Take the Pain Out of Next Year's Taxes
Looking for an antidote for those tax-time headaches? Try a dose of preparation.
By Cameron Huddleston, Contributing Editor, Kiplinger.com
April 2006
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Now that the forms have been filed, and while you're still smarting from the IRS's sting, it's a good time to think about how you can minimize the pain next year. You might even be able to trim your tax bill.
I know it's hard to think about next year's taxes. But if you spend time during the year to review past returns, keep good records, and take advantage of maneuvers to defer income or rack up deductions, you won't need the aspirin and antacids next April 15.
Adjust your withholding
To get an idea of how much you'll owe or get back next year, look at your last two tax returns. If you've received more than $500 or paid more than 10% of your total tax bill, it's time to adjust your withholding.
"A refund is a financial faux pas," says Andrew Keeler, a financial planner in Columbus, Ohio. "You've given Uncle Sam a no-interest loan." Increase the allowances you claim so less will be taken from your paycheck. Then you'll have more money to invest -- in a 401(k), for example -- during the year, Keeler says.
Decrease your allowances so more will be withheld from your paycheck if you're paying a hefty tax bill.
Get organized
Hang on to records and receipts. Throughout the year collect supporting documents -- such as letters acknowledging charitable contributions, brokerage account statements and medical bills -- in file folders.
Store stock trade confirmations, especially if you participate in a dividend reinvestment plan. These will help you track your investment basis, and serve as a handy backup for broker errors, says Keeler. For example, if you switch your account from one brokerage to another, your basis could get lost in the shuffle, he says.
Log IRA contributions, payments into 529 plans and education savings accounts. Be sure to record the date as well as the amount of the contribution. Keeler says he's had clients who were prepared to make an IRA contribution just before the tax-filing deadline until he reminded them that they'd already maxed out their annual contribution.
Keep receipts from major home improvements and repairs if you own a home or rental property. Renovations or additions to your home can increase your basis and reduce your taxable gain if you sell the house before you're able to take full advantage of the capital gains exclusion.
Tally business or home-office receipts. Non-reimbursed expenses such as mileage, car maintenance, tools etc., can be deducted from your wages or self-employment income. If you operate a home-office, even part-time, be sure to keep receipts for computer maintenance, home repairs or necessary office improvements.
Lower your income
A great way to lower your taxable income without taking a pay cut is to participate in your employer's 401(k). Your contributions are subtracted from your salary before taxes are applied. That means there's less salary to tax. If you're already participating in a 401(k), think about boosting your contribution. The contribution cap is $15,000 ($20,000 if you're 50 or older) in 2006. You can use this calculator to see how quickly bigger contributions add up.
You shouldn't let taxes drive investment decisions, but you can try to time buying and selling to your advantage. For example, if you want to sell appreciated property, dump some losers to help offset the capital gains. Or better yet, donate your appreciated property to charity and get a double tax break -- a write-off for your generosity and no capital gains. If you plan to sell a mutual fund, unload it before the dividend payout (which usually happens in December).
And if you'll be carrying forward any capital losses from the previous year, be sure to make a note of the amount, or copy last year's tax records, and drop it in your investment transactions file.
Speed up deductions
If you can't defer income, try accelerating deductions.
Interest. If you make your December mortgage or home-equity loan payment before year-end -- even if it's not recorded until January -- you can boost your deduction. If the payment doesn't show up on your Form 1098, you still can report the interest on your Schedule A and attach a note explaining the extra deduction.
If you're paying off credit cards or other loans and don't have a home-equity loan or home equity line of credit, consider getting one now while rates are low, says Nancy Flint-Budde, a financial planner in Clifton Park, N.Y. By tapping your home equity to pay off high-interest credit cards, you can write off the interest if you itemize deductions on your tax return.
Also, consider accelerating your student loan payments to get the maximum deduction of $2,500. Congress has wiped out the five-year limit on student loan interest deductions. So if you're in your sixth (or seventh or eighth and so on) year of repaying your loans, you still can get the deduction as long as your modified adjusted gross income doesn't exceed $65,000 for single filers, $130,000 for married filing jointly.
College bills. Pay spring semester tuition bills before December 31 to maximize the Hope or lifetime learning credits. The Hope credit is worth up to $1,500 a year for tuition and fees paid during a student's first two years at a vocational school or college. The lifetime learning credit is worth up to $2,000 for any year of post-secondary education (even graduate school). If you've already paid enough to get the full credit this year, consider postponing your bills until next year to take advantage of one of these credits once again.
Charitable contributions. If you're spring cleaning, don't throw out those old clothes. Donate them, get a receipt, then write-off the amount on your tax return. You also can deduct the full amount of cash contributions if you itemize deductions on your federal income tax return. A $1,000 deduction on your tax return translates into $250 in savings if you're in the 25% tax bracket.