Tax Planning

Tax planning can be intimidating, even for those who are financially savvy. It is one of the most complicated areas of managing your money, and many people put off dealing with it until they absolutely have to. However, preparing ahead of time for the inevitable makes the process more bearable-and creates opportunities to save considerable sums of money.

Proper tax planning starts with filing your return correctly and taking advantage of the tax breaks offered to you. But it also involves regular consideration and record keeping all year long as well as crucial moves before December 31.

What tips should I keep in mind when preparing my tax return?

If you worked for wages and had federal taxes withheld, you will have to file a return to get your refund.

Before mailing your return:

  • Review the return to make sure it is correct and complete.
  • Double-check all of your math.
  • Make sure you entered your Social Security number on the form.
  • Choose the correct filing status that gives you the most tax advantage.
  • Make sure you used the correct tax table column for your filing status.
  • Attach all W-2, 1099 and other forms that reflect tax withheld to the front of your return.
  • Put all the forms and schedules in order.
  • If you owe tax, enclose a check or money order payable to the U.S. Treasury and the payment voucher with your return. You can also pay by credit card or have the IRS withdraw payment directly from your bank account.
  • Sign and date the return and have your spouse sign if you are filing jointly.
  • Use the pre-printed label and envelope that came in the tax package.
  • File by April 15. If you cannot finish the paperwork in time, request an extension by April 15. The extension only applies to filing the actual return-you still have to pay any tax you owe on time.

What are common tax mistakes to avoid?

Do not lose track of your receipts. You have to have proof of your expenses if you want to deduct them. Keep them for at least 3 years, which is the statute of limitations for the IRS to disallow deductions. If you are audited before then, organize your receipts by deductible category to make the audit go smoother.

Figure out which form will enable you to pay the least in tax. Even if your finances are relatively simple, you might be able to take deductions with the 1040A and 1040 forms that you could not with the 1040EZ, and the longer forms do not take that much more time to fill out. For example, you might be able to deduct student loan interest and contributions to an IRA and therefore lower your overall taxable income.

Do not forget to report unearned income, such as interest and dividends, because the IRS already knows about it. You might owe tax on that money, and if you fail to report it, you will have to pay penalties and interest charges as well.

If you get married during the tax year, remember that the marriage penalty applies if both spouses work. You will both have to pay more in taxes than you would have if you had remained single. However, if only one spouse works, you will experience a tax savings from marriage. Adjust your withholding immediately so that it reflects your new situation, or you could end up owing more than you expected to pay.

How can I use my tax return to help me plan for next year?

Evaluate the following areas of your tax return:

  • Compensation income

Ask yourself if there is anything you can do to lower the amount of your taxable compensation income. One of the easiest ways to do that is to contribute the maximum allowable amount to your 401(k) plan and take full advantage of flexible spending accounts at work. Those contributions are made on a pre-tax basis and lower your taxable income for the year. Make those adjustments immediately.

If you are an executive, you may be able to participate in a deferred compensation plan with your employer, which allows you to defer some of your current compensation to future years and therefore defer taxes owed on that income for a long period of time.

  • Interest income

Consider changing your investment mix to lower your interest income. You might invest in fewer interest-bearing securities in favor of dividend-paying securities and securities that generate capital gains. Interest income is taxed as ordinary income at rates up to 35 percent, whereas qualified dividends are taxed at a maximum rate of 15 percent. Capital gains are also taxed starting at 15 percent.

If you invest through a qualified retirement plan, put high-tax interest-bearing securities, such as bonds, in your retirement plan where they can grow tax-deferred, and put low-tax dividend-bearing and capital gains-generating investments, such as stocks, in your taxable accounts.

IRA contributions

Contribute the maximum allowable amount to your individual retirement account (IRA). Make that contribution earlier in the year rather than later so you build up more tax-deferred income faster.

  • The size of your tax refund

If you received a large tax refund, adjust your withholding so that less money is taken out of your paycheck. Why make an interest-free loan to the government?

  • Estimated taxes

With the federal income tax system, you must "pay as you go." You are required to pay taxes over the course of the year rather than waiting until April 15. Most people meet this requirement by having taxes withheld from their wages. But if you make significant income from investments or freelance work, you must make quarterly payments of estimated tax.

As soon as you have filed your return, calculate whether you are going to need to make estimated tax payments for the current year. The general rule is you must pay estimated taxes if your withholding does not cover 90 percent of your tax liability. To avoid a penalty, you must pay either 90 percent of your expected tax for that year or 100 percent of what you paid in taxes in the preceding year.

Caution: If you are required to pay federal estimated tax, you may also be required to pay state estimated tax.

  • Alternative minimum tax

The alternative minimum tax (AMT) is an extra tax some people have to pay in addition to their regular income taxes. AMT was created to prevent wealthy people from using tax benefits to pay little or no tax. But the tax has become controversial because it affects a growing number of middle-class people every year. An AMT tax hit can be enormous, and every taxpayer should look out to prevent it.

