Tax Guide

E. Save Taxes by Shifting or Deferring Income

Shifting Income to Your Child - Children under the age of 18 in 2007 (under the age of 19 and full-time students under the age of 24 beginning in 2008) are subject to the so-called kiddie tax. This was enacted by Congress to restrict taxpayers from shifting large amounts of income to their children by taxing the child at the parent’s marginal tax rate. However, for children without earnings from working, there is no kiddie tax on the first $850 of investment income, and the next $850 is taxed at 10%. Once the child reaches age 14, all of their income is taxed at their own marginal rate. Once the child’s income reaches the point where it would be taxed at the parent’s rate, additional investments can be made through tax-deferred investment vehicles.

To avoid the negative effects of the Kiddie Tax, it has been a popular higher-education funding tax strategy for parents to transfer appreciated capital assets, such as stock, to a child to be sold after the child was out from under the Kiddie Tax rules at the age of 18. This strategy looked to be especially attractive for years 2008 through 2010 when the tax rate for long-term capital gains (and qualified dividends) drops to zero for taxpayers in the 15% or lower marginal rate. Parents of unmarried children age 18 to 23 who are full-time students expected that the children would also be able to enjoy the lower capital gains rates. However, Congress has essentially closed this loophole by subjecting children through age 18 and full-time students age 19 to 23 to the Kiddie Tax rules beginning in 2008. Another change to the rules may prevent some of these older children from falling into the Kiddie Tax trap; if the child’s earned income exceeds one-half of the child’s support, the Kiddie Tax rules won’t apply.

Because of these impending changes, a parent may want to reconsider any planned transfers of income-generating stocks, bonds, and other investments to children age 18, or those age 19-23 who are full-time students. However, placing or moving a child's funds into tax deferred or tax free investments such as U.S. Savings Bonds, tax-deferred annuities, municipal bonds, growth stocks, etc. that produce little or no current taxable income, can help avoid the Kiddie Tax, at least in the years until the investments need to be sold or redeemed to pay for the education expenses.
Investing in U.S. Savings Bonds - Interest income from U.S. Savings Bonds may be deferred until the bonds are cashed in. Thus, one can defer income for the life of the bonds.
Investing in Deferred Annuities - Because the interest earned on a deferred annuity is tax-deferred, your earnings are not taxed until withdrawn. This also allows the investment to compound faster.
Employing Your Child - Payments that you make to your child under the age of 18, who works for you in your trade or business that is a sole proprietorship or partnership in which each partner is a parent of the child, are not subject to Social Security and Medicare taxes. As long as the pay is reasonable for the necessary services to the business provided by the child, you can deduct that pay as a business expense. Assuming the child has no other income, he or she will not have any tax on the first $5,350 of wages from you in 2007. Your child may also make deductible contributions to an IRA of the lesser of earned income or $4,000. These contributions can offset income, so your child could receive $9,350 in gross income by combining the IRA deduction with the standard deduction and pay no tax.

IRA Contributions - For 2007, an individual may contribute the lesser of his or her compensation or $4,000 to their IRA accounts. The spouse can do the same even if he or she does not work, provided the joint compensation is at least $8,000 for the year. For individuals age 50 and over, the annual limit is increased by $1,000. Contributions to a Traditional IRA cannot be made once the taxpayer reaches age 70-1/2. For purposes of determining IRA deduction limits, individuals who receive taxable alimony and separate maintenance payments may treat the alimony as compensation even if it is the only income they have. This allows alimony recipients to save for their retirement by making either Traditional or Roth IRA contributions. Traditional IRA contributions are deductible if the taxpayer and spouse (if married) do not actively participate in another qualified retirement plan or if their AGI is below income phase-out levels. For married taxpayers where one spouse is an active participant in a qualified plan and the other is not, the IRA deduction is phased out when AGI is between $150,000 and $160,000 for the one who is not an active participant.

2007 TRADITIONAL IRA PHASE OUT AGI
Phase Out	Single & Head of Household	Joint* & Surviving Spouse	Married Separate
Threshold	$52,000	$83,000	$0
Complete	$62,000	$103,000	$10,000

*When both spouses are active participants in qualified plans.

If you cannot deduct your IRA contribution or you simply wish to generate tax-free retirement funds, you can contribute to a Roth IRA instead of the Traditional IRA, provided the owner’s AGI is below the phase-out levels shown in the table below. Roth IRA distributions are tax-free after a five-year waiting period and the owner has reached age 59-1/2 or becomes disabled.

ROTH IRA PHASE OUT AGI
Phase Out	Single & Head of Household	Joint & Surviving Spouse	Married Separate
Threshold	$ 99,000	$156,000	$0
Complete	$114,000	$166,000	$10,000

An individual can convert all or any portion of his or her Traditional IRA to a Roth IRA, provided their AGI does not exceed $100,000 in the year of conversion. Since income tax must be paid on the conversion amount, it makes sense to convert if there are many years to go before the individual plans to withdraw the funds. This allows the IRA to accumulate tax-free earnings and appreciation. If an individual has one or more IRA accounts invested in stocks or mutual funds that have declined in value, this might be an opportune time to convert it to a Roth IRA. Another reason to convert to a Roth IRA is to pass on money to your heirs. Unlike a Regular IRA, there are no mandatory withdrawals for the Roth IRA owner, and the heirs will not be liable for income taxes when the Roth IRA is distributed to them.

Beginning in 2010, new legislation: (1) Eliminates the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs, and (2)Permits married taxpayers filing a separate return to convert amounts in a traditional IRA into a Roth IRA. Under prior law, married taxpayers who filed separate returns were restricted from making conversions.

Roth 2010 Rollover Strategies - Looking ahead, there are some interesting strategies a taxpayer can employ to convert nondeductible traditional IRA contributions to a Roth IRA, thereby funding the more favorable Roth IRA. Taxpayers who have employer plans and are restricted from making deductible traditional IRA contributions because of income level can make nondeductible traditional IRA contributions in the tax years leading up to 2010 and then convert those nondeductible traditional IRAs to Roth IRAs with virtually no tax since they were nondeductible. Only the earnings would be taxable. Taxpayers who are prohibited from making Roth IRA contributions because their income exceeds the limit may also benefit from this strategy. Using the same strategy, even a taxpayer who can make a deductible contribution can elect to make it nondeductible, providing the same result as above.
Self-Employed Retirement Plans - The maximum deduction for a self-employed individual’s contribution on their own behalf to a profit-sharing or SEP plan for 2007 is the lesser of 20% of net self-employment earnings (after the deduction for one-half of self-employment taxes) or $45,000. In addition, a self-employed individual who is age 50 or older can make an additional catch-up contribution of $5,000 for 2007. Self-employed individuals are also allowed a 401(k)-style elective deferral of the lesser of the annual maximum ($15,000 in 2007) or the net profit from the self-employed business less the profit-sharing or SEP contribution.