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Plan NOW for your 2007 tax return!

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Head’s up folks – your 2007 Federal Income Tax return is due April 15, 2007, a little more than 9 months from now! Get ready now!

So how many of you think I’m nuts to tell you to start preparing now for your 2007 return? It may seem nuts to think about taxes now considering a child conceived today would be here before your return is due, but the advantage in thinking about taxes now is that you have time to do something about it.

Your biggest decision is going to be around whether to itemize deductions. If you incur deductible expenses but end up just taking the standard deduction, you get no tax benefit from those deductible expenses. What is the standard deduction going to be? For tax year 2007, the standard deduction will $5,350 for singles or married filing separately and $10,700 for married filing jointly or widow(er) with dependent child. Limits vary for seniors and the blind, as well as those filing as head of household.

Think about what deductions you’re likely to have at year-end. Charitable donations, mortgage interest, and state and local income and property taxes should be the biggest items on this list. Also included are uninsured casualty and theft losses, medical expenses, and unreimbursed job expenses, although these can be severely limited based on income, so be careful when adding these to your calculations.

If these amounts for you are minimal, great! Just take the standard deduction and be done with it. It is about as easy as you can get with taxes.

If these amounts well exceed the standard deduction for your filing status, just add everything up for your itemized deduction. A little more difficult, but a pretty easy decision.

Where it gets tricky is when you are relatively close to that standard deduction amount. You don’t get much advantage if any from itemizing deductions. However, if you can time your deductions to occur in one year or the other, you get the best of both worlds by itemizing in one year and taking the standard deduction in the next. It is a technique known as “bunching” of deductions, and it can save you a bundle on taxes.

Here’s an example to illustrate the point (using 2006 deduction amounts). Say you are married filing jointly and have a 25% marginal tax rate. You plan to give $2500 per year to charitable organizations, have to pay property taxes of $3500 each year (bill mailed in November due in January), and pay about $4000 per year in mortgage interest on your home.

Without trying to time the deductions, you have $10,000 of deductions each year. Your standard deduction is $10,300, so you don’t itemize on your taxes. At a 25% marginal rate, the benefit to you each year is $2,575, or $5,150 over two years.

Now let’s try timing the deductions. You know you’re going to give $2,500 for each year, so you go ahead and give $5,000 this year and don’t plan for any additional giving next year. You also go ahead and pay your property tax that is due next January before December 31, so you have the $3,500 you paid in January and the $3,500 you paid later in the year for a total of $7,000 in property tax paid. You can’t really time mortgage interest, so you still have the $4,000 in interest paid this year and another $4,000 paid next year.

In year one you have a total of $16,000 in deductible expenses ($5000 charitable, $7000 property tax, $4000 mortgage interest). As this is more than your standard deduction you itemize, yielding a tax benefit of $4,000. In year two you only have the $4000 in mortgage interest, so you take the standard deduction of $10,300, yielding a tax benefit of $2,575. Total tax benefit over the two years is $6,575, or $1,425 more than if you didn’t bunch the deductions.

As always you should do your homework and consult an adviser if necessary to make sure it will work for you, but unless you get ensnared by the Alternative Minimum Tax or some other landmine in the tax code, this is an effective way to minimize the amount that Uncle Sam steals from you each year.

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July 31, 2007 Posted by | Taxes, Tips | Leave a comment

Retirement Accounts: Diversifying for Taxes

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One of the big things you hear a lot about in investing is diversification of assets. Like the old advice, “Don’t put all your eggs in one basket”, the idea here is to spread your investment money among enough different assets so that if one loses money, you can still fall back on the others. We can look back to episodes like the Enron scandal, when some employees had their entire 401(k) invested in Enron stock and subsequently lost their entire nest egg, for evidence of why diversification is a good idea.

Although when we talk about diversification it is normally about what we are invested in, it is also worth considering diversifying where we are invested. Specifically, I am talking about the traditional IRA and 401(k) versus the Roth IRA and 401(k). With the traditional IRA and 401(k), you contribute with before tax dollars and pay tax on the principal and earnings whenever you withdraw from the account in retirement. With Roth, you contribution after-tax dollars and then withdraw both principal and earnings in retirement tax-free. The big difference is whether you pay taxes now or later.

In a perfect world where we know the future for a certainty, deciding where we should put our money is pretty easy. If our rate is higher now than in retirement, we use traditional retirement accounts. If our rate is lower now, we would use Roth accounts. Unfortunately, we don’t live in a perfect world and will never be able to predict these things for a certainty. Among the variables:

  1. If rates stay the same, will your income be higher now or in retirement?
  2. Will rates indeed stay the same, or will they increase? Will hell freeze over and rates be decreased?
  3. Will you retire in the same state where you have earned most of your savings? If so, will the tax rules and rates there change?
  4. Will the federal and state governments change the rules after the fact on the tax treatment of retirement account withdrawals in response to worsening economic conditions or the explosion of unfunded liabilities in entitlement programs?

