If you made less money than expected this year, you might qualify for some tax breaks you've never considered.
Chances are, this year hasn't been quite as lucrative as you hoped. Maybe you were laid off. Or maybe you simply didn't get that raise or bonus you had anticipated. And then there's your portfolio: I bet that's seen better days. If any of the above applies, please accept my condolences. And welcome to the club.
But as the old saying goes, it's an ill wind that blows no good. Your lowered financial circumstances may open up some nice tax-saving opportunities that were unavailable back when you were raking in the dough. So here are some make-the-best-of-it strategies for those whose wallets have become noticeably thinner in 2002.
Get Smart About Education Breaks
These days, the tax breaks on education expenses are more generous than ever — if you qualify. Many education-related breaks have adjusted gross income, or AGI, limits that prevent parents from taking advantage. Of course, this year's anemic income might change that. If necessary, you can even make yourself eligible by taking steps before year end to lower your AGI (more on that below).
You will be eligible for the new $3,000 college tuition deduction if you can get your joint 2002 AGI down to $130,000 or less; $65,000 if you're single. There's no AGI phase-out range for this break. You are either 100% eligible or 100% ineligible. (For a more detailed explanation of all the education-related tax breaks described in this section, click here.)
To qualify for the Hope Scholarship credit (which can knock $1,500 off your taxes) or the Lifetime Learning credit (which can be worth up to $1,000), your joint 2002 AGI must be $82,000 or less. For singles, the magic number is $41,000. If your joint AGI is between $82,001 and $102,000, you're allowed to claim a partial credit. Ditto for singles with AGI between $41,001 and $51,000. Both of these tax breaks are used to offset higher education expenses.
To take full advantage of the college tuition deduction, you must pay at least $3,000 in tuition and fees during 2002. To claim the maximum $1,500 Hope credit, you must spend $2,000 on qualifying college tuition costs before year end. And to be eligible for the maximum $1,000 Lifetime credit, you must pay at least $5,000 of qualifying higher education costs this year. For those struggling to get over these humps, the IRS says you can prepay for courses that begin during the first three months of 2003.
Student-loan interest may also be deductible. You can deduct up to $2,500 of college loan interest if you can get your joint 2002 AGI down to $100,000 or less; $50,000 if you are unmarried. If your joint AGI is between $100,001 and $130,000, you can claim a partial write-off. The phase-out range for singles is between $50,001 and $65,000.
Finally, you are eligible to contribute up to $2,000 to a Coverdell Education Savings Account (formerly known as the Education IRA), which is set up for your child, if you can get your 2002 joint AGI down to $190,000 or less; $95,000 for singles. If your joint AGI is between $190,001 and $220,000, you can contribute a smaller amount. The phase-out range for singles is between $95,001 and $110,000.
Keep in mind, CESA contributions are nondeductible, so making these contributions won't ease your tax hit this year. But the account's earnings grow tax-free, and you can eventually take tax-free withdrawals to pay for your child's education expenses, including costs for K-12 schooling.
Other AGI-Sensitive Breaks
The Child Tax Credit
You will be fully eligible for the child tax credit of $600 per under-age-17 (as of 12/31/02) dependent kid if you can get your joint 2002 AGI down to $110,000 or less; $75,000 for singles. If your AGI exceeds those figures, you may still be able to claim a partial credit. The AGI phase-out range depends on how many eligible dependent children you have.
If you own rental real estate, you know the passive loss rules can sharply limit your ability to deduct losses thrown off by your properties. Basically, you can only deduct losses against positive income (if any) generated by other properties. As a result, rental losses in prior years may have saved you little or nothing in taxes. But a special exception allows you to deduct up to $25,000 of rental losses if you can get your 2002 AGI down to $100,000 or less. With AGI between $100,001 and $150,000, you can deduct a portion of your rental losses.
Make a Roth IRA contribution of up to $3,000 ($3,500 if you'll be 50 or older by year end). You are eligible to make a full contribution if you can get your 2002 joint AGI down to $150,000 or less; $95,000 if you are unmarried. If your joint AGI is between $150,001 and $160,000, you can contribute a smaller amount. The phase-out range for singles is between $95,001 and $110,000. Like the CESA, Roth IRA contributions are nondeductible, but the account's earnings grow tax-free. You can then take tax-free withdrawals after age 59 1/2, provided you've had a Roth account open for five years or longer.
