Top 10 Tax Savvy Tips

Cutting your taxes is not quite as easy as it used to be, but you still have options. Just understanding your own tax situation and keeping track of deductible expenses can put money in your pocket. You can save some more money by carefully timing when you sell stocks, give money away, or pay your taxes And participating in a tax-deferred retirement plan will mean a deduction this year and the potential for further gains from now on.

Here are our top ten tips to help you save money on taxes this year and for many years to come.

1. Get Organized.

If you get organized at the beginning of the year, you can avoid a lot of grief later. Set up a spreadsheet, or use a program like Quicken® to track your expenses and income. Then, instead of throwing receipts into a shoebox, and scribbling check amounts on the back of an old bill, enter your expenses on the computer and save the receipts in file folders. Using a computer program helps to ensure that you have complete and accurate information next year, when you do your taxes.

Plan ahead for tax time.

• Get documentation for your expenses whenever possible.

• Record mileage for business or charity in a book that you keep in your car.

• Get receipts for charitable contributions.

Don't think you'll remember all this later. You probably won't.

Also, keep careful records of stock options. You need to know when they were granted and exercised -- and at what price. This information can save you money, and headaches, when you do this year's taxes and when you plan future investments, with an eye to reducing your taxes.

Savings: Possibly hundreds, even thousands, of dollars in forgotten expenses. Many hours of your time.

2. Contribute the Maximum to Your 401(k).

Check at the beginning of each year with your company that you are signed up for the maximum contribution. The ceiling for contributions, which is $12,000 in 2003, will increase by $1,000 every year until it reaches $15,000 in 2006.

As a way of deferring taxes, a 401(k) is hard to beat. It allows your investment to compound quickly, and you can contribute substantially more to it than to an IRA. If your employer matches your contributions, the extra money makes a 401(k) even more appealing.

Only if your investment choices are limited should you commit less than the maximum to the plan. If your plan limits you to company stock, put in enough money to get the full company match, and then diversify with contributions to an IRA.

Savings: $150 in federal taxes on every $1,000 in contributions for someone in the 15% tax bracket in 2003. Plus, funds grow unhindered by taxes until you withdraw them.

3. Adjust your Withholding.

If you received a big refund this year, you might want to consider decreasing your withholding, by revising your W-4. While many people look forward to getting a nice check from the government every April, it's a terrible way to manage your money. You are essentially giving the government a free loan when you could be putting your money to work for yourself.

On the other hand, you want to make sure that your company is withholding enough, so that you do not end up owing a lot, and leaving yourself subject to interest and penalties for underpayment of tax, if your company doesn't withhold enough.

Any time you have a major change in your life, your taxes are going to change.

• If you recently got married, your taxes may go up. Working couples may pay more in taxes than when they were single.

• If you're earning more than last year, you may need to increase your withholding, to avoid getting hit hard when you pay your income tax. As your income goes up, the withholding tables don't usually provide adequate withholding unless you have a large amount of itemized deductions.

• If you have just had a baby, or adopted a child, you have a new dependent, and can take an exemption to reduce your taxable income.

So after you get married, buy a home, get a new job, or have a baby, be sure to ask to fill out a new W-4 form.

Savings: Interest that you could have earned on overpayments to the government. Interest and penalties that you might owe to the government on underpayments.

4. Make Estimated Payments.

The income tax is pay-as-you go. If you can't manage to get your employer to withhold enough from your paycheck or if you are self-employed, you can make yourself penalty-proof with quarterly estimated payments. Figure what they should be early in the year. You can always change the amount later. Check your income, withholding and estimated payments periodically throughout the year to make sure you are staying on track.

According to IRS rules, you must pay 100% of last year's tax liability or 90% of this year's to be protected from penalties. If you made more than $150,000 last year, you have to pay 110% of last tax liability.

The due dates for quarterly estimates are April 15, June 15, September 15, and January 15 (of the following year).

Savings: Interest and penalties for underpaying your taxes.

5. Sell Stocks and Funds Early in the Year.

If you delayed selling a stock last year in order to postpone a gain, take that gain as early as you can in the following year to maximize the interest earned on the proceeds.

First, make sure that you have made yourself penalty-proof by paying the required amount of quarterly tax estimates. Put aside any extra money that you eventually will have to pay in taxes.

Then you can invest it until Tax Day, which could be more than a year away. Be sure to pick a CD or other short-term will not go down in value so that the funds will be available when you need them.

Savings: Interest on the investment that is earmarked to pay taxes.

6. Contribute to Your IRA Early.

Instead of waiting until the end of the year, put money into your IRA in January. Believe it or not, those extra few months can make a big difference over you'll do a lot better with interest compounding over the longer period.

