Just meeting with your tax pro is not enough, however.  You need to arrive prepared.  If you are dealing with a new preparer, give him or her copies of your last two or three returns.  Besides painting a fairly complete picture of your tax situation, your returns may contain valuable information about property you are depreciating and about losses or credits you can carry over into future years.

Be sure your records are complete and up-to-date.  You preparer cannot invent numbers to put in your return.  Unless you supply accurate information, money you spent on deductible items will be lost.  Remember that your income is even more important to the IRS than your deductions.  So make sure your professional has copies of all of your Forms W-2 and 1099 when preparing your return.

If you are coming in for tax-planning advice, bring an estimate of your year-to-date income, federal and state tax withholding, and deductible expenses.  Also carry along the latest monthly or quarterly statement from each of your investments; a summary of year-to-date capital gains and losses; a record of estimated taxes paid; and a record of deductible pension or savings plan contributions you made.

Write down any questions you have before coming in, such as whether there are any changes in the tax law that affect you or whether you will be subject to the alternative minimum tax (a special tax system with a flat rate levied on some wealthy people to ensure that they pay their fair share of taxes.)  Always ask if there is anything you should be doing to save taxes.

Use a tax manual to bone up on any areas of the tax law that affect you.  This is especially true when you come in during the filing season, because your busy preparer will have only a limited time to question you.  If you do not know that the cost of removing trees killed by southern pine beetles may be deductible, it is unlikely your preparer will uncover it unless you get around to chatting about your landscaping.

Mention changes in your family situation, too.  Unless you send your preparer a baby announcement, he or she will not know you have a new exemption to declare.  Keep your preparer informed of any marriage, divorce, births, or deaths in your family, children who leave home, and changes of address.
Unless you quake at the thought of an audit, make it clear that you want all the deductions you are entitled to receive.  Once your return is prepared, feel free to question any decisions you do not understand or challenge.  Ask for a reference to the tax law supporting his or her opinion if you are still unconvinced.

Remember that your preparer is only a phone call away.  Seek his or her advice before making any major financial move, such as buying a house or funding your child’s education.  Just give your pro enough time to research the tax angles.

Finally, act on your professional’s advice.  Don’t ignore it.  After all, in the long run, how much you save in taxes is up to you.

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Getting the Most Out of Your Tax Pro

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If you are unable or unwilling to appear in person, you may mail in your records.  A word of warming, though:  An audit conducted by mail can be much more costly than one done in person.  Unless your records are perfect and self-explanatory, you stand a good chance of losing the deduction, because you won’t be present to answer the auditor’s questions.

Usually, once an audit is started, it cannot be stopped.  There is one exception, though:  the repetitive audit.  If you went through a non-business audit for the same issues in either of the two preceding tax years, emerged without owing tax, and still get audited again on them, you can alert the IRS and tell the agency that it can’t audit you about these write-offs this time.

Assuming there’s no way out, though, you need to prepare.  First, get a copy of the tax return under audit and pull together all the documents that support the items being questioned.  Try to reconstruct any missing records.  Get copies of cancelled checks from your bank, duplicate receipts from your credit-card company, church, synagogue, or doctor, for example, or letters from people who can back up your claims.  For instance, if you deducted business expenses, get your boss to write a letter verifying their legitimacy.

Your records do not have to be perfect.  If you cannot dig up roof, try to prepare a convincing argument. The auditor usually must give weight to your oral testimony, except for disputes over business entertainment expenses.

If record keeping fails, the following guidelines may save the day:

Don’t volunteer information. What you do not know about the tax law can hurt you.  Answer the auditor’s questions, but do not feel compelled to elaborate.

Leave your emotions and hostility at home. Be courteous and cooperative.  That does not mean you have to automatically give in when the auditor disallows your donation to Goodwill or your trip to Miami.  In fact, being too eager to agree can raise suspicious.

Look for areas of compromise. The auditor will probably be willing to bargain in order to close your case.  If you are flexible and know the auditor may come away from the audit satisfied with the final bill.

