Top 10 Year-End Tax Tips
I keep hearing that I should do something or other to improve my tax situation before the year ends. Is there really anything I can do at this point?
Absolutely. Whether you are flying high with savvy investments, rebounding from recent losses, or still struggling to get off the ground, you may be able to save a bundle on your taxes if you make the right moves before the end of the year. But be careful. Some easy-to-follow advice that you read in the papers, hear on TV or read on the Internet can backfire.

Before you do anything, consider making income tax projections for this year and next (at least). If your situation is complicated enough, you will need a software program or help from your tax advisor. Once you have the numbers, however, you can see how any actions you take will affect your tax bill each year. With that information in hand, these tips can help you hang onto your cash.

1. Defer Income

The theory here is simple: Income you don't receive until after midnight on New Year's Eve isn't taxed until the following year. Even if you'll be in the same tax bracket, you win by putting off the tax bill. It's tough for employees to postpone wage and salary income. You can't ask your employer to hold your December pay until January; nor do you push income into the next year by not cashing your check until then. Income is taxable in the year it is "constructively received." Basically, that means the year you could have had the money if you wanted it. Say, for example, that in December your boss offers you a choice of receiving a Christmas bonus in December or January. Regardless of which you choose, the IRS will expect you to report and pay tax on the income with your return for the year the offer was made. If standard practice in your company is to pay year-end bonuses the following year, however, the income would be taxed in the year you get the check.

If you are self-employed or do free-lance or consulting work, you have more leeway. Delaying billings until late December, for example, can assure that you won't receive payment until the next year. If you are pressing for payment on an overdue account, it might make sense to give your client a breather. If you own rental property, you may want to be generous and suggest to your tenants you wouldn't mind if the December rent check didn't arrive until January. Business considerations certainly come first. But if it's unlikely you have anything to lose by holding off on collections, doing so can push some taxable income — and the tax bill on it — into the following year.

Of course, it only makes sense to defer income if you think you will be in the same or lower tax bracket next year. You don't want to be hit with a bigger tax bill next year if an extra chunk of income could push you into a higher income tax bracket. If that's likely, in fact, you may want to accelerate income into 2006 so you can pay tax on it in a lower bracket sooner than in a higher bracket later.

2. Exploit Last-Minute Deductions

Contributing to charity is a noble way to get a deduction. And you control the timing. Sometimes, though, it's best to put away your checkbook. You can supercharge the tax benefits of your generosity by donating appreciated stock or property rather than cash. As long as you've owned the asset for more than one year, you get to deduct the market value on the date of the gift and you avoid forever paying capital gains tax on the appreciation that occurred while you owned the asset. The charity you're interested in helping can help you with the details.

Note this change in the rules for charitable contributions that arrives in 2007: Current law requires that you have a receipt to substantiate any charitable contribution deduction of $250 or more. As of January 1, 2007, you must have either a receipt or a canceled check to back up any contribution, regardless of the amount. If you don't have such a written record, the IRS will reject the write-off if the lack of proper record keeping is discovered in an audit.

Accelerating payment of deductible expenses due in January can pull the write-offs into 2006. This could apply to an estimated state income tax bill due January 15, for example, or a property tax bill due early in the next year. Or a doctors or hospital bill. (But speeding up deductions could be a blunder if you're subject to the Alternative Minimum Tax, as discussed below.)

Before you go into high gear racking up deductions, make sure you'll be itemizing for 2006 rather than claiming the standard deduction. Unless the total of your qualifying expenses exceeds $5,150 if single or $10,300 if you're married and will file a joint return, itemizing would be a mistake. If you are on the itemize-or-not borderline, your year-end strategy should focus on bunching. This is the practice of timing expenses to produce lean and fat years. In one year, you cram in as many deductible expenses as possible, using the tactics outlined above. The goal is to surpass the standard-deduction amount and claim a larger write-off. In alternating years, you skimp on deductible expenses to hold them below the standard deduction amount - because you get credit for the full standard deduction regardless of how much you actually spend. In the lean years, year-end plans stress pushing as many deductible expenses as possible into the following fat year when they'll have some value.

3. Beware of the Alternative Minimum Tax

Sometimes accelerating deductions can cost you money… if you're already the alternative minimum tax (AMT) or you inadvertently trigger it. Originally designed to make sure wealthy people could not use legal deductions and congressionally created loopholes to drive their tax bill to zero, or close to it, the AMT is now increasingly affecting the middle class.

And that can be a particular problem for people who are not used to figuring out sticky tax issues.

The AMT is figured separately from your regular tax liability — with different rules — and you have to pay whichever tax bill is higher:
This is a year-end issue because certain expenses that are deductible under the regular rules — and therefore it might make sense to accelerate payments — are not deductible in AMT-land. State and local income taxes and property taxes, for example, are not deductible when figuring the AMT. Also, while medical expenses that exceed 7.5% of your adjusted gross income can be deducted under the regular rules, the threshold is 10% for the AMT. Interest on up to $100,000 of home-equity loan debt is deductible under the regular rules, no matter how you use the money – so you want to be sure you're up to date paying that interest. But under the AMT, home-equity loan interest is only deductible if the money was used to buy or improve your primary or second home.