An added bonus: in 2002 the maximum you can contribute to IRA accounts is $3,000 ($3,500 if you'll be 50 or older by the end of the year) and it eventually climbs to $5,000 in 2008.

If you're thinking about contributing to a Roth IRA, you might want to wait until you're sure you qualify. You might have to undo your contribution if you go over the income ceiling of $150,000 for married couples and $95,000 for singles. Those amounts didn't go up with the recent law changes.

Savings: More than $10,000 over 30 years if you contribute $3,000 at the beginning of every year, rather than at the end of the year, and get a 5% return on your investment.

7. Make Gifts to Children and Grandchildren.

If you have substantial assets, you can lower taxes on your estates by giving cash to your children and grandchildren every year. In 2003, the IRS allows you to give $11,000 to each person free of gift taxes. That gift helps to decrease the size of your estate, which means lower estate taxes.

How does the repeal of estate taxes affect this strategy? The maximum estate tax rate is reduced to 45% over the next several years until the estate tax disappears altogether in 2010, only to return in full force in 2011! The gift tax continues unabated.

The earlier in the year you make the gift, the better it is for keeping money in the family. Chances are that your children or grandchildren are in a lower tax bracket. If so, they will pay less in taxes than you would on the income they gain from that money.

Savings: Up to 50% on the amount you give away in 2002, depending on the size of your estate.

8. Consider Tax-Efficient Investments.

If you are in a high tax bracket and you have maxed out on your tax-deferred retirement accounts, you should think about putting money into investments without a big tax bite.

As early in the year as possible, project what your tax situation is going to be. If you're in a high tax bracket, it just doesn't make sense to buy taxable investments.

Tax-free municipal bonds have been good tax shelters for high-wage earners for a long time. But there are other ways to get a higher return without forking over a lot to the government.

Growth stocks paying low or no dividends help you postpone taxes almost indefinitely. When you sell, you pay taxes only on the appreciation of the stock at capital gains rates. These stocks often don't pay dividends, which are taxed at higher ordinary income rates.

You can get almost as much tax efficiency from some mutual funds, plus diversification and professional management. Consider ones that have low taxable distributions and hold a large proportion of stocks that don't pay dividends. They also keep the stocks they buy for the long haul so capital gains from turnovers are low. When they need to sell some stock, gains usually are offset by losses on the sale of other shares. Index funds historically have had a small tax liability because they have a low turnover in stocks.

Savings: A good chunk of the return on your investment, depending on your income tax bracket.

9. Consult your Tax Adviser About Stock Options.

In recent years, many middle-class employees benefited from company stock options. If you were one of the lucky ones, you also have some important tax issues. It may be time to ask for some professional advice even if you never needed any before.

When you exercise nonqualified stock options -- the most common kind—the company often withholds money for taxes at a flat rate. But you can easily owe more if your tax bracket moves up as a result of your new wealth. Your adviser can help you figure out whether you need to make quarterly estimated tax payments so you won't owe penalties and interest when tax-filing season rolls around.

If you are an executive, and receive incentive stock options—the less common kind—you will want to find out if your options make you vulnerable to the alternative minimum tax (AMT). To avoid the AMT, you may need to turn traditional tax planning on its head by deferring deductions into next year. You also may be able to spread out the sale of your options, which also spreads out your tax liability. Of course, this may be a good tax decision, but that doesn't mean it's a good financial decision. So... run the numbers to make sure you take the path that leaves you the most money.

Savings: Easily thousands of dollars, depending on the number of options, the stock price, and your income tax bracket.

10. Put Domestic Employees on the Payroll.

In the early 1990s Zoe Baird backed out of a presidential nomination to be attorney general because she had neglected to pay taxes for a nanny. After that, many, but not all, taxpayers came clean and put their nannies and housekeepers on the payroll. If you haven't done so yet, don't delay. Otherwise, you could be liable for penalties and back taxes.

If you pay a household employee $1,300 more during the year, then you're obligated to pay employment taxes. How do you know that your housekeeper and gardener are employees? The IRS tests can get confusing. But basically if you control their work, then they are employees. Someone who provides his own tools and offers his services to the general public might not be an employee.

Of course, reporting your employee's income means that he or she must have a Social Security number. So employing illegal aliens is out.

The paperwork is less burdensome than it used to be. Now you need to report your employee's income to the federal government only once a year. Some states still require quarterly reports, however. You also need to apply for an Employer Identification Number from the IRS.

In the short run, paying taxes for your employees will cost you some money. But you could save yourself a big headache in the future.

Savings: Back taxes and penalties. Plus you might get that government appointment you always wanted.