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Tax Planning for Major Life Events

Most of life’s major financial decisions have tax ramifications.  As you encounter those events, keep these tax-planning tips in mind:

Marriage or divorce — Either event should prompt a thorough review of your tax situation.  In both cases, your tax filing status will change, which may have an impact on your tax-planning situation.  Your filing status is determined as of December 31, so if you are planning to get married or divorced around year-end, review the tax ramifications first.  Consider these specifics:

    Check income tax withholdings.  You may need to adjust your allowances for income tax withholding purposes or review any estimated taxes that are being paid.

    Review fringe benefits.  In the case of marriage, you will want to coordinate your fringe benefits with your spouse’s benefits.  In a divorce, you may have to find another source for fringe benefits you obtained from your spouse’s employer.

    Understand the tax ramifications of any divorce agreements.  Determine who will claim minor children as dependents on tax returns.  Determine whether any payments are classified as child support or alimony, which have significantly different tax ramifications.  Review how the division of property will affect your gain or loss when you sell the asset.

Birth of a child — Each exemption on your tax return reduces your taxable income by $3,500 in 2008, although high-income taxpayers may find these exemptions reduced.  Other tax items to review include:

    Plan for other tax benefits.  A $1,000 child tax credit is available every year until your child is age 17, but the credit is phased out at higher income levels.  You may also be eligible for a child care credit if you pay for child care so you can work.  Check at your place of employment to find out if child care reimbursement accounts are available, which allow you to pay child care expenses from pretax earnings.

    Start saving for college.  It’s never too early to start saving for college.  There are a variety of tax-advantaged ways to save for college, including section 529 plans and Coverdell education savings accounts.  Once your child starts college, be aware of other ways to reduce the cost of college, including the Hope and lifetime learning credits, the above-the-line education deduction, and interest deductions for qualified higher education loans.

    Consider annual gifts to your child.  In 2008, you can gift $12,000 ($24,000 if the gift is split with your spouse) to each child on a tax-free basis.  This amount increases annually for inflation in $1,000 increments.  This reduces your taxable estate, and you avoid paying taxes on any earnings on those assets.  Be aware, however, of the “kiddie tax,” which refers to the way children’s investment income is taxed.  In the past, it applied to children under age 14, but now applies to all children under age 19 and to students under age 24, effective for tax years beginning after May 25, 2007.  In 2008, the first $900 of investment income is tax free, the second $900 is taxed at the child’s marginal tax rate (typically 10%), and any remaining investment income is taxed at the parents’ marginal tax rate.  Once the child is age 18 or older (previously age 14 or older), all investment income is taxed at his/her marginal tax rate.  Thus, until your child turns age 18, you might want to select investments with lower tax burdens, such as municipal bonds.

    Think about individual retirement accounts (IRAs).  Once your child starts earning income, consider setting up an IRA for him/her.  If the child does not want to use his/her money for the IRA, you can gift the money to the child.

Purchasing or selling a home — The tax benefits of owning a home are significant.  Consider these tax aspects of home ownership:

    Mortgage interest and property taxes can be deducted on your tax return, reducing the cost of owning a home.  Mortgage interest is deductible on up to $1,000,000 of original debt incurred to purchase a principal residence.  Additionally, interest paid on up to $100,000 of home-equity debt is deductible on your tax return.  You may want to replace loans that generate personal interest, which is not tax deductible, with home-equity loan debt.

    When you sell your home, significant capital gains can be excluded from income.  You can exclude up to $250,000 of gain if you are a single taxpayer and up to $500,000 of gain if you are married filing jointly, provided the home was your primary residence in at least two of the preceding five years.  You no longer have to purchase another home to qualify for the exclusion.  If you are forced to sell in less than two years due to employment changes, health reasons, or unforeseen circumstances, you can prorate the exclusion amount based on how long you lived in the home.

Planning for retirement — With all the other demands on your income, it’s easy to forget about planning for retirement.  However, you should take advantage of tax-advantaged ways to save for your retirement.

    Participate in your 401(k) plan.  Start contributing to a 401(k) plan as soon as you are eligible.  In 2008, you can contribute a maximum of $15,500, plus individuals age 50 and older can make an additional catch-up contribution of $5,000, if permitted by their plan.  These contributions reduce your current-year taxable income, although you still have to pay Social Security and Medicare taxes on the contributions.  If your employer matches contributions, make sure to contribute at least enough to maximize the match.

    Review IRAs.  Even if you are contributing to a 401(k) plan, take a look at IRAs as well.  In 2008, you can contribute a maximum of $5,000 to an IRA, plus individuals age 50 and older can make an additional catch-up contribution of $1,000.  Traditional deductible IRAs will reduce your current-year taxable income.  Roth IRAs do not reduce current-year taxable income, but qualified distributions can be taken income-tax free.  For those who are not eligible for traditional or Roth IRAs, consider contributing to a nondeductible IRA.  Starting in 2010, all taxpayers, regardless of income level, can convert traditional IRAs to Roth IRAs.

    Check your options before retiring.  The choices you make regarding distributions from your pension plans and IRAs will have a significant impact on your tax situation after retirement.  Make sure you review all your options before deciding how to withdraw those funds.

Please call if you’d like to discuss tax-planning strategies in more detail.

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