Tax Planning Simplified

By Robert Preston

In Brief

A Message from the Stump

A proverb reads, "If you want to make God laugh, make a plan." When tax laws keep changing, some practitioners find that the best strategy for them--and their clients--is to set goals, make financial plans based on the "knowns," and stick with them.

Rather than wasting time, energy, and money chasing after every tax-planning opportunity that new or proposed legislation presents, at least one CPA believes that the best players save their pieces by not playing a game where the rules keep changing.

Predicting the future is dicey at best. Whether you're talking about the direction of the stock market, the real estate cycle, or the balance of trade, prophesying accurately is a difficult science. Tax planning is no different. Can any of us really plan in taxes, given the environment in which we practice and the experience of the past 20 years? Since ERTA (Economic Recovery Tax Act of 1981), we have seen 18 major pieces of Federal tax legislation, all with significant provisions that affect what is taxable and what is deductible. Will the political atmosphere ever change to mitigate this trend? Hardly. The tax code is the source of much of Congress's power. Anyone who thinks representatives might relinquish some of that power is either naive or new to the business.

Carpe Diem--Worry About Tomorrow Tomorrow

I've practiced for many years (almost 20 as a sole proprietor) under a very simple credo, developed after much frustration trying to outwit the future. My axiom is basic and for all clients, bar none: Strive to minimize the tax bite now, this year, and worry about the future when it comes, next year.

Using this axiom, I employ every deduction and income deferral strategy I can muster for the current period and leave the next one to fate. This approach focuses all of my resources and thinking on the current fact pattern and doesn't waste effort on what might be.

I find that this approach works very nicely. Yet, with the vast amount of current thinking that attempts to see the future, and often the distant future at that, I sometimes feel like a minority of one. But, for the record, here are a few examples of how this technique of focusing on the present works:

* During a window period in 1997­1998, the excise tax on excess distributions from IRAs and qualified plans (e.g., distributions greater than $160,000, adjusted by the cost-of-living index) was suspended. A multitude of financial planners, CPAs, and attorneys ran projections for their clients and advocated the withdrawal of large amounts from IRAs and pension balances to avoid the "inevitable" 15% excise tax. My clients, however, all received this simple admonition: Sit tight and let your funds accumulate. I reminded them of Rule No. 1: We never pay taxes until we have to. As a result, we avoided paying a tax that was eventually repealed. My clients' balances continue to accumulate tax-deferred, while those of others are now exposed to the taxing authorities.
* A greatly increased exclusion for capital gains on the sale of residences became effective for sales after May 6, 1997. Many taxpayers prematurely jumped at the option under prior law to sell upon the attainment of age 55, to "capture" the $125,000 exclusion. Again, never make an economic or financial decision based on "what might be" with the tax laws. Not selling often minimized the current tax paid; waiting often minimized future taxes as well.
* Many small businesses severely curtailed their current pension deductions because of contributions to a prior plan (section 415(e)-mandated combined contribution limits for pension plans). They would shy away from establishing a defined benefit plan (a decision often reinforced by other planners) because of possible future business uncertainties, the section 415(e) limits, and increased regulation. My advice was consistent for small employers from one to 100 employees: If the parameters are right, set up the defined benefit plan and take it year by year. "Once the money has gone to Washington, it's gone forever." Not one of my clients has regretted setting up a defined benefit plan. In fact, despite the heavy regulatory burden associated with these plans, the funds accumulated have often proven to be the primary source of retirement income for the owner as well as the employees.

Mantra: Defer, Deduct, Defer, Deduct

Given any option to defer income, whether through 401(k) deferrals, pension contributions for the small business owner or self-employed, or a solid nonqualified plan with a secure "promise to pay" behind it, I advise my clients to defer (assuming no lifestyle need for current income). I never give a thought as to whether future tax rates will be higher or lower, sticking to the decision to defer or deduct.

In evaluating a lease vs. purchase option (after analyzing the cost and financial implications), the arrow usually points to the option with the highest current deduction possibilities.

With my clients, I always maximize deductions for the current period. For instance, pay state income and real estate taxes by December 31 whenever possible, using the rationale that overpayment can generally be applied to the first estimates due the following period. Always use accelerated depreciation if the section 179 write-off is not available.

How the Roth IRA Was Born?

Too often, planners base their advice on a what-if scenario that starts, "We'll pay a little today, to avoid a lot more tomorrow." I don't buy it. A good current example is the Roth IRA.

Because the recent flurry of interest surrounding the Roth IRA concept is a pet peeve of mine, let me speculate about the process in Washington that created the Roth IRA (enacted through the Taxpayer Relief Act of 1997).

