Take Steps Now to Lower 2006-2007 Taxes, CCH Says
(RIVERWOODS, ILL., October 16, 2006) – Congress has presented taxpayers with a mixed bag when it comes to tax planning for this year, according to CCH, a Wolters Kluwer business and a leading provider of tax information, software and services (CCHGroup.com). There are new opportunities to reduce taxes, but also new tax traps – and new uncertainties as Congress has yet to act on several expired tax benefits.
“There are many things the average person can do to lower this year’s taxes,” said Mark Luscombe, JD, CPA, CCH principal federal tax analyst. “But many people will have to keep an eye on Washington to see how their returns will be affected.”
Although nine months of 2006 are history, Congress has yet to act on tax breaks that expired at the beginning of the year. It was widely assumed that the deduction for state sales taxes and a deduction for teachers who buy their own classroom supplies would be renewed for 2006. But these measures – and several expired provisions affecting businesses – are still not part of this year’s tax law.
“It’s getting to the point where, even if Congress extends the provisions, the IRS may not be able to put the appropriate lines on the 2006 tax forms,” Luscombe noted. “That will mean confusion at the very least, and may mean that some taxpayers will not know how to take legitimate deductions.”
The deduction for state sales tax has the biggest impact for taxpayers who itemize and who live in states without a state income tax.
“Until Congress acts, or definitively refuses to act, some of these people will not know whether they can itemize or not in 2006, or what tax bracket they might fall in, and those are pretty basic questions that have to be answered for effective tax planning,” Luscombe noted.
Know Your Bracket
Tax planning begins with such simple things as knowing your tax bracket – the percentage at which your top dollar of income will be taxed. Brackets currently range from 10 to 35 percent. The income levels at which the brackets begin and end are adjusted annually for inflation.
As a general rule, it’s better for anyone to pay a tax later than sooner, but in addition, people in higher brackets benefit from the annual indexing of the brackets and other items for inflation, so more of their income will be taxed at lower rates in 2007 than in 2006.
If you’re an employee and are usually paid a year-end bonus, you may be able to make arrangements with your employer to have the bonus paid in and credited to 2007 rather than 2006. If you run your own small business and bill your clients, you might be able to defer income simply by not billing until next year.
Retirees may have an opportunity to lessen their taxes by carefully planning how they take large distributions from IRAs – for example, a distribution to buy a retirement home or pay off credit card debt.
“By splitting up a large distribution and taking part in December and part in January, you may avoid moving to a higher tax bracket in either year, and keep more of your Social Security benefits from being taxed as well,” Luscombe observed.
Making the Most of Deductions
You can exercise control over the timing of deductions, as well as income. If you have a property tax bill for 2006 that’s due in January, you can pay it in December to clinch a deduction on your 2006 return. Similar opportunities may exist with scheduling elective medical procedures or making a charitable contribution.
The question is whether accelerating deductions into the current year is always the best strategy. Sometimes it is and sometimes it isn’t.
“If your itemized deductions are close to the size of your standard deduction, you’re often better off ‘bunching’ deductions in alternate years. That can give you a significant amount of itemized deductions in, say, odd years while you take advantage of the standard deduction in even years,” Luscombe observed.
Another case in which it’s best to be careful with deductions is for people who may be subject to the alternative minimum tax, or AMT. In the topsy-turvy world of the AMT, some items that are deducted in figuring your regular tax are added back in to figure a tentative “alternative” minimum tax. If the alternative minimum tax is larger than your regular tax, you pay it instead.
“If your regular tax and alternative minimum tax are fairly close together, you’re probably better off not bunching deductions, but trying to smooth out the ones that can trigger AMT liability from year to year,” Luscombe suggested.
On 2006 tax returns, the effect of the phaseouts of itemized deductions and exemptions will begin to diminish. Taxpayers will experience only one-third the loss of itemized deductions and personal exemptions that they otherwise would.
“This means less of their income will be taxed and their deductions will count for more,” Luscombe noted.
Save Energy, Trim Taxes
As a result of last year’s energy legislation, you can save energy and trim this year’s tax bill, too. A number of energy-saving improvements to your home can earn you up to $500 in tax credits – and up to a $2,000 credit for major solar systems such as photovoltaics or a solar-powered hot water system. Credits are also available when you purchase a hybrid vehicle.
“You don’t have to itemize to take advantage of a tax credit, since a credit directly reduces your tax bill,” noted Luscombe.