Should you brave the IRS by yourself or, if you hired a tax pro to prepare your return, have him or her do the talking?  It all depends on what the IRS wants to know.  If you had a preparer fill out your return, when you get an audit letter from the IRS, show it to your adviser.  Then ask for his or her guidance.  If the issue is a simple one, you may be able to handle it on your own and save another fee to your tax preparer, either by sending back a letter to the IRS or meeting with the auditor.  However, if the IRS wants to ask a lot of questions, you’re being audited on a gray area of the tax law, or you took a write-off you shouldn’t, it’s best to let your tax adviser handle the audit for your.  In fact, you’ll probably be better off not even going to the audit, since you could inadvertently say something to the auditor that could be held against you.

After all the evidence has been presented, the auditor will make a decision.  This judgment may come at the end of the audit or after you have provided more information at the auditor’s request.  If you are in the IRS office, the auditor will give his or her ruling and explain any proposed changes to your tax liability.  Otherwise you will get an audit report by mail.  Call the auditor if there is something you do not understand.

Three outcomes are possible:  (1) no extra tax due; (2) additional tax due; or (3) a refund.  In four out of five cases, the wheel of fortune lands on more tax due.

If you agree, fine.  What if you don’t have a cash to pay the extra taxes?  The IRS says that if your audit bill is $10,000 or less, you can get a three-year installment payment plan.  Figure on owing annual interest and penalties at about 14%, however.  You’ll need to fill out Form 433 to get the installment plan.  If, however, you think you’ll never be able to pay the full amount, try to work out a settlement with the IRS.  Fill out Form 656, known as the Offer in Compromise form, and type in:  “Doubt as to collectibility of the full amount of tax, penalty, and interest.”  On average, the IRS accepts 15c on the dollar from people who get such offers.  It can take six months to a year to find out what kind of deal the IRS will make, however.

But bear in mind that the auditor’s findings are not necessarily final; you don’t have to accept them.  You have 30 days after you receive the audit report to decide what action to take.  During this period, you may submit additional information you believe might change the auditor’s mind.
If you have no information to help your cause, you may either agree or disagree with the audit report.  If you decide to agree, sign a copy of the report and mail it back.  Keep the other copy for your records.  You may send the IRS a check for the tax due with signed report or wait for a bill for the extra tax, plus interest and penalties, from the IRS Service Center.

If you decide the audit report is unfair or incorrect, tell the auditor within the 30-day period that you want to appeal.  The IRS gives you several choices if you want to keep fighting.  You can ask for an informal appeal to the auditor’s supervisor.  If you go that route and are still unhappy or you prefer to skip this stage, you can go to the IRS Appellate Division.  This is called a formal appeal.  Then, if you lose at the appellate level, you can take your case to court.  This decision should be made with the help of an experienced tax professional, however, since going to court can be extremely expensive and time-consuming.

Most tax disputes are settled in the U.S. Tax Court, although you can also take your case to the I.S. District Court in your area or the U.S. Court of Claims in Washington, D.C.  The tax court, which hears cases at sites around the country, has a special procedure for so-called small cases, in which the disputed amount is $10,000 or less.  With relatively informal procedures, you can represent yourself in these suits.  Unlike regular tax court cases and those in the district courts and court of claims, however, the ruling in a small tax case cannot be appealed.

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Dealing with IRS - what to do when being audited

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Another fairly new wrinkle:  audits based on your occupation through its Market Segment Specialization Program.  The IRS is in the process of focusing its sights on particular businesses, preparing audits manuals for agents specifically about the likes of every category from lawyers to Laundromat operators.  In these manuals, agents learn the tricks some wily taxpayers use to hide income based on their occupation.

Math mistakes are likely to be caught by the IRS computers.  In these instances, your audit is likely to be little more than a letter from the IRS saying that you screwed up in your calculations and you owe some extra bucks.

Where you live may make you more or less susceptible to an audit.  Research revealed that certain IRS districts –that’s the way the IRS divides up the United States –have far higher audit rates than others.  People living in the 10 toughest target districts, on average, face double the risk of being audited as taxpayers in the other 53.

You may be the target of an IRS special project.  In recent years, these projects have focused on tax shelters, home office deductions, direct-sales businesses (such as an Amway or Shaklee distributor), and the “underground economy” –unreported income by persons who moonlight for cash or barter.

