the year and mail them
before January 1, 2007.
Promise To Pay: A promise to pay or providing a note does not permit
you to deduct the expense. But you can take a deduction if you pay with
money borrowed from a third party. Hence, if you pay by credit card in
2006, you can take the deduction even though you won't pay your credit
card bill until 2007.
AGI Limits: The AGI limits on itemized deductions affect deduction planning.
Normally, overall itemized deductions are reduced by 3% of the AGI exceeding
$150,500 ($75,250 if married filing separately). However, for 2006, the
reduction is itself reduced to two-thirds of what it otherwise would be.
Similarly, certain deductions may be claimed only if they exceed a percentage
of AGI: 7.5% for medical expenses, 2% for miscellaneous itemized deductions,
and 10% for casualty losses.
Standard Deduction Planning: Deduction planning is also affected by the
standard deduction. For 2006 returns, the standard deduction is $10,300
for married taxpayers filing jointly, $5,150 for single taxpayers, $7,550
for heads of households, and $5,150 for married taxpayers filing separately.
If your itemized deductions are relatively constant and are close to the
standard deduction amount, you will obtain little or no benefit from itemizing
your deductions each year. But simply taking the standard deduction each
year means you lose the benefit of your itemized deductions. To maximize
the benefits of both the standard deduction and itemized deductions, consider
adjusting the timing of your deductible expenses so that they are higher
in one year and lower in the following year.
Medical Expenses: Medical expenses, including amounts paid as health
insurance premiums, are deductible only to the extent that they exceed
7.5% of AGI. Consider bunching medical expenses into years when your AGI
State Taxes: If you anticipate a state income tax liability for 2006
and plan to make an estimated payment, consider making the payment before
the end of 2006.
Charitable Contributions: Consider making your charitable contributions
at the end of the year. This will give you use of the money during the
year and simultaneously permit you to claim a deduction for that year.
You can use a credit card to charge donations in 2006 even though you
will not pay the bill until 2007. A mere pledge to make a donation is
not deductible, however, unless it is paid by the end of the year. Note,
however, for claimed donations of cars, boats and airplanes of more than
$500, the amount available as a deduction will significantly depend on
what the charity does with the donated property, not just the fair market
value of the donated property. If the organization sells the property
without any significant intervening use or material improvement to the
property, the amount of the charitable contribution deduction cannot exceed
the gross proceeds received from the sale.
To avoid capital gains, you may want to consider giving appreciated property
Hurricane Relief: Individual taxpayers may claim a $500 deduction against
taxable income for each "Hurricane Katrina displaced individual"
that the taxpayer houses for free in the taxpayer's principal residence
for a period of at least 60 days that ends in the taxable year. The deduction
is available in 2006. The aggregate total (including any amount claimed
in 2005) cannot exceed $2,000.
Pension Act Relief: Individuals can exclude from gross income qualified
charitable distributions of up to $100,000 from a traditional individual
retirement account (IRA) or a Roth IRA, made to a tax-exempt organization
to which deductible contributions can be made. A qualified charitable
distribution is any distribution from an IRA that is made in a taxable
year beginning after December 31, 2005, and before January 1, 2008, directly
by the IRA trustee to an organization described in §170(c). Direct
distributions are eligible for the exclusion only if made on or after
the date the IRA owner attains age 70 1/2. A distribution is treated as
a qualified charitable distribution only to the extent that the distribution
is includible in gross income. The exclusion does not apply to direct
distributions only if a charitable contribution deduction for the entire
distribution otherwise is allowable under §170. Effective for contributions
made after August 17, 2006, the following special rules are in effect:
(1) no deduction is allowed for charitable contributions of clothing and
household items if such items are not in good used condition or better;
(2) the IRS may deny a deduction for any item with minimal monetary value;
(3) these restrictions do not apply to the contribution of any single
clothing or household item for which a deduction of $500 or more is claimed
if the taxpayer includes a qualified appraisal with his or her return;
(4) in the case of a charitable contribution of money, regardless of the
amount, a deduction is denied, unless the donor maintained a cancelled
check, bank record, or receipt from the donee organization showing the
name of the donee organization, the date of the contribution, and the
amount of the contribution.
Self-Employed Health Insurance Premiums: Self-employed individuals are
allowed to claim 100% of the amount paid during the taxable year for insurance
that constitutes medical care for themselves, their spouses and dependents
as an above-the-line deduction, without regard to the 7.5% of AGI floor.
