Take full advantage of the federal annual gift tax exclusion and lifetime exemption

For 2008, you can give tax free up to $12,000 per recipient ($24,000 if the gift is from both you and your spouse) under the annual gift tax exclusion. Gifts over that amount are tax free to the extent of your $1 million lifetime gift tax exemption ($2 million lifetime GSTT exemption).

Contribute to 529 plans

If you fund a 529 plan for your grandchild's college education, you can contribute up to five years' worth of gifts at once; that's $60,000 per child, or $120,000 per child if you and your spouse elect to make the gift.

Pay tuition and medical expenses

You can make unlimited tax-free gifts by paying medical bills or college tuition on behalf of a recipient. Payments must be made directly to the medical care provider or college.

Make charitable donations

Donations to charity are completely free from gift tax and are also generally deductible for income tax purposes, subject to certain limitations.

Make gifts and pay the gift tax

This may seem counterintuitive, but sometimes making gifts and paying the gift tax can be advantageous. The reason is that gift tax paid is removed from your estate. So, gift taxes paid on lifetime gifts can significantly reduce overall federal gift and estate taxes.

Types of property to gift

Selecting the type of property to gift can be very important. Here are some things to consider:

• Gift property that may grow substantially in value over time, such as common stock, antiques, art, and real estate. This strategy removes any future appreciation of this property from your estate.
• Be careful when gifting appreciated property. Because a property's basis (generally its cost) is carried over to the recipient, gifts of appreciated property can be good in some circumstances but not in others. You may not want to give highly appreciated property if the recipient will recognize a substantial capital gain when the property is sold. On the other hand, you may want to make that gift if the sale of the property is imminent anyway and the recipient would owe less tax than you upon the sale.
• You should avoid giving property that is likely to lose value after the gift has been made. Also, it's not generally a good idea to give away depreciated property. The recipient's basis for recognizing a loss is the lower of your basis (carryover basis) or the current fair market value. The recipient may be unable to recognize the loss on the property. Both you and the recipient may lose the loss deduction.
• Gift assets that yield higher amounts of income instead of those that yield lower amounts. This will prevent the buildup of income in your estate. Similarly, gift assets that produce taxable income instead of those that produce less taxable income, such as municipal bonds.
• It may be possible to reduce your ownership interest in a closely held business (or an interest in real estate) so that it may be valued at a discount. For example, if you have a minority interest (49% or less) in the stock of a closely held business, you may qualify for a discount. Also, a fractional interest in real property may be valued at a discount. It may be beneficial to make a gift of stock or an interest in real estate to qualify for the discount.
• Be careful when giving S corp stock to a trust, as the business may lose S corp status.

In early May, the Treasury Department began the process of issuing rebate payments to over 130 million individuals--the result of provisions included in the Economic Stimulus Act of 2008, which was signed into law in February.

Who qualifies?

If you have a valid Social Security number, filed a 2007 federal income tax return, and had $3,000 or more of income, you probably qualify for a stimulus rebate. The rebate can be up to $600 per individual (up to $1,200 in the case of a married couple filing a joint federal income tax return). You may also be entitled to an additional $300 for each qualifying child you have under age 17.

If your adjusted gross income (AGI) exceeds $75,000 ($150,000 if you file a joint return with your spouse), the amount of your rebate payment will be reduced, or eliminated altogether. If you're not sure how much you're entitled to, or if you've received a rebate that was less than you thought it should be, check out the Economic Stimulus Payment Calculator on the IRS website, www.irs.gov

When will I get my rebate?

If you're entitled to a rebate, and filed your 2007 federal income tax return on time, the IRS will take it from there. If you had your 2007 federal income tax refund directly deposited into a bank account, your rebate payment will be directly deposited as well. (If you weren't due a refund, but filled out the direct deposit information anyway, your rebate payment will be directly deposited.) Otherwise, a paper check will be mailed to you.

The IRS has released a schedule for rebate payments for returns that were filed and processed by April 15, 2008. When you get your payment depends upon the last two digits of your Social Security number (on a joint return, it's the Social Security number of the primary filer--the individual who is listed first--that counts). Direct deposit rebate payments will be issued before paper checks.

What if I haven't yet filed my 2007 federal income tax return?

The announced schedules apply only to individuals with tax returns filed and processed by April 15, 2008. This is true even if you filed for an extension. In any case, to get a stimulus rebate payment this year, you'll need to file your return no later than October 15. After that date, the IRS will not commit to issuing rebate payments by the end of the year, and the Treasury Department has announced that no payments will be issued after December 31, 2008. So, if you don't file by October 15, you'll have to wait to claim the stimulus credit on your 2008 federal income tax return.