Give It Away
Sure, this has been a lean year, but you may still want to make gifts to favorite relatives and charities. Here's how to get the best tax results from being so nice in tough times.
Don't give away stocks that cost you more than they are currently worth. Instead sell these losers and claim the resulting capital losses on your 1040. You can then give away the cash from the sale proceeds. The additional capital losses will generally reduce both your 2002 tax bill and your 2002 AGI, which can lead to further tax savings for this year. On the other hand, if you've already exceeded the $3,000 limit on deductible capital losses, these extra losses will be carried over to next year, which will improve your 2003 tax situation. Either way, you come out ahead. (For more on selling your losers, see our Capital Gains Guide.)
If you are holding stocks that have appreciated, the opposite advice is true. In this case, you should give away the appreciated publicly traded shares that you've owned more than 12 months, rather than cash. By doing so you can claim a charitable write-off equal to the full market value of the shares. At the same time, you avoid having to pay capital gains taxes on the appreciation. Since charities are tax-exempt, they don't have to pay any capital gains taxes when they sell donated shares. The only loser in this deal is the IRS.
The same advice applies for those donating to relatives, except that it doesn't matter how long you've owned the shares. You effectively transfer the capital gains tax bill to the gift recipients. They may then qualify for lower tax rates when they sell.
Is Your AGI Still Too High? Here's How to Cut It
What to do if your AGI gets you close to qualifying for some of these juicy tax breaks, but are not quite there? Some strategic AGI-reducing moves could solve the problem.
Probably the easiest thing to do is to sell loser stocks and mutual funds from your taxable investment accounts. The losses will first offset any capital gains racked up this year. (As if you had any.) Then you can deduct up to $3,000 of net capital losses (losses in excess of gains) against your income from any other sources (salary, interest and so forth).
Whether you are offsetting capital gains or other income, the impact is the same. Your taxable income and your AGI both go down. When your taxable income goes down, your tax bill goes down. When your AGI goes down, you may qualify for more AGI-sensitive tax breaks, as explained earlier. Then your tax bill goes down even more. (Fun!)
Here are some other ways to lower your 2002 AGI for additional tax-saving pleasure:
• Catch up on deductible alimony payments before year end. These payments reduce your taxable income and your AGI. Since you'll have to pay the money at some point, you might as well reap extra tax benefits by paying now.
• Make a deductible IRA contribution of up to $3,000 ($3,500 if you'll be 50 or older by year end). This lowers both your taxable income and your AGI. Even if you don't qualify for a deductible contribution because you participate in a retirement plan through work or self-employment, your uncovered spouse might be eligible. For more on this, see our story.
• Max out on deductible contributions to your retirement plan. These payments reduce your taxable income and your AGI. This may be easier for the self-employed, but many 401(k) plans allow you to change your contribution amounts whenever you like. So if you aren't already on schedule this year to contribute the maximum $11,000, now's the time to do it. You'll reduce your AGI and have a comfier retirement to boot.
• If you're self-employed, defer income until 2003 and accelerate deductible expenditures into 2002. This strategy can produce triple tax savings: your taxable income goes down, which means your AGI goes down, which means your self-employment tax bill goes down, too. On the income side, wait to send out invoices for work completed between now and year end. You can also time things so you'll receive payment early next year rather than late this year. On the expense side, pay deductible business items late this year instead of early next year. You can claim 2002 deductions for expenses charged this year to VISA, MasterCard, Discover or American Express. The fact that you won't pay the credit card bills until 2003 doesn't matter.
If You Know Next Year Will Be Much Better
Now, if you are in the enviable position of already knowing your 2003 income is going to be significantly greater than 2002's, you might actually benefit from accelerating taxable income into this year and deferring deductible expenditures into next year. Keep in mind, this is the exact opposite of the usual year-end advice. But if accelerating income into 2002 means paying much lower tax rates on that money than you would in 2003, I suggest you do it.
By the same token, you should defer paying deductible expenses until 2003 if you'll receive much more tax-savings bang for the buck next year. Self-employed individuals are best able to implement this "reverse tax planning" strategy. Toward year end, send out billings promptly after the work is done to ensure you get paid before December 31. It's also easy to delay some deductible business expenditures until early next year.
Of course, you don't want to get too carried away with the "reverse tax planning" idea. Increasing your 2002 income by too much could cause you to lose out on AGI-sensitive tax breaks. And since you may not get another shot at them, be sure to enjoy 'em while you can.