Don’t fool yourself into thinking you know the answers to these questions, especially if you still have some time until retirement comes. We never know what life is going to bring, if we will be making as much on the eve of retirement as we do today. A job opportunity or family situation may convince you to move to a different state before you retire, which may have radically different tax structures. Imagine what an effect a move from Texas, where there is no income tax, to Massachusetts, where the unofficial state motto is “if you can dream it, we can tax it”, would have on your financial situation!

Questions #2 and #4 deal a little more with political risk. Do we know what the political winds will bring? Will the size of government continue to increase, and if so how will we pay for all of the services provided by government? My personal opinion is that our federal government is completely out of control with respect to spending, especially in entitlement programs. The taxes collected will not be enough to cover all of the promises that are being made.

Based on this reasoning, all else being equal tax rates would be higher in the future than they are now. Providing the rules do not change, it makes more sense to hold investments in Roth accounts since the tax benefit will be higher in the future than it is now. But what if things get really bad? Some promises made today may need to be broken, and who is to say that the tax treatment of Roth IRAs and 401(k)s as we know it today will be the same when it is time to retire? If things get really bad, it would likely be more politically viable for the government to take away money from those who have saved by declaring that Roth withdrawals are partially or fully taxable as opposed to raising taxes or breaking promises made through entitlement programs for those who have very little. I could easily foresee the day when Roth IRAs and 401(k) withdrawals are fully taxed simply because the government needs the tax revenue. In that case, it would make more sense to have invested in traditional 401(k)s and IRAs and claimed your tax savings on the front-end as opposed to investing in the Roth accounts with the promise of tax savings in the future that never materialize. In this scenario, a bird in the hand is worth more than two in the bush.

I don’t claim to know what will happen in the future, but as you can likely tell from my post I am not incredibly optimistic. What do I do, you ask? Most of most retirement money is currently in traditional 401(k)s, as that has been what was available. I also now invest in Roth IRAs (although the balances are small compared to the 401(k) plans) and am considering directing some money to a Roth 401(k), which our company just started offering this year. As with the uncertainty over the performance of different investments, we should also diversify for the uncertainty over the tax environment in the years to come.

July 1, 2007 Posted by | Retirement, Taxes | Leave a comment

Making the Most of Your Noncash Charitable Donations

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I posted previously about garage sales and how in many instances you do better simply donating the items to a worthy charity and taking the tax deduction. However, to make the most of your donation you have to be careful and keep good records. Here are a few things to look out for:

  1. Do you itemize your taxes? If not, than the donation provides you no financial benefit. If you aren’t sure if you will itemize or not, it would be very beneficial to do some quick planning and figure out how much you expect to pay in state and local taxes, property taxes, mortgage interest, and how much you plan on donating in cash to the charities of your choice during the year. A lot of people end up right around the standard deduction anyway, and if so it makes sense to try and lump those deductible items into one year and take the standard deduction the next. You may not be able to time mortgage interest payments, but you likely have some control over when you pay your property taxes and make other charitable donations.
  2. Document, document, document! Make an itemized list of everything you donate. Ideally your list should include what you donated, the condition of the donated items, and how many you donated. You may also want to consider taking a picture of your donated items to support your listing and…
  3. Get a receipt! Basically, any donation of goods over $250 must be supported by a receipt from the receiving charity. Just be sure to take your items to an attended drop-off site (don’t just put the stuff in the bin in the parking lot) and ask for a receipt. The attendant will likely give you a blank receipt and ask you to fill in your name and address and a description of the items you are donating. You don’t have to list everything – just keep it high level (i.e., two bags of men’s clothing). The detail will be on the itemized list you made in step two.
  4. Value your stuff fairly. When most people try to guess the value of their items, they usually grossly undervalue the goods. Remember that you are entitled to a write-off of the fair market value of the item. Just because your t-shirt would only get 50 cents at a garage sale doesn’t mean that is its true value. Programs such as H&R Block DeductionPro are great for providing fair valuations and organizing non-cash donations. If you can’t find the item you donated listed in your program, then you may want to go to eBay to try and determine a fair value for the item. It would likely be worthwhile to print out the source you are using for your valuation.
  5. Keep it small. For noncash donations of a single item or multiple items totaling $500 or more to a single charity on a single day, you must provide information on how you acquired the property donated, your basis (cost) in the property, and when you acquired it. However, for donations under $500 this information is not required. Keeping it small also allows you to work on cleaning out a room or closet at a time and getting unwanted goods out of your home quickly.
  6. Track your mileage, too. Mileage incurred for the direct benefit of a charity, including to bring a donation to the charity is tax deductible, although not at the standard business mileage rate. The charitable mileage deduction is about 14 cents a mile. Not a huge amount, but every little bit helps.
  7. Start a 2007 tax folder now, and put your documentation in it. What good is your receipt and listing if you can’t find it come tax time? Go ahead and start a folder to keep tax-related items (charitable donations, health care expenses, etc.) so you have a head start when it comes time to file next year.

