Taking Time Now to Tackle Taxes Can Pay Off in April
It's last-minute tax tip time--that joyful period near the end of the year when all taxpayers would be wise to take a look at how much tax they might owe in April, how much they've already paid and whether there's anything they can do to reduce the bill.
At this point, there are four kinds of tax-saving strategies, says Gregg Ritchie, partner in the personal financial planning group at KPMG Peat Marwick. You can accelerate deductions, delay getting income, save lots of money or give some money away.
* Delay the holiday bonus. If you're one of the fortunate folks who still gets an annual bonus around the holidays, you might ask your employer to pay it early next year. That would save 1996 income taxes on the money, and you'd still get the cash to pay the credit card bills in January.
* Bundle deductions. Certain itemized deductions can only be taken once they exceed certain thresholds. Miscellaneous business expenses are only deductible once they exceed 2% of your adjusted gross income and medical expenses once they surpass 7.5% of AGI, for example. If your expenses in either category are nearing the threshold, it might make sense to speed up other similar expenditures to generate a write-off. You might, for example, opt to renew a business magazine subscription in December even though it doesn't expire until February because if you wait, your business expenses wouldn't hit the threshold in either year.
* Save. If you haven't contributed all you can to your 401(k), deductible IRA or Keogh, now is the time to do it--or at least to get ready. Every dollar contributed to one of these accounts reduces your income by a like amount. That means you pay less current-year income tax. What's more, the investment earnings remain tax-free until they're withdrawn at retirement. Money must be contributed to a 401(k) by year-end to get the deductions. However, you can delay funding your IRA or Keogh until the tax deadline in 1997 and still get a 1996 deduction. The Keogh account must be set up before year's end, though.
* Generate losses. If you've taken a lot of gains in your investment portfolio--as have many people who sold stocks in this year's bull market--now is a good time to dig around to find any losers you'd like to unload. Capital losses on stocks and bonds reduce your capital gains income and can be used to offset up to $3,000 in ordinary income in any given year.
* Give to charity. Charity appeals go into high gear during the holidays, and for taxpayers, it's not a bad time to give. There are three viable options: Give cash, depreciated property such as old clothes or furniture, or appreciated property such as common stocks that are worth more today than when you bought them.
Cash gifts are simple. For taxpayers who itemize deductions, $1 in cash donated to a legitimate charity results in $1 less in taxable income. That will reduce your tax, assuming you're in the 28% marginal federal tax bracket, by 28 cents.
Giving property is a little trickier simply because you must determine its value. If you are ever audited, the IRS will expect you to have records of what was donated and how you determined its worth. With old clothes and furniture, the value is likely to amount to a fraction of what you paid for the items new. However, whether that value is two-thirds, one-half, one-third or one-quarter of what you paid is likely to depend on the item's condition and age. No idea how to figure it? Visit a thrift store and estimate values based on sales prices of similar items.
One caution on the depreciated property front: Many charities are now urging donors to give used cars. If the car is worth more than $500, you'll need to substantiate the deduction on a special form. If it's worth more than $5,000, you may need a certified appraisal. Some less reputable organizations contend you can inflate the value for tax purposes, but if you're thinking of trying that, be warned. Many experts believe auto deductions are being abused enough today to become an audit trigger tomorrow. It pays to a keep firm grip on your moral compass.
However, giving appreciated property can be fairly simple and lucrative for both the charity and you.
Consider a philanthropist who bought 100 shares in XYZ company 30 years ago for $10 a share. The shares, which trade publicly and are consequently easy to value, are now worth $23,000. Her intent is to sell the stock and give the proceeds to charity. If this taxpayer sells the stock, she'll pay a 28% capital gains tax on the $22,000 profit--about $6,160. She gives the remainder, $16,840, and gets a tax break amounting to $4,715, assuming a 28% federal tax bracket.
But if she gives the shares instead, she gets a deduction for the entire $23,000--that's worth $6,440 in tax savings. And the charity, a tax-exempt organization, gets $23,000 in shares, which it can sell without generating any tax liability. In the end, the charity gets $6,160 more and the philanthropist gets a deduction that's $1,445 richer.
* Buy business equipment. If you are self-employed or own a small business, remember that you can claim up to $17,500 in business supplies and office equipment expenses against your business income each year. If you're thinking about buying that new photocopy machine but don't have enough cash to pay outright, you should know that the current-year deduction is available as long as you put the machinery "in service" this year. It doesn't matter whether you pay for it over time, Ritchie says.
* Make an extra mortgage payment. Consider making your January mortgage payment a few days early to get the deduction for December. An extra $1,000 in mortgage interest expense deductions would save somebody in the 28% bracket $280 on his or her 1996 tax return. But be warned: Your mortgage interest deductions will drop in 1997.
If you happen to be a person with a negative amortization loan--one in which unpaid interest is added to the principal amount--and you happen to have a little extra cash this year, you can also pay the entire built-up interest amount and boost your 1996 interest expense deductions, Ritchie notes.
* Look forward to 1997. If you expect a dramatic increase in income next year, you may want to switch strategies, probably by taking as much income as you can this year and pushing deductions into next year. Also, legislation passed in 1996 may leave a few people with a few unusual planning opportunities for 1997, particularly with respect to medical expenses.
For instance, starting next year, the 10% early withdrawal penalty on IRAs will be waived for those who are uninsured and pulling money out to pay medical expenses or health insurance premiums that exceed 7.5% of their adjusted gross income. In addition, a new type of tax-favored medical spending account will be launched and available to some employees of small businesses, giving these workers a way to reduce their taxable income. And long-term care insurance benefits will become nontaxable, as will viatical settlements--that is, life insurance policy cash-outs provided to terminally ill individuals.
However, in most instances, accountants maintain, a deduction in the hand right now is better than two in the bush.