In recent years, lots of taxpayers fell into the claws of the AMT because of the AMT's special treatment of incentive stock options. Sometimes, though, selling stock acquired via options before the end of the year can get you out of AMT-land.

4. Sell Loser Stocks to Offset Gains

Your portfolio cries out for special attention as the year draws to an end. Since it's up to you when to sell securities – and convert paper gains and losses to real ones – you can mix and match your trades to deliver the tax outcome you desire.

Begin with an outline of exactly where you stand. Draw up a list of your trades so far and the gains or losses on each. Make another list showing your current holdings and the paper gain or loss to date. In other words, if you sold the securities today, what would your profit or loss be? Because the tax law treats different kinds of gains differently, you need to segregate your long-term (for securities owned more than one year) and short-term sales (for securities owned one year or less) so far this year and your open positions that would produce each kind of gain or loss.

A strategy for net gain

If your trades so far in 2006 have resulted in a net gain, take a hard look at the securities in your portfolio that show paper losses. Maybe now is the time to unload some of those stocks, using the loss to sop up the gain on other deals and pull down your tax bill. It's not a cockamamie idea to realize losses to save on taxes. After all, you suffered the loss when the securities fell in value. Selling just makes it official . . . and makes the IRS pick up part of the loss. What if you have a net short-term gain, which will be taxed at your top tax bracket? Taking any kind of loss – short- or long-term – can offset that gain dollar for dollar. And, although long-term gains get gentle tax treatment, net losses from either category can be deducted in full against other income such as your salary, up to a $3,000 annual maximum write-off.

A strategy for net loss

On the other hand, if your sales so far have produced a net loss, perhaps you should go in for some year-end profit-taking. Only $3,000 of net losses a year can be used to offset income other than capital gains, so if you have a bigger loss, you have an incentive to cash in some of your other profits. Because the loss will offset additional gain dollar for dollar, you can add to your income without adding to your tax bill.
Of course you don't let the "tax tail wag the investment dog," by allowing the search for tax savings to lead you into bad investment decisions. Your investment goals must be paramount. But if a particular investment is on the sell-or-hold borderline, perhaps the tax consequences can be decisive.

Last-minute sales

Since it takes several days to settle a trade — between the time you order the sale to the time you get your money — sales during the last few days of the year often straddle year-end. As far as the IRS is concerned, a gain or loss should be reported on the return for the year the trade occurs, regardless of when settlement takes place. That means profits and losses taken as late as the closing bell on New Year's Eve go on the current year's return.

5. Do a Bond Swap

The point of this year-end maneuver is to lock in a tax loss by selling bonds that have fallen in value (usually because market interest rates have risen) and reinvesting the proceeds in other bonds. Done right, you can maintain the income stream from your bonds. Consider this example: Assume you own $100,000 worth of AA-rated bonds with a 6% coupon and a maturity date in 2016. In November, as you begin your year-end planning, the market price of your bonds has slipped to $84,750. If you sell at that price, you'll have a $15,250 loss. At the same time, assume you can buy $100,000 face value of AAA-rated bonds, with a 7% coupon and a 2015 maturity, for $83,612.
If you sell one set of bonds and buy the other, look what happens: Since they have the same par value and coupon rate, your annual income remains the same: $7,000. Your bond rating increases from AA to AAA. You pull $1,138 out of the investment – the difference between what you got for the old bonds and what you paid for the new ones. And you can claim a $15,250 tax loss. If it offsets gains that otherwise would have been taxed at 20%, you save $3,050.

As with much year-end tax planning, the earlier you begin scouting for promising candidates for swapping, the better. The supply dwindles and competition from other investors heats up as the year draws to an end.

6. Don't Buy a Tax Bill

Mutual funds often pay out most of their capital gains and dividends in December. Don't think you're getting a windfall if you buy just before then. It's a tax mistake. When interest, dividends and profits are paid out, share values fall by the same amount. But the payout is taxable; you're better off buying after the distribution – you get your shares at the lower price and avoid the tax bill on what is essentially a rebate of part of your purchase price. Before you invest, call the fund to ask for the ex-dividend date – and buy after that day.

If you plan to sell shares around year-end, it usually makes sense to do so before the ex-dividend date. When you sell, any accumulated dividends and capital gains are included in the share price and therefore are considered part of your profit. If you've owned the shares more than 12 months, you get 15% long-term capital-gains treatment. When the fund pays out the dividends, the share price drops… and so does your taxable profit when you sell. But the 15% gains are replaced dollar for dollar by the income distribution – part of which could be taxed in your top bracket, as high as 35%.

7. Contribute the Maximum to Retirement Accounts

There may be no better investment than tax-deferred retirement accounts. They can grow to a substantial sum because they compound over time free of taxes. Company-sponsored 401(k) plans may be the best deal because employers often match contributions.

