Every year thousands of taxpayers overpay their income taxes because they use the standard deduction when itemizing deductions would be more advantageous. The causes are bad record keeping and simply not knowing or understanding the law. What follows is a basic review of what expenses qualify:

Taxes: State and local income taxes, real estate taxes, and personal property taxes are all deductible. Federal taxes, social security tax, and sales tax are not deductible.

Medical Expenses: You can deduct unreimbursed expenses for you, your spouse, and your dependents to the extent they exceed 7.5% of your adjusted gross income (AGI). This includes expenses for doctors, dentists, hospital care, prescriptions, nursing services, and medical aids. Also included are, insurance premiums, long term care premiums (within limits), and transportation and lodging.

Interest Expense: You can deduct interest paid on your primary residence and one second home. Also included are, first and second mortgages up to $1 million and home equity loans up to $100,000. Points are generally deductible and points incurred to refinance are amortized over the term of the loan. Interest paid on money used to acquire investments are deductible within certain limits.

Contributions: Donations to qualified organizations are deductible to the extent you receive no benefit in return. The organizations include churches, schools, libraries, and qualified charities. You can make donations in cash, check, or credit card. You can also deduct the fair market value of property other than cash. You must keep detailed records for donations of property other than cash, moreover you need a receipt for cash donations of $250 or more. All organizations must be located within the USA.

Casualty and Theft Losses: Losses from a fire, theft, or disaster are deductible within certain limits.

Miscellaneous Deductions: Included are certain unreimbursed employee expenses, investment expenses, gambling losses, and tax planning and tax preparation fees. Most of these expenses are subject to a 2% AGI floor.

To benefit the most, an awareness of the deductions that apply to you and good records are very important. If you have questions, please contact us.

In General: Defer income and accelerate deductions, harvest tax losses, maximize retirement plan contributions, avoid tax underpayments through withholding and estimated payments, and consider your exposure to the alternative minimum tax.

Car Donations: If you itemize your deductions you can donate a car (see previously featured article) to a qualified charity and deduct the fair market value of the car. Beginning in 2005, if you donate a car valued at more than $500 and the charity sells the car, you may only claim a deduction for the amount the charity receives, not the amount that you determine to be the fair market value.

Sales Tax Deduction: As a result of new tax legislation for 2004 and 2005, if you itemize your deductions, you can deduct the greater of either your state and local income taxes or your state and local sales taxes, but not both. This change will primarily benefit people in states with no state and local income taxes. Although, this change may even be advantageous for people who live in a low tax state or for people who have purchased big ticket items.

Year-End Donations: If you are planning a year-end donation to your favorite charity, consider giving shares of publicly traded stock or mutual fund shares that have substantially increased in value over the years. Provided you have owned the shares more than one year on the date of the donation, you can deduct the fair market value and not have to recognize capital gain on the increase in value on your Form 1040. Also, if you are considering donating cash but will not have the money until next year, charge your gift to a credit card this year. As a result, your donation is deductible this year even though you do not pay your credit card debt until next year.

Here is a three-step process that will enable you to review your overall tax situation during the last few months of this year so you can minimize any potential threat of underpayment penalties that may arise.

Tax Tips #1: Avoiding underpayment penalties

You can be assessed for underpayment penalties if your total tax due is $1,000. or more when you file your tax return. However, there are ‘safe-harbors” that protect you against penalties even if the tax you owe is $1,000. or more:

• If your withholdings and estimated payments are at least 90% of the current year’s tax liability, you will not be subject to any penalties, provided you pay the difference by April 15 of the subsequent year.
• If your withholdings and estimated payments are at least equal to last year’s tax liability you will not be subject to any penalties, with one exception: If your adjusted gross income is in excess of $150,000., you must pay 112% of the prior year’s tax liability in order to qualify for the “safe harbor.” This “safe-harbor” can be very advantageous for people who are experiencing a dramatic increase in income from the prior year. Even if your tax liability is two to three times greater in the current year you will be protected from penalties. You must pay the remaining tax you owe by April 15 of the subsequent year. In essence, you are receiving a short-term interest free loan from the federal government.

