Act Now to Reduce 2010 Income Taxes
April 12, 2010
Did you just spend all weekend working on your 2009 income tax returns instead of enjoying the beautiful outdoors? I can’t help your procrastination, but I can provide a few tips for reducing your 2010 tax bill.
Do you feel like you are paying too much income tax? The answer is "yes" by most people's standard. But are you doing everything you can to reduce your tax bill? Here are three easy strategies that you can implement today.
With the tax filing deadline upon us, it is too late to change 2009, but you can impact your tax bill for 2010. By choosing the right savings vehicle and paying attention to changing investment values, you can minimize your income tax liability for this year.
You are paying too much tax if…..
1. You are not maximizing your pre-tax contributions to your retirement plan.
Example: Stephanie was saving $1,000 per month by transferring funds to a mutual fund account directly from her payroll. However, she was contributing only $4,000 per year to her 401(k) plan. Stephanie can contribute up to $16,500 to her employer’s retirement plan this year ($22,000 for anyone over age 50). Since Stephanie’s marginal federal tax bracket is 28%, by shifting her monthly contribution from her mutual fund savings account to her 401(k), she can save $3,360 on her 2010 federal taxes and $600 on her state taxes (assuming a 5% state/local tax). Total tax saving of $3,960! This doesn’t include the benefit of the tax deferred earnings inside the 401(k) account.
Action: Check to see if you are scheduled to maximize your contributions to a 401(k), 403(b), or other defined contribution plan provided by your employer. If not, make the appropriate adjustment in your paycheck contributions. If you are self-employed, there are several types of retirement plans available for your use. Discuss the appropriate type with your financial advisor or tax accountant.
2. You are holding investments waiting for the price to increase instead of taking the loss.
Example: Several years ago, Rob purchased units of a stock mutual fund for a total investment of $10,000. The value today is $6,000. He has a loss of $4,000 in this investment. Rob should sell this mutual fund and recognize the loss. By reinvesting the proceeds in a similar stock mutual fund, he can maintain the appropriate allocation and diversification in his portfolio. The $4,000 loss can be used to offset any gain realized during the year. If Rob does not have realized gain to offset all the loss, he can reduce his ordinary income with up to $3,000 of realized loss each year. Any loss not used to offset gain or ordinary income can be carried over to the next year. Reducing his ordinary income by $3,000 will save Rob $990 at his marginal federal rate of 33% plus an additional state/local savings of $150. Total tax saving of $1,140!
Action: Review your portfolio frequently throughout the year for potential opportunities to create a loss without hindering your overall investment plan. Reinvesting proceeds must be done carefully to not violate the IRS rules. Stocks are more complicated, but with mutual funds, you can immediately reinvest the proceeds in a similar, but not the same, mutual fund.
3. You are not using a 529 Plan to save for college.
Example: Cheryl and Tim have a newborn daughter. They set up an investment account, named it "College Savings", and begin to contribute monthly. The earnings on the account are taxed each year. As more money is contributed to the "College Savings" account, the annual tax bit gets bigger. Cheryl and Tim can eliminate the tax by opening a 529 Plan. Since the funds will be used for paying qualified college expenses for their daughter, there is no taxation of the earnings. By simply using the appropriate savings vehicle, the earnings went from being taxed each year to tax-free. A simple calculation can determine the amount of tax savings by using the 529 Plan instead of a regular investment account. If we assume a monthly contribution of $500 for 18 years, a marginal tax rate of 33% (28% federal plus 5% state/local), and an average taxable return of 6%, the tax savings over the eighteen years will exceed $35,000! By using the correct savings vehicle, Cheryl and Tim will have more funds for their daughter’s college.
In addition, as a resident of Indiana, you receive a state tax credit when you make a contribution to the Indiana 529 Plan. The tax credit is 20% of your contributions up to $5,000 each year. If Cheryl and Tim continue to contribute $500 per month, they will receive the maximum tax credit of $1,000 on their Indiana tax return. More tax savings!
Action: The 529 plans are specifically designed as college saving vehicles. If you are saving money for this specific purpose, focus your savings on the correct vehicle that can save you taxes and increase your accumulation.
Summary
These are three quick examples of ways you can save taxes by utilizing the correct savings vehicles and by paying attention to your investments. It is your right as a taxpayer to minimize your taxes. It is your personal responsibility to take advantage of the opportunities.
