Before you ring in the new year, consider taking advantage of these seven tax-saving maneuvers.
As the year draws to a close, you're probably thinking more about your holiday credit-card bills than your 2004 tax bill. Big mistake. Squeezing in a little time for some year-end tax planning can save you big bucks come tax-return time. Consider it a holiday gift from Uncle Sam — albeit one you're going to have to do a little extra work to receive.
Here are seven tax-saving strategies for 2004 that should be employed before the ball drops in Times Square.
1. Take Advantage of the Long-Term Capital Gains Rates
When it comes to investing in a taxable account, it pays to be a long-term — as opposed to a short-term — investor. In fact, while you don't want to let the tail wag the dog, it could make sense to hold onto your investment just a little bit longer to make sure you fall into the long-term camp.
Why? Because short-term gains on investments held in a taxable account for one year or less are taxed as ordinary income, which means your tax rate can run as high as 35%. So if, for example, you hold appreciated stock for exactly one year before selling, you could owe the IRS up to 35% of your short-term profit. By contrast, if you hold the shares for just one more day, the maximum federal rate plummets to 15%. So selling just one day too soon could cost up to 20% of your profit in additional taxes.
For tax-law purposes, your ownership period begins the day after you acquire securities and includes the day you sell. So if, for instance, you bought shares on July 15, 2004, then your holding period started on July 16, 2004. And that means that July 16, 2005 is the earliest date you could sell and still benefit from the lower long-term capital gains tax rates. The reelection of President Bush removed the threat that capital gains from sales in 2005 might be taxed at higher rates. Therefore, the idea of holding on until next year in order to lock in lower long-term capital gains tax rates makes perfect sense from a tax planning standpoint. (I can't help you as to whether such a move makes sense in terms of the investment risk.)
Of course, you can ignore this advice if you have enough capital losses to offset this year's capital gains or if your appreciated investments are held in a tax-deferred account — such as an IRA, 401(k) account, variable annuity account, and the like. For more on the tax treatment of capital gains, click here.
2. Deduct the Sales Tax on 2004 Purchases
If you live in a state with low or no personal income taxes, you should be happy about the new federal income tax deduction for general state and local sales taxes. The new write-off was created by a law enacted in October, and it applies retroactively to Jan. 1, 2004. So you now have the option of deducting either state and local sales taxes or state and local income taxes on your 2004 return — but not both.
To take advantage of the new law, you'll likely have to use IRS-provided tables to calculate your deduction (unless you've hoarded all your receipts from 2004 purchases, in which case you can add up your actual sales tax amounts and deduct the total). If you're forced to use the IRS tables, you can still deduct actual sales taxes from 2004 purchases of vehicles and boats on top of the predetermined amount from the table. So buying a car or boat between now and year end could cut this year's federal income tax bill. Put it on your Christmas list!
Sadly, the new sales tax write-off will help only you if you itemize. And if you're hit with the dreaded alternative minimum tax (AMT), you'll lose some or all of the tax-saving benefit from the new deduction.
3. Prepay and Bunch Expenditures for Deductible Items
If you expect to be in the same tax bracket or a lower one in 2005, it can make sense to prepay your deductible expenses this year. (See the sidebar below for the 2005 brackets.) After all, you might as well gobble up all the potential tax breaks you can, as early as you can.
The easiest deductible expense to prepay is your January 1st home mortgage bill. Accelerating the payment gives you 13 months' worth of deductible interest in 2004. You can pull the same trick with a vacation home mortgage payment. Of course if you prepay this year, you'll have to continue the strategy for next year and beyond. Otherwise, you'll have only 11 months of interest in the first year you stop.
Next up on the prepayment menu are state and local income and property taxes. In particular, consider prepaying estimated state and local income tax installments that are not actually due until early next year. However, don't run this tax prepayment drill if you know you'll owe the AMT for 2004. Why? Because state and local income and property taxes (as well as sales taxes) are completely nondeductible for AMT purposes. As a result, prepaying these expenses will do little or no tax-saving good if you're unlucky enough to be in the AMT mode.
Next, try to bunch together expenses that are subject to limits based on your adjusted gross income (AGI). If you can bunch two years' worth of these types of expenditures into a single calendar year, you'll have a fighting chance of clearing the AGI hurdles in alternating years (instead of never). The two prime candidates are unreimbursed medical expenses and miscellaneous itemized deductions. Medical costs are deductible only to the extent they exceed 7.5% of AGI. Miscellaneous deductions — for investment expenses, fees for tax preparation and advice, and unreimbursed employee business expenses — count only to the extent that they exceed 2% of AGI. Unfortunately, the bunching strategy rarely helps AMT victims. That's because medical expenses must exceed 10% of AGI to be deductible for AMT purposes, and miscellaneous itemized deductions are completely disallowed under the AMT rules.
|Beware the AMT|
|Recent tax-law changes have done a lot to reduce your regular federal income tax bills. Unfortunately, they didn't do much to lower the odds that you'll owe the dreaded alternative minimum tax (AMT). It's important to evaluate all planning strategies (including the ones explained in this article) in light of both the regular tax rules and the AMT rules before taking action. Otherwise, you might not reap the expected tax savings. The AMT rules are complicated, so you might want to get advice from a professional if you think you're in the AMT zone.|
4. Itemize Only in Alternating Years
If you're right on the cusp of being able to itemize deductions rather than using the standard deduction, you might be able to clear the hurdle by shooting to itemize every other year. You can do this by bunching together expenditures for itemized deductions in alternating years.
