Next April, everyone's going to be wishing that they were getting a bigger income tax refund back from the IRS. But if you want to get serious about saving on your taxes, the time to think about it isn't a day or two before you file your return -- it's right now.
If you do the right things, you can cut your tax bill by hundreds or even thousands of dollars. Consider using some of the following simple methods and see how much savings you can get.
1. Contribute to retirement accounts like an IRA or 401(k).
The simplest way to get a tax break is to contribute to a traditional retirement account. For individual retirement accounts, or IRAs, there's not as much time pressure, because you actually have until next April to make a contribution for the current tax year.
But if you're eligible for a 401(k) or other employer-sponsored retirement plan at work, that's where you can pick up some truly colossal savings. The reason is in the contribution limits: 401(k)s let you contribute up to $17,000 this year, compared to just $5,000 for an IRA. Do the math, and you'll see that for someone in the maximum 35% tax bracket, a $17,000 401(k) contribution will give you $5,850 in savings on your taxes.
The rules for 401(k) contributions are different, though, in that you can't get a tax break this year for a contribution you make next year. So talk to your HR representative about boosting your 401(k) contributions before Dec. 31, and you'll see the impact when you file this year's return.
2. Don't fall into the mutual fund trap.
One way to make sure you don't pay more in taxes than you have to is to avoid unnecessary income. If you invest in mutual funds, though, there's a big trap that could jeopardize your tax refund.
Mutual funds don't pay taxes like people or businesses do. When they sell stocks at a profit or a loss, they accumulate the gains and losses throughout the year. Toward the end of the year, if the fund has net recognized capital gains, it has to distribute those gains to its shareholders. If you own the fund, then you have to include that income on your tax return.
If you've owned the fund long enough to have enjoyed the benefits of those gains, then that seems perfectly fair. But the way the tax laws work, even someone who owns shares for a single day right before the record date for the distribution will have to pay tax on the money received -- even though it's really just a return of the money they just invested. And even worse, you have to pay taxes even if you never take the money -- reinvesting it into more shares, as many fund investors do, won't save you.
As an example, look at the American Funds New Economy Fund. With an emphasis on companies at the forefront of innovation and new technologies, the fund has benefited greatly from many of its investments. On the mobile device front, both Apple (Nasdaq: AAPL) and Amazon.com (Nasdaq: AMZN) have seen impressive year-to-date gains on their respective dominance of the high-end smartphone and entry-level tablet markets. But the fund has also benefited greatly from good calls in the biotechnology space, with Gilead Sciences (Nasdaq: GILD) and Alexion Pharmaceuticals (Nasdaq: ALXN) both benefiting from successful drugs. Alexion's Soliris, fetching $400,000 per year from patients, has been a lucrative niche for the company, while Gilead just got its Stribild all-in-one combination HIV treatment approved.
With all this success, American Funds anticipates that it will pay out between 1% and 4% in capital gains on Dec. 28. If you buy shares before that date, you'll end up getting taxed on that 1% to 4%. The simple thing to do is to hold off on buying fund shares in taxable accounts until January.
3. Boost tax-deductible expenses and losses.
The other major category of ways to cut your taxes is to accelerate tax deductible expenses and losses. By paying for things in December rather than January, you could be able to write them off this year and save.
Something to keep in mind
The impending fiscal cliff actually changes the normal equation for tax savings this year. In the long run, if tax rates rise next year, you may be better off not doing things to minimize your 2012 taxes, instead saving those deductions for 2013. That's a decision only you can make, depending on your particular situation.
But if saving taxes now is more important, these three tips should get you started. The bigger income tax refund you'll get should make it all worth it.