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Tax Planning

Get a Jump-Start on Your 2011 Tax Bill

Make these moves now to reduce your tax tab.

EDITOR'S NOTE: This article was originally published in the July 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

The rites of summer: lawn chairs, sunscreen, ice tea, fireworks, tax returns . . . What?! Yep, tax returns. "Now is a great time to do planning for 2011," says Kathy Pickering, executive director of H&R Block's Tax Institute. "You have half a year left to make some adjustments."

By getting a jump-start on your tax planning, you can employ a number of strategies that will trim your tribute to Uncle Sam. Perhaps you can position your investment portfolio to reap capital-gains breaks. Or you can arrange for home improvements that are medically necessary -- and tax-deductible.

Your first tax chore is to check the bottom line of your 2010 return to see if you should change your tax withholding or revise your estimated tax payments. The average refund for 2010 rose to a record $2,900. If you got a big refund, don't consider it a bonus. Instead consider cutting back on what you're paying the government for the rest of 2011. If you owed a bunch of money, maybe you should up your withholding.

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If you're not employed or if you work for yourself, adjust your estimated payments accordingly. Employees should file a new W-4 form to change the number of allowances. Our tax-withholding calculator can give you a good idea of how many allowances to claim based on your marital status, income and size of your refund. Or you can look at IRS Publication 919, How Do I Adjust My Tax Withholding?, at www.irs.gov.

But don't assume that you'll owe the same tax in 2011 that you did in 2010. For example, if you had to boost payments in 2010 to cover the bill on a big capital gain, you can pay in less for 2011.

Also, taxpayers who converted a traditional IRA to a Roth in 2010 may have decided to split the income-tax bill over 2011 and 2012. "People who fall into this category should consider making bigger estimated tax payments during this year, or if they are still working, they should have more withheld from their paycheck," says Bob Scharin, senior executive editor at Thomson Reuters, a provider of tax and business information.

Newly retired? Now that an employer is no longer withholding taxes from a paycheck, you must do your own calculations. Rather than make quarterly estimated payments, Pickering suggests that you ask your IRA custodian and the Social Security Administration to withhold taxes for you. "At least you won't have to come up with the tax payment," she says. Fill out IRS Form W-4P to withhold from an IRA and Form W-4V for Social Security withholding.

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Plan for the AMT. Congress usually waits until the eleventh hour to temporarily raise the exemption for the alternative minimum tax. But when lawmakers extended the Bush tax cuts at the end of last year, they approved an exemption for 2011 as well as for 2010. That gives taxpayers, especially those who live in states with an income tax, extra time to engage in a bit of AMT strategizing.

Begin, says Melissa Labant, an expert in the tax division of the American Institute of Certified Public Accountants, by projecting your income and expenses for 2011 and 2012. Then figure out if you'll be subject to the AMT this year or the next.

Let's say it looks like you won't be subject to the AMT in 2011 but you may be in 2012. Because deducting state income taxes is not allowed under the alternative minimum tax, Labant says, send a check in December for the state-tax estimate that's due in January. "You will have the tax expense anyway," she says. "If you prepay it, you can take it as an itemized deduction in 2011." By doing so, you will reduce this year's tax tab.

Capital ideas. Check your 2010 tax records to see if you carried over any capital losses, perhaps from as far back as the market swoon in 2008. If so, recognizing those losses can effectively allow you to take tax-free capital gains on sales of appreciated securities. Capital losses offset capital gains dollar for dollar. "You can capture the gain, invest in another stock or mutual fund, and pay no capital-gains tax," says Jerry Love, a certified public accountant in Abilene, Tex.

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Beware, however, that harvesting gains to take advantage of carryover losses could backfire if you're in the 10% or 15% tax bracket (married couples with taxable incomes of up to $69,000 and individuals with incomes of up to $34,500). Long-term capital gains that take you up to the top of the 15% bracket are taxed at 0% for 2011, so it would be a waste of a carryover loss to wipe them out. Of course, you should never make investment decisions solely based on tax considerations, but be sure you understand the tax ramifications before you sell.

As you review your portfolio, consider the tax efficiency of your investments. Income from different kinds of investments is taxed differently depending on whether you hold the investments in a taxable account, a tax-deferred traditional IRA or 401(k), or a tax-free Roth IRA or 401(k).

You may be able to hold down your overall tax tab by placing certain assets in certain types of accounts. For instance, taxable accounts should hold assets that will pay out little in taxable income, such as municipal bonds and index stock mutual funds. Meanwhile, by holding taxable bonds in your tax-deferred account, you hold off ordinary-income tax on the interest until you tap the account. A Roth account, where assets grow tax-free, is a terrific tax shelter for actively managed stock funds and growth stocks.

However, be careful when you adjust what is held where. While switching between investments is tax-free within an IRA or 401(k), for example, selling stocks to move cash into tax-free munis could trigger a tax bill in a taxable account.

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All things Roth. Taxpayers who convert a traditional IRA to a Roth this year will not have the option to defer and split the tax bill, as they did last year. All taxes on a conversion this year will be paid on the 2011 return. If a big conversion would push you into a higher tax bracket, you can limit the amount you convert so your taxable income doesn't exceed the top of your current bracket. You can convert more in 2012.

If you converted in 2010 and took the two-year tax deal, be careful not to sabotage it. If you withdraw any of the converted funds from the Roth in 2011, you will pay taxes on half of your 2010 conversion, as you planned -- plus tax on the withdrawn amount, according to Ed Slott, an IRA expert and a certified public accountant from Rockville Centre, N.Y.