Every three years or so, the IRS has unloaded its big-gun project:  the Taxpayer Compliance Measurement Program, or the TCMP audit.  This is an excruciating line-by-line audit of randomly selected taxpayers; 153,000 people were selected for their ’94 returns.  It was postponed in ’95.

Many people believe that if the IRS does not call them in for an audit within six months after their return is filed, they are home free.  Receiving your refund checks does not mean you are immune from audit, however.  The IRS has three years from the date your return was filed or due, whichever is later, to audit your return.  (There is no statute of limitations for fraud, however.  If your reported income is overstated by 25% or more, the IRS has six years to audit).

There are three types of audits:

Correspondence audits originate at your IRS Service Center (where you sent your return) and are handled entirely through the mail.  For this reason, they generally involve only minor matters requiring a letter of explanation or simple documentation.  You are most likely to face a correspondence audit if the income on your return doesn’t match the amounts reported to the IRS on W-2 and 1099 forms.

Field audits usually target businesses, and for these an IRS agent comes to your home or business to review your records.

Office audits are the most common type, and for these an individual gets a personal invitation to come down to the local IRS office.  The audit notice will tell you to call for an appointment or to come in at a specified date and time.  Read this notice closely.  It contains valuable information about who may represent you at the audit and outlines your appeal rights.  It also tells you the items on your returns that are being questioned –usually broad categories, such as medical or employee business expenses.  Included with the notice will be information guides noting the types of records you’ll need to verify the items being audited.  Office audits are usually limited to two or three issues, so you won’t be expected to haul in all your records and prove every entry on your return.

An exception is the TCMP audit.  If you’re unlucky enough to get tapped for this one, you can expect an IRS agent to grill you on every single line of your return.  That’s because you are being used as a laboratory animal.  By studying returns like yours so closely, the IRS believes it can get a better idea of where taxpayers in general are fooling around on their returns or at least getting confused.  The data from these audits also is used to determine the average amount of exemptions, deductions, losses, and credits claimed by taxpayers at all income levels.  The results of this survey then get compiled to form a picture of the typical tax return, which the IRS computers will later use to judge whether a taxpayer’s return looks like good audit material.

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You think you can outsmart IRS? Think again!

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• The higher your income, the more likely you are to be audited.  Statistics indicate that just 3% of returns showing income between $25,000 and $50,000 are likely to be examined.  But some 6% of those reporting $50,000 and up are audited.

• Deductions larger than the national norm often are scrutinized, too.  If, for instance, you report charitable contributions or employee business expenses that are far higher than what most people with your income claim, the IRS is likely to want to know why.

Lately, the IRS has begun focusing more on returns through what it calls an “economic reality” approach to auditing.  If the IRS thinks that your write-offs seem unusual based on your lifestyle or occupation, your return may be flagged for an audit.  Particular targets of economic reality audits are self-employed people and owners of small corporations.  IRS agents lately have received special training in economic reality investigating, defined by the agency as “the process of gathering information about a taxpayer which is a reflection of the individual’s financial status”.  So the IRS thinks you’re living more lavishly than your income would normally allow, you may be called in on the assumption that you haven’t been reporting all your income.  Similarly, IRS agents might look at your prior tax returns to see how much investment income you reported.  If they spot a huge increase on your current return, you may be asked to explain where the money came from to produce that extra income.  Once you come face-to-face with an IRS auditor, you may be asked about everything from your country club memberships to the vacations you take to how much you spent on your daughter’s wedding.

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Dealing with the IRS

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One thing the IRS doesn’t tell you:  Electronic filing will cost you.  The fact is, you cannot file electronically without the help of a person or company approved by the IRS.  The cost varies from $25 to $100.  (To find an authorized transmitter in your area, call the IRS at 800-424-1041).  If you use one of the leading tax software packages, you can send your return information via modem or on a disk to an authorized service, which, for a fee, will file your return electronically with the IRS.

