Ravaged by your 1995 taxes? Feel like...
Ravaged by your 1995 taxes? Feel like you’re stuck again for 1996? Think again. There are dramatic tax savings available to brave souls willing to take some radical steps or, well, change their lives. Here are 10 ideas.
Give it away
In any given year, you can contribute up to 50% of your income to charity and deduct this generous contribution from your income taxes, notes Gregg Ritchie, partner in the personal financial planning group at KPMG Peat Marwick. If you had $50,000 in income, for example, and gave $25,000 away, you would pay just $3,379 in income tax. If you gave less, and claimed just a standard deduction, you would pay $9,180. So, by giving away $25,000, you save $5,801 in income tax and you get the warm and cozy feeling that comes from helping out others who, now, are nearly as financially troubled as you are.
Save like crazy
You earn $50,000 in wages and you hate paying taxes, so you pile as much as you can, which is 15% of your income, or $7,500, into a 401(k) plan. You also have $10,000 in self-employment income, which allows you to contribute an additional $2,000 into a Keogh plan, which is a tax-favored retirement plan for the self-employed. Finally, you pop $2,000 into a nondeductible IRA.
What does that get you? $9,500 in deductions and a passel of assets that will generate nontaxable investment income.
“On the 401(k), Keogh and IRA, you wouldn’t be paying any tax on your investment income,” says Phil Holthouse, partner at Holthouse Carlin & Van Trigt in Los Angeles. “If you can afford to live without the cash, tax-free compounding is a wonderful thing.”
In the end, your $60,000 in gross income dives to $44,100 in taxable income, assuming a standard deduction and one personal exemption. You save $2,660 in federal taxes immediately, and defer taxes on any investment income you earn on the retirement plans until you start to pull the money out at retirement.
On the other hand, if you withdraw your savings before retirement, you get hit with a hefty tax penalty. And, of course, you’ve got $11,500 less to spend each year, which is no fun at all.
Get divorced
If you are a dual-income family that is rich, poor or elderly, few tax-planning techniques can save you as much as simply cutting the legal ties that bind you to the one you love.
Consider Leon and Florentine, hypothetical seniors, who each have a pension that pays $20,000 a year, in addition to $12,000 each in annual Social Security benefits. Altogether, their annual income amounts to $64,000--$32,000 each.
They own a $400,000 home that they bought in 1950 for $20,000. Since it has long been paid off, they take only the standard deduction, which is a bit higher for them because they’re both over age 65.
Married, they pay $6,067 in federal income tax. If they divorced, they’d each pay $2,006--or $4,012 between the two of them. The $2,055 difference is the so-called “marriage penalty.”
If nothing changes and they both live another 20 years, it’s reasonable to assume that staying married will cost them better than $41,000 in the future.
But wait. It gets worse.
Let’s say they want to sell their house and move into an apartment. They have a $380,000 gain on the sale of their property. But, since they’re over age 55, they get to exclude $125,000 of the gain. They pay tax on the remaining $255,000 at the 28% capital gains rate--$71,400.
However, if they divorce before they sell the house, they each get to exclude $125,000 from capital gains taxes.
The end result: Leon pays capital gains taxes on $65,000--a total of $18,200. So does Florentine. Together they pay $36,400--a whopping $35,000 less than they would pay if they sold the house while married.
Sum total, this middle-income couple would be roughly $76,000 richer if they legally split. Of course, their children probably wouldn’t approve. And, of course, there could be added costs for some people who try this, from insurance complications to wrecked estate plans.
Get married
On the other hand, if you are cohabiting with someone of the opposite sex who doesn’t happen to have a job, you can save some major tax bucks by tying the nuptial knot.
A person with a $50,000 income, who switches from single filing status to married, filing jointly, with two personal exemptions rather than one, pays just $5,764 in federal income tax versus $9,180 when filing single.
Your friend, having no income, pays no tax under either scenario. So, aside from being legally hooked to you, he or she is unaffected by the deal. There might be other advantages. He or she might qualify for spousal benefits, such as health insurance, through your work, for example.
On the other hand, marriage is marriage--even if it’s only for convenience. It could cramp your dating style. Moreover, your spouse might someday sue you for alimony.
Leave the country
If you work and live abroad, you do not have to pay taxes on the first $70,000 you earn.
Those who really hate U.S. taxes and don’t mind going quite a distance to prove it, can turn in their passports, renounce their citizenship and move to a tax haven in the Bahamas, where the water is warm and income taxes are a pittance, says Harvey Gettleson, partner at Ernst & Young in Los Angeles. Those who have large estates get the dual benefit of being able to bequeath their assets to relatives, without worrying about U.S. estate taxes that can eat up more than half of a wealthy person’s fortune, he adds.
