A time-honored aspect of tax planning is to estimate your adjusted gross income (AGI) for this year and next year. It might be difficult, but in many cases it can save some tax dollars in the long run.
Why? Because, if you anticipate being in a higher bracket next year, you might benefit from accelerating income into this year and paying taxes on that income at a lower rate. If you believe that you'll be in a lower tax bracket next year, you can reverse the strategy and attempt to defer income into next year. To make the planning process even a bit more difficult, remember that tax rates will be falling over the next few years. So your planning should be prepared with an eye on the changing tax rates.
Remember also that any time you mess with your AGI you are also indirectly messin' with other tax items. Deductible IRA contributions, Roth IRA contributions, Roth conversions, medical expense deductions, miscellaneous itemized deductions, taxation of Social Security benefits, and the threshold for various tax credits are just a few of the items that can be affected when your AGI is increased or decreased. So be aware of how other items on your tax return will be affected by your decision to tinker with your income.
If you'll be in a higher tax bracket next year, ways to accelerate income into this year include:
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Year-end bonuses -- If your employer generally pays bonuses early next year, you might try to negotiate to have your bonus paid to you before the end of this year.
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Retirement plan distribution -- If you are taking money from a retirement plan, consider taking your withdrawals before the end of this year, rather than waiting until next year. Even if you have no immediate use for the money, paying tax this year and simply putting the money in the bank (or other investments) could be a smarter way to go.
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Accounts receivable collection/billing -- If you are self-employed and report your income and expenses on a cash basis, issue year-end bills early to receive payment by the end of the year. Also, attempt collection on any current or overdue accounts prior to the end of the year. Remember that many of your customers might also be in tax-planning mode and might want to pay their bills (and take their deductions) prior to the end of the year. They might be happy to pay for January's goods or services in advance.
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Roth IRA conversion -- If you converted a traditional IRA to a Roth IRA, all or part of the converted amount must be reported as taxable income in the year of the conversion. So you might want to increase your income this year by making a Roth IRA conversion prior to the end of the year.
- Investments -- Review your portfolio now. Try to determine your gains and losses for the year. See if there are stocks, bonds, or mutual funds you might want to sell in order to take some additional short-term stock gains this year. Your investment portfolio is the one area in which you have direct control. Don't overlook it.
If you expect that your marginal tax rate will be higher this year than next year, you'll benefit by deferring income into next year. Basically, as you can imagine, simply reverse the actions noted above.
Deduction planning
This goes hand-in-glove with income planning. If you believe that your marginal tax rate will be greater this year than it will be next year, try to accelerate deductions into this year's tax return. If you believe that the opposite is true, then you'll want to defer deductions into next year.
If deduction planning works for you, and you are a cash-basis taxpayer (which virtually all of us are), please remember these important deduction tips:
- If you use a credit card to pay expenses (such as last-minute charitable contributions, medical expenses, business expenses, etc.), the IRS considers the expense deductible in the year that the charge is incurred, not in the year that the credit card bill is paid. So consider using your credit card for those last-minute deductible purchases, services, and charitable contributions.
- If you make a payment by check, make sure that it is dated and mailed before the end of the year. It's not important whether the check actually clears the bank by the end of the year, just that you made the payment before the end of the year.
- Remember that a mere promise to pay (making a pledge for a charitable contribution, for example) doesn't constitute an actual payment and is, therefore, not deductible until the year actually paid.
- If you have a business, don't forget the impact of the Section 179 expensing election relative to various assets purchased. That election allows you to expense (i.e., deduct currently) purchases of business assets and property that you would otherwise be required to depreciate and deduct over a number of years. The total cost of Section 179 property that can be immediately deducted is $24,000 in 2002. After 2002, it's $25,000.
- And don't forget the impact of the new special 30% first-year bonus depreciation deduction allowed for qualifying business assets acquired before September 11, 2004. This additional bonus depreciation deduction is available even for assets placed into service on the last day of the year. Most new (but not used) property, other than buildings, qualifies for this additional depreciation deduction. Additionally, if you see an auto in your immediate future, the allowable first-year depreciation deduction for so-called "luxury" autos is also increased. For 2002, the first-year depreciation limit for new vehicles placed in service is $7,660 rather than the $3,060 that normally applies. So if you're thinking about purchasing new business equipment, doing so before the end of the year could give you a significant tax benefit.
Deductions and credits for non-itemizers
Just because you don't itemize your deductions doesn't mean that there aren't deductions and credits out there for you to use. Alimony paid, pension plan deductions (Keogh, SEP, SIMPLE, IRA, etc.), student-loan interest, job-related moving expenses, medical insurance for the self-employed, and deductions for self-employment taxes are all available to you -- regardless of whether you itemize deductions. This is true also for the many credits available to you even if you don't itemize your deductions.
Catch up your 401(k) contributions
Generally, your 401(k) contributions must be made throughout the year, but did you know that some 401(k) plans allow for "catch-up" contributions in December if your contribution level is less than the maximum allowed? Using your December bonus to fund the balance of your 401(k), when allowed, might be a good way to dodge some current taxes. If your employer matches some of your catch-up contributions, you're in even better shape. Not all 401(k) plans allow for this "catch-up" provision, so check with human resources or your company's benefits administrator.
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.