Is electronic filing worth the cost? Generally, if you compare the cost versus the financial benefit of a speedy refund, the answer is no.  Electronic filing is simply not economical for small refunds.  Although $25 may seem like a modest fee, if you figure how much your money could earn in the bank during the extra two to five weeks you have the use of your money, you need a refund of $4,000 or more to break even on the cost.  Paying to file electronically makes no sense at all if you owe tax.  You still have to mail a check for the balance due to the IRS by April 15, along with a statement showing that the return data was sent electronically.  About the only reason to file electronically is to do the IRS a good return.  The process saves the agency money on processing and storing returns and is less error prone than conventional proper returns.

Electronic filing has led to a booming business in loans against your tax refund.  The tax preparer will give you a check for your refund amount minus fees within a couple of days if you file electronically.  Unless you desperately need the money, though, do not bite.  These quick refunds are really short-term, very expensive loans.  The fees, which range from about $30 to$65, get you the use of your money only for an extra two to five weeks.  If you pay $40 to get a $400 refund loan, for example, you’re paying more than 100% interest on what amounts to a three-week loan.  Even if you need the money immediately, you should be able to find a cheaper source of credit.

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What about Electronic Filing

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Before you rush out to buy software (typical cost:  $20 to $40 for federal returns; perhaps $25 to $30 more for state returns), remember that you still have to gather all the information about your income, deductions, and credits.  Sadly, you cannot escape this scut work whether you do your return with a pencil, use a computer, or turn the whole mess over to a tax preparer.  Another piece of friendly advice:  If you’ve never used tax software before, it will take a while to get the hang of the program.

Tax software performs two functions.  It stores and organizes your income and expense records and uses this information to prepare your return or analyze tax strategies.  Although the major tax programs are fax from being clones, they all offer certain basic features: • Selecting the right forms. If you don’t know a Schedule E from a Form 2106, one of the brightest benefits of tax software is its ability to tell you which form you will need.  The software asks you a series of questions and from your answers lists the forms to be completed.  When you are done, the program checks to see if you have been thorough and tells you when a form seems incomplete.

• Matching the right number to the right line. The program lets you select a tax item from a list, such as church contributions, and carries the dollar amount you enter to the correct line of the correct form.

• Mathematical accuracy. With tax software, you can usually avoid worrying about any math errors.  The exception:  when there’s a bug in the software, as happened to many users during the 1995 tax-filing season.  Fortunately, software makers tend to be extremely apologetic when bugs are discovered and go out of their way to help customers resolve any problems.

• Internal consistency. That $2,532 capital gain on Schedule D will show up where it’s supposed to –on line 13 of the Form 1040 –and as $2,532, not $2,352 or some other transposed figure.

• Spotting omissions. You don’t have to worry about forgetting to include a critical piece of information to make your return complete.  Case in point:  To claim a child care credit, it’s not enough to enter the amount you spent, you also need to include the name and identification number of the child care provider.  If you forget, your software will remind you so that no form is left undone.

• Technical advice. At a minimum, you get the IRS instruction booklet online, with specific form and line instructions keyed to those places on the screen.  The amount of additional advice you get depends on the software.

• Tax forms. No more last-minute trips to the library for forms the IRS never sent.  They’re all in your computer; at least they are if your software includes your state’s forms, too.  If you have a laser printer, you can print forms that look just like the IRS version, with your tax information already typed in.

• Importing financial data. You will save hours at tax time if your tax information is already stored in a banking software program.  The tax program then can read your income and deductions from your checkbook files and transfer the data directly to your tax return.  Make sure the tax program you choose supports your banking program.  For example, Turbo Tax imports data from Quicken and Managing Your Money.

• Auditing.  When you have finished your taxes, the program checks for inconsistent or incomplete items, which could draw unwanted attention from the IRS.
The leading tax programs are Intuit’s Turbo Tax (Windows or Macintosh, $39.95; deluxe edition, $49.95).  You can also now file your taxes electronically on-line with Turbo Tax Online ($9.95; www.turbotax.com).  In a 1998 review of the software programs, MONEY rated Turbo Tax deluxe best.  The magazine said that this software, produced by the maker of the popular Quicken financial management software, was especially good at offering tax planning advice.  But if your tax return is simple and you’re looking for a good, quick, cheap way to fill it out and get it to the IRS, the Turbo Tax Online site is worth a shot.

