To Minimize ’94 Tax Bite, Plan a Strategy Now
By now, most Americans have put away the pencils, calculators and forms and vowed to forget about income taxes for another year. But if you’re smart, experts say, you won’t put away anything until you’ve considered ways to cut next year’s tax bill.
Need a little incentive? The Tax Foundation, a nonprofit research group, says the average American works 125 days each year just to cover federal, state, local, excise and other taxes.
Taxes are the average household’s biggest expense--they cost more than food, clothing and housing, the Tax Foundation says. Americans work 25 minutes of each eight-hour day to pay for recreation, but they work an hour and 48 minutes to pay their federal taxes, and almost another hour to pay state and local taxes.
How do you reduce that bite? The first step is to take a hard look at your most recent tax return, says Philip J. Holthouse, a partner in the accounting firm Holthouse Carlin & Van Trigt in Los Angeles. The reason for taking on this onerous task now is twofold: Your information is as organized as it will ever be, and it’s still fresh in your mind. Better yet, your tax accountant, if you have one, has plenty of time, now that the filing deadline is past, to discuss planning opportunities with you.
Some of the best tax-planning ideas are old standards: contributing to retirement plans, taking advantage of mortgage interest deductions, investing in tax-free municipal bonds and “bunching” certain expenses. But they’ve taken on greater significance--and there are a few new twists and turns--under the 1993 tax act passed last summer.
Here are a few ways to come out ahead on next year’s income tax bill:
* Convert consumer debt: If you own a home and have revolving balances on credit cards, consider paying off the consumer debt with a home equity loan. Most people can borrow up to $100,000 to pay off consumer loans--credit cards, car loans, personal lines of credit--and deduct the interest from their income on their annual tax return, says Ken Anderson, a partner in the national accounting firm Arthur Andersen & Co. Since loans secured by real property are usually less expensive than unsecured credit, you’ll save interest expenses too.
* Save for retirement: If you’re not already contributing the maximum amount to a 401(k), individual retirement account or Keogh plan, seriously consider doing so. All these savings plans allow eligible Americans to deduct their contributions from income. And the interest earned is tax-deferred--you don’t pay tax until you start pulling the money out, presumably at retirement age. The bad news is that there are hefty tax penalties for early withdrawal.
* Seek tax-free income: Income earned on municipal bonds is tax-free for everyone but retirees. (Technically, the municipal bond income is tax-free for retirees too, but it pushes more of their Social Security income into the taxable column.) And, thanks to the bond market’s collapse and rising tax rates, the tax-equivalent yields on these bonds can be generous even if you’re not in the highest federal tax bracket.
Income earned on certain insurance products, such as tax-deferred annuities, is also tax-deferred until retirement. But you get hit with the tax penalties if you withdraw the money early, and you may also get hit with insurance company penalties, called surrender fees.
* Bunch deductions: Take a close look at last year’s tax information to see if you missed limits on itemized deductions by small amounts. If so, try to bundle deductions by pushing certain expenses into a single year. For instance, medical expenses are deductible only if they exceed 7.5% of your adjusted gross income. If you get close to that threshold in one year because of an unusual event--the birth of a child or unexpected surgery, for example--consider pushing voluntary medical expenses, such as check-ups and prescription drug purchases, into the same year.
* Go back to work: There’s very little that retirees can do about the higher Social Security taxes that go into effect in 1994. But if you are retired and happen to have “passive” losses from rental real estate, you have a unique opportunity, thanks to last year’s tax act. If you go to work 750 hours a year in real estate--and real estate is your primary occupation--you can deduct your real estate losses against ordinary income. That has the dual effect of reducing your taxable income and reducing the income that’s subject to the higher Social Security tax, Holthouse says.
Technically, anyone who has substantial passive losses might want to consider real estate as a part-time profession, but it’s harder to meet the “primary occupation” test if you have another job as well.
* Donate appreciated property: The way you give to charity can have a substantial impact both on how much you can give and how much the charity gets. Whenever possible, give appreciated property rather than cash. Last year’s tax act exempts such gifts from the alternative minimum tax, which previously could trip up such donors.
How does giving appreciated goods help the taxpayer? Consider the hypothetical Jane Smythe, a well-heeled taxpayer who wants to donate $10,000 to her favorite cause. She happens to have $10,000 in stock she purchased for $5,000 five years ago. She considers selling the stock to make the contribution, but if she does, she’ll have to pay a 28% capital gains tax on the $5,000 gain. That costs her an extra $1,400.
If she gives the shares to the charitable organization, she gets the $10,000 charitable-contribution deduction. The charity gets a $10,000 security it can sell. Because the charity is tax-exempt, nobody pays a capital gains tax.
* Stress capital gains: The 1993 tax act widened the disparity between ordinary income tax rates--which now go up to 39.6%--and the capital gains rate of 28%. To the extent it fits your investment strategy, stress price appreciation rather than dividend or interest income with new investment selections.
* Buy business property: You can now “expense”--write off in the year purchased--up to $17,500 in property purchased to operate a small business. Business property worth more than that must be depreciated by a set schedule, usually over five to seven years.
