Tax Planning for Individuals and Families

The income tax owed by individuals is calculated as follows:

To reduce the total tax bill (i.e. the bottom line result of the above equation), one must do one or more of the following:

• Reduce total income as calculated by the IRS (line 1 above)
• Increase deductions (line 2 above)
• Increase itemized deductions (line 4 above)
• Increase tax credits (line 6 above)

Step 1: Reduce Total Income

One way to reduce your tax bill is to lower the amount of income that is subject to taxation. This notion may seem counterintuitive at first, but there are things that can be done to obtain income or income-like benefits that fall outside of the IRS's definition of income. Here are some ideas:

Defer Income If delaying income to next year would result in a lower tax rate, or if you simply want to delay the payment of tax to obtain the use of the money for another year, consider ways to delay the receipt of the income. Watch out, however, for the strict rules that govern when income is earned, referred to as a "constructive receipt".

Increase Non-Taxable Income Certain state and local bonds offer a yield that is free of federal tax and, if you live in the state or locality from which they were issued, free of state and local tax. U.S. Treasury bills, notes and bonds yield interest income that is exempt from state and local taxes. In addition, the tax benefit of these investments increase in value as your marginal tax rate rises.

Utilize Capital Losses Capital losses, such as losses in investments in publicly traded stocks, may be used to offset capital gains dollar-for-dollar up to the amount of any gains realized on other investments. In addition, a limited amount of capital losses that exceed capital gains may be used as a deduction against ordinary income.

Select Investments that Generate Little or No Income An alternative to current income is future income. Most publicly traded stocks pay few if any dividends and offer the potential for capital appreciation. Capital gains are not taxed until they are realized (sold). Some bonds may offer some deferral of income as well.

Move Money to Tax Sheltered Accounts Income generated on investments held in retirement accounts such as IRA and 401(k) is not taxable. In many cases, the contribution amounts may be deductible as well.

Home Sale Exclusion Home sales offer a tremendous opportunity for tax-free income. With the new laws, you don't have to reinvest the money and you can claim the exclusion every two years!

Step 2: Increase regular Deductions

The second step in lowering individual taxes is to maximize the allowable "regular" deductions. These deductions should not be confused with itemized deductions which appear on schedule A. These "regular" deductions can be made whether or not you itemize. In addition, don't confuse the term deductions with exemptions. Exemptions are a completely different type of deduction and are independent of the decision of whether to itemize or not. Below is a list of the allowable "regular" deductions:

Retirement Account Contributions If you are not covered by a retirement plan at work, or if you are but earn less than the phase out amount, you may contribute up to $4,000 for the tax year 2005 (to be contributed by April 15, 2006) and deduct the entire amount. Earnings within the account also accrue tax-free.

Student Loan Interest If you paid interest on a student loan you may be eligible to deduct some or all of it, whether the loan was for your own education, your spouse's, or that of a child or anyone else who was your dependent at the time the education was undertaken.

Medical/Health Savings Accounts Individuals who are self employed or who participate in a health insurance plan of an employer that averaged no more than 50 employees during the two preceding years may create a deductible Archer MSA or HSA account. Such accounts may be used as a vehicle for deducting from taxes a portion of the funds that go towards meeting the medical expense deductible of an insurance plan.

Health Insurance Payments If you are self-employed and pay medical insurance premiums for you and your family, you may be able to deduct 100 percent of the premium cost. If you choose to itemize, you can also deduct any amount not deducted here along with other unreimbursed medical costs ... subject to the 7.5 percent of AGI limitation.

Moving Expenses To qualify, your new place of employment must be at least 50 miles farther from your old residence than your former job was from your old residence. There are also stipulations for how long you were employed at your old employer and how long you remain employed at your new employer. Consult your tax advisor.

Alimony Payments A tax-deductible expense to the payer in the year that the expense is paid. Alimony payments are considered taxable income to the payee in the year that such payments are received.

Education Expenses Up to $4,000 may be deducted for "qualified education expenses" for post-high school academic or vocational courses.

Step 3: Increase Itemized Deductions

Every taxpayer may take the standard deduction, $5,000 in 2005. However, if your itemized deductions total a higher number you will want to itemize and use the higher number. The only way to find out is to go through the exercise. In some cases, however, you don't have a choice. For example, if your filing status is married filing separate and your spouse itemizes, then you must also itemize. Some itemized deductions can only be taken if they exceed certain levels. Miscellaneous itemized deductions such as tax preparation fees, employee expenses and investment costs can be taken only if they exceed 2 percent of your AGI. If your itemized deductions in any given year don't exceed the standard deduction, consider trying to combine payment of these types of expenses into one year so you can exceed the limit and take the deduction every-other-year.

