Some Popular Tax Strategies
by
Charles Lamson
Managing your taxes is a year-round activity. Because Congress considers tax law changes throughout the year, you may not know all the applicable regulations until the middle of the year or later. Like other financial goals, tax strategies require review and adjustment when regulations and personal circumstances change.
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Tax planning can become very complex at times and may involve rather sophisticated investment strategies. In such cases, especially those involving large amounts of money, you should seek professional help. Many tax strategies are fairly simple and straightforward and can be used by the average middle-income taxpayer. You certainly do not have to be in the top income bracket to enjoy the benefits of many tax-saving ideas and procedures. Series EE bonds are an excellent vehicle for earning tax-deferred income. Some other popular (and fairly simple) tax strategies follow.
There are other strategies that can cut your tax bill. Accelerating or bunching deductions into a single year may permit itemizing deductions. Shifting income from one year to another is one way to cut your tax liability. If you expect to be in the same or a higher income tax bracket this year than you will be next year, defer income until next year and shift expenses to this year so you can accelerate your deductions to reduce taxes this year.
Maximizing Deductions
Review a comprehensive list of possible deductions for ideas, because even small deductions can add up to big tax savings. Accelerate or bunch deductions into one tax year if it will allow you to itemize rather than take the standard deduction. For example, make your fourth quarter estimated state tax payment before December 31 rather than January 15 to deduct it in the current taxable year. Group miscellaneous expenses and schedule nonreimbursed elective medical procedures to fall into one tax year to exceed the required "floor" for deductions. Increase discretionary deductions such as charitable contributions.
Income Shifting
One way of reducing income taxes is to use a technique known as income shifting. Here the taxpayer shifts a portion of his or her income---and thus taxes---to relatives in lower tax brackets. This can be done by creating trusts or custodial accounts or by making outright gifts of income-producing property to family members. For instance, parents with $125,000 of taxable income (28 percent marginal tax rate and $18,000 in corporate bonds paying $2,000 in annual interest might give the bonds to their 15 year-old child---with the understanding that such income is to be used ultimately for the child's college education. The $2,000 would then belong to the child, who would probably have to pay $125 (0.10 x [$2,000 - $750 minimum standard deduction for a dependent]) in taxes on this income, and the parents' taxable income would be reduced by $2,000, reducing their taxes by $560 (0.28 x $2,000).
Unfortunately, this strategy is not as simple as it might at first appear. Under current tax laws, investment income of a minor (under the age of 14) is taxed at the same rate as the parents to the extent that it exceeds $1,500. For example, if a five year old girl received $2,500 from a trust set up for her by her parents, the first $1,500 of that income (subject to a minimum of $750 standard deduction) would be used at the child's rate, and the remaining $1,000 would be subject to the parents' (higher) tax rate. These restrictions do not apply to children (and presumably, with other older relatives, such as elderly parents).
Parents need to be aware that shifting assets into a child's name to save taxes could affect the amount of college financial aid for which the child qualifies. Most financial aid formulas expect students to spend 35 percent of assets held in their own name, compared with only 5.6 percent of the parents' nonretirement assets.
Tax-Free and Tax-Deferred Income
There are some investments that provide tax-free income; in most cases, however, the tax on the income is only deferred (or delayed) to a later day. Although there are not many forms of tax-free investments left today, probably the best example would be the interest income earned on municipal bonds. Such income is free from federal income tax. No matter how much municipal bond interest income you make, you do not have to pay any taxes on it. Income that is tax deferred, in contrast, only delays the payment of taxes to a future date. Until that time arrives, however, tax-deferred investment vehicles allows you to accumulate earnings in a tax-free fashion. A good example of tax-deferred income would be income earned in a traditional IRA.
All the income you earn in your IRA accumulates tax-free. This is a tax-deferred investment, so you will eventually have to pay taxes on these earnings, but not until you start drawing down your account. Roth IRAs, introduced in 1998, provide a way for people with AGI (Adjusted gross income is an individual's total gross income minus specific deductions. Wikipedia) below a given level to contribute after-tax dollars. Not only do earnings grow tax-free, but so do withdrawals if the account has been open for five or more years and the individual is over 59.5. In addition to IRAs, tax-deferred income can also be obtained from other types of pension and retirement plans and annuities.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 120-123*
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