Bump up your 401(k) contribution so that you are putting in the maximum amount of money allowed ($15,000 for 2006 and $15,500 for 2007, so start early). If you think you can't afford it, run the numbers. If you have a traditional 401(k), the fact that pre-tax money goes into your account means your savings go up more than your take-home pay goes down. If you're in the 25% federal tax bracket, for example, stashing an extra $1,000 in your 401(k) cuts take-home pay by just $750, and even less if you live in a state with a state income tax. If your firm offers the new Roth 401(k) option, an extra $1,000 into the account really cost you $1,000 now (because after-tax money goes into a Roth 401(k), but the fact that withdrawals in retirement will be tax free could make this the better home for your increased contributions.

If you are 50 or older by the end of the year, you are eligible to make "catch up" contributions to your 401(k) plan, if your employer's plan allows this provision. If you qualify for the "catch up" contributions, you can contribute an extra $5,000 to your 401(k) plan in 2005 (for a total of $18,000) and an extra $5,000 to your 401(k) plan for both 2006 and 2007.

If you're lucky enough to get a year-end bonus, you can steer part of it to your 401(k), if you haven't already maxed out.

Also consider contributing to an IRA for yourself and your spouse. You have until April 16, 2007, to make IRA contributions for 2006, but the sooner you get your money into the tax-shelter, the sooner it earns tax-deferred (in a traditional IRA) or tax-free (in a Roth version) returns. The basic contribution for IRAs (either traditional or Roth or a combination of the two) for 2006 and 2007 is $4,000, but those 50 and older by year end can contribute up to $5,000 each year.

Self-employed people should set up Keogh plans by December 31. Once the plan is in place, you can contribute up to $44,000 until the tax filing deadline (including extensions) for your 2006 return. (The limit goes to $45,000 in 2007.) Every dime you contribute can be deducted on your return to cut your tax bill for 2006.

8. Give Money Away

You can give away as much as $12,000 a year to any number of people without triggering the federal gift tax. The tax-free amount doubles to $24,000 if your spouse joins you in making the gift. You don't get an income tax deduction for such gifts unless the object of your generosity is a qualified charitable organization (and in that case, the $12000 limit doesn't apply). But there's an important advantage: Assets given away during your life – and any future appreciation – won't be in your estate to be taxed after you die. And income generated by the gift is taxed to the new owner, not to you. (If you give assets to your own children, however, the income can be taxed in your tax bracket until the children reach age 18.)

This issue is raised here, among possible year-end maneuvers, because if you're planning to make substantial gifts, you face a December 31 deadline. If you don't use your $12,000 annual exclusion by that date, you lose it. Each new year presents you with a new exclusion, but you can't reach back to benefit from a previous year's unused allowance.

Assume, for example, that a couple plans to give $48,000 to their son. If they give it all during one year, $24,000 of the gift would be sheltered from the gift tax, the other $24,000 subject to it. However, if half the gift was given in December and the other half in January, the full $48,000 would be protected.

If you make the gift by check, be sure the recipient cashes the December check before the end of the year. Unlike the rules for itemized deductions (which allow a deduction for the year you give the check regardless of when it is cashed) when a gift is involved, it is considered given in the year the check is cashed.

9. Check IRA Distributions

If you have reached age 70-1/2 (or if your parents have, remember that the law demands that payouts must be made from traditional IRAs after the owner reaches that age. Failing to take out enough triggers one of the most draconian of all IRS penalties: The government will relieve you of 50 percent of the amount that should have come out of the account but did not. How much you need to withdraw is based on your age, your life expectancy and the amount in the account at the beginning of the year.

If you make a withdrawal at year end, consider asking your IRA sponsor to withhold tax from the payment. Withholding is voluntary, and you set the amount, but opting for withholding could let you avoid the hassle of making quarterly estimated tax payments.

Note this: One of the advantages of Roth IRAs is that the original owner is never required to withdraw money from the accounts. The required minimum distributions apply to traditional IRAs.

10. Check up on Your Flexible Spending Accounts

Flex plans are fringe benefits offered by many companies that let employees steer part of their pay into a special account which they can then tap to pay child-care or medical bills. The advantage is that money that goes into the account avoids both income and social security taxes. By avoiding a 25% federal income tax bracket plus the 7.65% social security tax, $1,000 funneled through a flex plan can pay bills it would take $1,554 of pre-tax salary to pay. The catch is the notorious "use it or lose it" rule. You have to decide at the beginning of the year how much to contribute to the plan and if you don't use it all by the end of the year, you forfeit the excess.

That rule used to create a stampede to drug stores and dentists and optometrists each December as employees with money to spend rushed to use it before it disappeared. Now, however, the IRS allows companies to build in a two and one half month grace period. That allows employees to spend 2006 set-aside money, for example, as late as March 15, 2007. But you get this break only if your company has adopted the grace period. Make sure you understand your firm's rules and, if you've got leftover money that has to be spent by December 31, get crackin'.

Another important year-end point about flex plans. If this is open season at your company — when you must decide how much to set aside for 2007 — be aggressive. This is a very powerful tax-saver . . . so powerful, in fact, that you can forfeit 25% or more of the money and still come out ahead. You don't want to forfeit a dime, of course, so don't go overboard. But don't cheat yourself by being unduly afraid of the use-it-or-lose-it rule.