April 15 may be months away, however, year end is a great time to start planning for next year's tax-filing season. As a result of many recent tax changes, early tax planning is crucial, and it's not too early to begin today by crunching some numbers and mapping out your tax plan. Remember, there may be a little you can do to reduce your taxes for this year after Dec. 31.
Estimate Your Tax Liability
To begin, you need to know how much taxable income you will have this year and how much tax you will have to pay on it. You can visit www.irs.gov or call (800) TAX-FORM to get your tax forms, including the new Form 1040, its instructions and any additional schedules you may need. You may consider filling out the forms with estimates of this year's income and deductions. The forms you fill out for this exercise will give you a head start on your real 1040 form, due next year.
Maximize Your Savings
If you haven't already contributed the maximum to your retirement plans, consider doing so before year end. If you have a 401(k) plan at work, now is a good time to decide how much you'll contribute next year. Try to commit to the maximum especially if your employer makes matching contributions, which amounts to "free money." Remember that in 2005, the pre-tax employee contribution limit is $14,000 and the catch-up contribution is $4,000. Individuals, who are at least 50 by year end of the tax year, may be eligible to make an additional "catch-up" contribution to most retirement plans.
Alternative Minimum Tax
The 2003 tax law provided some generous breaks, such as tax cuts to capital gains and dividend tax rates. A 2004 tax law change extended the $1,000 per child tax credit for children under 17 years old through 2010 and extended marriage penalty relief for many couples through 2010. However, the Alternative Minimum Tax (AMT), a parallel federal tax system that operates alongside the traditional tax code, may adversely affect many people and makes year-end tax planning essential.
AMT is a tax calculation that uses slightly lower rates but eliminates deductions for "personal exemptions," state taxes, interest on certain home equity loans and some business expenses. It was originally a way to ensure that wealthy Americans paid at least some income tax every year. Because the regular income tax rates dropped without adjusting the AMT minimums for inflation, the tax now affects many middle-income filers in high-tax states.
At this time of year, many taxpayers typically look for ways to accelerate deductions and delay receiving taxable income. But taxpayers who may be subject to the AMT would be wise to look at the whole picture before they act.
Sales Tax Deduction
Taxpayers who itemize deductions will have a choice to claim a state and local tax deduction for either sales or income taxes on their 2004 and 2005 returns. The IRS will provide tables for those who would like to deduct sales taxes but did not save receipts.
Tax Deferred Plans vs. Taxable Accounts
You may want to also reconsider which investments really belong in your tax-deferred retirement plan. Dividends on stocks held in taxable accounts (such as brokerage accounts) used to be treated as ordinary income and were taxed at regular income tax rates, up to 35 percent. But now these dividends are taxed at a maximum of 15 percent. Until this 2003 change, it was often thought best to stash stocks generating hefty dividends yields in your tax-deferred account (so the dividends could compound tax-free). But now you might consider holding your income-paying stocks in your taxable account, making room for other investments within your 401(k) or IRA. The current rule on dividends is expected to expire after 2008.
On the other hand, now may also be the time to consider buying and holding growth stocks, if your risk tolerance allows, because the long-term capital gains tax was slashed from 20 percent to 15 percent (5 percent for those in the 10 percent or 15 percent brackets). When you cash out, you will only pay 15 percent on gains, at least through 2008. If you trade in a tax-deferred account, you can trade without a tax, but when the money is withdrawn, it is taxed at ordinary rates, possibly at a rate much higher than 15 percent. It depends on what rates apply when you retire.
Contributions to Your Favorite Charity
Year end is also a good time to consider charitable gifts. In addition to clothes and furniture, consider giving appreciated stocks so you don't have to pay capital gains tax on any profit. The deductible value of the donated stock is the market value of the shares on the date they are donated if you have owned the shares more than a year. If you love the stock and want to maintain a position in the shares after your charitable contribution, you can simply buy new shares in the company.
The dreaded wash-sale rules don't come into play for shares that you sell for a gain or contribute to a charity. Your favorite charity will be happy to help you with stock-donation transactions, but don't wait until the last minute to contact them. You will need some time to make sure the transfers take place this year.
Seek the help of a professional tax advisor to help ensure that you are taking advantage of recent tax law changes while there still is time to make a difference.
Sean Brown is a personal financial advisor with American Express Financial Services in Dallas. Contact him at 972-692-5068.