Like it or not, your 1997 tax countdown has begun.
As of today, you have less than four weeks left to take action to cut your taxes before one of the most complicated tax-filing seasons in more than a decade, thanks to the oxymoronic Taxpayer Relief Act of 1997.
“We’re calling this legislation the `Financial Planners Full-Employment Act,’ ” said John Mueller, a tax law analyst for CCH Inc. of Riverwoods, a publishing house for professional preparers. “The Cleavers need to bring in a few more people to help them figure out their situation.”
If complexity isn’t a compelling enough reason to start plotting your year-end tax strategy earlier than usual, here are two more: opportunity and fear.
Do things wisely, and you stand to save hundreds, if not thousands, of dollars in taxes. For example, this coming April, investors can slice the tax on capital gains, home sellers can pocket up to $500,000 in appreciation, business owners can write off larger expenses and small businesses and their workers can count the money they saved in the new SIMPLE retirement accounts.
There are even more breaks starting in 1998–everything from new child and education credits to higher-education breaks to revitalized individual retirement accounts.
Do things complacently or sloppily, however, and your decisions could haunt you–not just this coming April 15, not just on April 15, 1999, but throughout your retirement.
You must track a growing number of phase-outs that whittle down credits, deductions and exemptions. You must sidestep traps that threaten your individual retirement accounts. You must avoid stumbling into the anything-but-benign alternative minimum tax. Even the welcome news of lower capital gains rates can expose you to extra tax and market risk while raising questions about time-honored strategies on everything from stock options to investing in general.
“The last really big tax act was in 1986. You had a lot of change, a lot of education of taxpayers and clients. . . . The preparation got harder in 1986 for no benefit,” said Kathy Burlison, a tax research and training specialist for H&R Block Tax Services Inc. in Kansas City, Mo. “Tax preparation got harder this year, but there are lots of benefits to it.”
Despite all the tax law changes, a classic tax-planning strategy remains sound: “Bunch or defer” income and deductions into the year that will cut your tax more. Indeed, the lawmakers’ trend toward phasing out credits, deductions and exemptions for upper-income taxpayers makes bunching and deferring more vital than ever.
“It’s as good today as it ever has been,” said Leonard W. Williams, a Sunnyvale, Calif., certified public accountant. “It’s something real people can do.”
The strategy is based on three time-tested rules of tax planning:
1. Postpone tax whenever possible.
2. Take the income tax bite when your tax bracket is lowest.
3. Funnel deductible expenses into a year when your tax bracket is high.
To execute this strategy wisely, first sketch out your taxes for both 1997 and 1998. It’s important to identify income, deductible expenses and investment gains and losses you could judiciously move from one year to the other.
Bunching and deferring tends to be most effective if your income is irregular and you are straddling two tax brackets, giving small adjustments powerful leverage. It also works if your income is steady but you can regulate certain deductible expenses, bunching them every other year so they exceed the standard deduction every taxpayer is entitled to take, resulting in larger write-offs every second year.
Bunching and deferring also is effective if you are at the brink of various phase-outs or the alternative minimum tax (AMT). Among the items you might manipulate with significant effect:
– Income. This includes bonuses, fees, investment profits and payouts from retirement plans. For instance, it might be wise to ask your boss to postpone paying your year-end bonus until January if you expect to fall into a lower tax bracket in 1998. If you’re a consultant or run a business, consider waiting until January to bill customers for work you perform in December. Do so reasonably, however, so you don’t report an unrealistic income flow. And make sure you understand when billings become income.
“The most common misperception among the self-employed is they get the check in December but don’t cash it until January,” Williams said. “The rule is, it is income once you have the check in your hot little hand and have the discretion to cash it or not.”
Timing investment sales can pay off even if you remain in the same tax bracket. If you sell this year, the tax is due next April. By waiting until January to sell, you would postpone the tax bill until April 15, 1999–an extra year in which that money can work for you, not Uncle Sam.
– Deductions. There are three classes of deductions you can move from one year to another: itemized deductions, miscellaneous deductions and medical deductions. No matter what, in 1997 you are entitled to claim at least the standard deduction of $4,150 if you file singly or $6,900 if you file jointly as a married couple. (In 1998, CCH projects those deductions will rise with inflation to $4,250 and $7,100, respectively.)
For most taxpayers who itemize their deductions, the biggest write-offs generally are mortgage interest, state and federal tax payments and charitable contributions. Itemizing is worthless until you can pile up more than the standard deduction, however.
The second tier of deductions are so-called miscellaneous deductions. These include a laundry list of expenses ranging from union dues and safe-deposit-box rentals, to subscriptions to investment publications and unreimbursed employee business expenses. The problem is you can’t write off all these deductions. You can write off only the total expenses that exceed 2 percent of your adjusted gross income, or AGI. Similar logic is applied to medical expenses, except you can write off only the amount that exceeds 7.5 percent of your AGI.
