As mentioned in a prior blog, many of our clients make the mistake of waiting until the end of the year (or tax-filing time) to see what they can do to lower their taxes. The following article, the second of a three-part series, discusses everyday actions that taxpayers can take to lower their annual tax bill. See our previous blog posting for part one of this series.
71 Ways to Save on Taxes Now
by Mary Beth Franklin, Senior Editor, Kiplinger's Personal Finance
provided by Kiplinger.com
PART 2 of 3
Don't wait until you file your return to find ways to lower your tax bill. These moves will help you save throughout the year.
The stork brings tax savings, too.
A child born, or adopted, during the year is a blessed event for your tax return. An added dependency exemption will knock $3,650 off your taxable income, and you'll probably qualify for the $1,000 child credit, too. You don't have to wait until you file your 2010 return to reap the benefit. Add at least one extra withholding allowance to the W-4 form filed with your employer to cut tax withholding from your paycheck. That will immediately increase your take-home pay.
Tally adoption expenses.
Thousands of dollars of expenses incurred in connection with adopting a child can be recouped via a tax credit, so it pays to keep careful records. In 2010, the credit can be as high as $12,170. If you adopt a special needs child, you get the maximum credit even if you spend less.
Save for college the tax-smart way.
Stashing money in a custodial account can save on taxes. But it can also get you tied up with the expensive "kiddie tax" rules and gives full control of the cash to your child when he or she turns 18 or 21. Using a state-sponsored 529 college savings plan can make earnings completely tax free and lets you keep control over the money. If one child decides not to go to college, you can switch the account to another child or take it back.
Be aware of new rules for Coverdells.
A former boon to parents and grandparents who wanted to use tax-free dollars to pay private-school tuition and other education-related costs for elementary and high-school students is about to get a lot less generous. You can contribute up to $2,000 to a Coverdell Education Savings Account for any beneficiary in 2010, but starting next year, that maximum contribution will be slashed to $500. You don't get a deduction, but money you stash in a Coverdell grows tax-deferred and can be withdrawn tax-free to pay education bills. Beyond tuition and fees, you can use Coverdell money to pay for tutoring, books and supplies, uniforms and transportation. You can buy a computer for the whole family to use and pay for Internet access, too. But you better hurry. Starting in 2011 any earnings you withdraw from a Coverdell that are not used for college expenses will be taxable as ordinary income and subject to a 10% penalty. Consider rolling over the Coverdell money into a 529 savings plan next year. It’s a penalty-free move, as long as the accounts have the same beneficiary.
Use a Roth IRA to save for college.
Sure, the "R" in IRA stands for retirement, but because you can withdraw contributions at any time tax- and penalty-free, the account can serve as a terrific tax-deferred college-savings plan. Say you and your spouse each stash $5,000 in a Roth starting the year a child is born. After 18 years, the dual Roths would hold about $375,000, assuming 8% annual growth. Up to $180,000 -- the total of the contributions -- can be withdrawn tax- and penalty-free and any part of the interest can be withdrawn penalty-free, too, to pay college bills.
Fund a Roth IRA for your child or grandchild.
As soon as a child has income from a job -- such as babysitting, a paper route, working retail -- he or she can have an IRA. The child's own money doesn't have to be used to fund the account (fat chance that it would). Instead, a generous parent or grandparent can provide the funds, or perhaps match the child's contributions dollar for dollar. Long-term, tax-free growth can be remarkable.
Use a Roth IRA to save for your first home.
A Roth IRA can be a powerful tool when you're saving for your first home. All contributions can come out of a Roth at any time, tax- and penalty-free. And, after the account has been opened for five years, up to $10,000 of earnings can be withdrawn tax- and penalty-free for the purchase of your first home. Say $5,000 goes into a Roth each year for five years for a total contribution of $25,000. Assuming the account earns an average of 8% a year, at the end of five years, the Roth would hold about $31,680 -- all of which could be withdrawn tax- and penalty-free for a down payment.
Convert to a Roth IRA.
Switching a traditional IRA to a Roth requires paying tax on the converted amount, but that can be a fabulous tax-saving investment because all future earnings inside the Roth can be tax free in retirement. (Withdrawals from traditional IRAs are taxed in your top tax bracket.) If you convert to a Roth in 2010, you have up to three years to pay the tax bill. Rather than reporting the income (and paying tax on the conversion) with your 2010 return, you can report half of the conversion on your 2011 return (due in 2012) and the remainder on your 2012 return (due in 2013).
Undo a Roth conversion gone bad.
When you convert a traditional IRA to a Roth, you must pay tax on the amount you convert. But what if the investments in the new Roth IRA fall in value? You get a chance for a do-over. You have until October 15 of the year following the conversion to "unconvert" and avoid paying tax on the money that evaporated. You can then redo the conversion the following year.
Protect your heirs.
