Taking steps now can help keep your 2004 and future tax liabilities as low
as possible. Most income tax planning centers on a few basic concepts:
- Delaying taxation where practical.
- Taking advantage of tax favored treatments on some types of income.
- Taking maximum advantage of the marginal rate structure of the tax
code.
- Getting the most from your itemized deductions.
- Being aware of potential pitfalls.
Why delay taxation?
The answers are simple - the time value of money and tax-deferred
compounding. If you can control when you take an item of income, delaying the
recognition until after year-end will delay paying the tax until April 15th
of the following year.
The most common instance where this applies is deciding to take a capital
gain on a stock in December or January. Delaying until January can let you
earn interest on the amount you will pay in tax for an additional 11 or 12
months. IRAs and qualified retirement plans are other tools that let you
defer taxation and earn extra money on what you would have otherwise paid in
taxes until you withdraw the funds.
Tax favored treatment
Wages, dividends, interest and most other types of income are taxed at
normal rates. However, the tax law has special provisions for long-term
capital gains and interest on bonds issued by state and local
municipalities.
For stocks owned for more than one year and sold after 5/15/03, the
maximum tax rate on the gain is 15% compared with the normal top rate of 35%.
Stocks have other risks and you should not let the hope of saving some taxes
unduly influence any decisions to sell stocks. Be sure to review your
portfolio carefully, especially at year-end, to understand how your positions
stand relative to the one-year holding period. Net capital losses for a year
can only be used up to $3000. Net losses in excess of $3000 can be carried
forward to offset gains in future years.
Interest on bonds issued by municipalities and states are generally exempt
from federal income tax. These bonds usually pay lower interest rates than
comparable taxable bonds. To determine if tax-free bonds make sense for you,
compare the after-tax returns of the two types. The higher your income (and
marginal tax bracket), the more likely you may find tax-free bonds to be to
your advantage.
Marginal income tax rate structure
Our income tax laws are built around a marginal rate structure. This means
that income at lower levels is taxed at lower rates and income at higher
levels is taxed more heavily. The current rates start at 10% and rise to
35%.
If your income varies greatly from year to year, consider steps that even
it out so you get the maximum benefit of the lower rates each year.
Individuals that control portions of their income like bonuses and
commissions are the ones most likely to be able to apply this.
The other way to deal with marginal rates is to take full advantage of
lower rates for each member of your family. It used to be common for parents
to give money to children so the earnings would be taxed at the child's lower
rates. However, the rules were changed and now this is most practical after
the child has turned 14. Children under age 14 get a small
"exemption," but have most of their unearned income (dividends,
interest and other investment income) taxed at their parents' highest
rates.
Tax deductions
You are able to reduce your taxable income for certain types of expenses.
These itemized deductions are mostly for state and local taxes (income and
property), mortgage interest, charitable contributions and certain expenses
if they exceed a percentage of your adjusted gross income. Medical expenses
can also be deductible if they are large relative to your income. If your
itemized deductions are not large, the tax tables have a standard deduction
built into them.
To get the most benefit for your deductions, consider the timing of when
you pay them. For example, you may want to make your last quarterly estimated
state income tax payment in December rather than January (if your state has a
January due date) or carefully choose when you make charitable
contributions.
Avoiding the pitfalls
The income tax laws can be very complex. If your income is high or you have
a "complicated" tax situation, getting professional help may save
you money and reduce the stress and anxiety of dealing with your taxes.
Another factor for some is the alternative minimum tax (AMT). This additional
tax was instituted many years ago to make sure that high-income individuals
did not take unfair advantage of the tax laws to avoid or reduce their taxes.
However, as incomes have risen and especially with the lower rates from the
2001 Tax Act and the 2003 Tax Act, many individuals are being surprised by
the AMT. If your income is high, you have relatively large amounts of
itemized deductions or you have stock options, you should probably consult
with a qualified tax advisor to at least understand the AMT may apply to
you.
Final words
No one likes to pay more tax than is absolutely necessary and there are
completely legal ways to manage your taxes to some extent. However, cheating
on your taxes or letting the idea of saving taxes cause you to make unwise
financial decisions should not be parts of your strategy.
