Early tax planning can save you money

Changes in tax rules open the door to moves that may reduce your tax bill.

As Americans continue to weather what most financial experts view as the worst economy since World War II, effective tax planning has never been more important. Any successful year-end strategy should involve maximizing results for both tax years 2008 and 2009. Crafting that plan will test your assumptions regarding future income, the direction of financial markets, and possible changes in the federal tax code.

The treatment of all tax issues is complicated and individual. So before finalizing any critical tax decisions this year, it's best to review them with a tax accountant.

Some year-end topics to consider are:


The Alternative Minimum Tax (AMT) has become the most feared status, initially created by Congress to target a small group of high-income people who were not paying any taxes. It has rapidly expanded to include an increasingly large swath of individuals in high tax areas such as California, New York, and New Jersey, affecting people who earn between $100,000 and $500,000 annually.

If you determine that you are subject to AMT in 2008, accelerate ordinary and short-term capital gains income into this year, and wait until 2009 to make any moves – for example, charitable contributions – that will result in tax deductions. Remember that state and local income taxes, real estate taxes, and tax-advisory expenses are not deductible under the AMT. This year, Congress put a patch on the AMT to reduce the number of people affected. AMT exceptions for 2008 apply to single filers with adjusted gross incomes (AGI) of $46,200 and $69,950 for those married filing jointly.

Pace your income and deductions

Use an alternate-year deduction strategy, shifting tax-deductible expenditures into every other year to boost tax savings. In off years, claim the standard deduction. By focusing deductions into a single year, you increase the possibility that they will exceed the 2 percent of AGI required to write them off.

In addition, if you expect your income to be higher next year, pull income into 2008 and push deductions into 2009. If you expect to earn the same both years or you might earn less in 2009, take deductions in 2008, and defer income into 2009.

Sales or income taxes

The choice to deduct state and local income or sales taxes on your federal return was extended through 2009 as part of the bailout bill. This issue is important for retirees who don't have taxable income and for residents in states without income taxes such as Florida, Texas, and Washington. Deduct the tax which costs you the most.

Sell some losing stocks

Given the stock market's 2008 plunge, you may want to realize losses by selling losing investments before year-end. Lower your 2008 tax bill by deducting capital losses against any capital gains that you may have had during the first eight months of the year. If you have additional capital losses, carry them forward into 2009.

Timing mutual fund sales

Act quickly to take advantage of this strategy. Check with your broker to determine whether you will get a taxable distribution from your mutual fund before mid-December. Even if your investment portfolio has taken a loss, the distribution could create a capital gain and extra taxes. Consider selling the mutual fund ahead of the distribution and realizing the capital loss.

Put money from the sale into an index fund. Do not buy back the original investment for two months or longer or you may be assessed for short-term trading.

Two caveats: Don't sell a mutual fund if you bought it several years ago, because taxes will be assessed on capital gains since the purchase date. Also don't sell if the fund is in a tax-sheltered IRA, since its distributions are not taxable.

Educational credits

Lower-income earners may qualify for HOPE or Lifetime Learning credits. The standard tax credits and deductions for higher education are $4,000 for single filers with AGI less than $65,000, and $130,000 for married couples filing jointly. They gradually phase out for those earning more. The credits apply to both tuition and fees. Consider prepaying college tuitions for the months of January to March 2009 to qualify for a 2008 deduction. Taxpayers can claim education credits whether itemizing or using a standard deduction.

Recovery rebate credit

For those who did not receive stimulus rebate checks – $600 for individuals, $1,200 for couples, and $300 for each eligible child – here's a second chance to qualify. (Single filers with incomes over $75,000 and joint filers making $150,000 or more still aren't eligible.)

Three classes of taxpayers now qualify for "recovery rebate credit" based on their 2008 taxes: (1 if your 2008 AGI falls below the income threshold and your 2007 income disqualified you; (2 if you had a child born in 2008; (3 if you received only a partial rebate in 2007. In the latter case, you may qualify for the remainder of the credit if your 2008 AGI qualifies. Refer to irs.gov for a worksheet.

Disaster relief

If you reside in a federally declared disaster area in 2008 and have had primary-residence damage between May 20 and Aug. 3, you can withdraw, without penalty, money from an IRA, 401(k), 401(b), or other retirement plans. Affected states are Arkansas, Iowa, Kansas, Michigan, Minnesota, Missouri, and Wisconsin. Income reported from those withdrawals can be spread over three years. Replenish your retirement accounts when able.

First-time home buyers

Purchase a house from April 9, 2008 to July 1, 2009 and receive a tax credit equal to the lesser of $7,500 or 10 percent of the purchase price. You must have had no prior ownership of a principal residence in the US for the past three years to be eligible. This credit phases out when income exceeds $75,000 for singles and $150,000 for couples.

Mortgage forgiveness

Beginning in 2008, a surviving, not-remarried spouse may sell his or her principal residence within two years of a partner's death and can exclude $500,000 on the gain of a home sale. Equal benefits are available to a married couple filing jointly.

Taxpayers in 10 to 15 percent brackets

Beginning in 2008, long-term capital gains and qualified dividend income are taxed at 0 percent.

Underpayment penalties

Don't get hit with an underpayment penalty. This penalty does not apply if you have prepaid at least 90 percent of your 2008 tax bill by the end of this year, 100 percent of the tax shown on your 2007 return, or 110 percent if your tax bill in 2007 was more than $150,000.

Check back next week for a discussion of how tax changes may affect your retirement plans and gifting.

Dr. Kathleen Connell is a professor at Haas Graduate Business School, University of California, Berkeley.

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