START PLANNING NOW FOR AMT

If you thought the alternative minimum tax (AMT) was only for the most affluent taxpayers, think again. Although AMT was originally created to prevent the wealthy from avoiding tax, a rapidly increasing number of middle-income taxpayers are falling into its grasp.

In 1970, only 19,000 people owed AMT. By 1996 this figure had jumped to about 600,000. And the 2001 tax law will exacerbate the problem. The Congressional Joint Committee on Taxation projects that 1.4 million taxpayers will pay AMT for 2001, skyrocketing to more than 35 million by 2010.

Why is this happening? Inflation is the primary culprit. Unlike regular tax brackets, exemptions, and deductions, AMT tax brackets and exemptions have never been adjusted for inflation. As middle-class income grow, therefore, more and more taxpayers are exposed to AMT.

The new tax law, by reducing regular income tax rates, also increases the number of taxpayers subject to AMT (taxpayers must pay regular tax or AMT, whichever is higher).

Computing AMT

AMT is a separate tax system, with its own set of tax rates, deductions, and exclusions. And the rules are generally less favorable than those that apply for regular tax. To calculate AMT:

• Determine your alternative minimum taxable income (AMTI; see below).
• Subtract an exemption amount - $49,000 for joint filers, $35,750 for single filers. (The exemption is phased out for joint filers beginning at $150,000 of AMTI and is eliminated when AMTI exceeds $346,000. For single filers, the phase-out range is $112,500 to $255,000.)
• Multiply this amount by the AMT tax rate - 26 percent of the first $175,000, 28 percent on the rest. If your AMT is greater than your regular tax, you're liable for the larger amount.

Note: The 2001 tax law temporarily increased AMT exemptions as well as the income levels at which the exemptions are phased out. In 2005, absent further legislation, the exemptions will return to their previous levels of $45,000 for joint filers and $33,750 for single filers, and the top end of the phase-out range will drop back to $330,000 for joint filers and $247,500 for single filers.

Who's At Risk?

To determine your AMTI, you start with your regular taxable income and add certain deductions and exclusions ("tax preference items"). Taxpayers with large amounts of any of these items should plan for the possibility of AMT liability. Preference items include:

• Personal exemptions
• Deductions for state and local income taxes, real estate taxes, and personal property taxes
• Certain deductible medical expenses
• Certain miscellaneous itemized deductions
• Mortgage interest (unless the loan is used to buy, build, or substantially improve a residence)
• Investment interest expense
• Tax-exempt interest on certain private activity bonds
• The spread between the market price and exercise price of incentive stock options if not sold in the year of exercise

Planning

If you're at risk for AMT, there may be opportunities to minimize or eliminate its impact. Certain AMT adjustments, for example, generate minimum tax credits that can be used to reduce regular income tax in a later year.

Strategies for reducing or avoiding AMT include:

• Deferring deductions that aren't deductible for AMT purposes, such as state and local income taxes, to a later year
• Reducing AMTI to avoid phaseout of the AMT exemption
• Increasing regular taxable income to avoid AMT
• Postponing the exercise of incentive stock options that would trigger AMT liability
• Borrowing only the amount needed to buy, build, or substantially improve a residence

It's best to take a long-term approach to AMT planning. Don't take drastic measures to avoid the tax this year if it would result in a large tax bite next year. If you're teetering on the edge of AMT liability, project your income, deductions, and exclusions several years into the future and work with a tax advisor to develop an AMT strategy.

VIATICAL SETTLEMENTS:
MAKING THE MOST OF UNNEEDED LIFE INSURANCE

The viatical settlement is a technique by which an insured sells a life insurance policy to an insurance company or other investor in exchange for a percentage of the policy's face value.

Viatical settlements offer terminally or chronically ill persons an opportunity to trade life insurance for immediate cash on an income-tax free basis. Those in good health can also take advantage of viatical settlements (albeit on a taxable basis) if they no longer need or want their life insurance because of changes in estate or business planning needs, or economic conditions. The taxable amount is determined by subtracting the policy's basis (premiums paid) from the settlement proceeds.

Who Should Consider A Viatical Settlement?

A viatical settlement is an attractive option when one's circumstances make an existing life insurance policy unnecessary or undesirable. For example:

Businesses

• A policy purchased to finance a buy/sell agreement is no longer needed because the business has been sold to a third party.
• A key-man policy is unnecessary after the business is sold.
• Tax law changes reduced the benefits of some leveraged COLI (corporate-owned life insurance) programs by providing that interest on loans to fund such programs is no longer tax-deductible.
• A business owns a key-man policy on an executive who has retired or is no longer employed by the business.
• A company is in bankruptcy and must sell assets to pay creditors.
• Policies purchased to fund deferred compensation or retirement benefit programs are no longer needed, because of changes in the programs.

