by Bridget Hess
In a world full of difference, there is one thing that virtually all of us have in common: we aim to keep our hard-earned wealth. Yet without careful planning and the advice of a good tax adviser, those with even moderate wealth may carry a hefty tax burden. This article—the first of six that follow—is meant to share some ideas for minimizing income taxes. As with any complex financial issue, be sure to seek guidance from a trusted adviser who is familiar with the ins and outs of tax law.
Be Strategic About Income Tax
One of the most fundamental tools for reducing taxable income is to fund your company 401(k) or IRA to the max. Not only will this help decrease the dollars Uncle Sam receives, but it will also benefit your overall retirement plan. In addition, many employers allow their employees to set aside a portion of pre-tax income to pay for childcare, medical and dental expenses. This is another tool well worth using.
“Retirement plans are simply the best deduction strategy available under current law,” said Scott Slabot-sky, managing director of CBIZ Accounting, Tax & Advisory Services.
Slabotsky warns that, while individuals should look for opportunities to take deductions in order to reduce tax burden, it is also important to be very strategic about how they do this. For example, he often sees clients try to reduce their taxes by selling assets they have gained and lost on at the same time. However, with the capital gains tax rate currently at only 15 percent, he advises against reducing income that is only costing 15 cents on the dollar.
“The timing of deductions and projecting income and expenses for the next year are both important,” said Slabotsky. “It is one thing to know what is deductible, but it is another thing to be able to evaluate whether a deduction can benefit you at 15, 25 or 36 percent.”
Frequently Overlooked Itemized Deductions
At the federal level, standard deduction amounts in 2006 are $5,150 for singles or married people who file separately, $10,300 for married individuals who file jointly and surviving spouses, and $7,550 for heads of household. When you have enough itemized deductions to exceed the standard amount, itemizing is worthwhile.
While some deductions, such as mortgage interest, may be obvious, many Americans overlook less familiar deductions. Consider how many of the following apply to your household. And remember, it is important to keep receipts documenting expenses if you chose to itemize.
Charitable Contributions: Whether cash, clothes or household items, donations made to charitable organizations can be a write-off. Slabotsky recommends taking digital photos and keeping good records of items donated, especially large ticket items such as furniture, in order to deduct their true value. Also, don’t forget to include financial contributions to a church or synagogue.
Job Expenses: Some job expenses that are not reimbursed by employers may be eligible for a deduction. These may include travel costs, dues to a union or uniform costs. Such expenses, together with other miscellaneous itemized deductions, are deductible if they exceed 2 percent of your adjusted gross income.
Medical Expenses: If your medical and dental expenses exceed 7.5 percent of your adjusted gross income, they can be deducted.
Be aware, however, that for households with an adjusted gross income greater than $150,500, some itemized deduction benefits may be reduced.
Above the Line Deductions
There are certain deductions the IRS calls “above the line” that can be taken in addition to the standard deduction even if you do not itemize.
Alimony: Alimony paid to a former spouse, as long as it is not used for child support (child support is not tax-deductible) may be deductible.
Clean-Fuel Hybrid Vehicles: If you purchase a hybrid gas-electric car in 2006, you may be able to deduct $500 (the deduction is valid for the first year the car is purchased and driven). Check IRS.gov to see if your hybrid vehicle qualifies.
Higher Education Expenses: Depending on your household income, up to $4,000 of your, or your child’s, higher education expenses may be tax-deductible.
Student Loan Interest: Depending on your household income, up to $2,500 of the interest paid on stud-ent loans is deductible.
Self-Employed: There is a set of deductions for those who are self-employed. Above the line deductions may include health insurance premiums, retirement plans and one-half of self-employment taxes. There may also be additional self-employed deductions such as expenses associated with maintaining a home-based business.
To reduce state income taxes, Slabotsky recommends setting up 529 college savings plans for children or grandchildren, which are tax-deductible in both Kansas and Missouri. He also reminds clients that personal property taxes on vehicles can be deducted.
Again, itemized deductions are a powerful tool, however, it is important for everyone to sit down with a tax adviser to carefully strategize the true benefit of each deduction vs. their adjusted gross income from year to year.
Federal Alternative Minimum Tax
Despite the many tools allowing us to minimize income taxes, it is important to be aware that many of us will still get hit with the federal government’s Alternative Minimum Tax (AMT).
“AMT is an extra tax that people of a certain income level must pay above regular income tax. In theory, an individual can have so many deductions and tax preference items that they ultimately will lose some of the benefit if they are in AMT,” said William Lowe, senior vice president and senior wealth adviser for UMB Asset Management. “It mostly affects people who make a higher salary and have several deductions and dependent exemptions to take. Some other things that may cause AMT are deductions for state and local taxes, second mortgage interest used to pay off debt, tax-exempt interest, mutual fund interest, and in some cases capital gains. The tough part about AMT is that the only sure way to determine whether or not you will be subject to it is to actually fill out a tax return form and review the numbers.”
Selling Property Tax-Deferred
Aside from taxes taken out of our paychecks, some of the highest taxes paid are a result of selling assets. One of the most common circumstances when this occurs is in the case of selling expensive real estate. Yet, as Todd Campbell, a partner with Renkemeyer Campbell & Weaver, LLP, advises, there are some ways around this:
1. Installment Sale: When the seller takes back a note from the buyer for part of the purchase price, they will only need to pay taxes incrementally as they receive the proceeds. Yet the downside of this, as Campbell points out, is that the seller is still invested in the property and therefore shares some fiscal responsibility for it until the buyer pays it off.
2. Section 1031 Exchange: When selling one property and purchasing another, you may be able to avoid paying taxes if the IRS considers it a like-kind exchange.
3. Charitable Remainder Trust (CRT): Section 664 of the tax code allows individuals to transfer ownership of property to a CRT before selling it, thus only paying income taxes on the proceeds of the sale as they withdraw money and allow that money to grow tax-free. In addition, the contribution typically qualifies for a charitable deduction from your income taxes. At the end of the trust term, the remaining assets go to charity. The charity can be public or private, including private family foundations.
“Most all very wealthy people set up a family foundation, and while it looks like they are donating all of the money to charity, they still get to control and benefit from the assets,” said Campbell.
4. Deferred Sales Trust (DST): When a property owner sells property through a DST, he will only pay taxes as he withdrawals the money. Unlike with a CRT, part of the sales proceeds will not have to go to charity, yet this structure may incur higher fees.
With the above guide in place, take a careful look at the strategies you might use to reduce income taxes this year. And as always, it is important to consult with a trusted tax adviser regarding these and all tax issues.