As this year enters the home stretch, there is still time to plan to reduce your 2006 federal income taxes. Adding to existing tax-saving strategies are some new ones presented by recent tax legislation. On the other hand, the uncertain fate of several popular tax breaks that expired at the end of 2005 could make 2006 year-end planning more difficult.
Tried and True Strategies
Here are some proven strategies that may help you reduce your taxes once again this year. Of course, before applying any of these strategies to your personal situation, consult with one of our tax professionals.
Deductible Interest. Consider making your January 2007 mortgage payment (which includes December's interest) in late December 2006, so that the mortgage interest will be deductible on your 2006 return (applicable only if you itemize deductions on your income-tax return).
Medical and Miscellaneous Itemized Expenses. Your deductions are limited to the amounts that exceed 7.5% of adjusted gross income for medical expenses and 2% of adjusted gross income for miscellaneous expenses. Bunching two years of your or your family's unreimbursed medical or miscellaneous itemized expenses (such as certain job-related expenses and investment expenses) into one year may allow you to surpass the deduction floors and help you gain an itemized deduction for part of your expenses
Charitable Contributions. If you are planning to make a charitable donation in early 2007, consider a 2006 year-end donation instead. Contributions charged on your credit card in 2006 count as 2006 deductions, even if you don't receive or pay the credit card bill until 2007.
Taxes. If you pay quarterly estimated state income taxes, consider paying your last 2006 estimate by December 31, so that the taxes will be deductible on this year's tax return. Employees who have state income taxes withheld from their pay may wish to increase the amount withheld from their remaining 2006 paychecks to cover any projected underpayment.
However, if you are a high earner facing a limitation on your itemized deductions or if you expect to be in a much higher tax bracket in 2007, accelerating these payments into 2006 may not be your best course of action. In addition, if you claim high deductions in 2006, you may be subject to the alternative minimum tax. See us for more details.
Income Deferral. Review any opportunities you may have to push taxable income into a later tax year. Deferral strategies are especially effective if you expect to be in the same or a lower tax bracket in the year in which you will be reporting the income on your tax return. Any of these strategies may help cut your 2006 taxes.
· Ask your employer to defer paying your 2006 year-end bonus until early 2007.
· Maximize 2006 contributions to any tax-deferred retirement savings plan in which you participate, such as a 401(k) plan or a 403(b) tax-sheltered annuity. If you are age 50 or older, you may be able to make additional "catch up"contributions to your plan.
· If you are self-employed and use the cash method of accounting for income-tax purposes, time late 2006 customer billings so that payment won't be received until 2007.
Self-employed business owners who do not already have a tax-deferred retirement plan should consider starting one before year-end. Options to examine include a so-called "solo 401(k)"plan, a Simplified Employee Pension (SEP) plan, or a SIMPLE plan.
Investment Strategies. If you have investments with "paper losses"and you are thinking about selling any of these poor performers before the end of the year, remember that capital losses offset the capital gains you may have realized. Any net loss is deductible against up to $3,000 of ordinary income per year.
Consider selling appreciated stock or other investments on which you have "paper gains"before year-end to absorb any capital losses that exceed $3,000. If this is not desirable, any unused capital losses may be carried forward for deduction in future years, subject to limitations.
Remember, too, that the maximum tax rate on 2006 qualifying dividends and net long-term capital gains is 15%. Ordinary income tax rates range as high as 35%.
New Strategies
Prepare for a Roth Conversion. Earlier this year, a new law removed the income limit for high earners who want to convert their traditional Individual Retirement Account to a Roth IRA. But this change isn't effective until 2010.
If the income limit applies to you and you are interested in a Roth IRA, you might want to consider making contributions to a traditional IRA now with the intent of converting that IRA to a Roth IRA in 2010. Even if you cannot make deductible IRA contributions (due to you or your spouse being an active participant in an employer-sponsored retirement plan and exceeding certain income limits), you can make nondeductible contributions to a traditional IRA now. On conversion in 2010, only the IRA earnings on the nondeductible contributions would be taxed, and any Roth IRA earnings from then on would be nontaxable (assuming tax law rules are met). See us for more details.
Charitable Gifts from IRAs. If you are age 70½ or older, you can contribute as much as $100,000 a year from your IRA directly to one or more qualified charities without paying federal income tax on the distribution. So, if you are a charitably inclined eligible taxpayer, you can benefit your favorite charity with IRA money without having to receive a taxable distribution from your IRA. This tax break is only available for 2006 and 2007.
Charitable Gifts of Clothing or Household Items. New rules apply to contributions of clothing and household items made after August 17, 2006. In general, the items must be in "good used or better"condition. However, you can still deduct the value of an item that isn't in good or better condition if the value of the donation is more than $500 and you include a qualified appraisal with your tax return.
Kiddie Tax. To minimize income shifting from parents to their young children in lower tax brackets, the tax law requires children who have more than a small amount of unearned income ($1,700 in 2006) to pay tax on that excess income at their parents' marginal tax rate. A new law increases the age of children to whom this "kiddie tax"applies. Effective for 2006, the kiddie tax applies to children under age 18 (formerly, age 14). Due to this change, higher-income parents should consider investing any assets put aside for their under-age-18 children in investments that generate little or no current taxable income (such as U.S. savings bonds, municipal bonds, or growth stock index funds).
Energy Tax Breaks. Tax credits are available for energy efficient and alternative energy home improvements. Among the items for which credits are available: energy efficient exterior windows and doors, furnaces and central air conditioning units, and solar water heaters. Also, credits are available for the purchase of certain hybrid and alternative fuel vehicles.
Uncertain Tax Breaks
As we write this, Congress is still debating extending to 2006 certain tax breaks that expired at the end of 2005. Among those breaks: the itemized deduction for state and local sales taxes, the above-the-line deduction for the teacher's out-of-pocket expenses for supplies used in the classroom, and the above-the-line deduction for higher education expenses. Be prepared in your planning if these items are not extended.
For More Details
Want to learn more about these and other strategies that might cut your 2006 tax bill? Talk to us. Our tax planning know-how can benefit you.
