Your tax strategies should reflect your plans for long-term security
Seven lines. That's all there was to the first Form 1040, printed after passage of the Sixteenth Amendment in 1913. That amendment made it legal for the US government to collect taxes on its citizens' incomes.
And if the job of filling out the 1040 was light, so was the tax burden, by today's standards anyway. If you earned over $20,000 a year, you paid a 1 percent income tax. Anyone earning less than $3,000 a year ($4,000 on a joint income) - which included a big share of the population - paid no taxes at all.
Since then, of course, succeeding Congresses have built on that basic foundation to create a complex system of deductions, exemptions, tax tables, brackets, and credits. Today's 1040 has 68 separate lines, in addition to the dozens of different forms that may have to accompany that 1040 to the Internal Revenue Service (IRS). Taxes have gone up, too.
Keeping up with these changes, says Jeff Schnepper, a tax attorney and professor of tax law at the American College in Bryn Mawr, Penn., has meant a marked specialization of the tax-law and tax-accounting profession. The college specializes in teaching accounting, insurance, and financial planning.
Like some fast-sprouting family tree, the tax-accounting and tax-attorney professions have become increasingly specialized, emphasizing specific areas such as estate planning, employee benefits, small-business taxes, compliance, and tax shelters. In the last group, it is possible to find people who specialize in tax aspects of particular shelters, such as real estate, oil and gas, or equipment leasing.
''It certainly appears to me that more people are specializing,'' notes Vernon Jacobs, author of a newsletter on taxes.
To help individuals decide which tax specialist to use, Mr. Jacobs says, another professional - the financial planner - is emerging as a sort of traffic cop, directing specific tax problems to the right expert.
In fact, says James W. Zilinski, vice-president for financial planning at the New England Mutual Life Insurance Company, Boston, tax planning is quickly becoming just one aspect of an interrelated financial-planning process that includes estate planning, asset building, and retirement planning.
''Tax planning can't stand alone,'' Mr. Zilinski said. He often has people come to him whose primary goal is to cut the tax burden but who do not have an overall financial plan for themselves or their families.
For example, he notes, the decision about how much and what kind of life insurance to buy involves both personal-finance, estate-planning, and tax-planning considerations.
In recent years, many people looking for tax benefits from their life insurance policies have turned to universal life. This is the industry's answer to the ''buy term, invest the difference'' recommendation of many financial planners - but with a higher tax-free return than traditional whole-life policies offered.
Universal life combines insurance with a cash reserve. Part of the premium goes for insurance and part goes into a savings account, usually invested in long-term bonds. Current universal-life policies are paying 8 to 10 percent returns, tax-free. However, unless you have at least $2,000 to $3,000 a year to put in, universal life may not make sense because the policy's fees may outweigh the potential gains.
Insurance, or risk management, Mr. Zilinski says, is just one of six categories of financial planning. And all six categories have at least some tax implications. The other five are:
* Income and expense analysis. How much income you receive in a given year, when you receive it, and what form it takes (salary vs. investment income, for example) all have tax implications that should be discussed with a tax accountant or attorney. You also need to keep track of all deductible expenses, particularly if you are in business for yourself.
* Investment planning. While people invest to increase their income, the way you invest can make a difference at tax time. Deciding when to sell a stock, for instance, may determine whether you pay higher tax on ordinary income or a lower capital-gains tax on stocks held for more than a year. For this, Mr. Zilinski says, you have to decide ''if you are buying the stock for a quick gain, or for a long-term investment.''
* Estate planning. ''This has substantial tax-planning implications,'' he notes, particularly since the 1981 tax act provided for an unlimited marital deduction that can reduce or eliminate the tax on many estates. Tax strategies for estate planning have been completely altered. Many wills, for instance, have had to be rewritten to reduce the tax liability for a surviving spouse and other heirs.
* Tax planning. All by itself, this is an element of financial planning. ''If you can project four, five, six years out, you can get more control of taxes,'' Mr. Zilinski said.
You can, for instance, find ways to balance your tax rates from year to year. People who have substantial amounts of self-employment, free-lance, or investment income may find that their incomes vary greatly from year to year. When this happens, the taxpayer's ''annual average tax rate'' can be several hundred dollars higher or lower, depending on how much year-to-year variation there is in income.
One way to avoid wide variations in income is to decide when to take certain income or deductions. It may be better to defer some income until the following year, to claim investment losses or business deductions this year, or vice versa. It all depends on what is needed to maintain a steady income level, or at least an income that rises at a near-constant rate.
* Retirement planning. A collection of tax-advantaged retirement saving tools , including individual retirement accounts, salary-reduction plans, and annuities, is available to help retirement savings build interest and compound free of federal and most state taxes.
Beyond the elements of financial planning, however, there is another element of tax planning that is harder to work with: anticipating future changes in the tax laws. Considering the size of the federal deficit and the growing concern about that deficit's effect on the economy, a tax increase of some sort is quite likely in 1985, says Jonathan Flitter, manager of employee benefits in the Boston office of Touche Ross, the accounting firm.
''There are two likely ways deficits will be cut,'' Mr. Flitter says. ''Either Congress can cut entitlement programs or it can raise taxes.'' There probably won't be a tax increase in this election year, he adds, but ''everybody I talk to sees a likelihood of a major tax move in '85.''
Trying to predict where a new Congress will look for more revenues is very difficult, Mr. Flitter admits, but he does think some parts of the Economic Recovery Tax Act of 1981 (ERTA) might be likely targets. For example, he noted that ERTA provided for a way for companies to sell their tax losses to companies with too much cash. Eliminating that provision would save $6 to $8 billion, he estimates.
Thus is it likely, Mr. Flitter says, that the pattern he has seen since he graduated from law school in 1973 will continue: There have been five major changes in the tax laws in the 10 years since that graduation date, he notes.
If there is another change in 1985, he concludes,''the re-education, re-learning process'' for taxpayers and the professionals who help them will have to begin again.
Of course, with all effort being spent on trying to have the investment and personal finance pieces come together for a good tax picture, it is possible to become too involved with the idea of saving taxes.
''Sometimes, there is a preoccupation with the avoidance of paying taxes,'' says George Barbee, executive director of the Consumer Financial Institute, a financial planning firm in Newton, Mass. ''As a result, people can miss out on good investment opportunities.''
''People sometimes tend to over-shelter because of all the attention given to saving taxes,'' he continued. ''A shelter that's good for someone in the 50 percent bracket may not be good for someone in the 30 percent bracket.''
If the investment under consideration has a potential for a good return now or in the future, an individual should not be too concerned about having to pay taxes on the return. You are, after all, investing money to make money, or to support what looks like a good business venture. Taxes, most advisers say, should be a secondary consideration.