A number of significant tax changes are effective for the first time for tax year 1998. Major new tax breaks include a new child tax credit, two new higher-education-related tax credits, deductions for interest paid on education loans, and a new "education IRA." Because these tax breaks phase out over varying levels of adjusted gross income (AGI), the year-end-planning element common to all of them is the desirability of minimizing (AGI) through deferral of income from 1998 to 1999.

Thanks to the Taxpayer Relief Act of '97, and the IRS Restructuring and Reform Act of '98, you have new-for 1998 retirement planning opportunities in the form of Roth IRAs and liberalized rules for deductible IRAs. You also have new choices: contributing to traditional IRAs or Roth IRAs; converting traditional IRAs to Roth IRAs; and if the conversion route is taken, choosing between a unique 4-year income spread-forward or including all of the income resulting from the conversion in '98.

The '98 Act cut the minimum holding period to obtain the lowest possible capital gains tax rates from more than 18 months to more than one year, but that was of small solace if you are one of the investors who suffered actual and paper losses as a result of the precipitous stock market decline that began in August.

As in all years, year-end planning will have to be done on a very individualized basis, taking account of your specific situation and planning goals, with an eye to minimizing taxes to the greatest extent possible.

Who should try to reduce AGI for 1998, and how to do it

This is the first year that the new tax credits, deductions, and other tax benefits added by the '97 Act are available. Many of these tax advantages are reduced or eliminated if your adjusted gross income (AGI), or modified AGI, exceeds specified thresholds. As year-end nears, you would be wise, if you otherwise qualify for these tax breaks, to try to modify or reduce 1998 AGI.

The following are the new tax breaks whose availability is limited by AGI (or modified AGI):

Roth IRA: An individual may make a nondeductible Roth IRA contribution of up to $2,000 for '98, reduced by any amount contributed to a regular IRA, but the deduction phases out ratably for modified AGI between $150,000 and $160,000 for joint filers, between $95,000 and $110,000 for single filers, and between $0 and $10,000 for marrieds who file separately.

ROTH Rollovers: Starting with '98, an individual may roll over all or part of the amount in a regular (non-Roth) IRA to a Roth IRA, or convert a regular IRA to a Roth IRA, if modified AGI for the year does not exceed $100,000. Note: the '98 Act provides that the deduction for a contribution to a regular IRA isn't allowed in determining AGI for Roth IRA purposes.

IRA Deductible Contributions: The AGI phase-out ranges for making deductible contributions to regular IRAs by taxpayers who are active participants in an employer-sponsored retirement plan are significantly higher for '98 than they were last year.

For singles, the IRA deduction for "98 phases out over $30,000 to $40,000 of AGI. For marrieds, the IRA deduction for "98 phases out over $50,000 to $60,000 of AGI.

If you are wholly or partially ineligible to make deductible contributions you can still make nondeductible contributions of up to $2,000 a year to a nondeductible traditional IRA or to a Roth IRA (subject to income limits discussed above), less the amount of any deductible contributions.

Spousal IRA Contributions: Starting with '98 an individual isn't treated as an active plan participant merely because his spouse is one. The nonparticipant spouse isn't subject to the regular IRA deduction phase-out range, but can make the full deductible contribution to an IRA as long as the couple's AGI doesn't exceed $150,000.

Child Tax Credit: For '98, taxpayers are allowed a $400 child tax credit for each qualifying child under age 17. The credit is reduced by $50 for each $1,000 (or part of a $1,000) of modified AGI above $110,000 for joint filers, $75,000 for single filers, and $55,000 for marrieds filing separately.

Education Tax Credit: Individual taxpayers may claim an income tax credit equal to the sum of the Hope Scholarship Credit (up to $1,500 per year per student) and the post-June 30, '98 Lifetime Learning Credit (per taxpayer, up to $1,000 per year), for higher education expenses at accredited post-secondary educational institutions paid for themselves, their spouses and their dependents. These credits are reduced ratably at modified AGI between $80,000 and $100,000 on joint returns, and between $40,000 and $50,000 on other returns. Both credits can't be claimed in the same year with respect to any one student. No credit is available for married taxpayers who file separate returns.

Student Loan Interest: Individuals may deduct up to $1,000 of interest on qualified education loans due and paid during '98. This deduction reduces AGI. The amount deductible is reduced ratably at modified AGI between $60,000 and $75,000 on joint returns, and between $40,000 and $55,000 on other returns. Married taxpayers must file jointly to qualify for the deduction.

