Introduction

If you think the government takes too big of a bite out of your income, it's time to do something about it. Even if you haven't filed last year's tax return yet, a little advance planning now will put you on the right foot for the next year and help you avoid scrambling several months down the road.

But you still have options. Just understanding your own tax situation and keeping track of deductible expenses can put money in your pocket. The timing of when you sell stocks, give money away, or pay your tax obligations can be critical. And participating in any tax-deferred retirement plans available to you means a deduction this year and further gains every year after.

Very little has changed in the tax code for the year 2000 and beyond. The tips below will help you save money this year and for many years to come.

Get Organized

Start your taxes at the beginning of the year for a change. It will save you a lot of grief later. Instead of throwing receipts into a shoebox, put your expenses on a computer program like Quicken and file the receipts."Organization is critical," says Mitchell Freedman, a Sherman Oaks, Calif., CPA and personal financial specialist. "People should use a computer program so that their information is reliable."

Create documentation for your expenses whenever possible. Maintain a record book of chargeable mileage for business or charity. Get receipts for charitable contributions. Don't think you will remember later. You probably won't.

Also keep careful records of stock options. You need to know when they were granted and exercised – and at what price. This information can have important implications for this year's taxes and for next year's tax planning.

Savings:

Possibly hundreds even thousands of dollars in forgotten expenses and hours of your time.

Contribute the Maximum to Your 401(k)

Check at the beginning of the year with your company that you are signed up for the maximum contribution. The ceiling for contributions, which is $10,000 in 1999, is now indexed to rise every year.

As a tax-deferred vehicle, a 401(k) rarely can be beat. It allows your investment to compound quickly, and you can contribute substantially more to it than to an IRA. When employers match your contributions, the extra money automatically guarantees you a good return. Only if your investment choices are limited should you commit less than the maximum to the plan. Put in enough money to get the full company match if you can invest only in company stock, for example, and then diversify with an IRA. "I really recommend putting the maximum into your 401(k) before making other types of investments," Freedman says.

Savings:

$280 in federal taxes on every $1,000 in contributions for someone in the 28% tax bracket. Plus, funds grow unhindered by taxes until you withdraw them.

Adjust Your Withholding

If you're getting a big refund for 1999, it's an opportunity to fiddle with your W-4. While many people look forward to getting a nice check from the government in April, it's a terrible way to manage your money. You are essentially giving the government a free loan when you could be putting your money to work for yourself. On the other hand, you might leave yourself wide open for interest and penalties if your company doesn't withhold enough. Watch out if you got married recently. Working couples pay more in taxes than when they were single. You also may need to increase your withholding if you are earning more than last year. "As income goes up, the withholding tables are not adequate unless you have a lot of itemized deductions," Freedman says.

Any time you have a major change in your life, your taxes are going to change. So after you get married, buy a home, or have a baby, be sure to ask to fill out a new W-4 form. You can check with the IRS online to figure how many exemptions you should claim.

Savings:

Interest that you could have earned on overpayments to the government. On the flip side you will save on interest and penalties that you may owe to the government on underpayments.

Figure Estimated Payments

If you can't withhold enough from your paycheck or you are self-employed, you can make yourself penalty-proof with estimated quarterly payments. Figure what they should be early in the year. You can always change the amount later. Check your income periodically throughout the year to make sure you are staying on track. According to IRS rules, you must pay 100% of last year's tax liability or 90% of this year's. You have to pay more than that if you make more than $150,000 – 105% of last year's tax liability.

Savings:

Interest and penalties on tax underpayments.

Sell Stocks And Funds Early In The Year

If you deferred a capital gain from last year, take it early in 2000 for the most advantage. First, make sure that you have made yourself penalty-proof by paying the required amount of quarterly tax estimates. Put aside any extra money you eventually will have to pay in taxes. Then you can invest it until Tax Day, which could be more than a year away. Be sure to pick a CD or other short-term investment so that the funds will be available when you need them.

Savings:

Interest on the investment that is earmarked to pay taxes.

Contribute to Your IRA Early

Instead of waiting until the end of the year, put that $2,000 into your IRA in January. Believe it or not, those extra few months can make a big difference over time. "You will do quite a lot better because of compounding," Shambo says. You might want to wait until you are sure you qualify for a Roth IRA, however. You might have to undo your contribution if you go over the income ceiling of $150,000 for married couples and $95,000 for singles.