Tax Tips #2: It pays to plan

Individuals and business owners are not always aware that as the year progresses, they are accumulating a significant tax liability. If you are incurring a tax liability not subject to withholding throughout the year, you must make quarterly estimated payments to avoid the penalties. For calendar year taxpayers, the quarterly payments are due on April 15, June 15, September 15, and January 15 of the subsequent year. Business owners who are incorporated face similar rules. For calendar year corporations, the payments are due on April 15, June 15, September 15, and December 15. For fiscal year corporations, the payments are due on the 15th day of the fourth month, sixth month, ninth month, and twelfth month.

Tax Tips #3: Use the withholding rules to your advantage

You can compensate for earlier underpayments during the current year by adjusting your withholdings for the last few months of the year. The IRS considers withheld payroll taxes as being paid equally throughout the year, in spite of when actually withheld. In the case where your additional withholdings occur during the last few months of the year, bringing your total withholdings within the “safe-harbor” provisions, you will be able to avoid the underpayment penalties.

Market conditions are compelling investors to reassess their investment strategies. Investors again value investments that emphasize capital preservation. Fortunately, there are viable alternatives when seeking safety. Because safety means lower returns, you must maintain a strict policy of minimizing investment costs. Investments with a higher degree of safety can be found in bonds and annuities. The following discussion is not intended to recommend one investment over another, but to highlight the necessity to fully analyze any investment from an integrated tax, risk, return, and cost perspective.

Debt-Based Products

Bonds can offer a higher degree of principal protection than equity securities, but they are not as readily tradable. Due to liquidity factors, obtaining reasonable pricing requires considerable effort on an investor’s part. However, this effort is well rewarded because a bond’s fixed return component means that higher fees have a significant negative impact on returns. Options range from actively “pricing out” a bond issue, buying an initial bond issuance, or purchasing a low-cost bond fund. Bonds typically have a lower return potential than equities due to enhanced safety, although one can purchase junk bonds for higher returns, but with greater risk.

Treasury Securities

Treasury securities are backed by the full faith and credit of the U.S. government. They are considered the safest investment available. The major drawback is that yields on these securities have fallen to historic lows. The prior budget surplus has reduced the offering of these securities, but they still can be purchased directly from the U.S. government (www.treasurydirect.gov/). Directly purchasing from the government is a distinct advantage in that you can obtain a market-based price without having to negotiate with a third party on pricing and/or to incur trading commissions. The Treasury now only issues notes that mature in 10 years or less (the 30-year bond is no longer issued). Treasury interest is free from state income taxation.

Treasury Inflation Protected Securities

Treasury inflation protected securities (TIPS) are a relatively new investment option whereby an investor is protected against inflation. These bonds pay a lower fixed rate, but the principal value is adjusted upward to offset inflation (based on the Consumer Price Index). In the current low interest rate environment, this feature is highly appealing if interest rates start to increase. A major drawback is that the principal adjustment is taxable as credited, but not paid until maturity. The use of a tax-deferred or tax-free account (such as a Roth IRA) would make this tax problem irrelevant.

Agency Securities

Agency securities are debt instruments issued by a governmental entity that is part of the U.S. government. Because they are typically not backed by the full faith and credit of the U.S. government (only indirectly backed), they generally pay a slightly higher rate of interest than Treasury securities.

Ginnie Maes

Ginnie Maes securities represent pools of mortgages that are backed by the full faith and credit of the U.S. government. You can purchase a Ginnie Mae directly ($25,000 minimum), but the use of a low-cost Ginnie Mae mutual fund is probably a better approach. Funds can offer greater diversification in underlying pools and professional management. The major risk is that principal is typically paid back when interest rates fall, and therefore, Ginnie Maes would tend to lose value.

Municipal Bonds

Municipal bonds have the tax advantage that their interest payments are free from the regular federal tax. However, the alternative minimum tax (AMT) can be applicable if they are “private activity bonds issued after August 7, 1986.” The AMT is affecting more taxpayers with the imposed 2001 scheduled tax rate decreases. Private activity bonds tend to offer higher yields due to this distinct tax disadvantage. Another disadvantage is that state income taxation of municipal bond interest occurs if it is not issued from the state in which the taxpayer resides. The interplay of the federal regular income tax, alternative minimum tax and state income taxation necessitates a high degree of tax planning to maximize after-tax returns.

