A lot of rules have changed, and that's created some new opportunities to trim next year's tax bill.
Right now, your mind is probably focused on things like fruitcake recipes and holiday celebrations. And that's all good. But there's something else you should be thinking about right now: your taxes. I know — it's rather Grinchlike to be thinking about tax breaks instead of toys at this time of year. But fact is, making some smart moves now can reduce your 2001 tax bill by a nice chunk. And while that might not seem very interesting right now, trust me, you'll be thankful next year, when all those holiday bills start rolling in.
Here are four money-saving year-end tax moves:
1. Defer Income Until 2002
If you're self-employed or have some freelance work on the side, then you probably already know about the wisdom of deferring income. The theory is that by billing your clients in the beginning of the new year (rather than at the end of this one) you can postpone some income and defer some taxes from this year to 2002. And deferring taxes is always a good idea, since it gives you more time to invest the money yourself (or use it for whatever you see fit). That's why year-end tax-planning articles always tell you to "defer income" and "accelerate deductible expenditures," like your property taxes, or state income-tax bills.
This year, however, that advice is especially smart. Why? Because most federal income-tax rates will drop half a percentage point next year. For instance, the current 27.5% rate will fall to 27% in 2002. In fact, it could even drop to 25% if the Republicans get their way with economic stimulus legislation currently being tossed around in Congress. (It appears the 10% and 15% rates will remain unchanged no matter what happens, but all the others will decrease.) In addition, next year's tax brackets have been adjusted for inflation. For example, the 30.5% bracket for joint filers in 2001 kicks in at taxable income of $109,250, while next year's 30% bracket starts at $112,851. (For additional brackets, see the table above.)
So if you have some control over your cash flow, this combination of lower rates, higher inflation-adjusted brackets could result in meaningful tax savings. In fact, if deferring income and accelerating deductions never really seemed worth the trouble before, now might be time to change your attitude. And keep in mind, even if you aren't self-employed, you could still use this maneuver by waiting to take a withdrawal from your IRA (helping to stave off taxable income) or by prepaying your mortgage this year (thus increasing your mortgage-interest deduction).
For more on this, see our story.
2. Postpone That College Bill
Here's a little-known year-end planning jewel, courtesy of the Bush Tax Cut legislation. Starting next year, you may qualify for a new break allowing you to deduct up to $3,000 of college-tuition costs paid for your dependent child/student. This is welcome news for all parents of college kids, but parents of seniors need to be extra careful that they can take advantage of this new break, since they (mercifully) have a limited number of bills ahead of them. If you fall into this camp, and you have (or soon will) receive the tuition bill for your kid's final semester, hold off on payment until next year, since the write-off only applies to amounts paid after 2001.
So if you pay the final tuition bill this year, you'll get stiffed in 2002. Joint filers are eligible for this new break if next year's adjusted gross income turns out to be $130,000 or less. The income limit for singles is $65,000. (No dice for married folks who file separate returns in 2002.) Keep in mind you may qualify for this new write-off even though your income is too high to be eligible for the Lifetime Learning college tax credit or the college-loan-interest deduction.
Also, for you to claim the write-off, your student-child must be a deductible dependent on your 2002 return. That means you must pay over half the child’s support next year. Plus the child must either be a full-time student for at least five months during 2002 or have no more than $3,000 of income next year.
3. Did You (Foolishly) Exercise Incentive Stock Options This Year? Sell!
I know, I know. Right now, the idea of exercising incentive stock options (ISOs) is about as popular as vacationing in Afghanistan. That doesn't change the fact that lots of stocks have looked pretty darned attractive at various times during the year. So you may have exercised some ISOs when your company's shares were comfortably above your option strike price. Seemed like a good idea at the time, but the shares later dropped like a rock.
That's bad enough, but it can get a lot worse. Your ISO exercise could trigger a big 2001 alternative-minimum-tax (AMT) liability. Why? Because you must include the "spread" (i.e., the difference between the exercise price and the higher market price at the time you exercised the options) in income for AMT purposes. The fact that those ISO shares are now worth less (maybe much less) than you paid is irrelevant to the IRS. Unless, that is, you unload the offending shares by Dec. 31.
Bailing out before yearend will have therapeutic effects on your 2001 return. First and foremost, you'll wriggle off the AMT hook, because the spread that existed at the time you exercised your ISO will no longer have any impact on your tax situation. Instead, you'll simply have a garden-variety short-term capital loss. You can use the loss to offset 2001 capital gains from other trades or to shelter up to $3,000 of "ordinary income" from salary, interest, dividends, and so forth ($1,500 if you file for 2001 using married-filing-separately status). Click here for a cap-gains tutorial.
In contrast, if you're still hanging onto those ISO shares at the dawn of 2002, your AMT liability for this year will be locked in. (There's a proposed bill in Congress that would rectify this obviously unfair situation, but I'm pessimistic about its chances.) One more thing: If you decide to follow this advice and sell underwater ISO shares before year-end, please don't reacquire any company shares for at least 31 days. According to an IRS proposed regulation, reacquiring shares before then would cause all kinds of really nasty tax consequences that I don't have space to cover here. Trust me, just don't do it.
4. Don't Forget the New IRA Withdrawal Rules
This last point is inspired by a phone conversation I had just this week with my very own 73-year-old father. As you probably know, people in this age bracket (i.e., anyone over age 70½) must take annual taxable withdrawals from their IRAs and SEP accounts. The exact amount that must be withdrawn by no later than Dec. 31 of this year depends on: 1) the account owner's age on that date, and 2) the account balance at the end of last year. Failure to yank out at least the IRS-specified dollar figure can mean getting hit with a 50% penalty, based on the difference between the amount actually withdrawn and what should've been taken out.
This has always been a source of frustration for IRA owners who don't want to start draining their nest egg. Fortunately, new IRS rules issued earlier this year allow smaller required withdrawals in the great majority of cases. Smaller required withdrawals mean smaller 2001 tax bills, which, of course, is a good thing, so be sure to follow the new rules and not the old ones. (Both sets of rules are allowed in 2001; the new rules become mandatory in 2002.) For the details, see "Understanding the New IRA Withdrawal Rules."
Now, you'd think my dear old Dad, of all people, would be well-versed on the new withdrawal rules. Think again. In fact, he was poised to follow the old rules, which would've resulted in a larger-than-necessary withdrawal and a larger-than-necessary 2001 tax bill. Then he was going to tell my sainted Mother to do the very same (bad) thing with her IRA. Fortunately, I called Dad just in time, thereby keeping my name in the will for at least a little longer. Or so he says.