Plan Ahead to Trim Your Taxes

Gilbert Bahn is a deduction buncher. Well aware of the costly complexities of the U.S. tax code, the Moorpark retiree will put off paying certain creditors and expenses one year while making prompt payments the next.

By writing checks at just the right times, he can boost his tax deductions in years when he’ll itemize and reduce them when he takes the standard deduction. That allows him to get the biggest tax savings out of his deductible expenses--a classic year-end planning technique.

With income tax rates dropping, careful planners such as Bahn are worth emulating. President Bush’s tax relief package, signed into law this summer, launched a gradual decline in tax rates over the next five years. The top income tax rate will be cut from 39.6% to 35% by 2006, and the rates in other brackets will be reduced by 3 percentage points.

For taxpayers who itemize deductions, this means there’s more opportunity this year to cut their tax.

“The phase-in of new tax rate schedules puts us in a situation where the deductible expense is worth more in 2001 than it will be in 2002--and a lot more than in 2006,” said Vince Tarduogno, director and senior manager of financial planning marketing at Merrill Lynch in New York. “There’s more opportunity.”

But, as Bahn can testify, caution is key. The U.S. tax code is riddled with thresholds that taxpayers must either stay above or remain below to get the most out of their deductible buck.

“You have to start in October to plan the next two years,” Bahn said. “If you have bills coming up in November and December, you’ve got to know to put them over until January and get on track.”

What can individuals do to reduce their tax at this time of year?

Project. Before trying to strategize, taxpayers should estimate just how much tax they’ll owe in 2001 and 2002 by pulling out a copy of the previous year’s 1040 form and penciling in estimates of income and deductible expenses. Taxpayers who are nearing deduction and credit thresholds should consider whether shifting income or expenses from one year to the next will put them on the right side of those lines.

For instance, miscellaneous business expenses are deductible only if they exceed 2% of the taxpayer’s adjusted gross income. Suggested strategy: Pay two years’ worth of business dues, membership and subscription costs in years when other un-reimbursed business expenses are high. That sometimes earns a discount on dues and subscriptions. It also boosts the chance of clearing that 2% threshold in at least one year.

On the other hand, people who are covered by company pensions may fully deduct contributions to a traditional individual retirement account only if they earn less than $33,000 when single or $53,000 when married, filing jointly. Suggestion: Delay receipt of income if there’s a chance to duck below the threshold and claim the deduction.

Save. One way to get below adjusted gross income limits is to contribute to retirement plans, such as 401(k), 403(b) and 457 accounts.

Contributions to these accounts are taken out of pay before taxes are computed. The government acts as though the money were never earned.

Allowable contribution amounts to these accounts rise next year. In the meantime, anyone who hasn’t hit this year’s maximum contribution limit can “top off” their savings, Tarduogno said.

Homeowners may even be able to do this without out-of-pocket costs by coupling a mortgage refinancing with the boosted contribution levels, he added.

Consider a hypothetical example to illustrate: Henry Homeowner has a $200,000, 30-year, fixed-rate loan at 7.5%. Homeowner, who earns $60,000 annually, is contributing $5,000 annually to his 401(k) plan, because he says it’s all he can afford.

If he refinances that mortgage at 6.5%, his mortgage interest expenses will drop by about $134 a month, or about $1,600 a year. By using that savings to boost his 401(k) contribution by a like amount, he socks $6,600 into savings. Neither his tax situation nor his cash flow changes--401(k) contributions and mortgage interest expenses are both tax deductible--but he’s got a bigger bank account.

Remember points. Repeat refinancers should remember to write off any “points”--upfront interest costs--from a previous refinancing that haven’t already been deducted.

Points paid on a refinancing are deductible over the life of the loan. Taxpayers could claim an itemized deduction equal to one-thirtieth of the points paid on a 30-year mortgage each year, for instance.

However, when homeowners refinance a second time, any remaining points from the previous loan become deductible on the current year’s return.

Mine losses. Investors have plenty of paper losses, which can be used to create tax savings. Consider selling depressed shares that are unlikely to recover. The losses on those shares can shelter gains from the sale of appreciated stocks, plus as much as $3,000 in ordinary income.

Bunch. People whose itemized deductions are modest would be wise to follow Bahn’s example. Bahn estimates that a person with $40,000 in income could easily save $1,000 in federal income tax by managing how he or she pays deductible expenses. The concept is to itemize one year and claim the standard deduction the next.

In years when Bahn won’t itemize, he postpones every deductible expense possible, from real estate taxes to charitable contributions. He even accepts a penalty for making his final quarterly state income tax payment late every other year, so he can push that bill into the year he itemizes. The penalty costs $100, he said. The benefit is many times greater.

Give cash. Now is the time to consider charitable contributions. Remember, too, that there are two types of deductible donations--gifts of cash and gifts of property.

There is only one caution for those giving cash. Donations of more than $250 must be acknowledged with a receipt from the charity specifying whether it gave anything of value in return. If so, that value must be subtracted from the amount of the gift before the taxpayer claims a deduction. These acknowledgments do not need to be filed with tax returns but should be retained in the event of an audit.

Give property. Donations of property can be a bit more complex. Again, there are two viable alternatives.

* Depreciated property: Taxpayers can clean out their closets, garages and attics and donate their unused property--clothing, furniture, surfboards, games, toys, etc.--taking a deduction equivalent to the current market value of those goods. The taxpayer is charged with “guesstimating” that value based on the condition and original price of what’s donated. If a taxpayer donates more than $500 in property in any tax year, detailed records must be maintained.

* Appreciated property: Those who have charitable aspirations and appreciated stock may want to donate the shares directly. That saves the taxpayer from having to pay capital gains taxes on the share price appreciation when the stock is sold, said Philip J. Holthouse, tax partner with Holthouse Carlin & Van Tright in Los Angeles. However, never donate stock that has declined in value.

Why? By donating depreciated shares directly, the taxpayer loses the benefit of the capital loss. Those who want to donate the value of a depreciated security should sell the security first, Holthouse said. That allows them to claim the capital loss before donating the proceeds.

Plan. It won’t save on current-year taxes, but now is the perfect time to reconsider tax-saver accounts, Tarduogno said.

Many companies conduct open-enrollment periods at this time of year in which they give workers the option of saving some of their wages in dedicated accounts that can be used to pay dependent care or un-reimbursed health-care expenses.

The amount the employee saves is taken out of income before taxes are computed, much like 401(k) contributions. In addition to allowing income tax savings, they help taxpayers duck under income thresholds that might otherwise prevent them from claiming credits.

The catch: Any money placed in the account must be used during the year or it is forfeited. That’s no worry for those with relatively steady child-care or medical costs, but, Tarduogno said, it discourages many people who don’t think they can accurately project those expenses.

Still, for some, the tax savings are great enough that they could forfeit some of the money in the account and still come out ahead after tax. In any event, he said, they’re worth a close look.