The rules regarding AMT are complicated, but one common way to trigger AMT is to exercise incentive stock options. Before exercising these options, use your last tax return to do a projection for the current year and make sure you do not cross the threshold where AMT would apply.

TIP: Start maintaining tax records throughout the year. That way, you will always know where you stand and what steps you should take before year-end-and you will not have to scramble at tax time to find the information you need.

What should I do tax-wise before year-end?

  • Defer income

If possible, try to defer as much payment of income as possible until next year-for example, year-end bonuses. If you are self-employed, delay your December invoices so that you will get paid in January.

  • Accelerate deductions

Try to bunch deductible expenses, such as medical expenses and charitable contributions, into 1 year so you can itemize and take those deductions. Instead of spreading out the payments over the course of 2 years, try to accelerate those payments so they all fall into 1 year. That way, you might find that you can itemize every other year instead of not at all.

  • Take advantage of the gift tax exclusion

If possible, you want to gift up to $11,000 to each person you wish before the end of the year. You are allowed to give up to that amount per recipient per year without having to pay gift taxes. Of course, the earlier you do it the more capital appreciation the beneficiary can reap from the gift. Many people contribute their annual gift tax exclusion amount to a child's 529 college savings plan.

  • Realize capital losses

If you have capital losses, you want to realize them before the end of the year so you can use them to offset capital gains. You can write off all of your capital losses up to the amount of any capital gains you have. After that, you can deduct up to $3,000 more in capital losses against ordinary income. And following that, you can carry forward any remaining capital losses to be used to offset gains and income in future years.

  • Make charitable donations

Donations made to qualified charities before the end of the year are deductible in that tax year up to certain limits.

What kinds of charities qualify to receive tax-deductible donations?

Most well-known public charities are called 501(3) charities, or "50 percent limit" groups. That means that for cash donations, you can donate up to 50 percent of your annual adjusted gross income (AGI) to them.

You can still make deducible donations to qualified charities that are not 501(3) groups-such as fraternal societies and memorial scholarships-but you can only make cash donations up to 30 percent of your annual AGI.

For donations of appreciated property, such as investments or art, you can donate up to 30 percent of your AGI to a 501(3) organization and up to 20 percent of your AGI to a non-501(3) group.

TIP: If you donate appreciated property, transfer it directly to the charity. Do not sell it and give the group the cash because you will owe capital gains taxes on the profit from the sale.

The charity should be able to tell you what type of organization they are and to what extent donations to them are deductible.

How late in the year can I make a charitable donation and still take a deduction for that tax year?

In order to be deductible for that tax year, the contribution must be made by December 31. That is, the charity must receive your payment, either by credit card or check, by that date. The contribution is deductible even though your credit card company may not bill you or your bank may not debit your account until the new year.

TIP: If you have questions about the deductibility of charitable donations, call the IRS Tax Help Line for Individuals at 800.829.1040.

Can I donate my car to charity and get a deduction?

Yes. If you donate your car to a qualified charity, you can deduct the fair market value of the car. If the car is worth less than $5,000, you can look up its value in the Kelley Blue Book. If it is worth more than $5,000, you need to have its value determined through an appraisal.

What kind of documentation do I need to prove I made a charitable donation?

The more you donate, the more documentation you need:

  • For donations worth $250 or less, you do not need a receipt, but you do need to have a written record of the donation items, their worth and the date you donated them.6
  • For donations worth $250 or more, you must receive a written acknowledgment from the qualified charity-a receipt or letter-in order to claim the deduction.
  • For donations of property worth more than $5,000, you must provide a qualified written appraisal.

If the donation is worth less than $5,000, you do not have to attach the documentation to your tax return, but you do need to keep it in your records in case the IRS asks you to prove you made the donation.

How can I invest more tax-efficiently?

If you want to invest more tax-efficiently with income-generating investments, you might consider tax-free investments, such as municipal bonds or dividend-paying securities, which are now taxed at 15 percent in most brackets.

If you want to invest more efficiently with investments that provide capital appreciation, you should focus on long-term capital gains, which are taxed at 15 percent, rather than short-term capital gains, which are taxed at your ordinary income tax rate. Along those lines, you should consider mutual funds that hold stocks for longer than 12 months and have low turnover. Some mutual funds promote the fact that they are tax-efficient. Index funds and exchange-traded funds tend to be very tax-efficient because they do little buying or selling of securities and therefore generate few capital gains distributions.

Investing through tax-advantaged savings plans, such as IRAs, Roth IRAs, 401(k) plans, Coverdell Education Savings Accounts and 529 college savings plans are very useful ways to minimize taxes. Your contributions to these types of accounts may be tax-deductible and allow you to defer taxes on the earnings generated. It makes sense to keep high-tax income-generating securities in these accounts.

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