Five Basic Tips to Cut Your Tax Bill

TAXES

By Jeff Schnepper

Decision Center

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here's no way (legally) to avoid paying taxes. But you can avoid paying too much. Aggressive tax planning isn't for the timid, but there are five basic strategies you should consider to lighten your tax load. Let's look at them one at a time:

1. Minimize your gross income

If you can convert taxable income into non-taxable income you have reduced your taxes. The simplest way to do this would be to invest in tax-free rather than taxable investments. For example, if you're in the 28 percent bracket, a tax-exempt yield of 5 percent is the equivalent of a taxable yield of 6.94 percent. On a $100 investment, 6.94 percent is $6.94, out of which you pay 28 percent, or $1.94 in taxes. This leaves you with $5 after tax, or the same as a 5 percent tax-free return on the original $100.

The higher your tax bracket, the more advantageous tax-exempt income becomes. For example, if you were in the 39.6 percent bracket, the 5 percent tax-exempt yield becomes the equivalent of an 8.28 percent taxable yield. Suddenly, you're getting investment returns close to the historical returns provided by the stock market.

You can also minimize your gross income by modifying your compensation arrangement with your employer. For example, you might ask your employer to pay your college tuition in lieu of a bonus. Alternatively, in compensation negotiations, you might give up additional cash in exchange for alternatives to "earned income." Such alternatives might include hospitalization premiums, group life insurance premiums, accident and health plans, or other forms of non-taxable compensation.

Participation in dependent care assistance programs or qualified retirement plans also reduces your gross income. The concept is the same: Convert taxable income into money that's outside the government's reach. In this example, we're talking about expenses you would have made anyway, only now you'll end up saving money. In effect, have the IRS help pay for what you would have bought anyway.

2. Turn everyday expenditures into deductions

You can arrange your activities so that your personal spending can be deducted as business expenses. For example, if you qualify for a home office, you can deduct certain furniture and equipment (such as a computer or fax machine), part of your home insurance, mortgage interest, real estate taxes, heat, air conditioning, and even depreciation on part of your house.

Do you have kids? Are you giving them an allowance? If your kids can work for you, you have converted their personal allowance into deductible compensation. Your kids can earn as much as $6,250 in 1998 (standard deduction of $4,250 plus IRA of $2,000) and pay zero in federal taxes.

Moreover, if your kids are under 18 and work for your unincorporated business, no Social Security or Medicare taxes need be paid.

The payments to your kids, however, would be deductible for you. Remember that you don't have to give them more than $6,000 in payments. But, to the extent you're giving them money anyway, by structuring the payments as salary, the IRS is funding those payments.

3. Use the special tax credits

You can take advantage of special credits that the tax code allows as dollar-for-dollar offsets to your final tax liability. A $100 tax credit reduces your tax by $100; a $100 deduction in the 31 percent bracket reduces your tax by only $31. Child-care credits, special credits for the elderly and credit for excess Social Security withholding (if you work for more than one employer) can take a big bite out of your tax bill.

4. Know your marginal rate

A key feature of our federal tax system is its progressive nature. The higher your taxable income, the higher your marginal rate. Your marginal rate is the rate of tax you pay on your next dollar of taxable income. Rates start at zero, then 15 percent, and go as high as 39.6 percent. In certain circumstances, the top rate can exceed 50 percent.

You can reduce or eliminate your tax by allocating income to different family members in lower marginal tax brackets. For example, I can pay my daughter as much as $6,250 to work for my unincorporated business, and she'll owe zero taxes. I can deduct the $6,250 as a business expense and save on my own income, Social Security and Medicare taxes. If I'm in the 31 percent bracket, and normally pay 15.3 percent as a self-employed individual in Social Security and Medicare taxes, I'll save more than $2,893 in taxes in one year. I'll have additional savings on my state income tax, and now the IRS is helping to finance my daughter's college education.

Income allocation between brackets works even if you're not self-employed. In that case, rather than moving earned income, you can shift investment income from higher to lower bracketed family members. If I shift $10,000 in mutual funds earning 10 percent into my son's name, I will have shifted $1,000 in income from my bracket to his. Remember though, that while this will clearly save you tax dollars, the $10,000 now belongs to him. There are techniques, such as a family limited partnership, which will allow you to make this kind of shift without losing control of the funds. Your tax adviser can help here.

5. Take advantage of all your deductions

The tax code is filled with deductions and "loopholes" for you that serve a variety of purposes - some noble, some less than noble. And if Congress insists on enacting them, it makes sense to take advantage of them. If you don't, you're making an involuntary contribution to the IRS. (You can always make voluntary contributions to the government and when paid, they would be deductible.)

The most important strategy for cutting your taxes is to know what is allowable as a deduction.

Knowledge is the key to recognizing what the law does and doesn't mandate. Of course, not everyone has the flexibility to rearrange his or her life in response to every twist and turn of the tax laws. But if you can just cut $1,000 off your tax bill each year and invest that money in an IRA account, after 20 years you'll have close to $40,000 to add to your nest egg - and $90,000 after 30 years.

Not a bad return for a little knowledge.

If your kids are under 18 and work for your unincorporated business, no Social Security nor Medicare taxes need be paid.

The higher your tax bracket, the more advantageous tax-exempt income becomes.

What can I do now to reduce next year's taxes?