Corporate Bonds

Corporate bonds generally offer the highest yields but without the safety level of government-backed bonds. Additionally, they are taxable on the federal and state levels. You can obtain corporate bond pricing data from the National Association of Securities Dealers, Inc. (NASD) for approximately “500 investment-grade corporate bonds” at www.nasdbondinfo.com/asp/home.asp. One alternative is to invest in preferred and convertible preferred shares instead of corporate bonds.

Other Debt-Based Products

Other debt-based products are bank-based certificates of deposits (CDs), saving accounts, money market accounts and savings bonds. Savings bonds (HH, EE or inflation indexed) in certain circumstances are ideal investment vehicles. For the highest yielding money market funds and bank accounts, you can find yields at www.imoneynet.com and www.bankrate.com. However, a higher yield, as always, can indicate additional risks. A bank investment has the advantage of being federally insured up to $100,000. Money market funds are not insured, and losses, while infrequent, do occur.

Annuities

Annuities have income tax advantages, but they typically are loaded with excessive fees. A $50,000 annuity can generate brokerage fees of up to $4,000, which virtually negates the tax advantage. Proceeds in excess of the investment are taxable as ordinary income upon withdrawal. Also, amounts withdrawn before age 59 ½ are subject to a 10-percent early withdrawal penalty. Additional complicating factors are surrender fees and annual operating fees. It is essential that you seek independent assessment prior to purchase; we can assist you in this area.

Fixed Annuities

Fixed annuities offer a high degree of payout certainty (as long as the underlying company is financially viable). However, they are typically expensive to purchase, resulting in lower overall return potential. Web sites such as www.immediateannuity.com and www.brkdirect.com can be used to obtain competing rates of return. Caution is necessary in verifying an insurance company’s financial credit worthiness. Moody’s reported that American International Group, MetLife, Aegon and Prudential Financial each had over $1 billion in credit “exposure” from bond investments in Worldcom, Enron, Qwest, Williams, TYCO, Dynegy, Global Crossing, Adelphia Communications, Kmart and Xerox. In total, life insurers “held about $23 billion” in these companies, most of which were considered “financially stable” until recent events. State guaranty plans offer only limited protection.

Variable Annuities

Variable annuities are essentially mutual funds with tax deferral. They offer a limited insurance element to qualify under the tax law. There are low expense annuity options available, but “many variable annuities carry substantial fees, as high as 4% annually.”

Dividend Paying Stocks

Dividend paying stocks are now looking much more attractive. Companies, such as Disney, even converted from the standard quarterly distribution to an annual distribution. Dividend yields had dropped to one percent, but are now above two percent. Although, there is no guarantee that any company will pay dividends.

Real Estate Investment Trusts

Real estate investment trusts (REITs) speculate in real estate properties. They typically have a high dividend yield because, in order to qualify for favorable tax treatment, they must distribute 90 percent of their income back to the shareholders. REITs have had a remarkable performance in the current market conditions, but as history shows, the best performing asset classes do not maintain their status indefinitely. REITs can be equity or mortgage based or a combination of both. Mortgage-based REITs subject investors to additional credit risks and were often considered part of the prior problem with this asset class. REITS can be issued on a variety of rental properties.

Guarantee Funds

Guarantee funds are sold on their ability to guarantee investors at least the return of their initial investment (principal). The funds have high fee structures, are limited in the assets in which they can invest and typically offer a principal guarantee only after several years. As the market falls, they are forced to sell more of their equity holdings and place the proceeds into bond-based products. In essence, you obtain an expensive balanced fund (containing both debt and equity) that will move more towards bond-based funds when the markets fall. As the funds invest in more bonds, their yearly tax effect will increase, and therefore, they are not “tax friendly.” Sales charges over five percent are not uncommon, and these funds have an average annual expense ratio of 1.5 percent.

Tax-Integrated Investing

Besides offering an independent assessment of investment alternatives, we can assure that the tax impact of different investments is fully and correctly integrated in financial planning. Investors and/or their advisors all too often ignore the following:

1. Tax-exempt interest considerations

• How does the AMT affect the situation?
• Is interest on municipal bonds taxed at the state level?

