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You should never make an investment decision solely for tax reasons, of course, but it's silly to ignore the tax consequences, too. (Remember, trades inside a retirement account, such as an IRA or 401(k), don't affect your year-end tax picture. But because the IRS ignores such trades, you can reallign your investments in the plan without worrying about the tax consequences.)
But before you invest in a mutual fund near the end of the year, check to see when the fund will distribute dividends. On that day, the value of share will fall by the amount paid out. If you buy just before the payout, the dividend will effectively rebate part of your purchase price, but you'll owe tax on the amount. Buy after the payout, and you'll get a lower price and no tax bill.
This year the tax bill could be significant given the recent record-breaking stock market performance when the Dow Jones Industrial Average hit a five-and-a-half year high in early October. As a result, several major mutual funds are expected to post the highest year-end capital gains and income distributions since the start of the three-year bear market in 2000.
Although it's best to avoid buying a year-end tax bill if you can, taxable distributions don't represent permanent loss. Rather, these are taxes you pay sooner rather than later. That's because distributions that are reinvested into new shares raise your basis, and payouts that are not reinvested mean you'll report lower gains -- or perhaps even losses -- when you sell your shares. In either case, you'll pay lower taxes in the future because of the taxes you pay now.
Shopping spree
If you purchase big-ticket items like a boat or a car that racked up a big sales tax bill during the year, hang on to your receipts, particularly if live in one of the no-income tax states like Florida, Texas or Washington. Although the provision that lets taxpayers choose between deducting their state income taxes or state sales taxes expired last year, Congress still hopes to reinstate it for 2006 before adjourning for the year.
Odds and ends
When it comes to tax savings, paying attention to details and deadlines can add up. For example, if you have a flexible spending account at work for dependent care or medical expenses, make sure you clean it out. Although the IRS now allows companies to give employees a grace period until March 15 to spend their pre-tax flex dollars on health care, not all employers adopted the extension. Make sure you know your plan's deadline so you can use up the money before you lose it.
If your state offers a tax deduction for contributions to a 529 savings plan, you can take advantage of it even if your child is already in college, says Karen Cunningham, president of Oklahoma Financial Center. Contribute to the plan before the end of the year, claim the deduction, and then withdraw the money in January to pay tuition.
If you pay quarterly estimated state income taxes or have a real-estate tax bill due in January, you can pre-pay it in December and deduct it from your 2006 federal taxes. But beware. If you're among the growing number of taxpayers ensnared by the alternative minimum tax, this sooner-than-later strategy won't work for you.
The dreaded AMT
The AMT, a parallel tax system with its own set of rules, does not allow deductions for state and local taxes, home-equity loan interest (unless the borrowed money was used for home improvements), or items such as investment expenses. Nor does it allow personal exemptions-worth $3,300 this year-for yourself, your spouse or your children.
Essentially, you have to figure your taxes under two sets of rules -- the regular tax code and the AMT -- and pay whichever is higher. Regular tax brackets are indexed for inflation but the AMT isn't. Consequently, your chance of being trapped by the AMT increases each year, particularly if you claimed large deductions for state income taxes or property taxes or have a large family.
Although Congress approved a one-year patch that will prevent about 15 million new taxpayers from being hit by the AMT this year, if you paid it last year, you'll probably be caught again this year, says Roger Lusby, a CPA with Frazier & Deeter, LLC in Atlanta.
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