Year-End Tax Planning
While the average taxpayer will avoid thinking about income taxes until the approach of the April deadline forces him to do so, once the ball drops on One Times Square at midnight on December 31st and the New Year is rung in there is very little that can be done to cut your tax bill.
However, during the last two months of the year you can do a great deal to reduce your tax liability.
Sit down with paper and pencil and list your anticipated income for 2005 and all your allowable deductions to date. What you want to do is, using your 2004 return as a guide, prepare a projected 2005 return. Once this is done you can decide what steps to take to make sure you pay the absolute least amount of federal and state income tax possible for 2005 and 2006.Here are some year-end tips:
1) Traditional year-end planning calls for postponing the receipt of taxable income until 2006 and accelerating allowable deductions to be claimed in 2005, the idea being to reduce your 2005 taxable income to a minimum. This strategy will generally apply if you expect to be in the same tax bracket for both 2005 and 2006, or if you will be in a lower bracket in 2006.
If, however, you anticipate a substantial increase in taxable income in 2006, which will push you into a higher bracket, you should do the reverse and accelerate the receipt of taxable income to 2005 and postpone deductible expenses until 2006. Income received in 2005 will be taxed at a lower rate, and deductions claimed in 2006 will yield a greater tax savings.
Not sure what your 2006 income will be. Follow the rule of "when in doubt - defer" - go the traditional route and postpone income and accelerate expenses.
2) It does not pay to itemize unless the total of your allowable deductions exceeds the standard deduction that applies to your filing status, plus any additions for age or blindness. If you decide to accelerate allowable deductions to claim them in 2005, you can accelerate all you want, but it will be wasted unless your total "itemizable" deductions exceed your applicable standard deduction.
Let us say you usually do not have enough deductions to itemize. However, after preparing your projected 2005 return you discover that, because of some special circumstance, you will be able to itemize this year. During the last two months of the year you should incur, and pay for, as many deductible expenses as possible.
If, on the other hand, your projected return indicates that you do not have anywhere near enough deductions to be able to itemize, postpone making any deductible payments until 2006. Making these payments in 2005 would not produce any tax savings, while it is possible that by deferring them until next year you may be able to itemize in 2006.
3) The timing of deductions is especially important when it comes to medical expenses and miscellaneous job-related and investment expenses. You are allowed to deduct medical expenses only to the extent that they exceed 7 1/2% of your Adjusted Gross Income (AGI), and most miscellaneous deductions are only deductible to the extent that the total exceeds 2% of AGI.
If you anticipate a 2005 AGI of $70,000.00 you must exclude the first $5,250.00 of medical expenses - the first $5,250.00 is not deductible. If your medical expenses to date are close to or more than %5,250.00, and you will be able to itemize, pay any outstanding medical bills and schedule, and pay for, check-ups, doctor visits and needed dental work in November and December. If medical payments to date are substantially less than $5,250.00, put off paying any more medical bills until 2006. The same concept applies for miscellaneous deductions.
If you expect to be able to itemize, and you are making quarterly state estimated tax payments, make the 4th quarter payment in December, instead of waiting until the January 16, 2006 due date, so you will be able to deduct the payment on your 2005 Schedule A.
4) If you do not have the cash available to pay for the deductible items you have scheduled as part of your year-end plan, you can use a credit card to pay for the item and still get a 2005 deduction. Allowable expenses charged to a credit card (VISA, Master Card, American Express, Discover) are deductible in the year charged, and not in the year that you actually pay for the charge.
5) The option to deduct state and local sales tax paid instead of state and local income tax paid will expire on December 31, 2005. This option will not be available for 2006. If you are planning to buy a new car (other than a qualifying energy-saving hybrid - see tip #6), SUV, motorcycle, or other "big ticket" item in the near future you may want to do so before the end of the year to be able to deduct the sales tax.
6) The Energy Tax Incentives Act of 2005 creates new tax credits for certain energy-saving autos, consumer products and home improvements beginning in 2006. You may want to postpone any purchase of qualifying energy-saving items until next year to be able to claim the credit.
7) While postponing income and accelerating deductions may reduce your "regular" income tax for 2005, these actions may backfire and end up costing you if you fall victim to the dreaded Alternative Minimum Tax (AMT). Why? Because taxes and miscellaneous expenses are not deductible in calculating AMT, and medical expenses are only deductible to the extent they exceed 10% of AGI. When preparing your projected 2005 return be sure to determine if you will be subject to AMT and plan your strategies accordingly.
8) When preparing your projected return you should review the performance of your investment portfolio for the year. Add up all your realized gains and losses from actual sales of stock, bonds and mutual fund shares for the first 10 months of the year, with separate net totals for short-term (held one year of less) and long-term (held more than one year) activity. Gains and losses from inherited property are always considered long-term. Include in the long-term calculation any "capital gain distributions" from mutual funds.
Now do a similar calculation for unrealized "paper" gains and losses on the investments you still hold. You may want to sell some of your investments before the end of the year at a loss to wipe out year-to-date gains, or at a profit to take advantage of year-to-date losses in excess of $3,000.00.
There are no written in stone year-end tax planning rules that apply to all taxpayers in all cases. As with any other transaction, year-end strategies must be evaluated in the context of the special facts and circumstances of your individual situation. You may want to review your year-end situation with your tax professional.
And remember - your first criteria for evaluating any financial transaction you are considering should always be economic. Taxes are second.
Robert D Flach is a tax professional with 34 tax seasons of experience preparing 1040s for individuals in all walks of life.
He writes THE WANDERING TAX PRO weblog (http://rdftaxpro.tripod.com/weblog ), the NJ TAX PRACTICE BLOG (http://rdftaxpro.tripod.com/newjerseytaxpractitionernetwork ), and the website http://www.robertdflach.net , which has a wealth of tax planning and preparation advice and information.
He also writes and publishes THE FLACH REPORT, a quarterly tax newsletter. For more info on THE FLACH REPORT go to http://rdftaxpro.tripod.com/avoidtaxeslegally. The above article is taken from postings to THE WANDERING TAX PRO.