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End of the Year Financial Check-Up -- Beware of the “Phantom Income” Trap

January 01, 2005

It is amazing how quickly time passes.  Before we know it, we will be celebrating a new year. To add to our expanding list of "to do's" it is very important to review our  personal financial house, in preparation for the new year.

Many of us neglect to position our finances and to take advantage of strategies that will minimize our tax burden.

Here are some things you should be aware of when reviewing your financial house:

• If you plan on adding monies to a mutual fund, beware of the "Phantom Income". Many mutual funds, especially growth funds, accumulate their dividends or capital gains to be paid out in November or December. These accumulated monies are added to the share price and subsequently subtracted from it when paid. If you purchase your shares of the mutual fund at a price that includes those dividends and capital gains, that price becomes your cost basis. The very next day the fund could payout this income which reduces the value of your investment and to top it off, you now have to pay a tax on it. For example, suppose you purchase XYZ fund on December 15^th for $10.50/per share. On December 20^th it pays out a capital gain of $ .50 per share to you. The value of your investment is now worth $10.00. And to makes matters worse, you have to add the $ .50 as a capital gain distribution and pay a tax on it!
• Given that the last five years have been very challenging, many investors have realized losses they can carry forward. Perhaps your portfolio has capital gains that should be taken against those losses to offset the tax on the appreciated investment. Let's assume you have an appreciated investment that you want to continue to own. At the same time, you would like to minimize your tax liability by offsetting it with your tax loss carry forwards. What should you do? One strategy that can be used is to sell the appreciated asset and wait 31 days to buy it back. Now you have accomplished the goal of not paying taxes on the gain by using the loss carry forward and to establish a new higher cost basis. You must, though, wait 31 days before you repurchase that investment or the IRS will consider it a WASH SALE and will not allow you to offset your gain with the loss and establish a new higher cost basis.
• If you need to cash in an appreciated investment, another option to take into consideration is the possibility of liquidating half the position in the current tax year and the other half in January. This will allow you to pay one half of the tax liability by April 15, 2005 and postpone the remaining tax payment until April, 2006.
• If you need to lower the value of your estate, why not take advantage of the annual exclusion. Every US citizen is allowed to gift on an annual basis $11,000 per person. A husband and wife could gift a total of $22,000 to an individual by December 31, 2004, and in January another $22,000. This can be accomplished without affecting your Lifetime Unified Credit.
• Take advantage of maximizing your contributions to your company's retirement plans. Review your contributions to make sure they meet the new higher contribution limits. If you meet the income requirements, you may also make a tax deductible contribution to an IRA. Although not tax deductible at any income level, a ROTH contribution may make sense.

In addition, for individuals age 50 or older, additional "catch-up" contributions are available.

• If you are going to establish a retirement plan for your business, the deadline to establish most plans is 12/31. If you miss the deadline, you have until 4/15/05 to set up a SEP plan for the 2004 tax year.
• Last call for bonus depreciation. If you are a business owner and place new equipment in service by year end, you are entitled to deduct 50% of its cost. This so called bonus depreciation will not be allowed beyond 12/31/04.
• Review your 2003 business tax return. A new Internal Revenue Service regulation lets business owners only amend their 2003, 2004, and 2005 returns to increase the code section 179 write-off of equipment purchases which can include of-the-shelf software.
• The $160,000 cliff - the above the line deduction for college tuition is now available to joint filers with incomes as high as $160,000 and singles earning $80,000. Be aware, though, that one dollar of income above the threshold will entirely eliminate this deduction.
• Now you can deduct non-dependent parent's medical cost - Many middle age individuals are now caring for their elderly parents. A taxpayer can deduct medical expenses paid for someone who is not a dependent provided that the only reason that person cannot be claimed as a dependent is because their income for 2004 is greater than $3,100. Of course, the taxpayers medical expenses must be greater than 7.5% of AGI. If you are paying for your parent's medical expenses, make sure you pay the medical provider directly. This way you will avoid any gift tax issues.
• One trap most taxpayers are surprised to find themselves in is the "Alternative Minimum Tax". An in-depth look at this tax is beyond the scope of this article but in general it is a set of tax rules that apply when they produce a higher IRS bill than would the regular rules. If you itemize and earn $75,000 or more annually consider doing a multi-year tax projection beginning with 2004 to see if you owe or will owe the tax. Income or investments that will trigger this AMT tax should be avoided in those years. Be sure to consult with your tax adviser.

Very few taxpayers were affected by this tax but it no longer is so "alternative" anymore. It is estimated that 2.5 million to 3 million taxpayers will pay this tax for 2004. The figure is supposed to quadruple in 2005 if congress doesn't act.*

These are just a few items that can be used to your advantage. Please consult with your financial and tax advisor to review your specific situation and to advise you accordingly.

Have a happy and financially prosperous New Year.

* Financial Advisor, October 2004, pg 89

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