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Using Tax Software

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1. Use the long form 1040 instead if the 1040A or 1040EZ to be certain you don’t overlook any tax-saving deductions or credits.

2. Double-check your math.

3. If you’re married, include your spouse’s Social Security number.

4. Check the “65 and over/blind” boxes if you are claiming the extra standard deduction for being elderly or blind.

5. Claim the earned income credit if you are eligible.

6. Attach explanations of any item you think might be questioned.

7. Report the Social Security number of any dependent you will claim

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Seven Tax-Return Filing Tips

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1.    Find out whether you qualify for any special property tax breaks. Many states reduce property taxes for being 65 or older, a veteran, or disabled.  Make sure you take advantage of any general homeowner’s exemption as well.

2.    Check the accuracy of your home’s assessed value. Review your property record card on file at your local assessor’s office.  This card lists such characteristics as lot size and number of rooms.  If you find an error on the card –the assessor overstated your home’s square footage, for example –a visit to the assessor can usually win you a tax reduction.
3.    If you do not spot an obvious error, determine whether your home’s value has been overstated. Maybe your house has suffered damage or housing prices have plunged in your area.  To find out if your local tax assessor for your home’s official assessed value.  Compare that number with the result you get when you multiply your property’s fair market value by your town’s residential assessment ratio.  That figure, which is also available from your assessor, is the percentage of fair market value subject to tax.  To estimate your home’s fair market value, ask a real estate agent or your assessor for recent sales prices of comparable homes in your neighborhood.  If the assessed value you computed is less than the official assessed value, it’s time to appeal.  Roughly half of homeowners who do so are successful, often cutting their bills by 10% or more.

4.    Document your case. No tax official is going to take your word for it when you plead for a reduction.  If you’re fighting your assessment, you will need written verification of the sales prices of three to five comparable homes.  Drive by those houses to make sure they are similar to yours.  Then photograph the exteriors to strengthen your claim.  If your home has deteriorated or been damaged since the last assessment, take pictures of it, too.

5.    Appeal an unfair assessment. Make sure you follow your local appeals procedure to the letter.  The first step is usually an oral plea before the local assessor.  If that does not succeed, you must fill out an appeals form and request a hearing before the local, county, or regional board.  Ask for the board’s schedule and try to attend one meeting to get a feel for the process before your appeal is heard.  When it’s your turn, bring the documents and photographs you have assembled to back up your oral testimony.  If the appeals boards reject your challenge, you can go to court or the state review board, but you will probably need to hire a lawyer.

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5 Smart Property-Tax-Saving Strategies

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That’s just the first step, though.  Now comes the hard part: sifting through your state’s tax code for any odd twists and turns you can exploit.  For instance, some expenses that aren’t federally deductible are allowed as write-offs by many states.  A few examples are political contributions, a portion of your rent, and medical expenses that fall below the federal deductibility threshold of 7.5% of adjusted gross income.  Some states also offer their own tax credits not available from the federal government, such as a renter’s credit in Hawaii and, in several states, credits for installing energy-saving equipment.  Ask your tax pro or consult a state tax handbook, available in most libraries, for a listing of your state’s deductions, exemptions, and credits.

Here are ten ways to fight back against steep state taxes:

1.  Invest in municipal bonds. Most municipal bonds issued by your state pay interest that is exempt from federal, state, and local taxes.  This can be especially valuable in states that tax interest at a high rate such as California, Connecticut, and New York.  For instance, a California couple in the 36% federal bracket and the 9.3% state bracket who buy municipals yielding 6% would have to find a taxable investment paying 10.97% to make as much money after tax.

2.  Buy Treasury securities. Not only are they the safest investments, their interest is exempt from state and local taxes.  That lets you pocket up to seven-tenths of a percentage point in extra yield if you live in a high-tax state.  For the same reason, look at money-market funds that hold Treasuries; such funds offer yields very close to those on the best-performing nongovernment money funds.  After taxes, however, the government money funds pay nearly a point more in high-tax states.  Caution:  The words “U.S. Government” in a mutual fund name don’t necessarily mean all of its earnings are tax-free in your state.  For example, many states tax interest earned on U.S. government-backed mortgage securities known as Ginnie Maes.  The fund will usually enclose a list with its year-end statement, showing the percentage of its income that is exempt from tax in your state.

