Smart Year-End Tax Moves
From maxing out your retirement account to dumping a losing investment, here are several things you can do now to lower your tax bill in the spring.
By Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
November 7, 2006
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Normally, this is the time of year that you think about turkey, not taxes. But now is a good time to get a head start on end-of-year tax planning by harvesting investment losses and spreading some holiday cheer around to your favorite charities, lowering your tax bill in the process. Make these moves now, and you'll be giving thanks next spring.
This year there are new tax credits for installing energy-saving home improvements and buying hybrid cars. And, older taxpayers can take advantage of a new two-year window to take tax-free distributions from their IRAs that they donate directly to a charity. But for most people, the best way to cut your tax bill today is to maximize your retirement savings for tomorrow, says Mark Steber, vice president of tax resources for Jackson Hewitt.
Max out your 401(k)
You can contribute up to $15,000 to your 401(k) or other tax-deferred retirement account, such as a 403(b) for teachers or a 457 plan for police and other local government workers by the end of the year. That's $1,000 more than last year's limit. Tell your employer to adjust your remaining paychecks to boost your contribution if necessary, or if you receive a year-end bonus, ask if you can defer some or all of it to your retirement account. If you're 50 or older, you are allowed to shelter up to $20,000 of your salary from federal and state taxes this year (although you'll still be nicked for payroll taxes.)
Think green
Record-high gasoline prices earlier this year and concerns about heating fuel costs this winter may have you thinking about outfitting your home with new storm doors and windows or buying a gas-efficient hybrid car. If you install qualified home improvements by Dec. 31, you can claim an energy tax credit worth 10% of the cost up to $5,000, resulting in a maximum tax credit of $500. No more than $200 of that credit can be allocated to replacement windows.
If you bought a hybrid car or truck this year, you qualify for a tax credit ranging from $250 to $2,600 depending on the make and model. However, the tax credit for some of the most popular fuel-efficient vehicles -- the Toyota Prius, Toyota Highlander Hybrid and the Lexus RX 400h -- has already been cut in half now that the manufacturers have sold their initial 60,000 vehicle allotment. Effective October 1, the credits for qualifying Toyota and Lexus hybrids will range from $1,100 to $1,575.
The energy tax credits for cars and home improvements are also available next year. Check www.energytaxincentives.org for details.
Share the wealth
If you plan to contribute to your favorite charities, make sure you write your check, charge your credit card or make your cash contribution by December 31 and keep receipts to prove it. But, remember, you have to itemize your deductions to benefit from the tax break -- and only about one-third of taxpayers itemize.
While you're cleaning out your closets in search of year-end donations of clothing and household goods, be aware that new rules require they be in "good" condition or better to qualify for a deduction -- even through the IRS has yet to define what that means. Non-cash donations worth $500 or more now require an appraisal. Previously, only items worth $5,000 and up had to be appraised to qualify for a charitable deduction.
Retirees can take advantage of a new charitable tax break even if they don't itemize their deductions. If you're 70½ or older, you now can make tax-free distributions of up to $100,000 a year from your IRA directly to a charity both this year and next.
Under the new law, any IRA distribution that you send directly to a charity will not be taxed. Although you can't double dip and claim a charitable deduction, the tax break may be even more valuable because you won't have to include your IRA distributions in your adjusted gross income. As a result, you could benefit from other tax breaks, such as reducing taxes on your Social Security benefits or boosting your deductible medical expenses, both tied to your AGI, notes Mark Luscombe, principal analyst for tax information service CCH.
Another way to do well while you're doing good is to donate appreciated assets, such as stock, to your church, synagogue or favorite charity. You get to deduct the full value of the security at the time of donation, not just what you paid for it, and avoid the hassle of selling it and the expense of paying capital gains taxes on the profit.
However, if you have investments that have lost value, don't give them away. You're better off selling them and using the loss to offset any capital gains, and after that, up to $3,000 of ordinary income. Any excess losses can be carried over to future years.
Review your investments
Start by figuring how your trades so far in 2006 stack up in your taxable accounts. Do you have a gain or a loss for the year? Now, tote up your paper gains and losses on investments you still own in taxable accounts. If trades so far show a net gain, maybe the prospect of sheltering that profit from the taxman is the impetus you need to cull a stumbling investment from your portfolio. Dumping an investment that shows a loss will not only save on taxes, but also give you the opportunity to reinvest the proceeds of the sale in a better performer. If trades so far (and any carryover loss from 2005) show a loss, you have the opportunity to take some profit tax-free. Is it time to take some money off the table by selling some top performers to rebalance your portfolio?