Over time, this perfectly legal scheme can save hundreds or thousands in taxes by increasing your cumulative deductions. And if you live in a state with low or no personal income taxes, you have a better chance to bunch deductible expenditures for 2004 in order to itemize on this year's return. Why? Because you can now claim the new write-off for general state and local sales taxes. So if, say, you bought a pricey new car this year, you might find that it makes sense to itemize this year, even if you've used the standard deduction in the past.
For 2004, a $9,700 standard deduction is available to married joint filers, vs. $4,850 for singles and $7,150 for unmarried heads of households. For 2005, the figures are $10,000, $5,000 and $7,300, respectively.
5. Claim the $2,000 Tax Break for Your New Hybrid Car
In a little-noticed change, the Working Families Tax Relief Act of 2004 restored the $2,000 write-off for qualifying new (not used) hybrid gas-electric vehicles placed in service any time during this year or next. So if you buy a new hybrid car this year and drive it a few miles before year end, you can claim a nice $2,000 deduction on your 2004 Form 1040. Even better, you're entitled to this break whether or not you itemize and regardless of your income. The IRS has announced that the following hybrids are eligible for the $2,000 deduction:
- Honda Civic Hybrid 2004 model.
- Honda Insight 2004 model.
- Toyota Prius 2004 and 2005 models.
6. Donate Cars, Boats and Planes
In 2005, charitable donations of motor vehicles will fall under strict new rules if your claimed deduction exceeds $500. Your write-off will depend on how the donated vehicle is used by the recipient organization. If the charity sells the vehicle without using it significantly for charitable purposes or making material improvements, your deduction will generally be limited to the amount of gross sales proceeds received by the charity. This is a big — and unfavorable — change because current law allows you to deduct the full fair market value of a donated vehicle.
Starting next year, charities will also be required to issue detailed written acknowledgments to vehicle donors. The IRS can then require the organization to disclose the information included in your acknowledgment and check to see if it matches up with your tax return. The same unfriendly changes apply to donated boats and planes.
So if you're thinking about donating a vehicle (or a boat or a plane) worth more than $500, please take my advice and do your good deed before year's end. That way, you can deduct the full fair market value on your 2004 return, as permitted under current law. Be sure to ask the charity for a written acknowledgment of your donation to support your deduction.
7. Did You Turn 70 1/2 This Year?
If this is the year you turn 70½, you are now subject to the dreaded minimum required distribution (MRD) rules. These IRS guidelines require you to start taking annual taxable withdrawals from traditional IRAs set up in your name. You must include any simplified employee pension (SEP) accounts and SIMPLE-IRAs. (Roth IRAs set up in your name are exempt from the MRD rules for as long as you live.) For more on this, click here.
Here's the drill. By April 1 of the year after you turn 70½ (April 1, 2005 in your case), you must withdraw your initial MRD. This initial distribution is actually for the 2004 tax year — even though you can take it as late as April 1, 2005. However, you also have the option of withdrawing your initial MRD by Dec. 31 of this year. Either way, you must withdraw another MRD for the 2005 tax year and for all subsequent years by Dec. 31 of each year.
If you don't withdraw your initial MRD before the end of this year, you'll be forced to withdraw two MRDs in 2005 (the one for this year plus another for next year). The resulting double dip could easily push you into higher tax brackets in 2005, especially if you have big IRA balances. Next year's adjusted gross income would be higher, too. That could cause you to lose out on various AGI-sensitive tax breaks on next year's return. For these reasons, consider withdrawing your initial MRD by Dec. 31, 2004. This would mean foregoing a little tax deferral in exchange for potentially significant savings on your combined 2004 and 2005 federal income tax bills.
Tax Planning Info. for 2005
|2005 Federal Income Tax Rates and Brackets|
|10% tax bracket||$0-7,300||$0-14,600||$0-10,450|
|Beginning of 15% bracket||7,301||14,601||10,451|
|Beginning of 25% bracket||29,701||59,401||39,801|
|Beginning of 28% bracket||71,951||119,951||102,801|
|Beginning of 33% bracket||150,151||182,801||166,451|
|Beginning of 35% bracket||326,451||326,451||326,451|
|* Head of household|
|2005 Standard Deduction And Personal Exemption Amounts|
|Beginning of itemized deduction phase-out range (based on AGI)||145,951||145,951||145,951|
|Beginning/end of personal exemption phase-out range (based on AGI)||145,951||218,951||182,451|
|2005 Retirement Account Contribution Limits|
|Maximum contribution to traditional or Roth IRA||$4,000|
|Maximum IRA contribution if age 50 or older||$4,500|
|Maximum 401(k) salary deferral contribution||$14,000|
|Maximum 401(k) contribution if age 50 or older||$18,000|
|Maximum 403(b) salary deferral contribution||$14,000|
|Maximum 403(b) contribution if age 50 or older||$18,000|
|Maximum deductible SEP account contribution||$42,000|
|Maximum profit-sharing Keogh account contrib||$42,000|
|Maximum SIMPLE IRA salary deferral contribution||$10,000|
|Maximum SIMPLE contribution if age 50 or older||$12,000|
|Miscellaneous Tax-Planning Figures|
|Cap on Social Security tax (based on wages or self-employment income)||$90,000|
|Kiddie Tax threshold (based on unearned income of under-age-14 child)||$1,600|
|Annual federal gift tax exclusion||$11,000|
|Federal estate tax exemption||$1,500,000|