Just which purchases qualify for how much credit is complicated, though. In most cases, taxpayers must rely on manufacturers to certify that their products meet the energy-saving standards that qualify them for the credit. Time is a factor in determining the credits, as well. Many types of home energy-saving improvements only qualify for the credits during 2006 and 2007. A hybrid car qualifies for a full credit only until the manufacturer has sold 60,000 qualifying vehicles – then the credit phases out. On October 1, the credits for Toyota Prius, Highlander and Camry hybrids plus the Lexus hybrid were cut in half. They will be cut in half again next April 1 and will disappear completely on October 1, 2007.
Retiree, Health Plans Can Lower Next Year’s Taxes
The closing months of the year are often “open enrollment” periods for employee benefit plans that can reduce your taxes for next year, if not this one.
“Paying for health or dependent care expenses on a pre-tax basis and contributing to a 401(k) will directly lower your adjusted gross income for 2007,” Luscombe observed. “A lower adjusted gross income, in turn, can qualify you for more deductions and credits that are ‘phased out’ as income rises, as well as lowering your taxes directly.”
Some companies now offer Health Savings Accounts – HSAs – in conjunction with high-deductible health insurance plans. These offer the opportunity to pay for deductibles and co-payments with pre-tax dollars and even to roll over unused HSA dollars to future years.
“There’s a definite chance of saving on taxes with these plans, but there’s also a chance of incurring higher out-of-pocket costs than with traditional plans,” Luscombe observed. “As with many other financial decisions, tax consequences are only one factor to be weighed.”
Tax Savings with IRAs, Keogh Plans
Taxpayers who aren’t covered by an employer’s retirement plan can cut their taxes by contributing to a traditional, deductible, IRA or, if they are self-employed, to a Keogh plan.
In either case, they have until April 16, 2007 to actually deposit funds in their retirement account, but the Keogh has to be set up by December 31, 2006, for any contribution to be excluded from 2006 income. An IRA doesn’t have to be established until April 16, 2007 for contributions to count against the previous year’s taxes.
“You can use a refund to fund your IRA or Keogh, if you file far enough in advance to have the money in your hands by April 16, 2007,” Luscombe noted.
A New Roth IRA Possibility
Another option made possible by recent pension legislation is to fund a non-deductible IRA with an eye toward rolling it over into a Roth IRA in 2010. This does not reduce current taxes, but promises tax-free withdrawals from the Roth IRA in future years. In addition, Roth IRAs are not subject to minimum-distribution rules as other IRAs are.
“What’s new here is that high-income individuals are not allowed to establish Roth IRAs or convert from a traditional IRA to a Roth. But this year’s tax legislation opened the door to conversions in 2010,” Luscombe noted.
The conversion option would be attractive to people who are currently barred from setting up a Roth IRA and who do not have any funds in a traditional, deductible IRA.
“If you have a traditional IRA, you can’t set up a non-deductible IRA and then be taxed as if you had converted only the non-deductible IRA to a Roth IRA,” Luscombe said. “Whatever amount was converted would be treated as coming proportionally from both IRAs, triggering taxes on the funds deemed to come from the traditional IRA.”
Enjoy Your Tax Savings
As you take steps to lower your tax bill, you should take one more step – to make sure that those savings go straight into your pocket, rather than sitting in the IRS’s coffers until you apply for a refund.
“If you know your tax bill will be lower for any reason, you should take steps to enjoy your lower taxes now or in the future by increasing your take-home pay or your savings. You can invest the money, contribute to one of the many tax-advantaged retirement vehicles available or buy things you need without racking up credit card debt,” Luscombe advises.
“By adjusting your withholding on Form W-4, you can start receiving your 2006 refund this year, and your 2007 refund in January,” Luscombe said.
About CCH, a Wolters Kluwer business
CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax, audit and accounting information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill.
Wolters Kluwer is a leading multinational publisher and information services company. The company’s core markets are spread across the health, corporate services, finance, tax, accounting, law, regulatory and education sectors. Wolters Kluwer has annual revenues (2005) of €3.4 billion, employs approximately 18,400 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, see www.wolterskluwer.com.
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EDITOR’S NOTE: For members of the press, a complimentary copy of CCH's Tax Planning Strategies 2006-2007 is available by contacting Neil Allen at 847-267-2179 or neil. firstname.lastname@example.org or Leslie Bonacum at 847-267-7153 or email@example.com.