3.  Don’t pay tax on tax-exempt income. Social Security benefits are fully exempt from state taxes in California, Illinois, New York, Pennsylvania, and 22 other states.  Pension income is also exempted, or at least partially exempted, in 16 states.  The pensions of specific employees (usually military personnel) are not taxed in 14 states.  Lottery winnings –you should be so lucky –are also tax-free in many states.

4.  Benefit from favored capital-gains treatment. Four states currently protect a percentage of capital gains:  Kentucky (60%), Maryland (30%), Massachusetts (50%), and Wisconsin (60%).

5.  Take full advantage of your federal deductions for state and local taxes. If you itemize deductions on your federal return, remember to write off the state and local income tax withholding shown on your Form W-2, as well as your real estate tax and any personal property tax.  Don’t overlook such items as the state estimated tax payment for the previous year that you made last January and taxes for a prior year that you paid as a result of an audit or because you filed an amended or late return.  State disability insurance withheld in California, New Jersey, New York, and Rhode Island is also deductible.  Finally, ask your tax adviser or local tax agency what local charges, such as water or sewage fees, may be federally deductible.

6.  Know where your state is stricter than the feds. Don’t assume that the federal rules automatically apply to your state.  Among the snares:  10 states and the District of Columbia will not grant a extension for filing your state income tax return simply because you requested a federal extension.  Also, the estimated tax penalty may be different in your state from the one the feds use.  Under federal law, if you make estimated tax payments (quarterly taxes due if you don’t have enough withheld) and underpay your federal liability by $1,000, you’re hit with a tax penalty.  The cutoff can be much lower at the state level, however.  The feds say that you must make quarterly estimated tax payments to the IRS if you expect to come up with a tax due of $1,000 or more at the end of the year and your withholding won’t cover 90% of your tax or 100% of last year’s tax, whichever is less.

7.  See whether it pays to file separate state returns for you and your spouse. To ease the tax bite on two-earner couples, 11 states let married persons file separately, even if they file a joint federal return.

8.  Research the taxes of a locale before you move. Don’t jump from the frying pan into the tax fire.  For example, only the District of Columbia and five states exempt interest on out-of-state municipal bonds from income tax:  Indiana, New Mexico, and Utah and, in certain cases, North Dakota and Vermont.  A full 20 states refuse you the right to special five or ten-year averaging on lump-sum distributions (for more on the advantage of averaging pension distributions, see “How to Retire Comfortably’).  But six states (Hawaii, Illinois, Louisiana, Michigan, Missouri, and West Virginia) don’t tax lump-sum distribution at all if you elect special averaging on your federal return.

9.  Plan your state. Half the states impose estate or inheritance taxes independent of federal estate taxes.  The result:  Even a modest estate may be exposed to death taxes.  Consult an estate-planning lawyer for ways to reduce or eliminate death duties through charitable gifts, trusts, and other strategies.

10.  Move to a no- or low-tax state. If you are blessed with economic freedom of choice, you can always take tax flight.  Six states have no income tax at all.  They are Alaska, Wyoming, South Dakota, Nevada, Texas, and Washington.  Florida has no personal income tax but does levy an annual .1% wealth tax on portfolios above $20,000.  New Hampshire and Tennessee impose a flat tax on interest and dividends only.  Other states that take a smallish income tax bite include Alabama, Delaware, Louisiana, Mississippi, Missouri, New Mexico, and North Dakota.

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10 Smart State Income-Tax Saving Strategies

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26. Don’t forget about the exclusion from taxes on the sale of your home. In the past, many home sellers felt trapped by the IRS because they knew that if they didn’t buy another home costing as much or more, they’d owe taxes on their home-sale profits.  (There had been one exception to this rule, too:  If you were 55 or over, you could exclude from taxes once in your lifetime up to $125,000 in capital gains on the sale of your principal residence, as long as you had lived there for at least three of the past five years).  But the 1997 tax law changed all that.  Now a couple can exclude from taxes up to $500,000 in profits ($250,000 if you’re single) from selling a home and you can take this exclusion once every two years.  The age-55 special exclusion has disappeared, though.