Equipment Purchases: If you are in business and purchase equipment, you
may make a "Section 179 Election," which allows you to expense
(i.e., currently deduct) otherwise depreciable business property. In general,
you may elect to expense up to $108,000 of equipment costs (with a phase-out
for purchases in excess of $430,000) if the asset was placed in service
during 2006. In addition, careful timing of equipment purchases can result
in favorable depreciation deductions in 2006. In general, under the "half-year
convention," you may deduct six months worth of depreciation for
equipment that is placed in service on or before the last day of the tax
year. (If more than 40% of the cost of all personal property placed in
service occurs during the last quarter of the year, however, a "mid-quarter
convention" applies, which lowers your depreciation deduction.) A
popular strategy in recent years is to purchase a vehicle (usually an
SUV) for business purposes that exceeds the depreciation limits set by
statute (i.e., a vehicle rated over 6,000 pounds). Doing so would not
subject the purchase to the statutory dollar limit, $2,960 for 2006; $3,260
in the case of vans and trucks. Therefore, the vehicle would qualify for
the full equipment expensing dollar amount. However, for SUVs (rated between
6,000 and 14,000 pounds gross vehicle weight) placed in service in 2006,
the expensing amount is limited to $25,000. Hurricane Relief: Taxpayers
can deduct the lesser of $100,000 or the cost of qualified Gulf Opportunity
Zone property, in addition to the existing $108,000 amount for 2006. In
general, the property must be originally used by the taxpayer on or after
August 28, 2005, and placed in service before January 1, 2007 (January
1, 2008, for nonresidential real property and residential rental property).
The phase-out amount is also increased by the lesser of $600,000 or the
costs of qualified Gulf Opportunity Zone property placed in service during
NOL Carryback Period: If your business suffers net operating losses in
2006, you may apply those losses against taxable income going back two
tax years. Thus, for example, the loss could be used to reduce taxable
income—and thus generate tax refunds—for tax years as far
back as 2004. Hurricane Relief: The NOL carryback period is five years
for any qualified Gulf Opportunity Zone loss.
Bonus Depreciation: Taxpayers meeting certain criteria can claim a 50%
bonus depreciation allowance for Gulf Opportunity Zone business property
that is placed in service before 2008 (before 2009, for nonresidential
real and residential rental property) and exempts such depreciation allowances
from the alternative minimum tax. The original use of the property in
the GO Zone must begin with the taxpayer on or after August 28, 2005.
Education and Child Tax Benefits
Child Tax Credit: A tax credit of $1,000 per qualifying child under the
age of 17 is available on this year's return. The credit is phased out
at a rate of $50 for each $1,000 (or fraction of $1,000) of modified AGI
exceeding the following amounts: $110,000 for married filing jointly;
$55,000 for married filing separately; and $75,000 for all other taxpayers.
A portion of the credit may be refundable.
Credit for Adoption Expenses: For 2006, the adoption credit limitation
is $10,960 of aggregate expenditures for each child, except that the credit
for an adoption of a child with special needs is deemed to be $10,960
regardless of the amount of expenses. The credit ratably phases out for
taxpayers whose income is between $164,410 and $204,410.
HOPE Credit and Lifetime Learning Credit: The maximum HOPE credit is
$1,650 (100% on the first $1,100, plus 50% of the next $1,100) for qualified
tuition and fees paid on behalf of a student (i.e., the taxpayer, the
taxpayer's spouse, or a dependent) who is enrolled on at least a half-time
basis. The credit is available for only the first two years of the student's
post-secondary education. Hurricane Relief: For individuals attending
qualified education institutions in the Gulf Opportunity Zone in a taxable
year beginning in 2006, the eligible expenditures qualifying is expanded
to include books, supplies and equipment. In addition, the $1,100 amounts
for 2006 are doubled.
The Lifetime Learning credit maximum in 2006 is $2,000 (20% of qualified
tuition and fees up to $10,000). A student need not be enrolled on at
least a half-time basis so long as he or she is taking post-secondary
classes to acquire or improve job skills. As with the HOPE credit, eligible
students include the taxpayer, the taxpayer's spouse, or a dependent.
Hurricane Relief: The Lifetime Learning credit percentage is increased
to 40% for individuals attending qualified education institutions in the
Gulf Opportunity Zone in a taxable year beginning in 2006.
For 2006, both the HOPE credit and the Lifetime Learning credit are phased
out at modified AGI levels between $90,000 and $110,000 for joint filers,
and between $45,000 and $55,000 for single taxpayers.
Coverdell Education Savings Account: Beginning in 2006, the aggregate
annual contribution limit to a Coverdell education savings account is
$2,000 per designated beneficiary of the account. This limit is phased
out for individual contributors with modified AGI between $95,000 and
$110,000 and joint filers with modified AGI between $190,000 and $220,000.
The contributions to the account are nondeductible but the earnings grow
Student Loan Interest: You may be eligible for an above-the-line deduction
for student loan interest paid on any "qualified education loan."
The maximum deduction is $2,500. The deduction for 2006 is phased out
at a modified AGI level between $105,000 and $135,000 for joint filers,
and between $50,000 and $65,000 for individual taxpayers.
Rules are in effect to coordinate education provisions, such as the qualified
higher education expense deduction, the Hope and Lifetime Learning credits,
Coverdell education savings accounts, and qualified tuition plans, to
prevent double benefits.