Education IRA: Taxpayers may contribute up to $500 to a tax-exempt education IRA for any individual under 18. The maximum contribution is reduced ratably for modified AGI between $150,000 and $160,000 for joint filers, and between $95,000 and $110,000 for others.

Other Adjusted Gross Income (AGI) related tax items:

Besides the new-for-'98 tax advantages whose availability is keyed to AGI, there are other items of income, deduction, credit, and exclusion that are affected by levels of AGI or modified AGI. Key items affected are the: adoption credit; overall itemized deduction reduction; personal and dependency exemptions; social security benefits taxation; medical expense deduction; nonbusiness casualty loss deduction; exclusion of interest on EE bonds used for higher-education expenses; and the exclusion for employer-provided adoption assistance.

How to reduce Adjusted Gross Income (AGI)

Not all steps listed below will be available or desirable for every individual, but many whose income without any planning would be in the range of a threshold may be able to use one or more of the following strategies to keep AGI below the desired level:

Convert taxable interest to tax-exempt interest. This will be especially practical where an individual will recognize little or no gain on the disposition of a taxable investment, such as when shifting funds in a taxable money market account to a tax-exempt fund. The tax-exempt interest will not be included in AGI (except in determining the taxability of social security benefits), and for some individuals, the after-tax amount received from tax-exempt interest will be at least as much as the after-tax amount received from taxable interest. That's especially true if the tax-exempt interest is exempt from state or local income taxes as well as from Federal tax.

Convert taxable interest to tax-deferred interest or income. Instead of leaving funds in a savings or money market account generating taxable interest, some individuals may want to shift some funds to EE bonds. Unless the individual elects otherwise, "interest" on EE bonds isn't taxed until the bonds mature or are redeemed. Another alternative would be to buy Treasury Bills with a term of one-year or less that mature in '99 so that the income from the Bills won't be included in gross income until that year. Alternatively, individuals may shift funds from investments that produce currently taxable income to growth stocks, which pay little or no dividends and give the individual the ability to control when income will be realized by timing their sale to suit his tax goals. Switching to growth stocks also maximizes the proportion of income that will be taxed as apital gain as opposed to dividend income that is taxed at ordinary income rates.

Pay off debts. If an individual has both income-generating investments and debts on which he is paying interest, he should consider selling part of his investments and using the proceeds to pay off debt. In addition to reducing AGI, this may increase the individual's net income because the reduction in interest payments often is greater than the reduction in the income received on the investment.

If you're in this situation and reluctant to repay current debt for fear that you may need the capital in the near future, consider taking out a home equity credit line to draw on in case of need instead of keeping both income earning investments and debt.

Increase contributions to 401(k) plans, SIMPLE pension plans, etc. Some individuals may be able to reduce AGI by increasing contributions to retirement plans such as 401(k) plans, SIMPLE pension plans, and Keogh plans.

Increase contributions to flexible spending plans. An individual whose employer offers flexible spending plans, such as to pay medical or dependent care expenses on a pre-tax basis, should consider whether he would benefit by increasing salary reduction contributions to such a plan. Any increase in a contribution would reduce AGI.

Note, employee contributions to a flexible spending account generally is lost if not used by the end of the plan year. Therefore, employees should consider increasing their flex-account contributions only if they are pretty sure that they will be able to make use of the additional contributions.

Take capital losses in '98. Taxpayers with unrecognized capital losses should consider taking them in '98. This will be especially helpful if the individual can arrange to offset up to $3,000 of long-term capital losses against ordinary income in '98 instead of using them to offset long-term capital gain.

Careful handling of capital gains and losses can save taxes

Taxpayers who lost money on stock or other assets sold in '98 are likely to have other investment assets that have appreciated in value. These taxpayers should consider the extent to which they should sell appreciated assets that could be offset by the losses.

Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains. Individual taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing AGI.

Individual taxpayers are subject to tax at a rate as high as 39.6% on short-term capital gains and ordinary income. On the other hand, most long-term capital gains are taxed at a maximum rate of 20%. The maximum rate is only 10% to the extent the gain wouldn't otherwise push the taxpayer above the 15% tax bracket.

The planning strategies we covered in this newsletter may or may not be appropriate to your specific circumstances. Before implementing any of them, be sure to call us. As skilled professionals, we have the experience and knowledge to help you with your planning needs.