Savings:

More than $30,000 over 30 years if you contribute $2,000 at the beginning of every year and get a 10% return on your investment.

Gifts to Children and Grandchildren

People with substantial assets can lower taxes on their estates by giving cash to children and grandchildren every year. In the past the IRS allowed you to give $10,000 to each person free of gift taxes. This year (2000) that figure is indexed for inflation. That gift does not affect the amount that is excluded from estate taxes when you die, which are $675,000 this year. The amount excluded from taxes will continue to rise to $1 million in 2006.

The earlier in the year you make the gift, the better it is for keeping money in the family. Chances are that your children or grandchildren are in a lower tax bracket. If so, they will pay less in taxes on the gains from that money than you would have.

Savings:

Up to 55% on the amount you give away every year, depending on the size of your estate.

Consider Tax-Efficient Investments

People in high tax brackets who have maxed-out on their tax-deferred retirement accounts should think about putting money into investments without a big tax bite. "As early in the year as possible, you should project what your taxable situation is going to be," says Doug Stives, a Red Bank, N.J., CPA. "If you are in the 36% tax bracket, it doesn't make sense to buy taxable investments."Tax-free municipal bonds have been good tax shelters for high-wage earners for a long time. But there are other ways to get a higher return without forking over a lot to the government. Because you can postpone taxes almost indefinitely, growth stocks are a savvy tax-efficient investment. When you sell, you pay taxes on the appreciation of the stock at capital gains rates. These stocks often don't pay dividends, which are taxed at higher ordinary income rates.

You can get almost as much tax efficiency from some mutual funds, plus diversification and professional management. The best ones have low taxable distributions and hold a large proportion of stocks that don't pay dividends. They also keep the stocks they buy for the long haul so capital gains are low. When they need to sell some stock, gains usually are offset by losses on the sale of other shares. Index funds historically have had a small tax liability because they have a low turnover in stocks.

Savings:

A good chunk of the return on your investment, depending on your income tax bracket. High turnover of stocks can cut into mutual fund after-tax returns by 40% or more.

Consult Your Tax Adviser About Stock Options

More middle-class employees are benefiting from company stock options. If you are one of the lucky ones, you also have some important tax issues. It's time to ask for some professional advice even if you never needed any before. "I'm seeing a lot of working people become extraordinarily wealthy, and they don't even realize they have tax issues," Freedman says. "They think they've paid all their taxes, and all of a sudden they are hit with a huge tax bill."

When you exercise nonqualified stock options – the most common kind, the company often withholds money for taxes. But you can easily owe more if your tax bracket moves up as a result of your new wealth. Your adviser can help you figure out whether you need to make quarterly estimated tax payments so you won't owe penalties and interest when tax-filing season rolls around.

You also will want to know whether your incentive stock options will make you vulnerable to the alternative minimum tax. To avoid it, you may need to turn traditional tax planning on its head by deferring deductions into next year. You also may be able to spread out the sale of your options, which also spreads out your tax liability. "That may be a good tax decision, but that doesn't mean it's a good financial decision," Shambo says. So run the numbers to make sure you take the path that leaves you the most money.

Savings:

Easily thousands of dollars, depending on the number of options, the stock price, and your income tax bracket.

Put Domestic Employees on the Payroll

In the early 1990s Zoe Baird backed out on a presidential nomination to be attorney general because she had neglected to pay taxes for a nanny. After that many – but not all – taxpayers came clean and put their nannies and housekeepers on the payroll. If you haven't yet, don't delay. Otherwise, you could be liable for penalties and back taxes. If you pay a household employee more than $1,100 a year, then you are obligated to pay taxes. How do you know that your housekeeper or gardener is an employee? The IRS tests can get confusing. But basically if you control the work, then they are employees. Anyone who provides their own tools and offers their services to the general public may not be an employee. Of course, reporting your employee's income means that he or she must have a social security number. So employing illegal aliens is out.

The paperwork is less burdensome than it used to be. Now you need to report your employee's income to the federal government only once a year. Some states still require quarterly reports, however. You also need to apply for an Employee Identification Number from the IRS.

