Investing Strategies to Cut Your Taxes

INVESTING

Jeff Schnepper

Decision Center

..........................................

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Ask the Experts

ax planning is a year-round process. After Jan. 1, it's too late to do anything about last year's taxes (except for claiming all the deductions you're allowed for the prior year). If you wait until two weeks before April 15 when your return is due, there is little to nothing for you to plan.

Start now to think about areas of your financial life that could affect this year's and next year's taxes.

For example, do you expect to sell stock currently pregnant with a huge capital gain? That might put you into a higher tax bracket. Will you have to pay estimated taxes? If so, how much must be paid and when?

Do you expect to itemize deductions? If so, then the bunching of medical expenses or miscellaneous itemized deductions to exceed their deductible floors ( your medical expenses must exceed 7.5 percent of your adjusted gross income; your miscellaneous itemized deductions must surpass 2 percent of your adjusted gross income) becomes part of your planning process.

Will you be subject to the alternative minimum tax? If so, then you may want to accelerate income or defer certain deductions that wouldn't be allowed under that special add-on tax.

Here are some of the ways you can plan today to minimize your contribution to the IRS in April of next year.

1. Know what you expect to earn

Planning for tax time must be future-oriented rather than past-reactive. If your income is going to go up - because of a raise or the recognition of a large capital gain - then plan for it. You may end up in a higher bracket or be liable for estimated taxes. Your huge miscellaneous deduction for job-hunting expenses might subject you to the alternative minimum tax

In any case, future planning allows you to adjust your finances as needed. If you can defer some of this year's deductions to next year, for example, you might avoid the alternative minimum tax and could then write off those deductions in full.

2. Know how much in taxes you're going to pay

Another key to tax planning is to know how much you're going to pay the Internal Revenue Service this year. Our tax system is a pay-as-you-go system. If you receive wages, your employer withholds income taxes from those wages. If you have any other kind of income (self-employment income, dividends, interest, rents, etc.), you may have to pay estimated taxes.

The secret here is to send the IRS only enough to avoid interest or penalties. Any more constitutes an interest-free loan to the IRS. Never pay more than you have to; never pay before you have to. Better that you get the interest on the money than the IRS.

For the current tax year, as long as you don't owe more than $1,000 on your return, you won't have to pay any penalties. Likewise, if your total withholdings and estimated payments equal what you paid last year, you won't pay any interest or penalties either. This is regardless of your last-year's income and how much you owe the IRS for this year.

A key fact to remember is you shouldn't be patting yourself on the back if you get a huge refund from the IRS. That means you gave the government an interest-free loan. If you expect to have to pay a big bill in April, put the money in a money market account to earn interest.

3. Project your income and deductible expenses

Discipline is the key to all tax planning. To be successful, you must have the discipline to project your income and deductible expenses. This allows you to project your next year's tax and begin planning now.

As a subset of this strategy, expense bunching becomes an important planning tool. For example, certain expenses such as medical and miscellaneous expenses can only be deducted after you exceed a certain percentage of your income.

Only medical expenses in excess of 7.5 percent of your adjusted gross income and miscellaneous deductions in excess of 2 percent of your AGI are allowed. This means that if your adjusted gross income is $100,000, the first $7,500 of your medical expenses and the first $2,000 of your miscellaneous itemized deductions are not allowed.

The solution to this disallowance is deduction bunching. For example, if your adjusted gross income is $100,000 and you have paid $7,500 in medical expenses, none of them would be allowed. But if you can accelerate your medical expenses, for example, by prepaying your daughter's orthodontia in December rather than in January, then you will have exceeded the minimum. It's a kickback from Uncle Sam that you otherwise wouldn't have received in either year.

Other examples would include prepaying investment expenses, such as investment magazines, for tax preparation. Many of my clients paid their tax preparation expenses by mailing me a check on Dec. 31. They deduct it in the year mailed, I report it in the year received (the next year) and everybody wins (except the IRS).

