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4 Fundamental Tax Saving Strategies

... And How To Fully Use Them

Also see the tax strategy guide as a pdf file

Looked at the calendar lately? That’s right, year end is fast approaching — and with it the critical task of planning for your 2002 income tax. In light of last year’s big tax act (not to mention this year’s less-sweeping one), you may get that “deer-in-the-headlights” look when considering how to cope with your upcoming return. But remember, no matter how Uncle Sam tinkers with the system, some fundamental tax saving strategies will likely always pay off. Let’s look at four examples of these kind of tried-and-true ideas.

1. Timing Your Income Strategically

Knowing exactly when to recognize income can greatly affect your tax liability. So even before you begin filling out your return, consider what bracket you expect to be in next year. If it appears you’ll land in a higher one, accelerating income into this year can save you taxes because you’ll be taxed at the lower rate. Conversely, if you believe you’ll wind up in a lower tax bracket next year, deferring income to then will reduce your income taxes.

If you’re a business owner who recognizes business income on your personal return, controlling business income may help you minimize your individual taxes. For example, as long as your business uses cash method accounting, you can delay billing notices as you approach year end and pay as many expenses as possible.

Then again, if you use the accrual method, you can delay shipping products or delivering services until the new tax year. Of course, beware of the business risks of these types of strategies.

Whether or not you’re a business owner, various circumstances may complicate the accelerate-or-defer decision. For starters, if you’re subject to the alternative minimum tax (AMT) this year or next, you may need to modify your approach. (For more on this, see “Anticipating the AMT” later in this article.) Also, whether you must recognize income depends on its source. For example, up to 85% of your Social Security benefits may be taxable if your modified adjusted gross income (AGI) — AGI plus tax-exempt interest — exceeds threshold amounts. Then again, you may be able to exclude interest on some types of government bonds.

Ultimately, controlling your income is the key to timing it. Easier said than done, of course, but breaking down your income into its various sources can reveal opportunities. For instance, you may defer your cash salary or bonus as long as you don’t constructively receive (gain access to) it in 2002.

Or if you sell real estate or other nonpublicly traded property and use the installment sale method to report the income, you can recognize only the gain as you receive payments. Thus, you may defer most of it to future years. Better yet, you’ll get interest payments on the note you give the buyer.

2. Reaching Above the Line For Deductions

Effectively handling your above-the-line deductions can get your tax return off to a great start. But many people are so focused on itemizing, they fail to make the most of them. Fact is, above-the-line deductions are the critical adjustments that determine your AGI, which in turn determines your eligibility for various deductions, exemptions and credits. So these deductions can have a greater impact on your final tax bill than itemized deductions.

The above-the-line deductions available to you depend on your situation. For example, you can take this deduction type for alimony paid, but not child support. And students can deduct above the line a portion of qualified higher education expenses, while those finished with school — though not its expense — may claim an above-the-line deduction for up to $2,500 (with restrictions) of student loan debt.

Then again, if school is a distant memory and you’re looking ahead toward retirement by investing in a traditional IRA, you may be able to deduct above the line up to $3,000 or 100% of earned income (whichever is less). Similarly, you can take an above-the-line deduction for contributions to simplified employee pensions (SEPs) and Keoghs.

In fact, earnings in traditional IRAs, SEPs and Keoghs accumulate tax deferred. And this year the annual addition limits for defined contribution Keogh plans will increase to $40,000. The benefit limits for defined benefit Keogh plans will go up from $140,000 to $160,000. Meanwhile, the limit on compensation taken into account under qualified plans rises to $200,000 and will be indexed for inflation.

Or perhaps you use a different employer-sponsored retirement plan, such as a 401(k) or 403(b). Well, you needn’t worry about claiming above-the-line deductions for these accounts, because contributions to them are taken from your compensation pretax up to the legal limit — $11,000 for 2002. If the plan allows, individuals age 50 or up can make an additional “catch-up” contribution of $1,000 in 2002. Plus, your employer may match some of your contributions — also pretax. And plan assets grow tax deferred.

By the same token, under a Savings Incentive Match Plan for Employees (SIMPLE), you may elect to have your employer contribute up to $7,000 of your salary rather than pay you cash. Again, you may exclude the contribution from your income, though other
rules apply.