In the short run, paying taxes for your employees will cost you some money. But you could save yourself a big headache in the future. "I won't sign a tax return if I think someone hasn't reported household employee income," says Bob Doyle, a CPA and personal financial specialist in St. Petersburg, Florida. "It's not worth messing with."

Savings:

Back taxes and penalties. Plus you might get that government appointment you always wanted.

The Top Seven Taxpayer Mistakes

  1. Bad Math: According to the Internal Revenue Service, errors in addition and subtraction are the No. 1 mistake taxpayers make. All returns are examined for mathematical errors. Mistakes result in an immediate correction notice. If the error leads to a tax deficiency, you automatically receive a bill for that amount. If you overpaid, the excess is applied to future taxes. Check the figures on the IRS correction notice; they have been known to make their own mistakes.

  2. Forgetting about interest and dividends: Interest and dividend payments are reported to the IRS by banks, brokerage houses and other financial institutions, and are cross-checked in about 96% of the cases. As a result of the cross checking, the IRS sends out notices for taxes and interest on overdue taxes for income and other payments that were not reported.

  3. Not properly tracking investment "basis": A basis is the original value of your investments. If you have mutual funds, for example, each year those funds will report to you the dividends and capital gains you earned. These dividends and gains will be taxable to you in the year reported. When you sell these funds, your gain will be the difference between what you receive on the sale and your "basis" (technically your amount realized less your initial investment basis). The basis actually increases once any initial financial gains you reinvested are taxed.

  4. Getting married: It is suggested that you postpone a Christmas wedding until after the first of the year because the tax savings could pay for the honeymoon. There is a marriage penalty if both partners work. This tax penalty on marriage is compounded by the standard deduction. A married couple is allowed $7,200 in nontaxable income in 1999, two single workers get $4.300 each for a total of $8,600, therefore, by getting married an additional $1,400 becomes taxable. Of course, if only one partner works, marriage would provide a tax savings.

  5. Losing track of receipts:You either have proof of your deductions or you lose them. Deductible receipts and checks should always be kept for at least three years from the due date of the year filed, or the actual date filed, if later.

  6. Failing to bunch deductions:There are a number of deductions that are allowed only after you exceed a minimum amount. Your best planning strategy here is to bunch your deductions into a single year to exceed these minimum requirements. Prepay your tax preparer on December 31 for that year's taxes or bunch order your investment subscriptions and expenses to exceed that amount.

  7. Forgetting to donate unwanted items to charity before December 31st:Give your old clothes, furniture, appliances and other items away to your favorite charity. The wholesale value of those contributions is allowable as a charitable deduction. Make sure that you get a dated receipt. No receipt, no deduction. You can also deduct 14 cents a mile for any charitable work, including trips to bring the old clothes to the charity.

Top 10 Overlooked Deductions

  1. Pay off debt with a home equity loan rather than credit cards because the interest on that loan is deductible.
  2. Contribute old clothes, furniture and other items to charity. Make sure you get a receipt.
  3. Bunch your deductions because some deductions require a floor minimum.
  4. Let the IRS subsidize your job search because all job-hunting expenses are deductible.
  5. Keep up with your investment expenses because they are allowed as miscellaneous deductions.
  6. Keep receipts on any business supplies or business related gifts you purchase.
  7. Tax planning advice is deductible.
  8. Remember that not only medical expenses, but any special equipment or treatments you receive are deductible.
  9. Deductible medical procedures don't have to be done by your doctor.
  10. Self-employed owners can deduct the cost of hiring their children as workers.

Why Itemize?

When preparing your tax return, it's tempting to take the easy route by claiming the standard deduction rather than going through the hassle of itemizing. But you can save a lot of money by itemizing, especially if you're a homeowner or live in a high tax area.Everyone knows about common itemized deductions such as mortgage interest, property taxes and charitable donations. There are a number of often-overlooked deductions, though, that can really help you slap away the taxman's hand.The trick to taking advantage of many of these hidden deductions is to bunch them together to meet the IRS's thresholds. Make sure you're not missing out on any of these bunchable deductions:

Medical Expenses

To deduct your medical expenses, they need to add up to at least 7.5% of your adjusted gross income. That's a pretty steep threshold and let's face it: you can't always know when you are going to need medical care. By planning elective surgery though, or scheduling the kids' orthodontia, you may easily meet the 7.5% requirement, and save significantly on your tax bill.

