Taxes

Don’t confuse preparation with planning

Most families think about taxes only when they, or a professional preparer, sit down to complete their federal, and maybe state, income return for the previous year. By then, it’s too late to take certain deductions and credits based on strategies that needed to have been implemented during the year. Unlike preparation, planning is a year-round approach. Most strategies must be carried out no later than December 31 of that year, and often well before that. Examples include selling losing investments to offset other income, making certain retirement plan contributions, and taking actions that realize valuable medical and charitable deductions. Especially critical these days is planning for the dreaded alternative minimum tax (more on this later), which is hitting even middle-income taxpayers. The same advanced planning principle applies to estate taxes. Failure to establish and revise plans well before death or possible incapacity could cost your beneficiaries thousands of dollars in lifetime income. Good year-round planning also requires good year-round record keeping. You need to be able to substantiate your claims or else you lose out on valuable deductions.

Saving strategies

While laws change frequently, taxpayers can generally count on certain strategies and principles that have endured over the years, such as deduct, divert, convert, and defer. Here are a few, and your financial planner can identify many more.

Learn your marginal tax bracket. That’s the rate at which your last dollar of taxable income is taxed. This rate can tell you whether it’s worth investing in a taxable versus tax-favored asset, the benefits of a particular charitable contribution, or whether to take advantage of certain employee benefits such as flexible spending accounts.

Calculate your effective tax rate. This is determined by dividing your total income into your total tax bill. It shows you the impact of taxes on every dollar you earn and can help you with everything from calculating accurate estimated tax payments to putting together a realistic household budget.

Save in retirement accounts. The number and complexity of retirement accounts have multiplied over the past 20 years but the principle remains the same: saving in tax-favored accounts is a powerful tool for funding a secure retirement.

Look where you borrow. Deductions for many interest payments have been eliminated over the years, but loans secured by the equity in your home, within limitations, remain tax deductible. Many people also can deduct interest on college loans.

Time income and expenses. Depending on your situation, you can reduce what you owe by bunching together deductible expenses such as medical bills, or by accelerating or delaying receipt of income.

Shift income. You may be able to save by shifting assets to family members such as children who are in lower tax brackets. Use charitable gifting strategies. Simply gifting cash to your favorite charity isn’t always the best tax-saving method. The right charitable gifting technique or vehicle can save you more tax dollars, which means more money for the benefit of the charity.

Don’t let taxes control investment decisions

Taxes can eat away a significant portion of an investment’s return. Yet at the same time, you need to make sure that they don't dictate your investment plan. Investment decisions should be based first on the economics of the investment—its risk, the likely direction of its future returns, and whether it fits your current investment plan Read more about Investing here Taxes usually should be a secondary consideration. For example, the reluctance to pay capital gains taxes on stock profits accumulated during the bull market of the late 1990s, resulted in many investors hanging on to losing stocks during the bear market of 2000–2002. Nonetheless, numerous tax strategies can reduce the tax bite on your investment returns without compromising the investment itself.

Know the cost basis of your investment. Cost basis is essentially the cost of buying or taking ownership of an investment. An accurate basis is needed when determining an investment’s gain or loss from its sale in order to calculate the size of the tax liability (or deduction). Failure to adjust cost basis for such factors as fees or commissions paid when buying the investment, stock splits, or inheriting the investment could lead to a higher tax bite than necessary.

Don’t forget reinvested profits. When calculating their cost basis after selling mutual fund shares, investors often neglect to include reinvested dividends or capital gains. In taxable accounts, those dividends and gains are taxed annually, even if reinvested in the same fund. Shareholders who fail to include them in their basis end up paying taxes twice on those capital gains and dividends. The same principle can apply to some discounted bonds.

Keep an eye on mutual fund tax efficiency. Some mutual funds, or types of mutual funds, are more “tax efficient” for their investors than other funds. Learn more about Types of Mutual Funds here

Know when you bought your investment. Holding an investment for longer than a year provides substantial tax breaks—as long as holding it that long is worth the investment risk.

Offset capital gains and losses. You can offset gains from the sale of investments with corresponding sales of losing investments, or vice versa.

Choose tax-favored investments and strategies. You can minimize, delay, or even eliminate investment taxes through such vehicles as retirement accounts, annuities, municipal bonds, life insurance, or “like-kind” real estate exchanges.

Employ certain estate planning techniques. Tried-and-true techniques such as annual tax-free gifting or the gifting of appreciated assets can save substantial estate and income taxes. Learn more about Estate Planning here

Avoid common tax filing mistakes

As with time-honored tax-saving strategies, there are common tax-filing mistakes that seem to snag taxpayers year in and year out, regardless of the changing tax code.

Filing the wrong tax status. For example, qualified taxpayers often fail to file as head of household or as a qualified widow or widower.

Failing to contribute after the tax year ends. Didn’t contribute the maximum to your retirement account in the previous tax year? Depending on the account, you may still be able to contribute as late as your tax return filing date, or even later.

Using the IRS as a savings account. Many taxpayers, consciously or unconsciously, have too much withheld from their paycheck for income taxes. They think of it as a forced way to save. But the IRS doesn’t pay interest on refunds. Adjust your withholding and invest the savings from each paycheck.

Assuming you don’t have to pay the alternative minimum tax (AMT). Congress designed the AMT to ensure that wealthy earners did not escape paying federal income taxes by taking excessive advantage of numerous tax breaks. But the AMT is snaring more and more middle-income taxpayers. You need to calculate your taxes by regular rules and AMT rules to see which tax regime applies to you, or use tax software that will automatically do this for you.

Taking the standard deduction instead of itemizing. A U.S. General Accounting Office study estimated that roughly two million taxpayers overpaid their taxes an average of $500 each by failing to itemize for such things as their mortgage interest and charitable deductions.

Stay informed and flexible

The first key to making the most of changing tax laws is to stay informed and be flexible. That’s not easy at first blush. It’s the rare taxpayer who has the time or knowledge to stay abreast or comprehend all the nuances of the tax code. Are you aware, for example, that changes in the tax code in recent years have:

• Necessitated the rewriting of estate planning documents such as wills and trusts

• Dramatically influenced how families save for college and pay for health care and long-term care needs

• Altered the design of retirement accounts and how beneficiaries can withdraw funds from those accounts

But don’t let taxes dominate While keeping up with tax code changes is important, don’t let tax laws dictate your financial life. Fundamental money management principles are always in style, such as the need to save and invest, to budget, to be properly insured, and to have estate and retirement plans. Consider the challenge of saving for college education. Tax laws, particularly since 1997, have created an abundance of tax breaks and benefits for funding college education. Nevertheless, they haven’t altered the underlying principle of college planning: the smartest way to pay for your children’s college education is…to save regularly! It’s also wise not to base your tax and financial planning too heavily on what you think future tax laws might be. While it can be prudent to consider their potential impact, proposed tax law changes often have a way of never materializing or materializing in a significantly different version.

Remember, each saved tax dollar frees that dollar for such goals as funding a comfortable retirement, putting children through college, buying a business or a dream home, taking an exotic vacation, or leaving money to heirs. Saving taxes should complement, not dominate, your financial life. By paying attention to your taxes year-round instead of just at tax-preparation time, you can become a tax “survivor”…and, more important, enhance the quality of your overall financial well-being and prosperity.

C) 2004 The Financial Planning Association

Send mail to web@azmythfinancial.com with questions or comments about this web site.
Copyright © 2007 Azmyth Financial, LLC