Act Now to Make 2008 Less Taxing
What you don't do by the end of this year could end up costing you plenty next year.
A combination of market forces and the phasing out of certain tax benefits makes it extra-important to grab every tax advantage you can right now.
So before you completely check out for some holiday R&R, take a few minutes to make sure you have your portfolio fine-tuned to minimize that federal tax bill due next April.
Offsetting Pending Fund Taxes
Even though fund returns are shaping up to be less than stellar this year -- through November, the average equity fund is up less than 5 percent -- the taxable distributions made by funds is expected to be even higher than last year's $23 billion. How can that be?
Well, amid the market volatility managers have taken profits on some positions, and they no longer have any realized losses on the books from the 2000-2002 downturn to offset those gains. The net effect is that fund shareholders get hit with a taxable distribution. Remember, even if you reinvest that distribution, you pay tax on it if it's held in a regular taxable account.
I'm not about to suggest that you sell quickly before the distribution is paid out -- it never makes sense to bail out of a good investment purely for tax purposes. But at the same time, you can get strategic. Take a hard look at your entire portfolio, especially at any positions showing a loss.
A loss in itself isn't a reason to bail, either; an investment with a strong long-term story will often go through down periods. But if in fact you're showing a loss because the fundamentals of that investment have radically shifted from positive to negative, you should definitely consider selling. First and foremost because the investment doesn't make long-term sense for you anymore. And there's an added benefit: the realized capital loss can be used to offset any realized capital gains you have for the year. That can be a great way to neutralize the impact of any fund distributions.
Claiming the Sales Tax Deduction
According to a recent government study, an estimated 2.1 million taxpayers didn't take advantage of a valuable tax deduction last year: the ability to deduct either state income tax or state sales tax from a federal tax return. If you happen to live in one of the seven states that doesn't levy income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming have no income tax, while New Hampshire and
Even if you live in a state with a low income tax rate, I'd urge you to at least compare your potential savings from claiming the sales tax deduction rather than the income tax break. Of people who did claim the sales tax deduction, the average deduction last year was $1,718. That's a big savings.
And unless Congress jumps in and extends the sales tax deduction option, it'll disappear after Dec. 31 of this year. If you know you have a big-ticket purchase -- such as a car -- planned for early 2008, you might want to consider moving up the purchase into this year so you'll be able to claim the sales tax deduction. I'm not advocating going on a spending spree that you can't afford, of course. This advice is purely for those of you who have the need (not desire) to make a big purchase soon.
Not Exactly Child's Play
Congress continues to tinker with the so-called kiddie tax. Right now, kids under 18 with unearned income above $1,700 pay income tax at their parent's rate. But starting in '08, that tax rule extends to all kids under the age of 19. But it can hit kids (or, actually, their parents) all the way until a child reaches 24.
Under the new law that starts next year, any child with unearned income above $1,800 who's a full-time student and claimed as a dependent by a parent will pay tax on that income at the parent's tax rate.
The upshot here is that if you currently have investments in a child's name and that child is in the 18-to-24 age group, you might want to consider selling those positions today. Chances are your child's tax bill will qualify for the 5 percent capital gains rate. For parents whose own capital gains are taxed at the top 15 percent rate, that can make for a nice tax savings if you act fast.
A Senior Moment
Another tax break scheduled to become extinct at the end of '07 is the regulation that allows anyone over the age of 70-1/2 to make a direct charitable contribution from a traditional IRA. The contribution isn't tax deductible, but the amount that's donated is counted as part of the Required Minimum Distribution (RMD).
So what's the tax break? Well, since it's a charitable deduction, the IRS doesn't charge income tax on the amount donated. Remember, regular RMDs from a traditional IRA are considered taxable income. The maximum amount you can direct to a charity and shield from income tax is $100,000.
Increased IRA Limits for '08
I can't resist mentioning an important planning move for next year. The annual limit for IRA contributions rises in '08 to $5,000 (from the current $4,000) for everyone under 50 years old. The limit for the post-50 crowd is $6,000 a year. At the same time, Roth IRA eligibility rises a bit, too; in '08, individuals with income below $101,000 and married couples filing a joint tax return with income below $159,000 are eligible to invest the full $5,000 (or $6,000) in a Roth.
Taking advantage of the new higher limits in '08 can deliver a big payoff down the line. For example, if you just stick with the old rules and invest $4,000 in '08 and let it grow at an annualized 8 percent for 25 years, you'll have about $29,000 come retirement. But if you push yourself to invest the maximum $5,000 for '08, your retirement stash will be worth more than $36,000 after 25 years. And if you're over 50, make the full $6,000 contribution in '08 and your account could be worth more than $44,000 in 25 years.
Of course, Roth IRA contributions aren't tax deductible. But the money invested grows tax-deferred and all withdrawals will be tax-free in retirement assuming you follow some basic rules. Even better is that once you reach 70-1/2, there are no Required Minimum Distributions for Roth IRAs.
Mr. Freeman is an Enrolled Agent and the current president of the central Arizona Chapter of Enrolled Agent (CACEA). His practice is in Anthem, AZ. All calls are welcome. 623-518-2157