27. Write off points when you refinance. Usually points you pay to refinance a mortgage must be written off over the life of your new loan.  But refinance a principal residence a second time before all the points are written off on the first refinance and you can typically deduct the entire remaining balance in that year.  That could produce an instant write-off worth several thousand dollars.

28. Count the days if you plan to roll over a pension. You have just 60 days to deposit a pension distribution into an IRA account without paying tax.  Neglect can cost you a bundle.  For example, if you are under age 59 1/2, missing the deadline on a $10,000 lump sum distribution will raise your tax bill by $4,100 if you’re in the 31% bracket ($3,100 income tax and a $1,000 penalty for premature distribution).  Caution:  There is a 20% withholding tax on lump-sum distributions.  Take $10,000 out of your pension plan and you will get only $8,000 ($10,000 minus $2,000 withholding).  You must roll over the full $10,000, however, to avoid tax and penalty.  That means you’d have to come up with an extra $2,000 out of your own pocket.  You can avoid the 20% withholding trap by instructing your employer to transfer your pension distribution directly to your IRA trustee.

29. Swap, don’t sell. If you are thinking of selling rental estate you own, consider a nontaxable like-kind exchange instead.  If you sell, you may well have a huge capital gain because of the depreciation you have claimed over the years.  For example, if you sell for $1 million a building with an adjusted basis (its cost minus depreciation) of $100,000, you would pay a 28% capital gains tax, or $252,000, on your $900,000 gain; any gain attributed to earlier depreciation deductions may qualify for a 25% maximum tax rate.  But if you intend to reinvest in a similar property, you can avoid paying the tax now by having the buyer deposit the money with an independent third party, usually an escrow company.  You then identify another building, purchased with the money in escrow.  As long as you don’t get any cash or other property out of escrow and your new mortgage balance equals or exceeds the balance on your old one, you will defer the capital gains taxes until the new building is sold.  To make sure the complex requirements of the tax law are met, hire a real estate or tax pro who specialize in like-kind exchanges to arrange the transaction.

30. Spend insurance earnings tax-free. Unlike annuities and traditional deductible IRAs, which tax your withdrawals and often penalize them, cash-value life insurance policies let you pull out earnings without paying a penny in tax.  Within limits, you simply borrow the money from your policy.  No payback is required; the amount of any unpaid principal and interest will be subtracted from your death benefit.  If you choose to pay the interest, you can do so whenever you wish.

31. Take advantage of the new IRAs.  The 1997 tax law created two types of IRAs, described in more detail elsewhere in the book.  A brief rundown:  The new Roth IRA doesn’t let you deduct your annual contribution of up to $2,000.  But your earnings are tax-deferred while they grow in the account, just like a traditional deductible IRA.  And, best of all, your withdrawals are fully tax-free as long as you have had the IRA for at least five years and you are 59 ½ or older, are disabled, or will use the cash to buy a first home.  To open a Roth IRA, your income cannot exceed $110,000 if you’re single or $160,000 if you’re married.  The Education IRA (yes, that’s a contradiction in terms; blame it on Congress) lets you put aside up to $500 a year per child in a nondeductible but tax-free account whose proceeds will be used to pay for college.  Maximum income to open an Education IRA:  $160,000 for married couples and $110,000 for singles.

32. Deduct long-term care costs if you can. A little-known 1996 law now lets some of the premiums or fees you pay for long-term care insurance or services qualify as a tax-deductible itemized expense.  Only the expenses combined with other medical outlays that exceed 7.5% of your adjusted gross income can be written off, though.  The amount you can deduct rises with your age and the medical-cost inflation rate.  Lately, people 61 to 70 could write off up to $2,000, while those 71 and older could claim up to $2,500.

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Continuation: 32 (26-32 last batch) Fool-Proof Federal Income-Tax-Saving Strategies

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