Alternatively, if you can't exceed the minimum in one year, you might want to defer deductible expenses into the next year.

4. Prepare for an audit.

Always prepare yourself for the worst; and in the tax world, that's an audit. I urge all of my clients to use what I call the "envelope system." Wherever they have an expense that might be deductible, I ask them to get a receipt and put that receipt in a box or special file.

Once a month, or whenever they reconcile their bank statements, I ask them to break down the receipts into individual deductible categories, and have an envelope for each category. For example, you could have an envelope for medical expenses, another envelope for miscellaneous deductions, charitable contributions, etc. At the end of the year, add the receipts and the checks and put that amount on the envelope. These envelopes would then be the basis for your tax returns

An audit is a substantiation process. You have to prove your deductions. But if your charity envelope has $500 in receipts and checks, and if that's the number on your return, all you have to do is hand the auditor the envelope.

In effect, by using this system to accumulate the data used to prepare your return, you have effectively pre-audited yourself. There are few things as rewarding and enjoyable as leaving an IRS audit with a "no change" letter.

Conversely, if you get a big refund after an audit, it doesn't mean you should be happy either. What it really means is that your return was not prepared as well as it could have been. It also casts doubt as to your other, non-audited returns.

Tax planning is not a once-a-year deal. It must be continuously monitored and your transactions adjusted accordingly. There is no one silver bullet to kill the annual tax wolf at your door. This is one axiom that's particularly true in tax preparation: People don't plan to fail, they just fail to plan.

The secret here is to send the IRS only enough to avoid interest or penalties. Any more constitutes an interest-free loan to the IRS.

There are few things as rewarding and enjoyable as leaving an IRS audit with a "no change" letter.

How can I minimize the impact of taxes on my investment returns?