There’s a trick to it, though.
If you left mainly for tax purposes but get sick of the Bahamas and try to return to the United States in less than a decade, the IRS has the ability to “look back” at all the income you earned in the years you were gone and tax you on it. And a new tax has been proposed that would essentially impose a toll for leaving on people who hope to take valuable assets with them, Gettleson notes.
Take a risk
There is actually one true tax shelter left in the 40,000-page U.S. Tax Code that provides you with write-offs that far exceed your investment. That shelter is low-income housing.
If you buy into a qualified low-income housing deal, you can get roughly $9,500 worth of tax credits each year that will reduce the federal income taxes you pay dollar-for-dollar.
The catch? While the return in tax benefits can be substantial, the chance of getting your initial investment back is slim, particularly when the housing project is in a state with high land values and high construction costs, says Donna Hansen, national director of the affordable housing practice at KPMG Peat Marwick in Long Beach.
For corporations and a few high-income individuals who materially participate in the real estate industry, the tax breaks may be reward enough. But for most other people “it may not be the most appropriate investment,” Hansen says. “You have to evaluate it assuming that you don’t get back any of your initial investment.”
These deals also require you to invest for a minimum of 15 years. If you want out early, you’ll have to give back a portion of the tax breaks.
Gamble on small company stocks
The 1993 tax bill ushered in a funky little tax break for people who agree to become long-term investors in little corporations. Specifically, if you buy shares directly from a company when it has less than $50 million in assets, you might be able to exclude 50% of your gain on the stock’s appreciation if you hold the shares for five years or more.
Emphasis on might because nobody actually knows whether you will make money or lose money on a small company stock. Moreover, no one has had time to see if the securities they purchased actually fit all the little caveats in the law. For instance, to get the tax break, the company has to be in a qualified trade or business. And excluded from that definition would be companies whose “principal asset was the reputation or skill of one of its employees,” says Stephen Corrick, partner at Arthur Andersen & Co. in Washington. That’s a fairly nebulous standard, which might--or might not--exclude companies like Netscape, he notes.
The purpose of this tax break was to make it easier for small companies to raise operating capital, Corrick adds. However, his clients complain that it’s not working because neither they nor their investors have any idea whether their companies will prove “qualified.” To add insult to injury, Congress is weighing plans to give all capital gains the same preferential treatment. If that happens, taking the added risk that comes from investing in small, largely untested firms seems foolish indeed.
Become a slave to your mortgage
Let’s say you earn $40,000 a year--$3,333 a month--and you figure you could easily afford a $734 monthly payment on a $100,000 mortgage at 8% interest. Better yet, buying a house is going to save you a few bucks in income taxes because the interest you pay--and most of your payment in the first few years is interest--is tax-deductible.
But, if you really want to save some money on income tax, throw out the idea of buying an “affordable” home and go for the gusto. Get a bigger house; borrow $200,000; and scrimp to make those payments. Sure, you’ll have to pay a higher interest rate, because your banker knows you’re overextended. Sure, you won’t be able to buy another thing for 30 years, or until you get a much higher-paying job. Sure, the risk of a housing downturn will be greater for you.
Still, on the federal income tax front, you’re a winner.
You, as a renter, paid $6,380 in federal income taxes. As the buyer of that piddling home, you would have paid about $5,148--$1,232 less. But, as the overextended homeowner that you are, you pay just $2,626. You save a tidy $3,754 annually.
Of course, once you pay the mortgage, utilities, insurance and maintenance on your house, you can barely afford gas for your 1972 Pinto. We promised only tax savings, not chicks or the trappings of cool.
Sacrifice investment returns
Another sure-fire way to save on income taxes is to invest all your money in double tax-free bonds, which are municipal securities issued within your own state. Of course, these securities pay paltry rates of interest--about 5% when taxable investments are yielding 8%. Or, to put it another way, if you had invested $300,000 in municipal bonds and were living on the income, you would get $15,000 in income each year on your 5% municipal bonds, but you’d pay no income tax. If you invested in Treasuries, which are not subject to state income tax but are subject to federal income tax, you’d earn about 8% on your money, or $24,000 annually.
By investing in the munis, you save $2,644 in federal tax, but you sacrifice $9,000 in investment income.
Quit
As long as we’re on the subject of living on less, there’s one sure-fire way to save money on income taxes: Don’t earn any money. If you have no income, you pay no income taxes.
All you need is the right attitude and very understanding relatives.
Kathy M. Kristof welcomes your comments and suggestions for columns but regrets that she cannot respond individually to letters and phone calls. Write to Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053, or message kathy.kristof@latimes.com on the Internet.
