Tax Tips
To Roth or not to Roth?
That’s a question that’s easier to answer, thanks to
last year’s Pension Protection Act (PPA). A Roth 401(k) —
which allows participants to make nondeductible
contributions but withdraw earnings tax-free — can be an
attractive option, especially for highly compensated
employees who are ineligible for Roth IRAs.
Although Roth 401(k) plans have been available since the
beginning of last year, employers have been slow to offer
them. Some were reluctant to incur the additional
administrative expense for a plan feature that was scheduled
to disappear after 2010. Others were concerned about adding
complexity to participants’ investment decisions, which
might raise liability concerns or cause participation rates
to decline.
PPA includes several changes that should ease these
concerns:
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It makes the Roth 401(k) option
permanent.
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It makes it easier for 401(k) plans
to boost participation with an automatic enrollment
feature, by overriding state laws that prohibit
automatic enrollment and providing a safe harbor for
employers who set up a default investment option that
meets certain requirements. Employers who fall within
the safe harbor will be protected against liability and
will be deemed to have satisfied nondiscrimination
rules.
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It allows 401(k) providers to offer
personalized investment advice to participants.
Life insurance’s potentially fatal flaw
Did you know that, if you own an insurance policy on your life, the proceeds
will be included in your estate and could be subject to federal estate taxes as
high as 45% (assuming that the estate tax isn’t repealed) and state taxes? The
best way to avoid this problem — and preserve more benefits for your family — is
never to own the policy in the first place. By setting up an irrevocable life
insurance trust (ILIT) to buy and own the insurance, the proceeds will bypass
your estate and go directly to your beneficiaries tax-free.
If you already own a life insurance policy, you can avoid estate taxes by
transferring it to an ILIT. But the sooner you do it, the better: If you die
within three years after transferring the policy, this strategy won’t work and
the proceeds will be drawn back into your estate.
Burden of proof
Claiming a deduction for small charitable contributions just got a little
harder. Previously, you could deduct cash you deposited in the church collection
plate or Salvation Army kettle as long as you kept a written log or other record
of your donations.
But starting this year, all monetary gifts — no matter how small — must be
substantiated by a canceled check, a bank or credit card statement, or a receipt
from the charity showing the organization’s name, amount and date of
contribution. As before, gifts of $250 or more require a written acknowledgment
from the nonprofit.
Flex appeal
If your business is looking for new ways to attract and retain employees,
consider offering a flexible spending account (FSA). It’s relatively simple and
inexpensive to set up and administer, and it provides tax benefits for your
workers and business.
Employees can use an FSA to reduce their taxable income by paying qualifying
medical and child-care expenses with pretax dollars. And your business benefits
because salary reductions used to fund FSAs are exempt from payroll taxes.
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Finding your comfort zone
Annuities can provide financial peace of mind
With life expectancies continuing to climb, you may be
concerned about whether your savings will last. If you’re
approaching retirement, an annuity may help you feel at ease
with your planning efforts.
With their modest rates of return, annuities are no
substitute for other retirement planning vehicles. But they
can make up for their lack of earning power with the peace
of mind that comes with a guaranteed income stream for life.
Also, unlike other “safe” investments, such as certificates
of deposit, annuities offer tax-deferred growth.
What’s an annuity?
An annuity is an investment contract with an insurance
company or financial institution. In exchange for a lump sum
or annual premiums, the provider makes periodic payments to
you for a specified term or for life. Payments can start
right away (an “immediate annuity”) or at a later date (a
“deferred annuity”).
The payment amount is based on several factors, including:
- The amount you invest,
- Your age and gender,
- The payout term, and
- Certain investment assumptions, such as current and
expected future interest rates.
Life annuities provide greater peace of mind than term
annuities. They’re sometimes described as the opposite of
life insurance: Life insurance protects you from dying “too
soon” and leaving your loved ones financially insecure,
while a life annuity protects you from living “too long” and
outlasting your savings.
Other options include annuity payments that continue over
the lives of both you and your spouse, or a life annuity
with guaranteed payments for a specified term. In other
words, you receive payments for life, but if you don’t
survive the term, the remaining payments go to your
beneficiary.
Keep in mind that there are several possible investment
structures. For more on the types, see the sidebar
“Annuities come in three flavors.”
How does it compare to other investments?
When you invest in an annuity, your earnings grow
tax-deferred. In other words, you don’t pay income taxes
until you receive a payment. A portion of each payment is
treated as interest income and a portion as tax-free return
of principal. Other tax-advantaged retirement vehicles —
such as IRAs and 401(k) plans — offer both tax-free growth
and current tax deductions.
Generally, you should max out these accounts before you
consider an annuity. Currently, the maximum contribution to
an IRA is $4,000 per year ($5,000 if you’re 50 or older).
For a 401(k) plan, you can contribute up to $15,500 in 2007
($20,500 if you’re 50 or older). (Note that other rules may
further limit your contributions.)
