By Rosilyn H. Overton, CFP, CRPS
We often start thinking about our tax bill at the end of the year, but a few cool moves now can make next spring less rainy. The easiest way to reduce your taxes is to reduce your taxable income. This doesn’t mean you should quit your job. Instead, look around for tax deductions. Employee benefits, smart investment sales, converting consumer interest to home equity loans or margin loans, and smart purchases can all reduce taxable income.
First, look at your employee benefits. Many people shy away from contributing to their 401(k) plan or SIMPLE plan because they need every penny now. However, if you are lucky enough to have a 401(k) plan or SIMPLE plan where you work, it is possible that you might reduce your taxes, increase the size of your savings account, and actually end up with more spendable cash.
Here is how it works: Let’s say that you make $50,000 per year. You have been trying to save 6 percent of your income, or $3,000 per year, $60 per week except for your two-week vacation. You are in the 27 percent Federal tax bracket, so your taxes are about $13,500 per year (We are ignoring the 11.87 percent combined New York State and City taxes here, and FICA and FUTA to keep it simple.) Out of the remaining $36,500, you put $3,000 in a savings account, leaving you with $33,500. If, instead, you put $3,000 of before-tax money into your 401(k) or SIMPLE plan, your taxable income is now $47,000. You pay tax of $12,690, leaving you with $34,310. You have $810 more spending money, and the same amount of money in savings.
Wait, there’s more. Assuming your employer matches completely your first 3 percent of salary contributed to your plan, you have also received a match of $1,500, making your savings balance $4,500. So, you have $810 more money in your pocket, and, due to your employer’s generosity, an additional $1,500 in savings.
Contributing to a plan often looks impossible to lower income taxpayers, such as starving students and those just getting started in their careers. There is good news this year. For those who make less than $25,000 as a single filer, or less than $50,000 on a joint return, there is a participation tax credit that could make it more attractive to save. A tax credit of 50 percent, 20 percent or 10 percent of what you contribute may be available, up to a limit of $2,000 contribution. This means that you possibly could get back up to $1,000 of your $2,000 contribution.
Your Human Resources brochure may yield another way to reduce income. If you are eligible, a cafeteria plan or flexible spending account from your employer can be a winner. These are typically offered by larger employers, and can be used for child care expenses or medical bills, as well as pre-paid legal services, etc. Like the 401(k) plan, the money you set aside comes out of your paycheck on a pre-tax basis. Your only problem is to make sure that you set aside the right amount. Most plans do not give you back any excess that you do not use.
Since the stock market has been so terrible the past two years, chances are that you have stocks that you could sell at a loss. It is difficult to recognize the loss, but selling that stock now could protect you against big gains for the next several years. Even if you didn’t make a penny on selling stock this year, you will be able to create yourself a bank of tax loss carry forwards that will pay your capital gains taxes for the next several years. What’s more, you can take up to a $3,000 loss each year without an offsetting gain.
If you are a renter, soaring house prices may have caused you to put off buying a house. Generally speaking, you should not wait. Buy something that you can afford, even if it isn’t the house of your dreams. If you live in the house for two years or more, then sell it, any profit you make up to $500,000 will be tax-free, so you can convert your rental payments to tax-free gains. In the meantime, the mortgage interest and property taxes are tax-deductible, so you reduce your tax bill. Buying this summer instead of next year will give you six months of deductions plus a six-month or more start on the two-year holding period. Even a co-op or condo qualifies for this exemption on profits on the principal residence.
As an individual, only mortgage, home-equity and margin interest are still deductible. Converting consumer debt into one of those three can save you up to 40 percent of the interest in taxes. Every bank has brochures about home equity loans, but margin loans are less often thought of for general purposes. If you have bonds or stable, dividend-paying stocks, consider a margin loan. Margin loans usually have lower interest rates than home equity loans, and are much more flexible to repay. Your broker-dealer will automatically apply your dividends and interest earned against your loan, plus you can pay any amount on your loan at any time. If you wish a defined repayment schedule, you can usually arrange to have a certain amount sent from your checking account each month. This kind of loan is particularly attractive to people who have fluctuating incomes, since you can pay them down substantially in good months and let them go in bad months.
Finally, check that the amount of tax that you are withholding or paying in quarterly estimates is on target. Underpayment can lead to serious penalties, and overpayment costs you since the government pays no interest on prepayments. If you have had a substantial change in income, dependents or deductions, take what you have contributed so far, and see if it will come out right. If not, adjust the amounts now so you come out even at the end of the year.
The big advantage of taking these steps now is that there is time for them to affect your situation before the end of the year. You can enjoy a better tax return next spring.
Rosilyn H. Overton is a Certified Financial Planner and a Chartered Retirement Plan Specialist. She owns the office of Mid-Atlantic Securities, Inc. (Member, NASD & SIPC) on Northern Boulevard in Little Neck. An advisor with more than 30 years experience, she is a past chairman of the Financial Planning Association of New York. She can be reached at 631-4000.
