Tax-saving investments for 1998 - tax relief under non-Employee Retirement Income Security Act retirement plans - Personal Finance

Healthcare Financial Management, August, 1998 by William G. Kistner

Adjusted gross income (AGI), which is total income minus certain deductions, is used to determine one's eligibility for tax breaks, such as deductible IRAs or deductible medical expenses, and to calculate itemized-deduction and personal-exemption phaseouts for high-income taxpayers. Careful planning with respect to AGI can help taxpayers reduce their income tax liability.

Deferring some compensation through qualified and nonqualified (non-ERISA) retirement plans is an effective way to reduce current taxes while providing for one's financial future. Participating in a 401(k), 403(b), or 457 plan allows one to reduce AGI and accumulate retirement funds on a tax-favored basis. A Keogh, SEP-IRA, or SIMPLE plan can provide similar benefits to the self-employed.

In addition to qualified retirement plans, a nonqualified deferred-compensation arrangement between employer and employee may allow the employee to defer some current pay to a future year, typically after the employee has retired and is in a lower tax bracket. Under such an arrangement, the employer will pay the deferred amount plus interest or some other type of return on the amount deferred. Nonqualified plans have grown tremendously in popularity and availability in recent years due to the increased restrictions on qualified plans, especially for highly compensated individuals. The election to defer compensation generally has to be made before the period in which it will be earned, so elections made in 1998 usually would cover 1999 compensation. One may be able to defer a 1998 year-end bonus in 1998, however, if the election is made before the bonus has been earned.

Compensatory stock options, another valuable, tax-saving benefit, allow the stockholder to control the timing and amount of income recognition. There are two types of options, nonqualified stock options and incentive stock options. Both options give the holder the right to purchase shares at a fixed price within a stated period. Incentive stock options are given more favorable tax treatment under the Internal Revenue Code. By delaying the exercise (the purchase of the shares) as long as possible (ie, until just before expiration of the option period), one can defer taxation of the bargain element or "spread" (the difference between the option price and the fair market value of the stock) and take advantage of the growth in value without increasing current AGI.

Although exercising incentive stock options does not increase one's AGI for regular tax purposes, the incentive stock option spread is considered income for alternative minimum tax purposes. Thus, planning for incentive stock option exercises requires careful monitoring. As long as the stock acquired through the exercise of an incentive stock option is not sold within two years of the date of the option grant (the date the employer offers the option to the employee) or within 18 months of exercise, any gain realized on sale will be taxed at 20 percent (or 10 percent for individuals in the 15 percent tax bracket).

Individuals planning for future financial goals should consider emphasizing growth-oriented investments (eg, certain stocks and stock-owning mutual funds) that produce long-term capital gains, which are taxed more favorably than ordinary income. In general, owning stocks directly, rather than indirectly through mutual funds, gives the holder more control over the timing of capital gain (or loss) recognition in an investment portfolio.

Tax-free municipal bonds and/or bond funds may allow those in the 28 percent or higher tax brackets to increase after-tax return on the fixed-income portion of a portfolio. In addition, keeping higher yielding, taxable, fixed-income investments (eg, corporate bonds or bond funds) in tax-deferred accounts will defer taxation of investment returns until the funds are withdrawn.

Variable annuities offer yet another way to shelter investment income from current taxation. Retirement-plan distributions are treated as ordinary income. One should consider depleting nonretirement-plan assets before taking nonrequired distributions from retirement plans to cover living expenses or other expenditures, because capital gains are taxed more favorably than ordinary income. This approach is recommended even if one has to sell appreciated property to raise cash. In addition, one could sell assets that have depreciated in value to generate capital losses that could shelter current-year capital gains. Up to $3,000 of net capital losses can be used to offset ordinary income each year.

If a person with an AGI of more than $100,000 owns rental real estate that generates tax losses that cannot be used currently (ie, the losses are "suspended") due to passive-loss rules, there may be an opportunity to convert a portion of the loss into a current deduction. These losses probably are produced at least partly by the interest paid on a loan secured by the property. By using the proceeds of a home-equity loan or by borrowing more than the outstanding balance on a pending refinancing of a residence to pay off or pay down the loan on the rental property, one could convert annual rental losses to net rental income, thereby using up suspended losses. Such an arrangement would generate a current-interest deduction for the home-equity interest (limited to $100,000 of home-equity indebtedness). Alternatively, one could use "excess" cash that currently produces taxable investment income to pay off or pay down the rental loan, freeing up those suspended losses while reducing AGI. For those with either deductible or nondeductible traditional IRAs, using techniques to keep AGI at or below $100,000 can be very attractive, because certain limitation rules begin to take effect at this level of AGI.