Wednesday, May 16, 2012

Effective tax planning requires forethought

Q: When I finished preparing my tax return for this year, I discovered I owed the government close to $10,000, which was far more than I thought I'd have to pay. How do I avoid future surprises like that?

A: Sometimes the situation you describe can't be helped. Maybe your practice had an especially good year or you earned a large one-time consulting fee. Even those of us who don't see payments like that face occasional tax surprises. Those surprises are maddening, but you can use a few tricks to keep them tolerable.

Effective tax planning is done in real time. It's done with a bit of research, good record-keeping, and deliberate decision-making. Most taxes are saved by not incurring them in the first place.

Retirement plans provide a good example. They come in a variety of shapes and sizes. Some are suited to sole proprietors, whereas others to partnerships or corporations. But most require some set-up and adoption before tax year-end. A bit of forethought sends dollars to retirement, not Uncle Sam.

The same principle holds true for charitable giving. In general, gifts given by December 31 count toward that year's tax. Because taxes usually aren't prepared until April (much of the required paperwork doesn't come until late January of after), it's difficult to measure tax effect without some late-in-the-year projections. Talk with your accountant each December to "mock up" that year's income obligations. Then you can make informed decisions about giving.

Remember these three steps: research, record-keeping, and deliberate decision-making. Useful tax-related information is available on the Web, or at the library or bookstore. If you don't want to do the research yourself, hire an adviser or ask your accountant. The point is, don't wait until your taxes are prepared or until they are due before acting.

Q: My wife died last year, leaving assets of less than $5 million. Must I file a federal estate tax return?

A: It is not required, but for your beneficiaries to enjoy the benefit of both your and your wife's exclusion at the time of your death through "portability," you are required to file a Form 706 (the federal estate tax return). This form generally is due 9 months after the death of a spouse. If your spouse died in the first half of 2011, however, the Internal Revenue Service has permitted retroactive extensions, giving you 15 months from the date of death to request an extension and to file Form 706.

Q: Because my children are the beneficiaries of my estate, does it make sense to name my estate as my individual retirement account (IRA) beneficiary?

A: Generally, it does not. Even if your children are beneficiaries of your estate, if they are not the direct beneficiaries of the IRA they must take distributions based on your life expectancy, not theirs. Designating the children individually as beneficiaries allows them to spread the withdrawals over their own life expectancies, producing lower annual withdrawals and continued deferral of taxes.

Q: What happens if an individual retirement account (IRA) owner who is older than 70 1/2 years dies without having taken a distribution for that year? Is the heir required to take a distribution by December 31?

A: If you are past age 70 1/2 and die before taking the current year's withdrawal, your IRA beneficiary must take a distribution by the end of that year. The distribution is based on your life expectancy and should be reported as ordinary income on your heir's own tax return. Most custodians require that the beneficiary set up an inherited IRA account and move the assets into it before taking the current year's withdrawal.

Q&A session published in the May 10, 2012 issue of Medical Economics magazine. Questions answered by Dan Danford, CFP(R) and Principal/Chief Executive Officer of Family Investment Center, and Medical Economics editorial consultant David Schiller, JD, of Schiller Law Associates in Norristown, Pennsylvania.

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