Also, annuities aren’t the best choice for long-term
accumulation of wealth. If retirement is years or decades
away, you’ll probably want to look at stocks, bonds, mutual
funds and other investments that can offer healthier returns
and — provided your investment horizon is long enough and
your portfolio is properly diversified — relatively low
risk. They also offer greater flexibility to withdraw or
reallocate the funds. Once you invest in an annuity, you’ll
be subject to surrender charges if you withdraw too much or
too early, and a 10% penalty tax on withdrawals before age
59½.
When should you consider it?
If you’re retired or getting close to doing so, an annuity
can be an excellent way to shield some of your assets from
market volatility. Fixed annuities won’t break any
performance records, but they guarantee a stream of income
that you can’t outlive. By ensuring a minimum level of
retirement income, an annuity can give you peace of mind and
a higher comfort level with your riskier investments.
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Energy-efficient buildings can provide insulation from
taxes
The Energy Policy Act of 2005 created more than $14 billion
in tax breaks to promote energy production and conservation
in the United States. One of these breaks is a tax deduction
of up to $1.80 per square foot for commercial building
owners or tenants who make their properties more energy
efficient.
The Tax Relief and Health Care Act of 2006 extended the
deduction through 2008. Property or improvements placed in
service between Jan. 1, 2006, and Dec. 31, 2008, qualify.
Generating tax savings
The energy-efficient commercial buildings (EECB) deduction
is available for buildings in the United States that are
covered by Standard 90.1-2001 of the American Society of
Heating, Refrigerating and Air-Conditioning Engineers (ASHRAE)
and the Illuminating Engineering Society of North America (IESNA).
This means most commercial buildings, including multifamily
residential structures of four or more stories above grade,
are eligible. Generally, the deduction goes to the person or
organization that bears the expense of construction (usually
the owner but, in some cases, a tenant).
To qualify for the EECB deduction, you must install
“energy-efficient commercial building property” — such as a
state-of-the-art lighting or HVAC system — in a new or
existing building. You’ll also need a certification from a
licensed engineer or contractor stating that these
improvements are part of a plan designed to reduce annual
energy and power costs by at least 50% in comparison to a
“reference building.” A reference building is a similar
building that is located in the same climate zone and meets
the minimum requirements of ASHRAE/IESNA Standard 90.1-2001.
In June 2006, the IRS published Notice 2006-52, which
provides interim guidance on the deduction until final
regulations come out. Among other things, the notice
prescribes guidelines regarding the content of the
certification and the certifier’s qualifications. It also
provides for a public list of approved software products for
calculating energy and power consumption and costs. You can
find the list on the U.S. Department of Energy’s Web site at
www.eere.energy.gov/buildings/tools_directory.
When measuring energy savings, you may consider reductions
in the cost of only heating, cooling, ventilation, water
heating and interior lighting. Reductions in other energy
costs — such as refrigeration, cooking, elevators and
certain manufacturing or business processes — are not taken
into account.
Conserving your energy
To achieve energy-savings targets, improvements must
otherwise be depreciable and must be installed as part of an
eligible building’s:
- Interior lighting system,
- Heating, cooling, ventilation and hot water systems,
or
- Building envelope (for example, insulation, exterior
windows and doors, and certain metal roofs).
The Energy Policy Act also authorizes a partial deduction
of up to $0.60 per square foot for improvements to any one
of these systems that meet energy-savings targets
established by the IRS. Notice 2006-52 allows the partial
deduction for improvements that reduce total energy use by
at least 16⅔% (one-third of the 50% target for the full
deduction).
In addition, the IRS Notice provides an alternative interim
target for interior lighting systems. Upgrades that reduce
lighting power by specified amounts and meet certain other
requirements entitle you to a partial deduction between
$0.30 and $0.60 per square foot.
Plugging in the numbers
The best reasons for making your building more energy
efficient are to protect the environment and reduce your
operating expenses. But the EECB deduction provides another
powerful incentive to make the investment.
To determine whether there are opportunities for
improvement, you’ll need to assess the energy performance of
an existing or planned building. The federal government’s
Energy Star program provides free tools you can use to make
an initial assessment. (See
www.energystar.gov/benchmark.) You’ll also want to
estimate the cost of retrofitting an existing building or
upgrading the design of a planned structure to meet the EECB
deduction’s energy-savings target.
Keep in mind that the deduction is limited to the actual
cost of EECB property, up to a cap of $1.80 per square foot
for the full deduction or $0.60 per square foot for the
partial deduction. Costs in excess of the cap are
depreciated over 39 years (27½ years for residential
buildings). Here’s an example:
Wayne owns a 50,000-square-foot office building. After
consulting with a lighting engineer, he learns that
installing a new interior lighting system can reduce his
annual energy costs by 17% in comparison to a reference
building. Wayne installs the new system in 2007, at a cost
of $40,000. He deducts $30,000 on his 2007 income tax return
(50,000 x $0.60), and depreciates the remaining $10,000 over
39 years.
