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Don't Wait Till Next Year

Congratulations. You made it through another tax year. Unless you decided to file for an extension, or you live in storm-affected areas that received an extra two days to file, your time's up. You're done worrying about what deductions you're going to claim or whether you had enough money withheld from your paycheck.

Before you put away your tax stuff for another year, however, it's worth your while to take a look at how you did in 2006 to see how you can improve your 2007 tax picture. If you paid too much this year, or you want to get a bigger refund next year, here are some things you can do right now that will make a difference next April.

1. Lower your income.
The easiest way to keep your taxes low is not to make any money in the first place. But that's not what I'm talking about here. If you participate in a 401(k) plan at work, you may notice that when you got your W-2, your income didn't reflect the amount of your salary. Instead, it was less, by the amount of your 401(k) contributions plus any other pre-tax benefits you used, such as flexible spending accounts or your health insurance contributions. That's because when you put money in your 401(k), you're technically deferring your receipt of that amount of compensation until you take it out of your retirement plan. For tax purposes, therefore, the IRS treats it as though you never received that money.

So keep the tax man at bay by making a bigger 401(k) contribution. Every penny will go into your account, along with any matching contribution your employer makes.

2. Be a tax-aware investor.
With your investments, you have a lot of power in deciding how much tax you'll have to pay.

First, keep in mind that stocks currently get a significant preference when it comes to taxation. Dividends and long-term capital gains on many stocks have a maximum rate of 15%, while you might pay as much as 35% on your interest from bonds, savings accounts, and other fixed-income investments. Because of this, many people are looking more closely at high-income blue-chip stocks, including Merck (NYSE: MRK  ) , Citigroup (NYSE: C  ) , and Verizon (NYSE: VZ  ) , as a way of generating income. You can learn a lot more about this strategy in the Fool's Income Investor newsletter, which can be had free for 30 days.

Second, don't sell your investments without knowing the tax impact -- although that shouldn't be the only thing you consider in deciding whether to sell. As it gets later in the year, the benefit from delaying a sale increases. If you're comfortable holding off until the beginning of next year, you may be able to put off having to pay the tax on that gain for an entire extra year.

Finally, if you invest in mutual funds or ETFs, know what to expect when it comes to year-end fund distributions. Mutual funds are required to pass through the taxes on their portfolio transactions, and because most funds wait until December to make their largest payouts, these distributions and the tax liability that comes with them often come as a surprise to investors. Keep an eye out for estimates on fund gains, which some fund managers provide as early as October.

3. Pay attention to phaseouts.
Much of the complexity of the tax laws comes from the way they determine eligibility for certain tax benefits. Countless provisions apply only for taxpayers that earn a certain amount. For instance, taxpayers who have income above $100,000 aren't allowed to convert regular IRAs to Roth IRAs. For years, this has kept higher-income taxpayers from doing Roth conversions, even when they wanted to incur the immediate tax that would result from them. Other provisions link eligibility for tax credits and deductions to your adjusted gross income, or take away exemptions and itemized deductions for people making more than certain limits.

After you've spent a little while thinking about how you can make your next tax bill look a little better than what you just finished paying, take a break. You've earned it. Best wishes for a happier tax season in 2008.

Related articles:

You can also learn more about managing your taxes in our Tax Center.

Fool contributor Dan Caplinger is OK with how he did on his taxes this year. He owns shares of Merck. The Fool has a disclosure policy.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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