Congress was close to passing legislation that would grant middle-class America many benefits, including increased estate tax credits, several educational tax incentives, increased exemption limits on the sale of a principal residence, and liberalization of health-care and home office deductions for the self-employed. After reviewing the overall effects of the bill, legislators were concerned that the revenue reduction would be too much. A quick review of the provisions showed no areas begging revision. However, the Ways and Means Committee developed a new IRA concept, one without deductions for IRA contributions, but with ongoing and "tail end" tax advantages. Individuals would have the option of converting their traditional IRAs to Roth IRAs, then paying a significant tax over a four-year window period.

Many members of Congress probably thought the idea foolhardy. However, some committee members recalled that whenever something similar had been passed (e.g., the temporary repeal of the 15% excise tax in 1996), a financial planning bonanza ensued, with many taxpayers being "consulted" to pay taxes now to forego some in the future. Hence the Roth IRA concept was launched, an idea that not only would increase current revenue by disallowing IRA deductions for many but also might increase revenue by "enabling" existing IRAs to be converted.

My own hypothesis is that some members of Congress thought the idea was preposterous: "The public will never buy it--there won't be any takers." But, again, Congress was ahead of the electorate. The financial community took to the bait and has spent the past several years convincing John Q. Taxpayer that the Roth is a wonderful idea, thus generating an abundance of professional fees for the advisors and a windfall for the Treasury in taxes that never would have been collected without the Roth concept.

Why anyone would pay a bundle in taxes now, on the premise that the laws affecting IRAs will stay the same for the next 20 years, is beyond me. Taxes seem to be more the result of current budget needs and which party is in control of Washington than of logic and sound economics. And I don't trust my clients' money to the former. So again, my motto is to minimize the bureaucrats' take today and worry about tomorrow when it comes. Thereby we accumulate as large a pile of assets as possible. Tax-deferred or after-tax dollars, the distinction is immaterial. The goal is the same: a mountain of money with which to face the uncertainties of the future.

Already our profession has seen some adverse results of Roth conversions. Some taxpayers converted at high stock market valuations, only to watch their portfolios decrease after the conversion. The result: more consulting and expert advice to recharacterize and reconvert. Alas, the process of forecasting the future, coupled with the need for adroit timing decisions, could aptly be called a fool's fancy.

Back to Basics

How does my philosophy apply to estate planning? My first admonition to clients is to structure their financial plan to maximize income and financial security during their retirement years, in particular the year we are addressing. Next, we seek to minimize estate taxes. We never structure assets to minimize future estate taxes at the expense of control or current enjoyment of wealth. Life insurance "planning" gets little attention: The premiums are good for the agents and the benefits are vague and uncertain for the taxpayer. Usually too many contingencies or variables must prove true to justify the cost of future premiums. Indeed, one of the proposed provisos of the Financial Freedom Act of 1999 was the eventual repeal of estate and gift taxes for deaths after 2008. Not knowing what the future may hold and not trying to outguess it may prove a bonanza for many of my clients.

Again, a major irritation to me has been the attention that many professions, including ours, have given the Roth concept. Already, with the possible repeal of estate taxes, converting to a Roth may prove to be a poor financial planning decision, as all those assets paid in taxes during conversion would not be taxed at death. I submit that other income tax changes could sprout that would also make the Roth a poor decision for all but the financial community that has feasted on the consulting frenzy it produced. And, if Congress were to pass a national sales tax, universal value-added levy, or flat tax, any of these options would negate the Roth concept overnight.

Does my philosophy lead to lower consulting fees from my clients, translating into a lower income for my practice? Maybe, but I don't think so. While I've believed in practicing solo for a myriad of reasons, my clients have benefited from very focused, year-to-year integrated tax, estate, and pension work, and many have become wealthy as a result. Referrals still form the bulk of my new clients, so I have had to devote little time or money to marketing. I have always maintained that the best way to grow a practice is to effectively serve an existing client base with true excellence; given that, growth is a natural by-product.

I encourage anyone who is still not convinced to read the provisions in the proposed Financial Freedom Act of 1999. Anyone care to predict which items will become law? Washington has a casino mind-set, and subjecting your clients' pocketbooks to the decisions these representatives may make in the future could be considered poor professional steerage.

KISS--keep it simple, stupid--is a tax strategy worth considering. *

Robert Preston, CPA, is a sole practitioner based in Danbury, Conn., with 20 years of experience in consulting and retirement planning, serving both individual and business clients.

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