What if I'm not required to file a federal income tax return?

Many individuals who are not actually required to file a 2007 federal income tax return should do so anyway to claim their rebate payment. If you have at least $3,000 of qualifying income (qualifying income includes wages, net self-employment income, Social Security benefits, Tier 1 Railroad Retirement benefits, VA disability and survivor benefits, and combat pay), you may be eligible for a rebate payment of $300 ($600 for married individuals filing joint returns) even though you would owe no taxes and aren't required to file a federal income tax return. Again, if you're not sure, check the IRS calculator.

How will the rebate affect my 2008 taxes?

Your stimulus rebate payment is actually the prepayment of a 2008 tax credit. When you file your 2008 federal income tax return in 2009, you will reconcile the amount of the credit that you're entitled to--using 2008 figures--with any rebate payment that you've already received. If it turns out that you're actually entitled to a larger credit based on your 2008 tax return, you'll get the difference as a tax credit on your 2008 return. But, if it turns out that you should have received less than the amount that you received as a rebate, you don't have to pay back the difference.

Where can I get more information?

The IRS has consolidated all announcements and has posted an incredible amount of helpful information on a new "stimulus payment" section of its website, www.irs.gov.

Of course, a tax or financial professional can also help you with any questions you may have.

Gather information

Your benefits are taxable if one-half of your Social Security benefit plus your other income (called your "combined income") exceeds a certain amount (called the "base amount"). To determine if your benefit is taxable, you need to know three things: (1) how much you received from Social Security during the year, (2) your combined income, and (3) the base amount for your filing status.

Find out how much you received from Social Security

Each January, the Social Security Administration (SSA) will send you a Social Security Benefit Statement (Form SSA-1099) showing the amount of benefits you received during the previous year. You'll need to use this information to figure out whether any of your benefit will be taxable.

Calculate your total income

Once you know how much you've received from Social Security, it's time to calculate your combined income. This figure includes the following:

• One-half of Social Security benefits received
• Other income including wage income, and taxable interest and dividends
• Tax-exempt interest income
• Income that's normally excludable--interest from qualified savings bonds, employer-provided adoption assistance, foreign earned income or foreign housing, and income earned by bona fide residents of American Samoa and Puerto Rico

The IRS has a worksheet you can use to calculate your combined income and determine whether or not your Social Security benefits are taxable. You can find this worksheet and more information about the taxation of Social Security benefits in IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits.

Compare your combined income against the base amount for your filing status

Once you've calculated your combined income, you must compare that against the base amount for your federal income tax filing status. If your total income is less than the base amount, then your Social Security benefits won't be taxable. If your combined income is more than the base amount, then part of your benefits will be taxable. Base amounts aren't indexed for inflation, so they're the same year after year.

Your base amount is:

• $25,000 if you file as single, head of household, qualifying widow(er), or married filing separately and you lived apart from your spouse for the entire tax year
• $32,000 if you file as married filing jointly
• $0 if you file as married filing separately and you lived with your spouse at any time during the tax year

For example, let's say your combined income for the year was $30,000 and you file your taxes jointly with your spouse. Because your combined income is less than the base amount for your filing status, $32,000, your benefits won't be taxable.

How much of your benefit is taxable?

Even if your combined income exceeds the base amount for your filing status, you won't have to pay taxes on the entire amount of benefits you've received. Generally, up to 50% of your benefits will be taxable, but if your combined income is more than $34,000 ($44,000 if you are married filing jointly), or if your tax filing status is married filing separately and you lived with your spouse at any time during the tax year, up to 85% of your benefit will be taxable. Again, see IRS Publication 915 for worksheets you can use to figure your taxable benefits.

Keep in mind that taxation of Social Security benefits can be complicated. Different rules apply to certain U.S. citizens and nonresident aliens living abroad and in other situations. If you have any questions, consult your tax professional.

The credit for light vehicles (8,500 pounds or less) contains two components: (1) the fuel economy credit, and (2) the conservation credit. The fuel economy credit amount (ranging from $400 to $2,400) depends on its fuel efficiency compared to 2002 standards. The conservation amount (ranging from $250 to $1,000) is based on the estimated lifetime fuel savings of the vehicle as compared to a comparable 2002 vehicle. Medium and heavy hybrid vehicles get a credit amount based on a certain percentage of the incremental cost of the hybrid over similar gas-powered vehicles.