Be sure beneficiary designations for your IRAs and 401(k)s are up to date. If your IRA goes to your estate rather an a designated beneficiary, unfavorable withdrawal rules could cost your heirs dearly.
Roll over an inherited 401(k).
A recent change in the rules allows a beneficiary of a 401(k) plan to roll over the account into an IRA and stretch payouts (and the tax bill on them) over his or her lifetime. This can be a tremendous advantage over the old rules that generally required such accounts be cashed out, and all taxes paid, within five years. To qualify for this break, you must name a person or persons (not your estate) as your beneficiary. If your 401(k) goes through your estate, the old five-year rule applies.
Help your adult children earn a credit for retirement savings.
The Retirement Savers Credit can be as much as $1,000, based on up to 50% of the first $2,000 contributed to an IRA or company retirement plan. It's available only to low-income taxpayers, though, who are often the least able to afford such contributions. Parents can help, however, by giving an adult child (who cannot be claimed as a dependent and who is not a full-time student) the money to fund the retirement account contribution. The child not only saves on taxes, but also saves for his or her retirement.
The bank of mom and dad.
If your adult children ask for a loan to help them buy a house or start a business, beware that Uncle Sam has something to say about the deal. If the kids want to borrow more than $10,000, you may be required to charge a minimum amount of interest. And if you don't? You have to report the "phantom" interest as income anyway.
Deduct interest paid by mom and dad.
Until recently, parents had a good reason not to help their kids pay off student loans. If the parents were not liable for the debt, then no one got to deduct the interest. Now, however, when parents pay it's treated as if they gave the money to the real debtor who then paid off the loan. The child gets the tax deduction, as long as the parents can't claim him or her as a dependent, even if he or she doesn't itemize.
Make the most of the tax-free home sale profit.
Up to $250,000 of home-sale profit is tax free ($500,000 if you are married and file a joint return) if you own and live in the house for two of the five years leading up to the sale. If you are bumping up on the limits, consider selling and buying a new home to start the tax-free clock ticking again. There is no limit on the number of times you can claim tax-free profit on the sale of a home.
Don't underestimate the cost of home-equity debt.
Generally, interest on up to $100,000 of debt secured by your home can be deducted, no matter what you use the money for. But if you are among the growing number of taxpayers subjected to the alternative minimum tax (AMT), home-equity debt is only deductible if the loan was used to buy or improve your home.
Second homes can offer a vacation from taxes.
If you're trying to figure whether you can afford a second home, remember that you'll get some help from the IRS. Mortgage interest on a loan to buy a second home is deductible just as it is for the mortgage on your principal residence. Interest on up to $1.1 million of first- and second-home debt can be deducted. Property taxes can be written off, too. Things get more complicated -- and perhaps more lucrative-if you rent out the place part of the year to help cover the bills.
Watch the calendar at your vacation home.
If you hope to deduct losses attributable to renting the place during the year, be careful not to use the house too much yourself. As far as the IRS is concerned, "too much" is when personal use exceeds more than 14 days or more than 10% of the number of days the home is rented. Time you spend doing maintenance or repairs does not count as personal use, but time you let friends or relatives use the place for little or no rent does.
Stay actively involved in rental real estate.
Generally, anti-tax-shelter legislation prevents losses from real estate investments from being deducted against other kinds of income. But, if you are actively involved in a rental activity, you can deduct up to $25,000 of such losses ... if your adjusted gross income is less than $100,000. You don't have to mow grass and unclog toilets to qualify as actively involved; but you should make sure you're involved in setting rents and approving tenants and management firms.
Use a tax-free exchange to acquire new property.
By trading one rental property for another, for example, you avoid the capital gains taxes you'd incur if you sold the first property ... leaving you with more to invest in the second.
Use an installment sale of real estate to defer a tax bill.
If the buyer pays you in installments, the IRS will let you pay the tax bill on your profit in installments, too. You must charge interest on the deal, and each payment you receive will have three parts: interest (taxable at your top rate), capital gain (taxed at a maximum of 15% in 2010) and return of your investment (tax-free).
Convert a vacation home to your principal residence.
Until 2009, there was a sweet tax break for folks who sold their homes, claimed tax-free profit and then moved into a vacation property. After they lived in that home for two years, they could sell and claim tax-free profit again ... including appreciation from the days the place was a vacation home. There can still be some real tax benefits to this strategy, but the value will fall over the years. Starting in 2009, a portion of any profit on the sale of a vacation-home-turned-principal-residence will not qualify as tax-free home-sale profit. The taxable portion will be based on the ratio of the time after 2008 the property was used as a vacation home to the total period of ownership. So if you have owned a vacation home for 18 years and make it your main residence in 2011 for two years before selling it, only 10% of the gain would be taxed. The rest qualifies for the exclusion of up to $500,000. Homes owned for a short time prior to a post-2008 conversion fare the worst tax wise.