Home Mortgage Interest, Points and Investment Interest Home mortgage and investment interest are the only types of interest expense that are deductible for individuals. The IRS definition of "home," referred to as a "qualified residence," can include condominiums, cooperatives, mobile homes, boats, recreational vehicles and time-share units. The home must simply have basic living and sleeping accommodations. Interest incurred on debt associated with the ownership of a second residence may be deductible as well. Investment interest expense is only deductible to the extent of net investment income. Points paid on a primary residence may be deducted either in the year paid or over the life of the loan. Points paid for a second residence must be amortized over the life of the loan.

State and Local Taxes, Real Estate Taxes and Personal Property Tax Subject to phase out for high-income individuals, state, local, personal and real property tax costs may be deducted in the year they are paid. Individuals should consider the timing of actual payment of such taxes in light of marginal tax rates.

Charitable Contributions Donating to a worthy cause not only does good but it can reduce your taxable income. Empty your closets of old clothes, furniture and the like and donate them to a charity. Remember to get a receipt and figure out the fair market value of the goods you donate. If you're audited, no receipt means no deduction. Also, a powerful way to reduce taxes and maximize deductions is to donate appreciated assets. Doing so will save you from owing tax on the capital gain and you will still be able to deduct the full, appreciated value of the stock.

Unreimbursed Health, Medical and Dental Expenses If you own a company but don't offer a health insurance plan, consider adding one. As long as the plan has a rational basis for any discrimination (i.e. excluding any employees), then your company can deduct the expense and you and your dependents may be able to receive the benefits tax-free or on a tax-advantaged basis.

Casualty, Theft or Disaster Loss If you suffer from a loss of property due to theft or a sudden, unexpected or unusual event, you may be able to claim a loss equal to the lesser of your adjusted basis or fair market value, net of any reimbursement from an insurance company. If you suffer loss to personal or business property resulting from a disaster occurring in an area that has been designated a disaster area entitled to federal assistance, you have the added option to deduct the loss on the prior year's tax return, which serves to accelerate the benefit.

Education Expenses and Miscellaneous Deductions To the extent that education expenses are not available for a regular deduction or credit, they may be deductible as an itemized expense if required by your employer. Deductible miscellaneous expenses are mostly related to expenses incurred in the pursuit of taxable income such as legal fees, investment fees, uniforms, professional subscriptions, job search costs, union dues, professional association membership and unreimbursed expenses incurred on the job.

Step 4: Increase Tax Credits

Tax credits are dollar for dollar reductions to your tax bill. Deductions are dollar for dollar reductions of your taxable income. There is a big difference. Tax credits are much more valuable than deductions because a $100 credit reduces your tax bill by $100, regardless of your tax bracket. In contrast, a $100 deduction simply reduces your taxable income by $100 and your tax bill by $25 (if you are in the 25% percent tax bracket). Use this list as you begin to assess the credits that might be available to you.

Child Tax Credit Every individual or family qualifies for a credit for each dependent child, stepchild, grandchild or foster child under the age of 17.

Adoption Tax Credit Adoption expenses not reimbursed by your employer may be deducted, up to certain limits.

Dependent Care Expense Credit If you incur child care expenses so you or, if married, you and your spouse can go to work, you may be able to deduct 20 percent of the expense.

Elderly and Disabled A credit is available to certain low-income individuals 65 years of age or older, and to individuals under age 65 if they are retired with a permanent and total disability and have taxable disability income from a public or private employer. The income limits are low.

Elective Contributions to Retirement Plans Low-income earners may take as a tax credit up to 50 percent of elective contributions to an employer sponsored retirement plan or IRA. Phase-out provisions begin at low income levels.

Hope Scholarship Credit If you, your spouse or a dependent was enrolled at least half-time in the first or second year of college, you may be able to deduct qualified expenses incurred.

Lifetime Learning Credit For those who already have two years of college and can't qualify for the Hope credit, the Lifetime Learning Credit provides a smaller tax benefit for an unlimited number of years in which you take postsecondary educational courses. You can claim the credit for yourself, your spouse if filing jointly, and for any dependents for whom you claim an exemption on your tax return.

Social Security Tax If you changed jobs in 2005 and expect to gross more than $90,000, you may have paid too much social security tax. You're liable for social security tax only on the $90,000, but both employers are required to pay their shares. If you paid too much, you can get it back with a tax credit against your income tax liability.