Further, once 60,000 qualifying vehicles are sold by a particular manufacturer, the credit begins to be phased out. Fortunately for you, the burden is on the manufacturer and dealer to supply you with certification that indicates what the credit will be. (You must also meet certain other requirements to qualify.)

Here is a partial list of the credit amounts the IRS has announced for 2008 models:

But if your distribution includes employer stock (or other securities) you may have another option--you may be able to defer paying tax on the portion of your stock distribution that represents net unrealized appreciation (NUA) until you sell the stock. What's more, when you sell the stock, the NUA will be taxed at the long-term capital gains rate--typically much lower than the ordinary income tax rates. This strategy can, in some cases, result in significant tax savings.

What is net unrealized appreciation?

A distribution of employer stock consists of two parts: (1) the cost basis (that is, the value of the stock when it was contributed to, or purchased by, your plan) and (2) any increase in value until the date the stock is distributed to you. That increase in value is referred to as the net unrealized appreciation.

For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA.

How does the taxation of NUA work?

If your distribution qualifies as a lump-sum distribution, then you can choose to pay ordinary income tax at the time you receive your distribution only on the cost basis in the employer securities ($50,000 in the above example). You won't pay tax on the NUA until you sell the securities at a later date, at which time the NUA is taxed as long-term capital gain, no matter how long you've held the securities outside of the plan (even if only for a single day). Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain, depending on how long you've held the stock outside the plan.

Using the example above, if you elect NUA tax treatment, you would pay ordinary income tax on $50,000, the cost basis, when you receive your distribution. Let's say you sell the stock after five years, when it's worth $750,000. At that time you would pay long-term capital gains tax on your NUA ($450,000). You would also pay long-term capital gains tax on the additional appreciation ($250,000), since you held the stock for more than one year. (Note that since you've already paid tax on the $50,000 cost basis, you won't pay tax on that amount again when you sell the stock.)

If your distribution includes cash in addition to the stock, you can either roll the cash over to an IRA or take it as a taxable distribution.

What is a lump-sum distribution?

This special NUA tax treatment applies only if you receive the employer stock as part of a lump-sum distribution. To qualify as a lump-sum distribution, your distribution must satisfy both of the following requirements:

• You must receive a distribution of your entire balance, within a single tax year, from all of your employer's qualified plans of the same type (pension, profit-sharing, or stock bonus plans)
• Your distribution must be made after you reach age 59½, or it must be paid as a result of your separation from service (if you're an employee) or after you've become permanently and totally disabled (if you're self-employed)

When is NUA treatment the best choice?

In general, this NUA strategy makes the most sense for individuals who have a large amount of NUA and a relatively small cost basis. However, whether it's right for you depends on many variables, including your age, estate planning goals, and anticipated tax rates. In some cases, rolling your distribution over to an IRA may be the better choice. And if you were born before 1936, other special tax rules might apply to your lump-sum distribution, making a taxable distribution your best option. Finally, keep in mind that if your beneficiary receives a lump-sum distribution after your death, that distribution may also be eligible for NUA tax treatment.

If you're expecting a distribution of employer securities from an employer plan, make sure you speak with a financial professional before you take any action. He or she can explore the different options with you to help ensure you make the most tax-effective decision.

Federal tax treatment

Income tax--The federal income tax treatment of 529 plans is straightforward. There is no income tax deduction for contributions, but contributions to a 529 plan (prepaid tuition plan or college savings plan) grow tax deferred, which means you don't pay taxes on the earnings (if any) each year. And, in 2006, withdrawals used to pay qualified education expenses (called qualified withdrawals) were made permanently tax free--a huge tax advantage, considering the large sums of money that all 529 plans accept.

However, if you have to withdraw money from your 529 plan for reasons other than qualified education expenses (for medical, housing, or emergency purposes, for example), you'll face a double consequence--the earnings portion of the withdrawal will be taxed at the marginal tax rate of the recipient (either the account owner or the beneficiary) and be subject to an additional 10% penalty.

Gift tax--Contributions to a 529 plan are considered "present interest gifts" that qualify for the annual gift tax exclusion, currently $12,000 per recipient per year. So, annual contributions of less than this amount won't trigger gift tax. And there's a favorable twist: Under special rules unique to 529 plans, you can make a lump-sum contribution up to $60,000, elect to spread the gift evenly over five years (effectively making the gift a series of smaller gifts each $12,000 or less), and completely avoid gift tax, provided no other gifts are made to the same beneficiary during the five-year period.

