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Year-End Tax-Planning Tips

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By Roy Lewis
November 8, 2002

There is very little you can do after Dec. 31 to reduce your taxes for the current year. So take stock of your tax issues before the end of the year to see what you can do about them -- how you can pay Uncle Sam only what he is legally due, and not a penny more. Today is the first installment of a series of articles discussing year-end tax-saving strategies. (Tune in next week for Part II.)

Keep one eye on your AGI
There are many tax deductions and credits that are phased out (i.e., you lose the deduction) when your adjusted gross income (AGI) exceeds certain limits. Some of those deductions and credits include the following:

  • The Child Tax Credit
  • The education credits (both the Hope and Lifetime credits)
  • Traditional IRA contributions
  • The student loan interest deduction
  • The new tuition deduction
  • Reduction of allowable itemized deductions
  • The Earned Income Credit
  • Deductible medical expenses
  • Allowable miscellaneous itemized deductions
  • Passive rental loss deductions (the $25,000 exception)
  • Taxation of Social Security benefits 

While it would be lovely if all of the phase-out amounts were consistent, that's not the case. They're different for each separate deduction and/or credit. So if there is a deduction or credit out there that you hope to claim on your return this year, make sure that you know if there is an AGI limitation. If you find that your AGI is greater than allowed, you still have time to reduce your AGI and keep it under the required amount.

Keep your other eye on the AMT
More and more folks are becoming subjected to the dreaded alternative minimum tax (AMT). This is a completely separate tax, with different rules used to calculate your AMT. You compare your normal tax to your AMT, and your "alternative" is to pay the greater of the two. It's not much of an alternative, but it's one to be aware of since the IRS computers can catch this overlooked tax. 

You could be subject to the AMT If you have any of the following: a large number of personal exemptions; large amounts of state and local taxes paid; large amounts of miscellaneous itemized deductions; large deductible medical expenses; the bargain element of incentive stock options (ISOs); and/or large capital gains. 

Planning for the AMT is even more difficult than for your normal taxes because each situation is unique. But if you see yourself in the AMT zone, make sure that you understand the impact on your bottom line. Even if you can't do anything to reduce your AMT, at least know it's there so you won't make any year-end moves that would make matters worse.

Defer income and accelerate deductions
Due to the time value of money, it's better to pay taxes later than sooner. But this is an even more important technique now with the impending reduction of the general tax rates. While tax rates are the same for 2002 and 2003, there will be an across-the-board 1% reduction in rates come 2004, and another 1% cut in 2006. Shifting taxable income from 2002 to later years might reduce your overall taxes due to the impending rate reductions. We'll tell you exactly how you can shift some of your income and deductions in Part II of this series.

Contributions to your favorite charity
If you have appreciated stock that you've held for more than one year, you might want to keep the cash in your pocket and donate the stock. You'll avoid paying tax on the appreciation, but will still be able to deduct the full value of the stock. You win, your charity wins, and the only loser is Uncle Sam (but he doesn't really mind, which is why this tax break has been written into the law). You might also consider the donation of appreciated stock into a "donor-advised fund." 

If you still love the stock and want to maintain a position in the shares after your charitable contribution, you can simply buy new shares in the company. The dreaded wash-sale rules don't come into play for shares that you sell for a gain or contribute to a charity. Your favorite charity will be more than happy to help you with stock-donation transactions, so don't be afraid to contact them directly.  But don't wait until the last minute -- you'll need some lead time to make sure that all of the transfers take place this year. 

Use your credit card
What was that? I thought the Fool was all about getting out of debt? Well, you're absolutely correct. We're not talking about running up your credit card unnecessarily. However, credit cards can be useful tools. (In fact, we even offer some Foolish cards ourselves.) Here's a way you can use a credit card to your advantage: If you have deductible expenses (such as business expenses, medical expenses, miscellaneous itemized deductions, charitable contributions, etc.) that for some reason you don't want to pay for now, you can use your credit card to make the purchase this year, take the deduction this year, and pay your credit card bill next year. When you pay with a credit card, the IRS considers the expense deductible in the year that the charge is incurred, not necessarily when you pay the credit card charge.

Of course, it's important that you pay off the loan quickly enough so the interest you pay doesn't offset the benefit of the tax deduction. If you have the right credit card, you can receive a 30-day "float" that amounts to an interest-free use of the bank's money if you pay it off when the bill comes.

Prepay your state and/or local taxes
If you believe that your tax bracket next year will be no higher than this year, and you won't be bothered by any alternative minimum tax issues, consider making those state and local tax payments before the end of this year. After all, you're going to owe the money anyway, right? So, why not make those payments before Dec. 31 and take the federal tax deduction this year?

You might think that this strategy only applies to people who have fourth-quarter estimated tax payments to make in January, but it doesn't. If you are a W-2 wage earner and expect a state/local tax balance due, you can use a state/local prepayment voucher and make your tax payment before the end of the year. But before you leap, make sure to take a look at your alternative minimum tax position. If you find yourself in the AMT zone, prepaying your state taxes will not result in any additional deduction. 

Also, make sure that you can itemize your deductions in the current year. If you can't otherwise itemize, prepaying your state taxes will not be of any benefit to you. And to make things even sweeter, many states will now allow you to pay your taxes using your credit card, which generates the deduction this year, but allows you to pay the credit card bill some time in the future.

Looking for more ways to reduce your taxes before Father Time rings in 2003? Then join us next week -- same tax time, same tax channel.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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