Six Smart Tax Moves The rules have changed for tax filers, mostly for the better. With some savvy moves, there's a chance to significantly cut your tax bill.
(FORTUNE Magazine) – First the bad news: The hours are ticking away, and there's little you can do to lower your April 15 bill. Now the good news: The 1997 Tax Act is chock full of tax breaks for the new year--and it's the perfect time to start capitalizing on them.
Okay, so the new law offers nearly 300 changes wrapped in byzantine complexity, creating what New York City CPA Joel Isaacson calls "an accountant's and attorney's dream." If you look past that wrinkle, you'll find $152 billion in tax breaks, many of which may apply to you.
Though tax breaks abound, they won't fall into your lap. Most of the biggest benefits from the recent tax law require that you act to get your share. That's where we hope to help. With the advice of tax experts, we've highlighted key points that could mean the most to you. Here are six important steps to take now, plus a primer on the latest changes in estate taxes:
If you're sitting on big capital gains from many different sources, Schedule D may feel like the schedule of the damned. It presents a dizzying array of new rules regarding holding periods, purchase and sale dates, and tax brackets (see table). But offsetting that is the elixir of sharply lower tax rates--specifically, the drop in the maximum long-term capital gains rate from 28% to 20%. Even here there's a twist: The maximum tax rate on long-term capital gains from the sale of art, antiques, or other collectibles remains a steep 28%.
If you invest in mutual funds, you must divide the payouts from your fund, separating gains that qualify for the new, lower rate from those that will still be taxed at 28%. A few fund companies, including Vanguard and American Century, have mailed new 1099-DIV forms that include a separate column showing the dollar amount of your so-called 28% gain. Most fund companies, however, simply tell you the percentage of your long-term gains that you must report as taxable at 28%. It's up to you to do the math. One bit of advice: marshal all this data, and do the math before you take on the tax forms.
AN IRA FOR A SPOUSE
You can make a tax-deductible IRA contribution of up to $2,000 no matter how high your adjusted gross income, if you're single and not covered by an employer-sponsored retirement plan. That's also the case for married couples who lack retirement plans at work. Individuals covered by employer-sponsored retirement plans can contribute the maximum amount to a tax-deductible IRA only if their AGI falls below $25,000 ($40,000 for married couples filing jointly).
If your income is too high for a tax-deductible IRA and your spouse earns little or no income, consider a spousal IRA. Under the old rules your spouse couldn't make a tax-deductible IRA contribution if you participated in a pension plan. If you enjoy an employer-sponsored retirement plan but your spouse doesn't, you can now deduct a contribution of up to $2,000 as long as your combined AGI is under $150,000. The deduction phases out for couples with AGIs of $150,000 to $160,000.
THE ROTH IRA
Senate Finance Committee Chairman William V. Roth's new baby is a boon to bigger earners who can't contribute to tax-deductible IRAs. You can sock away up to $2,000 a year in a Roth if you're married and have a combined AGI below $150,000 ($95,000 for single filers). Phaseout ranges for partial contributions are $150,000 to $160,000 for married couples and $95,000 to $110,000 for single filers. If you earn too much to contribute to a Roth, other members of your family may still be able to profit from them. If your children or grandchildren have earned income and are eligible to open Roths, encourage them to do so by giving them gifts to replace the cash they contribute to their accounts.
As with a traditional nondeductible IRA, contributions to a Roth aren't tax-deductible, but your investment in the account grows tax-free. That's where the resemblance ends, however. You'll pay taxes on the earnings you eventually withdraw from a nondeductible, traditional IRA. Withdrawals from a Roth, however, are tax-free--if you make them after age 59 1/2 and after you've held your account at least five years. You can also withdraw up to $10,000 tax-free at any age after the five-year holding period--if you use the cash for expenses related to the purchase of a first home for you, your spouse, or any of your children, grandchildren, or ancestors.
Roths boast a couple of other very attractive features. You can keep contributing to one after age 70 1/2 but not to traditional IRAs. In addition, you don't have to make withdrawals from a Roth during your lifetime, as you must starting at age 70 1/2 with a traditional IRA. "That makes the Roth an excellent estate-planning tool," says attorney Steven Lockwood of Lockwood Pension Services in New York City. "You can bequeath your Roth to your children or grandchildren and pass a tax-free lifetime annuity to a second generation."