Your goal is to bunch deductions in whichever year gives you the bigger bang. If that’s 1997, that commonly means paying your January mortgage bill, April property tax or fourth-quarter estimated tax payments in December. If you’re a landlord and your income is likely to rise next year, identify inevitable repairs you can put off until January to offset that income. If you’re buying a home as the year winds down, consider closing escrow in January if the mortgage points and interest wouldn’t help push you past the standard deduction. If you want to give to charity but won’t have the cash until January, charge your contributions; your deduction is based on when you gave the money, not when you pay it.
Here’s how bunching could work to your advantage. Say you and your spouse own a home free and clear, leaving you with no mortgage write-off but with $2,000 in property taxes, $2,500 in state taxes and $2,000 in annual contributions to your church. All told, that’s only $6,500–$400 shy of the $6,900 standard deduction in 1997.
One solution would be give your church $4,000 this year but none in 1998, pushing your 1997 deductions to $8,500. The church comes out even over two years, but you’d write off more than 10 percent extra–$15,600 instead of just the $14,000 you’d get by taking the standard deductions of $6,900 in 1997 and $7,100 in 1998.
Keep in mind, however, that deductions aren’t as powerful as they might seem. The actual break is proportional to your marginal tax bracket, unlike a tax credit, which reduces your tax dollar for dollar. So resist ringing up expenses senselessly.
“Don’t do something unless you were going to do it already,” said Howard Lyons, an enrolled agent and financial planner who owns Lyons Financial in San Jose, Calif. “Some people work very hard trying to save taxes–and they spend a lot of money doing it.”
As effective as bunching and deferring is, there are two ways it can blow up in your face.
First, bunching can leave you holding unexpected bills for federal and state alternative minimum taxes.
The AMT is essentially a second tax system in which certain income, deductions and credits are disallowed. Taxpayers are supposed to calculate both their regular income tax and AMT, then pay whichever is higher. Among the adjustments that can snare high-income taxpayers are certain state, local and foreign property taxes and the “bargain element” of stock options.
In addition, the AMT blunts write-offs of mortgage interest, itemized deductions, medical expenses, personal exemptions and the standard deduction. Therefore, the standard strategy of prepaying the first installment of your 1998 property tax actually could increase your AMT bill.
Second, bunching can backfire because piling up income in one year boosts your adjusted gross income. Among other things, that can limit how much itemized and medical expenses you can write off, eliminate certain tax exemptions and credits, expose a greater share of Social Security benefits to taxes and block you from making deductible contributions to an IRA.
And if you push too much income into 1998, you could become ineligible to convert an existing IRA into the new Roth IRA. Managing this decision poorly could cost you in retirement.
The cost of phase-outs isn’t new, but it is growing. That’s because lawmakers were intent on limiting the 1997 tax bill’s breaks to lower- and middle-class taxpayers. To do so, they imposed a tangle of differing phase-outs.
“It’s booby-trapped nine ways to Sunday with phase-outs,” Williams said.
Figuring out which tax break comes with a phase-out is one thing. Keeping track of when a phase-out begins and when a tax break disappears is another. But a further complication is that some phase-outs are based on different definitions of “modified adjusted gross income,” which is a derivation of the AGI figure you calculate at the bottom of Page 1 of your 1040 form. For example, you might have to add back such things as losses from rental property, IRA deductions and foreign income-tax exclusions, Burlison said.
“If anyone is anywhere close . . . to a phase-out, I would want to look at the definition of modified adjusted gross income,” Burlison said.
The phase-outs could have an impact far beyond your 1040 form, too. CCH’s Mueller says it’s conceivable that a taxpayer would reject a promotion at work because the pay raise would eat into 1998 child or education credits and make it harder to justify the extra time and stress of the new job.
“In the past, families didn’t have those kinds of issues to deal with,” Mueller said.
SOME TIPS FOR NEXT YEAR
– Lower that refund. If you’re on course to file for big refunds next April 15, cut back your withholding immediately. That way your cash will stay in your pocket, not in government vaults. If tax refunds are your illogical way of saving, then how about authorizing automatic withdrawals into, say, an IRA instead?
– Account for those kids. Starting in 1998, you can claim a $400 credit for every qualifying dependent age 16 and under. (It will rise to $500 in 1999.) So reduce your withholding accordingly in January to avoid an oversized refund on April 15, 1999.
– Plan your gifts. An efficient way to pass along your estate tax-free is to give annual gifts to your eventual beneficiaries. You can give up to $10,000 per person each year. File a gift-tax return (Form 709) if you give assets that are hard to put a price tag on, such as founders’ stock, says Sharon Stengel of Coopers & Lybrand.
– Brace for a fiscal hangover on New Year’s Day. You max out on Social Security tax once you earn $65,400. The problem is those FICA deductions will start chipping away at your paycheck again starting Jan. 1. “The Christmas bills hit, then guess what, you come up short because you’re back on the FICA trail,” said Greg Finley of Mohler, Nixon & Williams. So, don’t get too giddy during these FICA-free days.