This feature has made 529 plans a popular tool for estate planning purposes, particularly for grandparents. That's because a married couple can make a lump-sum gift to a 529 plan of up to $120,000 ($60,000 from each spouse), elect to spread the gift over five years, and avoid gift tax--all while removing the money from their estate for estate tax purposes. Plus, if one member of the couple also happens to be the account owner of the 529 plan, they'll have the added bonus of being able to retain control over their money.

State tax treatment

Income tax--Unlike the federal government, 31 states offer an income tax deduction (typically capped at a certain amount) for 529 plan contributions--Arizona (starting in 2008), Arkansas, Colorado, Connecticut, Georgia, Idaho, Illinois, Iowa, Kansas, Louisiana, Maine, Maryland, Michigan, Mississippi, Missouri, Montana, Nebraska, New Mexico, New York, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, South Carolina, Utah, Virginia, West Virginia, and Wisconsin. Kansas, Maine, and Pennsylvania allow a deduction for contributions to any 529 plan; all other states require that the contribution be made to the in-state plan.

As for tax-free qualified withdrawals, all states follow the federal government and offer this tax benefit (except for the nine states that have no income tax). But one state, Alabama, requires that the withdrawal be made from an in-state 529 plan.

Regarding nonqualified withdrawals--those made for purposes other than qualified education expenses--state laws vary, so consult a tax professional who is familiar with the laws of your state. You may owe income tax on the withdrawal. Also, at one time, before the 10% federal penalty was imposed, states levied their own penalties. If a state's penalty isn't officially "off the books," you might be subject to a state penalty too. Finally, gift tax rules differ from state to state, so make sure you understand your state's rules before making a large contribution to a 529 plan.

The answer has to do with the difference between your profit when you sell fund shares, and the fund's profit when it sells individual securities. As a fund buys and sells securities during the year, it will typically have some gains and some losses. At the end of the year, losses are subtracted from gains to determine the fund's shareholder distribution. The fund also may use losses from previous years to help offset gains.

By law, gains and/or income must be distributed each year; typically, those distributions occur around the end of the year and are taxable (unless the fund is held in a tax-advantaged account such as an IRA). Even if a fund is down at the end of that year, it may still have capital gains from earlier sales of securities.

Example: In 2002, Harry's stock fund bought 10,000 shares of XYZ Corporation for $33 a share. By the end of last year, the share price had reached $50, helping to push up the net asset value (NAV) the fund reported on its year-end statement to shareholders. This year, XYZ's price drops to $43. The fund's manager, concerned that XYZ might fall still further, sells the shares for a $100,000 profit. However, other shares held by the fund drop in value, and Harry's end-of-year statement now shows a lower balance compared to the year before. Because the fund did not sell shares to realize losses, it must still pass its $100,000 XYZ profit on to shareholders as capital gains distributions.

Good news, bad news

Owing taxes on distributions from a fund that's down is especially likely in years when a fund experiences substantial redemptions. If your fellow investors in a mutual fund have been pulling money out, the manager might have had to sell securities in order to meet those redemption demands. High market volatility also could mean a greater than usual level of capital gains distributions by funds with managers who traded actively, either to try to lock in gains or avoid further losses.

Some capital gains distributions this year may be affected by what happened in 2000-2002. Many funds that suffered during the bear market could use those losses in subsequent years to offset any capital gains and minimize that year's taxable distribution. However, many funds have now used up their losses from the down years, leaving their managers with fewer leftover losses to offset any current gains from selling individual securities.

Tax factors to consider in fund selection

One way to minimize such problems is to consider a fund's tax efficiency in advance. Taxes shouldn't be the single deciding factor in any investment decision. However, when assessing the capital gains impact of a potential purchase, consider the following points:

• Some mutual funds tend to be more susceptible to the capital-gains dilemma than others. For example, funds with a high turnover ratio buy and sell more often and may generate more capital gains distributions.
• Some actively managed funds are designed specifically to be tax efficient, taking capital gains into account when making trading decisions.
• A fund's long-term capital gains will be taxed at a more favorable rate than its short-term gains.
• Bond funds can experience capital gains and losses from the sale of individual bonds.
• Each mutual fund must report its after-tax return in its prospectus.

In the small consolation department ...

If you are squeezed by both a loss in your fund's value and a capital gains distribution this year, remind yourself that at least the maximum tax rate on long-term capital gains and qualified dividends is 15% until January 1, 2011 (less if you're in the 15% or 10% tax bracket).

You also may be able to offset capital gains from one mutual fund by taking a capital loss on another investment. A financial professional can help you assess the potential tax impact of a given mutual fund, as well as the best way to manage any capital gains liability.