The Roth IRA is so appealing, you might consider switching your regular IRA to a Roth. To qualify for a conversion, you'll need to have an AGI of $100,000 or less, no matter whether you're single or married and filing jointly. (Couples can't file separately to push their AGIs below $100,000.) And, of course, you'll have to pay tax on the money withdrawn from your IRA before it can go into the Roth account, but you can spread the tax over four years if you convert in 1998.
In general, the longer you have until retirement, the higher your tax bracket in retirement, and the higher your expected rate of return, the better off you'll be switching from a traditional IRA to a Roth.
If you plan to start taking distributions from your retirement accounts soon or expect to land in a much lower tax bracket after you call it quits, a Roth's advantages will decline or might even disappear. You can crunch your own numbers using various IRA calculators available on mutual fund companies' Websites or with T. Rowe Price's $9.95 IRA Analyzer software.
A $500,000 TAX BREAK
The old tax law encouraged home sellers to continually trade up to more expensive houses. Under that law you could defer the gain on the sale of a principal residence if you spent the sale proceeds on a replacement house within two years. There was also a once-in-a-lifetime $125,000 exclusion on the sale of a principal residence, but only taxpayers age 55 and older could take it.
The new law, which takes effect for sales after May 6, 1997, allows you to exclude up to $250,000 of any gain that you realize. Married taxpayers jointly can shield up to $500,000. You can use this new exclusion once every two years if you've owned and occupied a home as your principal residence for at least two of the five years prior to its sale. (Interestingly, a home you own can qualify as your principal residence even if a separation or divorce forced you out.)
How best to cash in on this generous tax break? "If your kids have grown up and left home, this is probably a good time to consider trading down to a house that's more in line with your current lifestyle," advises John Gardner, a senior manager in KPMG Peat Marwick's Washington national tax office.
Even corporate gypsies get a bit of a break. You can claim a prorated portion of the exclusion if you fail to meet the two-year residence requirement because of a job transfer.
Tax attorney Alan Zipp brings up another point: If you qualified for the old $125,000 exclusion in the past but didn't use it because you realized a modest gain on your home sale and expected to make a bigger profit on a future home sale, you may qualify for a refund of the taxes you paid. File an amended return if you've paid tax on a home sale within the past three years.
TAX BREAKS FOR EDUCATION
Starting this year you can contribute up to $500 annually to an Education IRA for a child (or grandchild) under age 18. The $500 is in addition to the $2,000 annual limit on contributions you can make to your own IRAs. While contributions to Education IRAs aren't tax deductible, they do grow tax-free. Withdrawals also escape tax as long as the child uses them by age 30 to pay higher-education expenses.
Eligibility to fund an Education IRA phases out for singles with AGIs of $95,000 to $110,000 and for married couples filing jointly with AGIs of $150,000 to $160,000. You can get around those limits, however, simply by giving your kids the cash to open their own accounts.
If the thought of putting away a relatively paltry $500 a year per child doesn't get your blood rushing, look at the bright side. "Sure, it's not going to pay for college," says KPMG's Gardner. "But anytime you can save on a tax-deferred basis, you should do it." Be careful where you invest, however. Many mutual fund companies and brokerage houses charge annual maintenance fees for Education IRAs. If a $500 Education IRA earns 10% or $50 a year, for example, a $15 fee will devour 30% of its return.
NEW HOME-OFFICE RULES
The new tax law clarifies who can deduct operating and depreciation expenses associated with home offices. Starting next year a home office will qualify as a principal place of business if it's used regularly and exclusively to administer or manage your business and if there's no other fixed location where you perform substantial administrative activities. That is a big improvement over the old rules, which required that your home office be your primary place of business in order to qualify for deductions. So now, if you run a business from one location but administer it from your den, that room qualifies as your home office. Since the law requires that your home office be used exclusively for business, Tom Jackson, a partner with Deloitte & Touche in Chicago, suggests some new house rules to save you from trouble with the IRS: "Take your kids' Nintendo off the TV in your den and put it on another set in some other room."
INSIDE: Heirs get new tax breaks, page 178... Why should bond investors pay taxes? page 180... Stock picking made easy, page 182... Retirement software gets real, page 184