Alternative Motor Vehicle Credit: Available for the first time in 2006,
a credit is available for purchases of motor vehicles powered by certain
alternative fuels. A credit, the dollar amount depending on fuel savings
and weight of the vehicle, is available for vehicles placed in service
on or after January 1, 2006. The most popular vehicles subject to the
credit are hybrids. However, when a particular manufacturer sells in the
United States its 60,000th of the particular hybrid, a phaseout period
kicks in. The phaseout will reduce the credit from fully available to
nothing being available. The phaseout begins in the second calendar quarter
following the calendar quarter where the manufacturer sold its 60,000th
hybrid vehicle following December 31, 2005. Credits are also available
for lean-burn technology vehicles (subject to the same phaseout), qualified
fuel cell motor vehicles, and qualified alternative fuel motor vehicles.
Residential Energy Efficient Property Credit: Tax incentives are available
to taxpayers who install certain energy efficient property, such as photovoltaic,
solar water heating or fuel cell property. In 2006, a credit is available
for the expenditures incurred for such property up to a specific dollar
limitation. The property purchased cannot be used to heat swimming pools
or hot tubs. The credit is set to expire for property placed in service
Nonbusiness Energy Property Credit: Tax incentives are available to taxpayers
who remodel their home and/or incorporate specific energy efficient property.
Beginning in 2006, a credit is allowed for the purchase of qualified energy
efficiency improvements. Such property includes advanced main air circulating
fans, natural gas, propane, oil furnace or hot water boiler, windows,
insulation material, exterior doors, etc. that meet certain energy efficiency
standards. The credit is capped in dollar amounts per item of property.
The credit is set to expire for property placed in service after 2007.
Small Employer Pension Plan Startup Cost Credit: For 2006, certain small
business employers that did not have a pension plan for the preceding
three years may claim a nonrefundable income tax credit for expenses of
establishing and administering a new retirement plan for employees. The
credit applies to 50% of the first $1,000 in qualified administrative
and retirement-education expenses for each of the first three plan years.
Employer-Provided Child Care Credit: For 2006, employers may claim a
credit of up to $150,000 for supporting employee childcare or childcare
resource and referral services. The credit is allowed for a percentage
of "qualified child care expenditures" including for property
to be used as part of a qualified child care facility, for operating costs
of a qualified child care facility and for resource and referral expenditures.
The following rules apply for most capital assets in 2006:
• Capital gains on property held one year or less are taxed at
an individual's ordinary income tax rate.
• Capital gains on property held for more than one year are taxed
at a maximum rate of 15% (5% if an individual is in the 10% or 15% marginal
Timing of Sales: You may want to time the sale of assets so as to have
offsetting capital losses and gains. Capital losses may be fully deducted
against capital gains and also may offset up to $3,000 of ordinary income
($1,500 for married filing separately). In general, when you take losses,
you must first match your long-term losses against your long-term gains,
and short-term losses against short-term gains. If there are any remaining
losses, you may use them to offset any remaining long-term or short-term
gains, or up to $3,000 (or $1,500) of ordinary income. When and whether
to recognize such losses should be analyzed in light of the changes in
the capital gains rates applicable to your specific investments.
Dividends: Qualifying dividends received in 2006 are subject to rates
similar to the capital gains rates. Therefore, qualifying dividends are
taxed at a maximum rate of 15%. Qualifying dividends includes dividends
received from domestic and certain foreign corporations.
Depending on the recipient's modified AGI and the amount of Social Security
benefits, a percentage—up to 85%—of Social Security benefits
may be taxed. To reduce that percentage, it may be beneficial to defer
receipt of other retirement income. One way to do so is to elect to receive
a lump sum distribution from a retirement plan and to rollover that distribution
into an IRA. Alternatively, it may be beneficial to accelerate income
so as to reduce the percentage of your Social Security taxed in 2007 and
Other Tax Planning Opportunities
We also can discuss the potential benefits to you or your family members
of other planning options available for 2006, including §529 qualified
tuition programs, which were made permanent by legislation enacted in
Alternative Minimum Tax
In 2006, the alternative minimum tax exemption amounts are: (1) $62,550
for married individuals filing jointly and for surviving spouses; (2)
$42,500 for unmarried individuals other than surviving spouses; and (3)
$31,275 for married individuals filing a separate return. Also, nonrefundable
personal credits can offset an individual's regular and alternative minimum
Some of the standard year-end planning ideas will not reduce tax liability
if you are subject to the alternative minimum tax (AMT) because different
rules apply. Because of the complexity of the AMT, it would be wise for
us to analyze your AMT exposure.
If you have any questions, please do not hesitate to call. I would be
happy to meet with you at your convenience to discuss the strategies outlined
above. There is still time to implement these strategies to minimize your
2006 tax liability.
Very truly yours,