Power of Deductions
Americans who hoped the new tax breaks Congress passed last year might help them save big money this filing season probably will be disappointed.
There are dozens of significant changes in the tax code, including liberalized retirement-savings provisions and increased college-savings options. But only a few of the new tax breaks went into effect during 2001 and thus are of any use on the tax forms that must be in the mail by April 15.
But cheer up. Many of the tax breaks go into effect this year. By planning now--yes, even while struggling with your 2001 tax return--you can take advantage of them and save hundreds, even thousands, of dollars on your taxes next year.
“Even people who can’t take advantage of all the breaks could save a few hundred dollars if they plan ahead,” said Joel Isaacson, director of tax planning at Joel Isaacson & Co. in New York.
The savings will vary widely among taxpayers, however, because the new law’s benefits target specific groups.
Taxpayers who are adopting children, going back to school or saving for retirement or their children’s college tuition will qualify for the biggest breaks. A taxpayer with no children and no savings will benefit only from slight reductions in the marginal tax brackets.
There’s a caveat in all of this for Californians. Until legislation is passed in Sacramento bringing the state’s tax laws into line with the changes made in the federal tax code, California residents won’t be able to claim any of these breaks on their state tax returns. But they can still qualify for big savings from Uncle Sam.
Here are the major changes that go into effect this year and can be claimed on U.S. tax returns due April 15, 2003:
* Maximum contributions to 401(k) and 403(b) retirement plans rise $500, to $11,000 a year.
* Maximum contributions to 457 retirement plans rise $2,500, to $11,000 a year.
* Maximum contributions to traditional and Roth IRAs rise $1,000, to $3,000 annually.
* Individuals older than 50 can make additional “catch-up” contributions to retirement plans. The maximum is $500 a year for an IRA and $1,000 for a 401(k), 403(b) or 457 plan.
* Maximum contributions to Education IRAs rise $1,500, to $2,000 annually.
* Distributions from education savings accounts, also known as 529 plans, become tax-free.
* Deductions for student loan interest are expanded to cover more loans and higher income levels.
* As much as $3,000 in higher-education expenses become deductible.
* The value of adoption tax credits is doubled for normal adoptions, allowing taxpayers to get credits for a maximum of $10,000 in qualified expenses. Those who adopt special-needs children can claim a $10,000 tax credit, even if their qualified adoption expenses are less than that.
* Self-employed people can deduct more of their health insurance expenses--as much as 70%, up from 60% in the previous year.
Many of the new tax breaks aren’t available to taxpayers above certain income levels. But some of the breaks--so-called before-the-line deductions--can lower your income to the point that you may qualify for some of the other tax breaks.
Smart taxpayers who are near the income thresholds should consider using more before-the-line deductions to get the full benefit of other lucrative credits.
Before-the-line deductions are chiefly contributions to retirement and employee benefit plans, such as 401(k), 403(b) and 457 plans. But they also include interest paid on student loans, alimony payments, moving expenses, self-employment taxes and health insurance deductions for self-employed people.
Before-the-line deductions reduce your adjusted gross income, which is used to determine eligibility for child tax credits, the Hope tax credit, student loan interest deductions and other tax breaks.
Consider a single mother with $46,000 in income and two teenage children, one of whom is starting college in the fall.
Theoretically, taxpayers can claim a credit of up to $1,500 to recover a portion of their first $2,000 in college education expenses. But this credit phases out once a taxpayer’s adjusted gross income exceeds a certain level--$41,000 for the 2002 tax year.
If this single mother doesn’t contribute to a retirement plan or claim some other before-the-line deduction to reduce her income, she’ll be able to claim only half of the tax credit, or $750.
But if she contributes $5,000 to a 401(k) plan, her adjusted gross income drops to $41,000, allowing her to claim the entire $1,500 credit. Also, her taxable income drops and her total federal income tax bill falls from $3,101 to $1,601.
The income limits vary by tax break, so it’s difficult to figure out what you’ll be able to take advantage of. But anyone considering actions that have tax consequences, such as refinancing a house, adopting a child or sending a child to college, should look at the income thresholds that could affect them and see what type of benefit they might reap by increasing their before-the-line deductions.
Other tax breaks coming this year could provide savings even further down the road.
For instance, last summer’s tax law boosted the annual contribution limit on Roth IRAs to $3,000 this year. Those 50 or older can contribute an extra $500, for a total of $3,500.
Unlike regular IRAs, Roth IRAs don’t offer upfront tax deductions. But when the money is pulled out at retirement, everything--principal and interest--is exempt from federal tax.
To figure the potential tax savings a Roth IRA might provide, taxpayers need to project an approximate rate of return and determine how much they might save and for how long.
Say you’re 50 years old and you put $3,500 in a Roth each year for the next 10 years. At a 9% annual rate of return, the account would grow to $53,175 by the time you turned 60. If you withdrew all of the money at that point--and assuming you were in the 30% tax bracket--the Roth account would allow you to avoid $5,452 in federal taxes. (That’s 30% of the investment earnings of $18,175.)
Education savings accounts--both 529 plans and Education IRAs--offer a similar benefit. Federal law makes distributions from these accounts tax-free if the money is used for qualified education expenses.
Although there are no deductions for contributing to the accounts, the future tax savings possible by financing higher education through these accounts can be significant--particularly for parents who have small children and plenty of time to accumulate investment returns.