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IRAs and Other Tax-Deferred Retirement Plans
Tax Shelters: Still Alive and Well

Next Steps

Go to Money's Tax Estimator Worksheet

	TAXES

	Five Basic Tips to Cut Your Tax Bill By Jeff Schnepper Decision Center

.......................................... WEB LINK Ask the Experts	here's no way (legally) to avoid paying taxes. But you can avoid paying too much. Aggressive tax planning isn't for the timid, but there are five basic strategies you should consider to lighten your tax load. Let's look at them one at a time: 1. Minimize your gross income If you can convert taxable income into non-taxable income you have reduced your taxes. The simplest way to do this would be to invest in tax-free rather than taxable investments. For example, if you're in the 28 percent bracket, a tax-exempt yield of 5 percent is the equivalent of a taxable yield of 6.94 percent. On a $100 investment, 6.94 percent is $6.94, out of which you pay 28 percent, or $1.94 in taxes. This leaves you with $5 after tax, or the same as a 5 percent tax-free return on the original $100. The higher your tax bracket, the more advantageous tax-exempt income becomes. For example, if you were in the 39.6 percent bracket, the 5 percent tax-exempt yield becomes the equivalent of an 8.28 percent taxable yield. Suddenly, you're getting investment returns close to the historical returns provided by the stock market. You can also minimize your gross income by modifying your compensation arrangement with your employer. For example, you might ask your employer to pay your college tuition in lieu of a bonus. Alternatively, in compensation negotiations, you might give up additional cash in exchange for alternatives to "earned income." Such alternatives might include hospitalization premiums, group life insurance premiums, accident and health plans, or other forms of non-taxable compensation. Participation in dependent care assistance programs or qualified retirement plans also reduces your gross income. The concept is the same: Convert taxable income into money that's outside the government's reach. In this example, we're talking about expenses you would have made anyway, only now you'll end up saving money. In effect, have the IRS help pay for what you would have bought anyway. 2. Turn everyday expenditures into deductions You can arrange your activities so that your personal spending can be deducted as business expenses. For example, if you qualify for a home office, you can deduct certain furniture and equipment (such as a computer or fax machine), part of your home insurance, mortgage interest, real estate taxes, heat, air conditioning, and even depreciation on part of your house. Do you have kids? Are you giving them an allowance? If your kids can work for you, you have converted their personal allowance into deductible compensation. Your kids can earn as much as $6,250 in 1998 (standard deduction of $4,250 plus IRA of $2,000) and pay zero in federal taxes. Moreover, if your kids are under 18 and work for your unincorporated business, no Social Security or Medicare taxes need be paid. The payments to your kids, however, would be deductible for you. Remember that you don't have to give them more than $6,000 in payments. But, to the extent you're giving them money anyway, by structuring the payments as salary, the IRS is funding those payments. 3. Use the special tax credits You can take advantage of special credits that the tax code allows as dollar-for-dollar offsets to your final tax liability. A $100 tax credit reduces your tax by $100; a $100 deduction in the 31 percent bracket reduces your tax by only $31. Child-care credits, special credits for the elderly and credit for excess Social Security withholding (if you work for more than one employer) can take a big bite out of your tax bill. 4. Know your marginal rate A key feature of our federal tax system is its progressive nature. The higher your taxable income, the higher your marginal rate. Your marginal rate is the rate of tax you pay on your next dollar of taxable income. Rates start at zero, then 15 percent, and go as high as 39.6 percent. In certain circumstances, the top rate can exceed 50 percent. You can reduce or eliminate your tax by allocating income to different family members in lower marginal tax brackets. For example, I can pay my daughter as much as $6,250 to work for my unincorporated business, and she'll owe zero taxes. I can deduct the $6,250 as a business expense and save on my own income, Social Security and Medicare taxes. If I'm in the 31 percent bracket, and normally pay 15.3 percent as a self-employed individual in Social Security and Medicare taxes, I'll save more than $2,893 in taxes in one year. I'll have additional savings on my state income tax, and now the IRS is helping to finance my daughter's college education. Income allocation between brackets works even if you're not self-employed. In that case, rather than moving earned income, you can shift investment income from higher to lower bracketed family members. If I shift $10,000 in mutual funds earning 10 percent into my son's name, I will have shifted $1,000 in income from my bracket to his. Remember though, that while this will clearly save you tax dollars, the $10,000 now belongs to him. There are techniques, such as a family limited partnership, which will allow you to make this kind of shift without losing control of the funds. Your tax adviser can help here. 5. Take advantage of all your deductions The tax code is filled with deductions and "loopholes" for you that serve a variety of purposes - some noble, some less than noble. And if Congress insists on enacting them, it makes sense to take advantage of them. If you don't, you're making an involuntary contribution to the IRS. (You can always make voluntary contributions to the government and when paid, they would be deductible.) The most important strategy for cutting your taxes is to know what is allowable as a deduction. Knowledge is the key to recognizing what the law does and doesn't mandate. Of course, not everyone has the flexibility to rearrange his or her life in response to every twist and turn of the tax laws. But if you can just cut $1,000 off your tax bill each year and invest that money in an IRA account, after 20 years you'll have close to $40,000 to add to your nest egg - and $90,000 after 30 years. Not a bad return for a little knowledge.	If your kids are under 18 and work for your unincorporated business, no Social Security nor Medicare taxes need be paid. The higher your tax bracket, the more advantageous tax-exempt income becomes.
	What can I do now to reduce next year's taxes?
	Articles \|

	Start Planning Now for Next Year's Taxes IRAs and Other Tax-Deferred Retirement Plans Tax Shelters: Still Alive and Well

	Next Steps \|

	Go to Money's Tax Estimator Worksheet Illustration by James O'Brien Copyright 1998 Microsoft Corporation