Let's say you're a 65-year-old who converted $100,000 from a traditional IRA to a Roth in 2010, says Slott. You intended to report $50,000 of conversion income in 2011 and $50,000 in 2012. This year, however, you need to withdraw $15,000 from the Roth to pay for some medical expenses. In 2011, you will pay income tax on $65,000. The tax bill on the remaining $35,000 of the conversion income would be due with your 2012 return.

You can reverse a 2010 Roth conversion by October 17 if you change your mind. "If your account is worth less today than it was when you converted, you may want to undo the transaction," says Labant.

From now until October, keep a close eye on your Roth balance. Maybe you're in the 25% tax bracket and you converted when the account was $50,000. You'll owe $12,500 in taxes, even if your account has dropped to $40,000. If you undo the conversion, you won't pay tax on the money that has disappeared.

If you're converting this year, you can set up several Roths, one each for various asset types -- say, for U.S. stocks, foreign stocks and bonds. That gives you the flexibility to undo just the Roth that is holding assets that fall in value. You can undo a 2011 Roth conversion up until October 15, 2012.

Profit from your good deeds. Once again, Congress is allowing individuals 70 1/2 and older to take a tax-free distribution of up to $100,000 from an IRA and donate it directly to charity. The donation can count toward a required minimum distribution, but the money must be transferred directly from the IRA to the charity. Contact your IRA custodian and the charities you choose for direction on conducting the transfer.

You won't get a deduction for the donation, but the withdrawal will not increase your taxable income. That sounds like a wash, but taxpayers who don't itemize -- and thus can't take advantage of the charitable deduction -- could benefit from this break. "The withdrawal is not included in their taxable income," says Scharin.

By reducing taxable income, the IRA-to-charity maneuver also could make it easier for some taxpayers to qualify for other breaks, such as lower or no taxes on Social Security benefits and the 0% rate on long-term capital gains for taxpayers in the 10% and 15% brackets. Also, since out-of-pocket medical expenses that exceed 7.5% of adjusted gross income are deductible, keeping an IRA payout out of AGI can boost the size of that write-off.

Planning to buy a new car this year? Don't expect too much of a break if you donate your old car to charity. In most cases, tax deductions for vehicle donations are limited to the amount the charity receives from a sale. To get the biggest break you can, Scharin says, ask several charities how they go about selling their donated cars. "If the charity sells at a quickie auction, you'll end up with a smaller deduction," he says.

As you consider charitable contributions, remember that donating appreciated securities can give you double bang for your buck. Perhaps you bought 100 shares at $20 and they are now worth $40 a share. As long as you have held the stock for more than a year, your deduction is the $4,000 market value, and neither you nor the charity has to pay the 15% capital-gains tax on the $2,000 profit. That will save you an extra $300 on your tax bill.

Don't donate shares that have fallen in value. Instead, sell them and give the proceeds to charity. Say you bought a stock for $15,000, and the shares are now worth $10,000. If you sell the shares and give the $10,000 in proceeds to charity, you get the $10,000 write-off, as well as a $5,000 capital loss that you can use to offset any gains.

Keep track of what you're spending while you're performing charitable work. For instance, you can deduct the costs related to fund-raising events and the expenses of the ingredients for meals you make for the homeless. Keep a log of the number of miles you drive your car for charity; you can deduct 14 cents per mile (see IRS Publication 526, Charitable Contributions, for more information).

Track your medical expenses. With health costs being what they are, there's a good chance you could exceed the 7.5% income threshold for deducting medical expenses. (For the AMT, medical costs must exceed 10% of AGI to be deducted.) During the year, toss your receipts for unreimbursed medical expenses into a special folder. Besides doctor and hospital bills, you can deduct ambulance services, crutches, exercise programs if recommended by a doctor for a specific condition, and a portion of long-term-care insurance premiums. (For more eligible expenses, read IRS Publication 502, Medical and Dental Expenses.)

Keep careful records of the cost of medically necessary home improvements. You can take a deduction for home improvements that exceed any added value to your home. Perhaps you'll install an elevator for medical purposes at a cost of $10,000. If it increases the value of your house by $6,000, you can count $4,000 toward the 7.5% of AGI threshold. Make similar calculations for adding a wheelchair ramp, lowering counters or widening a doorway.

Don't forget to save records on your transportation costs to and from medical facilities. You can deduct the cost of taxis, trains, planes and parking fees. If you're driving your own car, you can deduct 19 cents a mile for mileage from January 1, 2011, to June 30, 2011; the rate goes up to 23.5 cents a mile for mileage from July 1, 2011, to December 31, 2011. You also can write off up to $50 a night for lodging if seeking medical care requires you to be away from home overnight. The $50 is per person, so if you travel with a spouse or adult child to get medical care, you can deduct $100 a day.

A healthy tax move. You can trim your taxable income by maximizing contributions to tax-deferred retirement accounts or to a health savings account. One source of the cash: the extra money in your paycheck from this year's cut in the payroll tax for employees, to 4.2%, from 6.2%. That cut is scheduled to disappear in 2012.

Open a health savings account or maximize tax-advantaged contributions to the one you already have. An account must be paired with a high-deductible insurance policy that is considered "HSA compatible." If you have employer-based coverage, you can make pretax contributions to the HSA. If you buy an individual insurance policy, you can deduct the contributions.

You can carry over the account balance from year to year, allowing the earnings to grow tax-free. You can withdraw cash tax-free in later years to pay for medical expenses. Before you're 65, money used to pay for non-eligible medical expenses is subject to income tax and a 20% penalty. After age 65, you can use HSA money for non-eligible expenses without a penalty, although you will pay tax on the withdrawal.

An HSA-compatible policy has a deductible of at least $1,200 for self-only coverage or $2,400 for family coverage. It also limits annual out-of-pocket costs. You can contribute up to $4,050 if you're 55 and older or $7,150 for a family.