2. Treasury securities

• Ability to defer income taxation to the next tax year
• Advantageous avoidance of state income taxation
• Ability to match maturity of a Treasury security with the tax obligation

3. Use of tax-deferred accounts to invest in unfriendly tax investments (interest paying, TIPS, etc.)

4. Utilization of the new capital gains rates of 18 percent and 8 percent

5. Proper use of tax losses

6. Consideration of transfer taxes and stepped-up basis issues

Conclusion

The current market downturn has forced investors to reassess their financial plans. Emphasis needs to be placed on investments with better return characteristics, as opposed to recommending a particular investment product. We believe that clients require unbiased information, not a sales pitch. Due to the fact that most brokers work on a commission basis, a direct conflict of interest exists between brokers and their clients. We can ensure that you are fully aware of the tax, risk, return, and cost factors of investing.

Faced with a turbulent stock market and an economy in flux, we are increasingly worried about our finances. And though investors admit to financial planners’ expertise, few consult one. So says a survey the AICPA commissioned to better understand how we manage our money.

Harris Interactive, an Internet-based market research firm, conducted the survey, “Report on America’s Financial Health,” for the AICPA. Almost all respondents (91%) said they manage their finances themselves, doing their own research, and obtaining advice from family, friends, the Internet, or a broker. The survey revealed that almost three out four respondents (71%) have been thinking more about their finances in the last three years. But only 20% thought they were very prepared for retirement. Others were uncertain about their financial future, 81% were not sure their investments were earning as much as possible and 57% were not certain they knew how to minimize their taxes through proper planning.

The survey also revealed that even individuals who felt confident about their money management skills may have been off the mark. More than half of those who believed they were maximizing savings and earnings felt this way because they had personally researched their mutual funds, understood how much investment risk they should take, had a short-term savings plan or owned real estate. But almost 90% of the respondents lost money in the last six years because of quick decisions they made about financial matters without talking to a planner.

Why didn’t more of the investors consult one? Most sought out professional advice in special situations rather than as a matter of overall strategy. For example, respondents said they would contact a financial planner if they inherited money, wanted to plan for retirement, needed estate planning advice, wanted to rollover 401(k) or IRA funds or were confused by changing tax laws.

Tips for Your Asset Allocation

There is no one-asset allocation formula suitable for all investors. You must evaluate your risk tolerance, time horizon, and rate of return requirements in order to determine how you should allocate your portfolio among the various investment categories. Consider the following:

• The idea behind asset allocation is that different investment categories are affected differently by economic events and market factors. Some asset classes move in opposite directions (negatively correlated) while others move in the same direction (positively correlated). By investing in different types of assets, it is hoped that when one asset declines in value, other assets will increase in value.
• Investments with higher return potential generally have higher risk and more volatility. While most investors want higher returns, they may be uncomfortable assuming higher risk levels. Asset allocation enables you to combine more aggressive investments with less aggressive ones. The combination can help reduce the overall risk in your portfolio.
• Not only should you diversify across broad investment categories, such as equities, bonds, and money market funds, you should also diversify within the category of equities. For instance consider large-capitalization stocks, small-capitalization stocks, value stocks, growth stocks, and international stocks.
• Determining your risk tolerance is one of the most important components of asset allocation. You are determining your emotional ability to stay with an investment when the returns are less than expected. The last two years should serve as a good framework for that assessment.
• The longer your time horizon, the more aggressive you portfolio can be. Those with a time horizon of less than five years should not be invested heavily in equities. Look at bonds and money market funds for your short term needs. As your time horizon increases, you should have a higher percentage of equities in your portfolio.
• Have reasonable return expectations. Basing your portfolio on a rate of return too high may cause you to increase the risk in your portfolio.
• Rebalance your portfolio at least annually, if warranted. With time, your asset allocation percentages will change from your desired percentage as a result of varying rates of return for your different investments.
• Be patient. The results of an investment program are best evaluated over a period of years, not days, weeks, or months.

1. Start now, not later.
2. Set reasonable savings goals, and then live below your means. Being frugal is the cornerstone of wealth management.
3. Know what to expect based on a long history of investor experiences. Look at average rates of return over long periods of time.
4. Manage your risk – it can’t be avoided. There are two types: Volatility – actual returns vary compared to expected returns. Inflation – relates to losses in purchasing power.
5. Diversify.
6. Maintain a long-term perspective – the market rewards the patient investor.
7. Do not attempt to time the market on what you or the experts expect the market to do.
8. Know what your costs are – avoid loads, commissions, and expensive investment advice.
9. Beware of the experts.
10. Defer taxes unless unavoidable. Pay later than sooner.