Continuation: 32 (7-12) Fool-Proof Federal Income-Tax-Saving Strategies
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7. Defer taxes. Certain kind of investments let you postpone paying taxes on earnings to a later year, when you maybe on earnings to a later year, when you may be in a lower bracket. One sure advantage of tax federal is tax-free compounding. Series EE U.S. savings bonds offer this feature, as do annuities. You can defer paying taxes on the interest on savings bonds until the bonds are cashed. With an annuity, taxes aren’t due until the income is actually paid out. Another tax-delaying tactic: Buy Treasury bills that mature next year. Although you get your T-bill interest when you buy the security, you don’t need to report the income on your federal tax return until the T-bill matures.
Every rule has its exception, so here’s this one’s. Quite a few of the changes in the 1997 tax law provide tax breaks only if your income is below certain levels during the year. So you may find that in order to claim them you’ll want to push income into the current tax year in order to keep your income lower next year, when you’ll then be able to grab these new tax breaks. For instance, say you’re a married couple with two children under 17 and your adjusted gross income will be $126,000. If your income will be the same next year, you won’t be able to claim the full $400-per-child tax credit created by the 1997 law, since it phases out for couples with incomes over $16,000 of next year’s income into this year (or just find new ways to keep the tax man away from $16,000 of your income next year), you’ll get the credit after all. One way to do this: Increase your pretax contributions to your employer-sponsored retirement plan and flexible savings account next years, which will lower your adjusted gross income.
8. Bunch your deductions if you will have trouble itemizing. You may find that you don’t have quite enough write-offs to exceed the standard deduction $7,100 in 1998 for married couples filing jointly; $4,250 for singles) and itemize on your tax return. In that case, see whether there are some deductible expenses you expect to incur next year that you could make this year to let you itemize and get some extra write-offs. (Some often over-looked deductions: legal fees relating to the production, collection, or advice about taxable income and investment expenses such as financial planner fees, IRA custodian fees, subscription to investment publications, or the cost of safe-deposit boxes in which you store securities or tax documents). Conversely, if it’s pretty clear you won’t be able to itemize, try to postpone to next year expenses that you could write off if you itemize. That’s because next year you might just have enough deductions to itemize.
By the way, make sure you understand the difference between a tax deduction and a tax credit. A deduction isn’t as valuable as credit. That’s because a deduction reduces the amount of your income subject to tax, so that only a percentage of the expense gets recouped as tax savings. A credit, however, reduces your tax liability dollar for dollar. Put another way, if you owe $5,000 in taxes but have a tax credit of $500, you would owe only $4,500 in taxes.
The 1997 tax law created three new tax credits:
• The $400-a-child tax credit for children under 17, which rises to $500 in 1999; maximum income to claim the full credit: $119,000 in 1998 for a couple with one child.
• The Hope scholarship credit of up to $1,500 a year for tuition paid during the first two years of college (100% of the first $1,000 in costs and 50% of the next $1,000); maximum income to take the full credit: $100,000 for couples and $50,000 for singles.
• The Lifetime Learning credit of up to $1,000 a year for tuition and related expenses paid after June 30, 1998. This credit is available for undergrads, grad students, and even people taking a class to improve their job skills through a training program. You can claim 20% of up to $5,000 in tuition costs; up to $10,000 starting in 2002. You can’t take this credit and the Hope credit in the same year, though.
9. Make sure to claim a child care tax credit for all your costs that count. If both you and your spouse work and you pay someone to take care of any children under age 13, you’re entitled to a child care credit equal to as much as $720 a year for one child and $1,440 for two or more. What you may not realize, however, is that the IRS lets you include the cost of summer day camp, nursery school, and the extra cost of having a nanny live with you.
10. Fund higher education without higher tax. Look for investments for your child’s college fund that avoid the kiddie tax. Consider buying investments that pay no interest until maturity –ideally after the child turns 14 –such as Series EE U.S. savings bonds and tax-free municipal bonds or bond funds. Growth stocks or growth stock mutual funds unlikely to pay more than $1,300 in dividends are a sensible option, too. You won’t owe any taxes on their capital gains until you sell the stocks or funds.
11. Keep wages all in the family. One of the best substitutes for an allowance, of you have self-employment income, is to put your child on the payroll. Because the salary is deductible as a business expense, you not only succeed in having your earnings taxed at a lower rate, you also reduce your net profit subject to self-employment (FICA) tax. Furthermore, your child can earn up to $4,150 a year or so and pay no federal tax. The next $25,350 (in 1998) of earned income is taxed at just the 15% rate. Wages paid to a child under the age of 18 are exempt from employment taxes. Just be sure that the salary you pay is reasonable for the services rendered.
12. Don’t file jointly with your child. As a convenience, you may decide to avoid filing the kiddie tax return (Form 8615) for your child under age 14 by reporting his or her investment income on your own Form 1040. This election can be a mixed tax blessing, however. By effectively raising your income on your tax return, you may lose deductions for medical expenses, casualty losses, for miscellaneous expenses, which all become tougher to claim as your adjusted income goes up.
Also conceivably affected by increasing your income this way: the phase-out of itemized deductions and exemptions for wealthy people (deductions are reduced by 3% of the amount your adjusted gross income exceeds $124,500 in 1998; exemptions are phase-out for couples with income between $186,800 and $311,800 and for singles with incomes between $124,500 and $249,500).
Finally, this ploy could backfire on your state taxes. In 36 states and the District of Columbia, your state tax liability is pegged to your federal income or tax. Adding your child’s income to your own can, therefore, wind up boosting your state tax. Moreover, if you instead file separately for your son or daughter, the child’s standard deduction and exemption could wipe out his or her state tax.
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