Don’t think we’ve forgotten about the self-employed, either. In 2002, you can deduct 70% of your health insurance costs for yourself, your spouse and your dependents. In 2003, this percentage rises to 100%. This above-the-line deduction is limited to the income you’ve earned from your trade or business. You can also deduct above the line half of the self-employment tax you pay on your self-employment income.

3. Maximizing Your Itemized Deductions

After getting all you can from your above-the-line deductions, you’ll need to decide whether to claim the standard deduction or to itemize. Most homeowners and higher net worth individuals usually opt for the latter — because their total deductions exceed the standard one. (In case you’re interested, however, the standard deductions for 2002 are: $4,700 for single, $6,900 for head of household, $7,850 for married filing jointly and $3,925 for married filing separately.)

Examples of itemized deductions are numerous. Investors can deduct the interest — up to their net investment income for the year — on any money they borrow to buy or carry taxable investments. But be careful: Unless you make an election and forgo the lower long-term capital gains tax rate, you can’t include long-term capital gains in your net investment income for deduction purposes.

Then again, maybe you prefer to keep your money close to home. In that case, your residence provides many great opportunities. You may be able to deduct mortgage-related points. And you can claim an itemized deduction for your property taxes, too.

In addition, you may be able to maximize your interest deduction by paying off nondeductible interest — such as that on credit cards or auto loans — with money from a deductible class, such as a home equity loan. Currently, you may deduct interest on as much as $100,000 of home equity debt used for these or other similar purposes.

Are you a giving person? If so, your charitable contributions are generally deductible — meaning the more you donate, the more you save. You can occasionally impart relatively small gifts.

Or you may donate larger amounts more regularly using sophisticated charitable vehicles such as private foundations, donor-advised funds or charitable remainder trusts (CRTs). All of these generate itemized deductions.

Whatever your situation, bunching specific deductible expenses in one year can help you exceed applicable floors. So if your miscellaneous itemized deductions already exceed the 2% floor, you should record and prepay these expenses (which include deductible investment expenses, professional fees and unreimbursed employee business expenses) before year end. Remember, though, that most of these deductions are not deductible for AMT purposes.

4. Anticipating the AMT

As you may know, the AMT is an alternate tax system designed to catch taxpayers skilled enough to bob and weave their way out of regular tax liability. Your AMT liability is determined by adding various tax adjustments back to your taxable income and deducting an exemption depending on filing status — $35,750 for single and head of household, and $49,000 for married filing jointly. This exemption starts to phase out when AMT income exceeds $112,500 for single or head of household, $150,000 for married filing jointly and $75,000 for married filing separately.

Bottom line: Those the AMT snags are taxed at a 26% rate on the first $175,000 of AMT income and 28% for income exceeding that amount. So if you get caught this year, defer to next year any non-AMT deductions, such as state and local income taxes. Then postpone other deductions to 2003 even if you can deduct them against AMT income — they’ll likely be more valuable then.

Also, accelerate ordinary or short-term capital gain income to this year to qualify for the lower AMT rate. Particularly do this if you suspect you’ll wind up in a higher regular tax bracket next year. Last, delay exercising any incentive stock options if you are subject to the AMT. You could fall into AMT liability on the spread between the fair market price and the exercise price.

And what if you’ll escape the AMT in 2002, but you’ll probably face it next year? Do the opposite. For example, prepay your state income tax this year. After all, that deduction won’t matter in 2003. Also, defer income to next year (instead of accelerating it to this one), because you’ll likely garner a relatively lower AMT rate at that time. Finally, be sure to rid yourself of any private activity bonds.

Remember, if you paid the AMT last year, you may be able to claim a credit, depending on which adjustments generated it. Common adjustments include depreciation adjustments, passive activity adjustments and the tax preference on the exercise of incentive stock options.

Saving a Slew in 2002

These are just a few of the fundamental ways you can cut your tax bill. We haven’t even mentioned exemptions, which reduce the amount of income you pay tax on. Indeed, this year you’re allowed a $3,000 exemption each for yourself as well as your spouse and dependents. And what about tax credits? These take dollars directly off your bill and include the Child, Adoption and Dependent Care credits (for parents) as well as the Hope and Lifetime Learning credits (for students or parents of students).

Truth is, we’d need an article longer than this one to summarize all you can do to save on income tax this year. And even then, we couldn’t address your specific needs. So please call us; we can help you with these fundamentals and other tax saving strategies.