Miscellaneous Costs

Many miscellaneous expenses are deductible; assuming that once you bunch them together they amount to at least 2% of your AGI. Consider these:

Tax Preparation:

For starters, you can claim the cost of personal income tax preparation software, or books, as a miscellaneous deduction. Or if you pay a pro to figure out your taxes, his or her bill is also a potential miscellaneous deduction.

Back to School:

If you've been taking classes to maintain or improve your work skills, the tuition is another deduction waiting to happen. The same is true for the subscription fees for any professional journals and magazines you read to keep up-to-date at the office. You can also claim annual dues paid to a professional society or union.

Job Hunt:

If you've been looking for a job – regardless of whether you are currently employed – the IRS is happy to help by allowing you to claim all job-hunting costs as miscellaneous deductions. That includes the cost of printing and mailing your resume, the phone bill for all calls related to your job hunt, and travel costs to a job interview.

Car Costs on the Job:

When you use your car for business purposes (sorry, your commute doesn't count) you can claim a deduction for the mileage (32.5 cents per mile for business miles driven before April 1, 1999, 31 cents per mile for business miles driven after March 31, 1999) as well as the cost of any tolls and parking fees.

Investment Costs:

If you subscribe to any magazines or journals pertaining to your investments, or buy a computer program to help you monitor your investments, you can deduct the cost if it helps push you over the 2% AGI rule.

In addition to miscellaneous deductions, you also want to make sure you take full advantage of these other IRS-approved tax breaks:

Real Estate:

If you used today's low-interest environment to refinance a mortgage, and you still have unamortized points left to deduct from an earlier refinancing, don't miss out on this deduction: You get to claim all the unamortized points from the earlier refinancing this year as deductible interest.

Home Equity Interest:

The days of deducting interest payments for consumer loans such as cars and credit card balances are long gone. But if you've got one of these high-interest non-deductible loans, consider taking out a Home Equity Loan. You can use the HEL to pay off the more costly loans, and the IRS permits you to claim the interest payments on up to $100,000 of a HEL. Of course, only use a HEL if you can comfortably afford the cost of the payments; 'cause remember, it's your home that's collateral for the loan.

One final word of warning: Document. If the Internal Revenue Service decides to ask questions about any of your deductions, you want to be able to whip out all your pertinent receipts.

College/Education:

Make Your Education Less Taxing

Headed back to the classroom to upgrade your job skills? Your education expenses will probably provide you a tax break. If you're taking classes to improve your skills in your present occupation, your expenses are deductible as an itemized deduction. This deduction, however, is limited to the amount of your qualified education expenses that – when grouped with certain other expenses – exceeds two percent of your adjusted gross income. Keep in mind that the same expenses are probably eligible for the lifetime learning credit. You can only use one tax break for each set of education expenses, so you'll want to determine which will save you more money.

Student Loan Interest

This new tax-saver, which appeared for the first time on 1998 returns, allows you to deduct up to $1,000 of student loan interest, even if you don't itemize deductions. The right to this write-off disappears as income rises, though. The maximum deduction diminishes gradually as adjusted gross income moves from $40,000 to $55,000 on an individual return and from $60,000 to $75,000 on a joint return. The deduction is for interest on any loans (not just federal student loans) taken to pay qualified higher education expenses (including room and board) for yourself, your spouse or your dependent that is at least a half-time student.

Options for College Savings:

Kids too young for college? Now is a good time to start a college savings program. Look into the following investments, all three of which carry significant tax advantages.

Credit Opportunities for College Expenses:

College kids heading back to campus soon? Remember that you may qualify for the Hope scholarship credit of up to $1,500 if your student is in his or her freshman or sophomore years of undergraduate school. Also check out the lifetime learning credit of 20 percent of qualified educational expenses up to $5,000, which may be used by anyone who qualifies, not just college freshmen or sophomores. Both credits are subject to income phase-out limits.

Filing your taxes can be very complicated and overwhelming. This checklist will let you know what you need and help you get organized.

Personal Data

Employment & Income Data

Homeowner/Renter Data

Financial Assets

Financial Liabilities

Automobiles

Expenses

Self-employment Data

Deduction Documents

Packet Published 1999, 2001

Researched and composed in 1999.

Revised by Betty Snyder 1999, John Menard 2001

SBI Legal Assistance Director: Alex Melville

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