Please note I am talking about donations of small household items only. There are special rules around donations of more valuable property, collectibles, real estate, automobiles, cash, and financial instruments, to name a few. Be sure to do your homework if any of these apply to you, and call a reputable CPA or tax attorney for guidance if needed.

June 25, 2007 Posted by | Taxes | Leave a comment

The Economics of Garage Sales

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OK, everyone has either held one or been to one. I’m talking about garage sales, that great piece of Americana where you put all the crap from your house that you no longer want or need out in your garage, driveway, or patio and let a bunch of random strangers come rummage through it and try to negotiate off your marked price of about 5% what you originally paid for the item. FiveCentNickel posted about garage sales this past week which got me to thinking – are garage sales worth the effort?

I think the biggest determinant of that is whether you itemize deductions on your taxes, and if so what is your marginal tax rate? If you don’t itemize or your marginal tax rate is only 10% or 15%, than having a garage sale will probably net you the most money. However, if you do itemize and your marginal rate is 25% or more, you’ll likely do much better just donating the items to Goodwill or another worthy charity and taking the deduction. Using the H&R Block Deduction Pro valuations for used goods, here is a quick breakdown of what a few sample donated items are worth and your tax benefit at a 28% marginal tax rate.

  • Men’s Dress Slacks (Like New) @ $15.10 = $4.23 tax savings
  • Men’s T-Shirt (Like New) @ $6.92 = $1.94 tax savings
  • Men’s T-Shirt (Minor Wear) @ $3.52 = $0.99 tax savings
  • Women’s Dress Slacks (Minor Wear) @ $9.30 = $2.60 tax savings

Clothes (except baby and kids) are usually the things that get the least at a garage sale, so if you have a lot of clothes ask yourself if the price you could get is greater than the tax savings numbers above. Other household items generally sell at slightly higher prices, so it may be worthwhile if you have a lot of random knick-knacks and such. Just remember that with a garage sale you also have the cost of signage, newspaper ads, and the cost of your time to set up and supervise your garage sale.

Another good thing to do whether you plan to have a garage sale or donate is to check to see if you could get more for items on eBay. If it is a higher-value item that could be easily shipped, you’ll likely do better on eBay than selling at a garage sale or taking the tax deduction.

If you decide to have a garage sale, be sure to check out FCN’s garage sale tips here.

June 22, 2007 Posted by | Taxes, Tips | Leave a comment

IRS notice? Don’t pay just yet!

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Unless you filed an extension or are one of those kooks that have come up with some justification why the US Constitution doesn’t allow the federal government to levy an income tax, you have probably already sent in your tax return for this past year. If you are unlucky, you may get a nice letter from the blood-sucking IRS that there was an error on your return and you owe them more money.

However, as this article from MarketWatch illustrates, don’t be so quick to just write a check to make the problem go away. Turns out that the IRS has sent out quite a few notices in error, particularly from the service centers in Ogden UT and White Plains NY. Most of the reported issues so far have been related to “unreported” income from state and local income tax returns when including state and local tax payments in itemized deductions, but then having to back those payments out from allowed deductions due to being subject to the AMT.

Moral of the story: just because the folks at the IRS are evil doesn’t necessarily mean they are smart. Double-check any notice you receive claiming you owe additional taxes, and if you are right don’t hesitate to fight it.

May 23, 2007 Posted by | Taxes | Leave a comment

Avoid the Post Office When Sending Tax Returns!

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I never realized this until I was putting my paper return together today. If you are sending in paper returns to the IRS, you don’t have to use the post service certified mail to send the return with an acceptable proof of mailing. The IRS has authorized DHL, FedEx, and UPS as “Private Delivery Services”. The approved methods for sending a return are as follows:

1. DHL Express (DHL): DHL Same Day Service; DHL Next Day 10:30 am; DHL Next Day 12:00 pm; DHL Next Day 3:00 pm; and DHL 2nd Day Service;

2. Federal Express (FedEx): FedEx Priority Overnight, FedEx Standard Overnight, FedEx 2 Day, FedEx International Priority, and FedEx International First; and

3. United Parcel Service (UPS): UPS Next Day Air, UPS Next Day Air Saver, UPS 2nd Day Air, UPS 2nd Day Air A.M., UPS Worldwide Express Plus, and UPS Worldwide Express.

Taxpayers should still retain proof of mailing to avoid a late filing penalty.

This is great news for me because I owe the IRS a significant sum this year, so there is no way in hell I am sending in my return early, but I hate having to fight the masses and deal with the incompetent postal workers at my local post office (not to say that all postal workers are incompetent, but I’m honestly shocked the ones at my post office don’t drool on themselves). It may cost a little more, but it is well worth it to be able to print the shipping form from my computer and have the UPS guy pick it up with the rest of the items.

http://www.irs.gov/irb/2004-52_IRB/ar10.html

March 22, 2007 Posted by | Taxes | 1 Comment