Individuals

• A change in the size of the insured's estate or in the tax laws has reduced the amount of insurance needed to pay projected estate taxes.
• Changes in the insured's financial circumstances have made the premiums unaffordable.
• Vanishing premiums have reappeared.
• There are large loans against a policy, making it expensive to maintain.
• The insured wishes to remove a policy from his or her estate.
• The policy is no longer appropriate because survivorship coverage is preferable.
• The insured outlives his or her beneficiaries.

The amount of the settlement varies depending on the remaining premiums required and the health of the insured. There are circumstances in which term insurance policies, which have no cash surrender value, nevertheless have a significant value in a viatical settlement.

Viatical settlements aren't appropriate for everyone, but under the right circumstances they can present an attractive option.

INVESTING IN UNCERTAIN TIMES

For many investors this year, the stock market has been unnerving, even before September 11. But it's important to remember that, despite periodic setbacks, the stock market has historically moved steadily upward. Since 1926, for example, the S&P 500 posted negative returns in 21 separate years, or 28 percent of the 75-year period. Yet during this same period, the index generated an average annual return of approximately 15 percent. Although the past is no guarantee of future results, history shows us that over the long term, achieving healthy returns requires patience through many down markets.

If you've constructed a well-diversified portfolio that takes into account your long-term goals and risk tolerance you need not lose sleep over market volatility.

Diversification

Even a seemingly rock-solid investment has the potential to go both up and down, sometimes by large amounts. Even though the long-term direction of the market has historically been positive, it's difficult to predict whether a particular stock will go up.

In volatile markets, you can improve your chances of success by diversifying your portfolio. The more stocks you own (to a point), the less likely that poor performance in any one will be disastrous for your overall returns. That's why many people are attracted to mutual funds, which often own 100 or more individual securities. By investing in a single fund, you're able to achieve a level of diversification that would be difficult to achieve on your own.

Once you've ensured your portfolio has a sufficient number of investments, you should then look to balance the types of securities you own. Your goal should be to own a variety of investments that all respond to market conditions differently. For example, if you already own a number of large-cap stocks, perhaps your next investments should be in small - or mid-cap stocks. Or if your portfolio is tilted heavily toward growth, you can help smooth its performance by adding stocks that display value characteristics. If all your investments are in U.S. businesses, consider adding a few overseas companies.

Asset Allocation

Asset allocation is another way of saying you should make sure your portfolio is divided properly between different asset classes, or investment types. The most common asset classes are stocks, bonds, and cash. Stocks offer the highest returns but at the greatest risk to your investment. Bonds provide regular income as well as opportunity for capital gains or losses. Investing in cash, or money-market investments, offers modest rewards but carries minimal risks.

Each asset class may outperform the others at varying times, and this can work to your favor during market turbulence. Therefore, owning a mix of investment types helps protect you during periods of market volatility. For example, owning bonds along with stocks may limit your potential returns during rising stock markets, but they may also provide welcome stability during falling ones.

Understanding your tolerance for risk is especially important. Risk tolerance is partly personality-based - some people are naturally more comfortable with the idea that they could lose part or all of their investments. Yet your risk tolerance can also change over time. When you're 21, for example, you might be willing to invest entirely in stocks because you have more time to ride out market volatility. A few years later, however, you might be preparing to make a down payment on a house and decide to allocate more of your assets into investments offering greater stability. The right asset allocation for you at any given time is the one that provides you with the best opportunity to meet your financial goals, regardless of market conditions.

For your investment strategy to remain effective, you must continuously monitor your portfolio and make adjustments as needed. If your investment goals change, for example, you may need to rethink your asset allocation. Perhaps your goal was to save for retirement, but now you have a shorter-term goal of saving for a child's college education. Depending on the number of years until the child is ready for college, it may be appropriate to shift some of your funds into less volatile investments.

Another reason for regular monitoring is that the balance of assets in your portfolio will naturally shift as certain investments outperform others. In a period of rapid growth in the stock market, for example, you may find that your portfolio quickly becomes more heavily weighted toward stocks than you originally desired. So you may want to rebalance your portfolio to be consistent with your original target allocations.