Stepping on the gas
Currently, the EECB deduction is set to expire at the end of
this year. If you wish to take advantage of this incentive,
you’ll need to start planning for it right away. Check with
your tax advisor to monitor the status of final regulations
and proposals to extend the deduction.
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Be TRU to your beneficiaries
A total return unitrust can help avoid conflicts of
interest
Most estate plans rely on trusts to achieve a variety of tax
and nontax objectives. And though they’re very effective
estate planning tools, traditional trusts have one
significant drawback: They can create a conflict of interest
between your current beneficiaries, who receive the income
the trust generates, and your remainder beneficiaries, who
receive what’s left at the end of the trust term.
A total return unitrust (TRU) may help you avoid these
conflicts by aligning the interests of your current and
remainder beneficiaries.
Matters of trust
A typical trust pays out income — in the form of interest
and dividends — to its current beneficiaries. Naturally,
these beneficiaries prefer investments that maximize their
income, such as bonds. But this sort of short-term approach
neglects the interests of the remainder beneficiaries, who
would like to see the trust invest in assets that emphasize
long-term growth, such as stocks.
This conflict of interest not only creates tension between
beneficiaries, but also makes the trustee’s job difficult.
As fiduciaries, trustees have a duty to treat all
beneficiaries fairly and impartially. To avoid the
appearance of favoring one group over another, trustees
often adopt middle-of-the-road investment strategies that
yield middle-of-the-road returns.
For example, they might allocate trust assets equally
between stocks and bonds. A portfolio weighted too heavily
in bonds may have trouble keeping pace with inflation. As a
result, the inflation-adjusted value of the trust principal
and income payments may erode over time. A portfolio that
emphasizes equity investments is more likely to outperform
inflation in the long term, while enjoying more favorable
tax treatment of any capital gains and dividends.
TRU values
A carefully constructed TRU can resolve the conflict between
beneficiaries by providing current beneficiaries with income
while still investing for long-term growth. Rather than
receiving the income earned by the trust, the current
beneficiaries receive a fixed percentage of the trust’s
value, redetermined annually.
If it’s done right, everyone’s happy:
- The current beneficiaries enjoy a regular income
stream, regardless of the trust’s actual earnings.
- The trustee and your investment advisors have the
freedom to design an investment strategy that focuses on
maximizing after-tax returns and long-term growth, which
benefits the remainder beneficiaries.
An added benefit for current beneficiaries is that, as the
trust’s value grows, their payments steadily increase.
TRU plans
An effective TRU requires meticulous planning. To achieve
your objectives and satisfy all of your beneficiaries, your
advisors must carefully develop an investment portfolio to
outperform the payout rate over time. Only then can you meet
your current beneficiaries’ income needs without impeding
the trust’s long-term growth.
A potential drawback of a TRU is that payouts to current
beneficiaries may fluctuate with short-term swings in stock
values. One solution is to value the trust based on a
rolling three-year average.
TRU obstacles
In theory, a TRU is an innovative strategy that can solve a
thorny estate planning problem. But there may be some
obstacles to putting that theory into practice.
Consider the marital trust. Couples concerned about estate
taxes often employ a two-trust strategy to leverage their
estate tax exemptions (currently $2 million each) while
making the most of the unlimited marital deduction. Their
estate plan provides that, when one spouse dies, a “bypass
trust” is funded with assets equal to the then-applicable
estate tax exemption. The trust provides an income interest
to the surviving spouse, but the principal ultimately goes
to the couple’s children or other heirs, bypassing the
surviving spouse’s estate.
The remainder of the spouse’s estate goes into a marital
trust, which is designed to avoid estate taxes by qualifying
for the unlimited marital deduction. To qualify for the
deduction, the trust must, among other things, pay all of
its income to the surviving spouse, at least annually, for
life. But can a TRU satisfy this requirement? Until
recently, it wasn’t clear whether TRU payouts met the
federal tax definition of “income.”
Fortunately, IRS regulations now provide that marital trusts
(and other trusts required to distribute their “income”) can
be designed as TRUs — and existing trusts can be converted
into TRUs — without adverse tax consequences. But the
technique must be authorized by applicable state law, and
the payout to current beneficiaries must be between 3% and
5%.
The regulations also allow states to authorize “equitable
adjustment” provisions, which give trustees the power to
make impartial reallocations of income to principal or
principal to income in order to treat beneficiaries fairly.
Aiming TRU
Even if relationships between your beneficiaries are strong,
traditional trusts can create unnecessary tension and make
it difficult for your trustee to develop an effective
investment strategy.
A TRU can ease this pressure by eliminating conflicts and
aligning your beneficiaries’ interests. If you think that a
TRU would improve your estate plan, check with your advisors
to see if it is authorized in your state. If it isn’t, it
may still be possible to take advantage of this technique by
setting up a trust in, or moving an existing trust to,
another state.
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