Doing your taxes? It's the last thing most people want to think about, especially with the holidays approaching. But before you sit down to that Thanksgiving turkey, consider making a few financial moves. They'll lower your tax bill next April 15.
New IRS rules, combined with the stock market's recovery, have created some intriguing tax-trimming possibilities, financial experts say.
One of the most prominent features of the new tax law applies to investors who sell stocks for a profit. If it's a long-term gain, Uncle Sam will tax it at a lower rate: 15 percent instead of 20 percent. The lower rate applies to assets held longer than one year and sold after May 5, 2003. (If you sold long-term investments before then, sorry. The old rate still applies.)
Many investors, whether they own stocks or mutual funds, probably saw their portfolios rise this year after the three-year bear market. As a result, "This is a good time to look at what you have in realized gains and losses," says Sue Stevens, director of financial planning at Morningstar Inc., in Chicago.
For example, people who sold losing stock and mutual-fund investments can use their losses to offset gains from any sales this year, Ms. Stevens says, Even if those capital losses came in 2000, 2001, or 2002, those losses can be carried forward to offset this year's gains. And, once you've offset all your capital gains, you can deduct any remaining losses against up to $3,000 of ordinary income from salary, interest, and retirement-plan distributions.
The next couple of months also gives investors a chance to rebalance their portfolios, says Karen Altfest, a financial planner in New York. A strong stock market has left some investors with more money in stocks than they should have, given their age and risk tolerance, she points out. If that is the case, she suggests selling some of this year's winners to take advantage of the lower capital-gains tax, and then reallocating. "People tend to hold on to investments too long because they're worried about taxes when they sell. This law takes away some of that worry," Ms. Altfest says.
Something else people can do with stock that's risen in value: give it away. Anyone can give a child up to $11,000 in cash or appreciated stock without any gift- or estate-tax consequences. As long as the stock was held by the donor for at least a year, the child can sell the shares this year and only pay 5 percent tax. If they choose, married couples could make a combined gift of $22,000 to each child before the end of this year.
Be warned: Stock gifts must be in the recipient's account by Dec. 31 to count as a 2003 gift. Shifting stock from one account to another can take several weeks, so planners advise making such transfers soon.
The lower capital-gains tax also should prompt investors to think about the kind of investments they hold in taxable and tax-deferred accounts, Altfest says. People who buy and hold stocks or invest in mutual funds that employ a buy-and-hold strategy should consider putting those assets in taxable accounts. "Investors can now feel more comfortable with equity funds in their taxable accounts," Altfest says. At the same time, investments that are not as tax-efficient, such as mutual funds that trade stocks often, may work better in tax-deferred accounts like IRAs.
On the subject of retirement plans, many Americans can lower this year's tax liability by contributing up to $3,000 to a traditional IRA as late as April 15, 2004. Those over age 50 can put in $3,500. Financial experts, however, often recommend contributing instead to a Roth IRA, which allows tax-free withdrawals after age 59-1/2 as long as the account has been held for at least five years.
Employees can also cut their tax bill by increasing contributions to a 401(k) or 403(b) before year-end. The maximum contribution for this year is $12,000 for most workers. Employees age 50 and older can put in as much as $14,000. If you are well below those limits, ask your employer to increase your payroll deductions.
Another tax-rule change could present a problem for some people who receive dividend income, says Thomas Ochsenschlager, a tax partner with Grant Thornton, an accounting firm in Washington, D.C. The good news for most people is that most stock dividends are now taxed at 15 percent. Before, dividends were taxed as ordinary income.
But many individuals who receive dividends from preferred stock may face larger tax bills than expected, Mr. Ochsenschlager points out. He estimates that as much as 80 percent of preferred stock is actually corporate debt, structured to look like preferred stock. Although these debt instruments are good for the companies - they can deduct the interest payments - the income from that debt is taxed at the investor's regular rate. It may be too late to avoid the higher tax from these investments, he says.
Another tax move is to accelerate deductions into this year and defer income into 2004, Ochsenschlager says. Several ways to bring more deductions into this year, include pre-paying state and local taxes before year-end, paying deductible fees such as legal expenses, and making charitable donations, including cash, clothing, and furniture. Also, if you can make your January 2004 mortgage payment by Dec. 31, you'll get an additional deduction for the interest paid.
As for deferring income, if you expect a bonus from your employer, make sure you get it after the New Year. If you're self-employed, send out your bills near the end of December, so you'll get paid in January.