As yet another tax season rolls around, here are some planning tips that can be critical to saving you money:
The Standard Deduction
The first decision you should make is whether to use what is called the “standard deduction.” This is a fixed amount that anyone is allowed to claim: $10,700 for marrieds and $5,350 for singles. However, if your deductions add up to more than that, it might be wise to “itemize” them. The items you can deduct are state taxes paid, real estate taxes paid, mortgage interest, charity, and, sometimes, medical and job expenses. You can only itemize these deductions that you paid before yearend.
Your medical expenses are only deductible to the extent they exceed 7.5 percent of your income. They include just about anything that is needed for your health: doctors, dentists, therapists, etc. Medical expenses can include special educational expenses for learning disabilities, nursing home expenses, long-term care insurance, and, sometimes, unusual items. One couple managed to deduct their daughter’s clarinet lessons, which were recommended to correct an overbite.
The best way to handle medical expenses is to make use of a cafeteria plan. This is a system that must be set up at work. You are allowed to put money from your paycheck into a fund. This money is then available for you to use for medical expenses. Any money put in is all pre-income tax. In essence this eliminates the 7.5 percentage mentioned above that would be lost. If you did make deposits into a “cafeteria plan,” check about deadlines, because there is a “use or lose” aspect to these plans. If you don’t use the money set aside for medical expenses by the deadline, it is forfeited. If employers do not offer such a plan, mention it. They might not be aware of its benefits to both the employee and the employer.
Charity
Keep excellent records of all your donations! Used clothes, for example, must now be in good condition or you get no deduction at all, although it is not easy to define good condition. Charity given as cash is not deductible; you must have a receipt or a cancelled check. That means that all those dollars you give to a pushka or meshulachim are not deductible! A way to make them deductible is to buy Agudah scrip with a check and give that instead of cash.
It could be advantageous to donate appreciated stock. For those over age 70, it can be very effective to contribute your IRA money directly to a charity. This must be explored with your advisor.
Tuition
College tuition paid qualifies for various tax deductions, all of which have limitations. I sometimes see people who spend a lot on tuition one year and then nothing the next year. For example, if your daughter is in seminary, you want to make your final payment in 2008, so that you get tax benefits for 2008 as well. Paying all of it in 2007 could result in a loss of $1,650 on your 2008 tax return. Check the date on your final post-dated check to your child’s seminary.
You can establish a Coverdell (educational) IRA for children. The interest earned on a Coverdell will not be taxed. These funds can be used for grade school as well. However, it is only the interest that is tax free, not the funds you put into the account, so the benefit is limited.
Another educational strategy is for a parent to set up a savings account for their children’s college education. This is called a Section 529 plan. (Here in Maryland it is handled by T. Rowe Price, at 1-888-4MD-GRAD. See the website www.collegesavingsmd.org.) These funds can be used for tuition, fees, books, supplies, and even room and board. The advantage of these plans is that there is a tax deduction of up to $5,000 per child on the state of Maryland state tax return. Get the details before you jump in, and don’t go overboard, since any funds not used for college will be subject to a penalty.
Pensions
Putting money into pensions is one of the most popular tax saving devices. Participate in your pension plan at work, especially if your employer is matching your contribution. For those without pension plans, you can still contribute $4,000 to your own pension, called an IRA. (If you are age 50 or older, you can contribute $5,000.)You have until April 15, 2008 to contribute for 2007. There are also Roth IRAs. Deciding which is better for you will require some calculating and forecasting.
Children
In addition to the deductions mentioned above, one gets to deduct their family members. Indeed the simplest of all deductions used to be your wife and children. Each family member provides a deduction of $3,400. You can deduct other relatives in certain situations. In addition, you get a $1,000 reduction in taxes for each child under 17. This is a full $1,000 in your pocket – a “tax credit,” not a tax deduction. When parents are divorced or when children are supported by other relatives, you have to read the rules carefully, as they have actually gotten very complicated.
Miscellaneous Deductions
Some miscellaneous deductions include tax preparation fees, investing advice, job hunting expenses (including resumé prep), work travel, work clothing and supplies, education needed for work, union dues, IRA custodial fees, and, possibly, home office expenses, for those who must work at home. These items, all totaled, are deductible to the extent they exceed two percent of your income.
Some employees have to spend money on job-related expenses. These expenses provide a larger savings if deducted by the employer and reimbursed to the employee under what is called an accountable plan. Simply stated, the employee may only be reimbursed for his out-of-pocket expense and no more. Be very meticulous with your receipts and records.
Potpourri
Certain deductions will not help those who are paying the “alternative minimum tax.” This parallel tax system limits deductions for various items, including children and state income taxes. This alternative tax can hit hard with a big surprise. Basically it goes like this: After figuring up your deductions and taxes, there is another tax form that decides that you have too many tax deductions and starts to limit them. This has been in the news a lot lately, with some very last-minute law changes to limit its impact.
You can deduct up to $2,500 in student loan interest and up to $6,000 in child care expenses, and even moving expenses, if needed for a job change. Time your payments for maximum savings. For example, let’s say that a couple will incur $7,000 in childcare expenses in one year and $5,000 the next. For the first year, you will not get a benefit from $1,000 of your payments. It would be advantageous to delay paying $1,000 to year two in order that you will be able to claim the two-year total of $12,000.
If you have sold stocks for a profit, you should consider also selling the losers you are holding, since the losses will count against the gains. You can buy them back but must wait 30 days to do so.
If you are a low earner with children, you can receive the “earned income credit.” Make sure your income from investments is below $2,800, or you will be completely ineligible.
If you are near a “cliff,” some creative ideas can help. A cliff is when your income goes up a little and your deductions really drop off. For example, if you earn under $160,000, you can deduct $2,000 for college education. If you earn over that amount, then you cannot. So, if you put one dollar in an IRA – reducing your income to $159,999 – you will be back under the limit and you will save $800 on income taxes. Not bad for a dollar. Another example involves the credit for retirement savings. A couple earning $32,000 could save $749 by putting $1,000 into an IRA. That means that you put $1,000 into your retirement account, and it only costs you $251 out of pocket. The government refunds you the other $749.
Social security benefits are tax free, if your income is on the low side. Don’t push it up by selling stocks or making IRA withdrawals. These can have a snowball tax effect!
Some good news: If you sell your house for a profit, the first $500,000 in profit is tax free. In addition, a new energy bill took effect in 2006, which provides tax credits for home energy savings, like new windows, and also provides savings if you purchase a hybrid car.
Let me stress that all of the above items come with rules, details, and limitations. It is important that you be thorough and get good advice. Don’t assume anything on your own. For instance, I have seen people who bought a house believing that they would save a lot on taxes, only to discover that the savings were smaller than they had imagined. With good advice and planning, however, you can hopefully effectively implement these suggestions and save on your taxes.
Eli Pollock is a CPA in Baltimore. He can be reached at elipollock2@yahoo.com.
