April 1999 Bulletin

Get ready for '99 taxes

Tips on retirement, investment income, student loan interest

By Morgan Pearsall

Now that the 1998 tax-filing season is still fresh in your mind, some tax planning for 1999 may be in order. Following are three potentially high impact tax savings ideas that you may wish to explore in further detail with your financial or tax advisor. They are maximizing retirement accumulation; wisely allocating investments between tax deferred and taxable accounts; and taking advantage of the new tax deductibility of student loan interest.

The most well-known and still most powerful way to reduce your taxable income is to contribute to a retirement savings plan. If you are self-employed, this can be done by establishing a Keogh plan or an SEP-IRA. While the Keogh plan is a bit more complex to set up and administer, it provides for a greater annual contribution ceiling, 20 percent of earned income (up to a maximum contribution of $30,000) versus 13.04 percent to an SEP-IRA (not to exceed $24,000).

Less well-known and perhaps providing a greater benefit is to establish a defined benefit plan. This generally works best for the physician who is closer to retirement. With a defined benefit plan, the amount of contribution is determined actuarially, based on the benefit to be paid upon retirement. The retirement benefit is usually defined by a formula incorporating earned income and number of years of service. Currently, the annual retirement benefit cannot exceed $130,000. Since the retirement formula can take into consideration years of service prior to the establishment of the plan, you can play catch up in the funding of the plan.

Depending on your plan specifics and number of years to retirement, this can provide for a much greater annual tax deductible contribution than available in the Keogh and SEP-IRA plans mentioned earlier. Whether a defined benefit plan will make sense in your situation will depend on a number of factors, including the number and years of service of other employees who must be covered by the plan.

Investment income provides a number of opportunities for lowering your tax bill. If you are an active buyer and seller of stocks or similar investments, you may be generating short-term capital gains that are taxed at your highest ordinary tax rate (up to 39.6 percent). However, if you purchase and hold a stock for the long haul, you enjoy tax-deferred growth and when you sell the stock, are subject to the lower long-term capital gain rate of 20 percent.

For your taxable accounts then, it may make more sense to purchase stocks or funds, which will have minimal turnover during your investment horizon, and to place your actively traded stocks or high growth mutual funds in your tax deferred accounts.

Because of the income phase-out tests of many of the new tax credits for children and education, most may be of little use. One tax change effective in 1998 that you may be able to use, however, is the deductibility of student loan interest. Again, this benefit is subject to an income phase-out (for incomes above $75,000, married filing jointly). However, by having your child borrow funds and, if possible, deferring payment until after graduation when the child may generate earned income, he or she may be able to take advantage of the deduction. By using your annual gift tax exclusion of $10,000 per child per parent, you can then annually gift to your child sufficient funds to meet the after-tax cost of the student loan, thus indirectly capturing some of the tax savings for yourself.

Morgan Pearsall is a senior manager at Ernst & Young LLP who counsels physician groups.

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