Now that this year's tax-filing deadline has passed, if you’re like most people, you probably want to stuff those papers in a box and put the whole business out of mind.
But first, look through the 2006 return one more time. It’s a good way to start your tax-minimizing strategy for 2007. That will mean using some standard tactics as well as looking at new opportunities.
Some low- and middle-income taxpayers, for example, now have an unusual opportunity to avoid capital gains tax entirely by postponing sale of profitable investments until 2008. And mutual fund owners need to be especially wary of those nasty year-end distributions, which could be bigger than ever this year.
But first, some longstanding tips:
- Swear you’ll never do this again — wait until the last minute. Tax rules change every year, and last-minute filers, on top of going gray and snapping at their families, are more likely to make costly mistakes.
- Put all you can afford to into your 401(k) or similar tax-deferred plan at work. Every dollar invested will cut your tax bill by 25 cents, assuming a 25 percent tax bracket.
- Use flexible-spending plans at work to get similar tax savings on money set aside for dependant care and medical expenses. Your benefits folks will have details.
- If you have children or grandchildren, think about setting up a state-sponsored Section 529 college-savings plan. There’s no up-front federal tax savings, but contributions are deductible in some states. And investment gains will be tax free if used for tuition and other qualified expenses. Investigate these at www.savingforcollege.com.
- Keep good records. Starting in 2007, for instance, you’ll need cancelled checks or receipts to support cash contributions to charity.
Now, think about this past tax season.
Did you get a refund? Most people are happy to. But this really means you gave Uncle Sam an interest-free loan. It’s better to get that money earlier and earn interest yourself. You can do that by filing a new W-4 form at work to reduce your paycheck withholding. Your payroll people should have the form, or you can get it, as well as all other IRS forms and publications, at www.irs.gov.
If you had to pay money this spring, you can avoid a repeat by filing a new W-4 to increase your tax withholding. This will help you avoid interest charges and penalties that often accompany a balance due.
Oftentimes, a balance due is caused by investment gains realized during the year – when you sell a profitable stock or mutual fund, for example. It’s hard to know just how much tax these will trigger because you may have money-losing investments that can be sold by year-end to offset the gains.
Still, make your best estimate of the tax due and pay it during the year with Form 1040-ES. The first estimated payment was due April 17, and the remaining three June 15, Sept. 17 and Jan. 15. Payments will reduce or eliminate interest and penalty charges, and any overpayment will come back in a refund next year.
While you have your tax papers out, go through the 1099 forms that show payments you received from sources like brokerages and mutual fund accounts. Look for capital gains distributions from mutual funds. Typically received late in the year, these represent net profits earned by funds on stocks or other holdings the fund managers sold during the year.
These distributions are taxable unless the fund is held in a tax-favored account like an IRA or 401(k) — even if you have the payment automatically reinvested.
Investors could face especially large distributions later this year if the stock market continues its recent roll. In 2006, capital-gains distributions totaled nearly $260 billion, compared to $129 billion the year before, according to the Investment Company Institute. It was the largest sum since the record $326 billion in 2000, and it dwarfed 2003’s $14 billion.
Prospects for distributions should be considered when you choose new investments. You may, for example, find two funds that tend to produce the same returns, while one makes big distributions and the other does not. In a taxable account, the second would be preferable.
Shop by using the Similar Funds tool at www.morningstar.com. It will list funds with the same types of holdings. Then click on individual funds and look at the Tax Analysis page. Seek funds with tax-adjusted returns very close to pre-tax returns. That means tax bills are not chewing away gains.
As I said above, low- and moderate-income investors have some new tax-saving opportunities. In 2008, 2009 and 2010, the long-term capital gains rate will be zero for people in the 10 and 15 percent income tax brackets. This year, people in those brackets pay 5 percent on those gains, while people in higher brackets pay 15 percent.)
If you’re in these brackets, it could well make sense to postpone sales of profitable investments until 2008, as long as you don’t think those holdings will fall in value before then.
It’s too soon to know the tax brackets for 2008, but they’re not likely to rise much, because inflation is low. For 2007, the 10 and 15 percent brackets cover married couples filing joint returns showing taxable income of up to $63,700. For single people that figure is $31,850.