Although taxes are inevitable, strategic planning can significantly reduce the amount you owe. And the more you know about the strategies available, the more effective your plan will be.
To this end, we present our Top 10 tax planning strategies - which most taxpayers can use – followed by special strategies for specific types of taxpayers, such as parents, homeowners, the self-employed, investors, retirees and charitable donors.
1. Accelerate or Defer Income
If you expect your tax bracket will be higher next year, accelerating income to 1999 may make sense. Conversely, if you expect to be in lower tax bracket in the upcoming year, deferring income may provide tax savings. Even if your marginal tax rate remains the same, deferring income to a later year is generally advantageous.
In addition to wages, salary and tips, sources of income may include interest, dividends, profits and losses from businesses, capital gains and losses, rents royalties, partnerships, S corporations and trusts, taxable Social Security benefits, withdrawals from individual retirement accounts (IRAs), and state and local income tax refunds.
2. Maximize Above-the-Line Deductions
The adjustments to your income to determine your adjusted gross income (AGI) are often called above-the-line deductions. They are an important tax planning tool because
- you can take them in addition to the standard deduction or itemized deductions, and
- AGI determines your eligibility for various deductions, exemptions and credits. Possible adjustments include certain retirement plan contributions, certain moving expenses, self-employment tax (50%), self-employment health insurance costs (60%) and penalties on early withdrawals of savings.
3. Contribute to Your Retirement Plan
The deduction for contribution to IRAs, simplified employee pensions (SEP)s and Keogh plans is above-the-line, so you can take it in addition to your standard deduction or itemized deductions. Furthermore, traditional IRA, SEP and Keogh plan earnings accumulate tax-deferred. You can deduct contributions to a traditional IRA of up to $2,000 or 100% of your earned income (whichever is less). And the Taxpayer Relief Act of 1997 gives you the Roth IRA option as well as more opportunities to make penalty-free withdrawals from your IRA.
Most 401k plans allow employees to contribute pre-tax dollars, up to the maximum allowed by law ($10,000 for 1999). Not only do plan contributions reduce your taxable income, the earnings also accumulate tax-deferred. When compared with saving on an after-tax basis, the power of deferred compounding is significant. Under Savings Incentive Match Plans for Employees (SIMPLE)s, eligible employees may elect to have their employers contribute up to $6,000 of their salaries rather than pay them cash, similar to a 401k plan. The employee excludes the contribution from income, and certain other rules apply.
4. Maximize Itemized Deductions
Claiming itemized deductions will save you taxes if your total itemized deductions exceed the standard deduction. Itemized deductions include medical expenses, interest expenses, state and local taxes, charitable contributions, casualty and theft losses, gambling losses, and miscellaneous expenses (which include un-reimbursed employee expenses, tax preparation fees, investment fees and expenses, safe deposit rental charges, and expenses incurred to protect income and capital). If your AGI exceeds certain limitations, the amount of your allowable deductions for certain interest expenses, state and local taxes, charitable contributions, and miscellaneous expenses will be reduced by 3% of you AGI over the threshold amount. The reduction cannot exceed 80% of otherwise allowable deductions.
Many itemized deductions, such as medical expenses, casualty and theft losses, and miscellaneous expenses, are subject to limitations or phase-outs, which reduce or eliminate their benefit. By claiming several deductible expenses in one tax year, you may be able to exceed the applicable floor.
5. Pay Off Nondeductible Interest
You can maximize your interest deduction by paying off nondeductible interest (such as that on credit cards and personal loans) with money from a deductible class (such as home equity loans).
6. Give to Charity
Giving to charity is one tax reduction strategy that allows both you and others to benefit. Since charitable contributions are fully deductible (subject to income limitations), as long as your itemized deductions exceed the standard deduction, the more you donate to charity, the more tax benefit you receive. You must receive documentation from the charity for each contribution of $250 or more, including the value of anything you received in return. Canceled checks are no longer sufficient proof.
7. Claim All the Exemptions You Can
Make sure you determine whether certain relatives in addition to your spouse or children qualify for a personal exemption as dependents on your tax return. Possible dependents include parents, nieces, nephews or other relatives whom you may be supporting. The exemptions are reduced and eventually eliminated for taxpayers with AGI above certain thresholds.
8. Understand State Tax Returns
Be sure to take advantage of claiming a credit for taxes paid to another state if you live in one state and work in another. You may also benefit from rules relating to interest and gains from municipal securities of your resident state and additional exemptions that may be available.
9. Consider Estimated Tax Payments
You may be penalized if your withholding and estimated tax payments don’t meet the minimum required amounts. To avoid such penalties, during the current year you can pay 90% of your current year’s tax liability or 100% of your prior years tax liability (105% if you are a high-income taxpayer). This is beneficial if you expect your tax to increase in 1999, because you can defer any tax due in excess of your 1998 tax liability until April 15, 2000.
10. Watch Out for the AMT
If your alternative minimum tax (AMT) liability exceeds your regular tax, you must pay the AMT. To calculate AMT income, various tax preferences and adjustments are added back to your taxable income and a $33,750 exemption ($45,000 for married filing jointly and $22,500 for married filing separately) is deducted. The exemption starts to phase out once AMT income exceeds certain levels. If you are likely to be subject to the AMT, time the receipt of income and the payment of certain deductible expenses to ensure you get the maximum benefit. For example, if you expect to pay the AMT in 1999, you may not benefit from prepaying your fourth-quarter state estimated tax in December, since you cannot deduct state taxes for AMT purposes. You may be able to claim a credit in future years for AMT paid, depending on which adjustments generated the AMT.
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