Articles

Taxable, Tax-Deferred and Tax-Free Investments

Next Steps

Go to Money's Investment Portfolio
Go to Money's Tax Estimator Worksheet

	INVESTING

	Investing Strategies to Cut Your Taxes Jeff Schnepper Decision Center

.......................................... WEB LINK Ask the Experts	ax planning is a year-round process. After Jan. 1, it's too late to do anything about last year's taxes (except for claiming all the deductions you're allowed for the prior year). If you wait until two weeks before April 15 when your return is due, there is little to nothing for you to plan. Start now to think about areas of your financial life that could affect this year's and next year's taxes. For example, do you expect to sell stock currently pregnant with a huge capital gain? That might put you into a higher tax bracket. Will you have to pay estimated taxes? If so, how much must be paid and when? Do you expect to itemize deductions? If so, then the bunching of medical expenses or miscellaneous itemized deductions to exceed their deductible floors ( your medical expenses must exceed 7.5 percent of your adjusted gross income; your miscellaneous itemized deductions must surpass 2 percent of your adjusted gross income) becomes part of your planning process. Will you be subject to the alternative minimum tax? If so, then you may want to accelerate income or defer certain deductions that wouldn't be allowed under that special add-on tax. Here are some of the ways you can plan today to minimize your contribution to the IRS in April of next year. 1. Know what you expect to earn Planning for tax time must be future-oriented rather than past-reactive. If your income is going to go up - because of a raise or the recognition of a large capital gain - then plan for it. You may end up in a higher bracket or be liable for estimated taxes. Your huge miscellaneous deduction for job-hunting expenses might subject you to the alternative minimum tax . In any case, future planning allows you to adjust your finances as needed. If you can defer some of this year's deductions to next year, for example, you might avoid the alternative minimum tax and could then write off those deductions in full. 2. Know how much in taxes you're going to pay Another key to tax planning is to know how much you're going to pay the Internal Revenue Service this year. Our tax system is a pay-as-you-go system. If you receive wages, your employer withholds income taxes from those wages. If you have any other kind of income (self-employment income, dividends, interest, rents, etc.), you may have to pay estimated taxes. The secret here is to send the IRS only enough to avoid interest or penalties. Any more constitutes an interest-free loan to the IRS. Never pay more than you have to; never pay before you have to. Better that you get the interest on the money than the IRS. For the current tax year, as long as you don't owe more than $1,000 on your return, you won't have to pay any penalties. Likewise, if your total withholdings and estimated payments equal what you paid last year, you won't pay any interest or penalties either. This is regardless of your last-year's income and how much you owe the IRS for this year. A key fact to remember is you shouldn't be patting yourself on the back if you get a huge refund from the IRS. That means you gave the government an interest-free loan. If you expect to have to pay a big bill in April, put the money in a money market account to earn interest. 3. Project your income and deductible expenses Discipline is the key to all tax planning. To be successful, you must have the discipline to project your income and deductible expenses. This allows you to project your next year's tax and begin planning now. As a subset of this strategy, expense bunching becomes an important planning tool. For example, certain expenses such as medical and miscellaneous expenses can only be deducted after you exceed a certain percentage of your income. Only medical expenses in excess of 7.5 percent of your adjusted gross income and miscellaneous deductions in excess of 2 percent of your AGI are allowed. This means that if your adjusted gross income is $100,000, the first $7,500 of your medical expenses and the first $2,000 of your miscellaneous itemized deductions are not allowed. The solution to this disallowance is deduction bunching. For example, if your adjusted gross income is $100,000 and you have paid $7,500 in medical expenses, none of them would be allowed. But if you can accelerate your medical expenses, for example, by prepaying your daughter's orthodontia in December rather than in January, then you will have exceeded the minimum. It's a kickback from Uncle Sam that you otherwise wouldn't have received in either year. Other examples would include prepaying investment expenses, such as investment magazines, for tax preparation. Many of my clients paid their tax preparation expenses by mailing me a check on Dec. 31. They deduct it in the year mailed, I report it in the year received (the next year) and everybody wins (except the IRS). Alternatively, if you can't exceed the minimum in one year, you might want to defer deductible expenses into the next year. 4. Prepare for an audit. Always prepare yourself for the worst; and in the tax world, that's an audit. I urge all of my clients to use what I call the "envelope system." Wherever they have an expense that might be deductible, I ask them to get a receipt and put that receipt in a box or special file. Once a month, or whenever they reconcile their bank statements, I ask them to break down the receipts into individual deductible categories, and have an envelope for each category. For example, you could have an envelope for medical expenses, another envelope for miscellaneous deductions, charitable contributions, etc. At the end of the year, add the receipts and the checks and put that amount on the envelope. These envelopes would then be the basis for your tax returns . An audit is a substantiation process. You have to prove your deductions. But if your charity envelope has $500 in receipts and checks, and if that's the number on your return, all you have to do is hand the auditor the envelope. In effect, by using this system to accumulate the data used to prepare your return, you have effectively pre-audited yourself. There are few things as rewarding and enjoyable as leaving an IRS audit with a "no change" letter. Conversely, if you get a big refund after an audit, it doesn't mean you should be happy either. What it really means is that your return was not prepared as well as it could have been. It also casts doubt as to your other, non-audited returns. Tax planning is not a once-a-year deal. It must be continuously monitored and your transactions adjusted accordingly. There is no one silver bullet to kill the annual tax wolf at your door. This is one axiom that's particularly true in tax preparation: People don't plan to fail, they just fail to plan.	The secret here is to send the IRS only enough to avoid interest or penalties. Any more constitutes an interest-free loan to the IRS. There are few things as rewarding and enjoyable as leaving an IRS audit with a "no change" letter.
	How can I minimize the impact of taxes on my investment returns?
	Articles \|

	Taxable, Tax-Deferred and Tax-Free Investments

	Next Steps \|

	Go to Money's Investment Portfolio Go to Money's Tax Estimator Worksheet Copyright 1998 Microsoft Corporation