Look for Trade-Offs and Traps This Year


Year-end tax planning--usually an exercise in merely delaying tax liability--could produce modest but permanent savings this year, thanks to last summer’s tax law. However, it also poses some risks.

“The traditional strategy of postponing income and accelerating deductions is worth more right now because rates are declining in future years [thanks to the new tax law],” said Mark Luscombe, principal tax analyst at CCH Inc., a tax research company in Riverwoods, Ill.

Normally, if you pay a deductible expense in one year, it’s not available to reduce your tax in the next. And pushing back the receipt of income reduces the pain in the current year only to increase it later. But now, any income you can delay until 2002 will be taxed at a lower rate, creating permanent tax savings.

Deductions are worth more in 2001, so paying deductible expenses early can be wise.


But the U.S. tax code is rife with income-contingent tax breaks--deductions and credits that taxpayers lose when their income rises beyond set thresholds, said Brenda Schafer, senior tax research coordinator at H&R; Block in Kansas City, Mo. Families that can qualify for these credits and deductions must be cautious about traditional tax planning, Schafer said.

Taxpayers have to calculate the trade-off between the money saved by shifting income and taking deductions and what it would cost if they lose some of the tax breaks they had enjoyed.

The best way to illustrate is to consider a hypothetical family--Jane and John Smith and their 17-year-old college-bound daughter. John earns $40,000 annually. Jane is a contract employee who bills her clients on a quarterly basis and she also earns roughly $40,000 a year.

If the Smiths had no children, Jane might want to postpone receiving her final payment of $10,000 until January. That would not only delay the Smiths’ obligation to pay $2,750 on those earnings--the Smiths’ marginal tax rate in 2001 is 27.5%--for a year, it would permanently save the Smiths $50 in federal income tax. That’s because federal income tax rates drop by half a percentage point next year.


However, if they do that, the family’s income probably will jump in 2002 from $80,000 to $90,000. That would jeopardize their ability to claim the Hope Scholarship tax credit, which would provide a $1,500 reduction in the Smiths’ tax liability.

The Hope tax credit phases out for those earning more than about $80,000 annually and is eliminated once income exceeds about $100,000. (The exact income threshold applicable in 2002 is not known.)

Consequently, by pushing income into 2002, they would exceed the credit threshold and lose about half the credit. Net result: They’re behind by roughly $700--the $750 lost credit, minus the $50 savings.

Traditional tax-delaying strategies still can be valuable, but taxpayers need to step more carefully to avoid traps like these, Schafer said. Families that qualify for income-contingent breaks--ranging from the child tax credit to the lifetime learning credit--simply must consider their tax position in both this year and the next before they make any moves to shift deductions or income.


Though the traps have existed since income-contingent tax breaks began to proliferate during the Clinton administration, the temptation to delay income to take advantage of permanent tax savings is greater now thanks to the stair-step rate reductions in the new law.

“Don’t simply put off some income and figure it’s going to save you a lot of money,” said Schafer. “Take a look at the impact it will have in both years.

“Although the rates are lower next year, the decrease in other credits and deductions could put you in a worse position if you are near any of the phase-out ranges.”