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Navigate the Money Maze this Tax Season

USAA Magazine, Spring 2008

By Dennis McCafferty

SMART TAXPAYERS have discovered ways to pay their financial respects to Uncle Sam and keep more of their cash at the same time. They take advantage of their investment plans, gift-giving activities and other tax-saving steps. Here’s how you can, too.

Just do it!

Some 10 percent of taxpayers file after April 15, according to Cohesive, a tax-preparation and planning firm in California. But they might as well dump their money on the street. “At least 98 percent of the clients who come to us late pay more taxes,” says Cohesive founder and owner Karla Dennis, enrolled agent. “In several instances, we point out missing deductions, but there’s simply no time to gather the needed documentation to support them.” Late-filing penalties usually amount to 4.5 percent of taxes owed for each month that a return is late for up to five months, and no less than $100 for a return that’s 60 days late.

Why do people risk such penalties? “Taxpayers often build a psychological block when it comes to preparing their tax returns,” says Michael Hanley, managing partner of a New York based tax-preparation and accounting firm. “For whatever reason, many taxpayers walk into my office thinking the worst and walk out surprised that they don’t owe as much as they thought.”

Look into a traditional IRA

Consider a traditional IRA, or individual retirement arrangement, to defer tax burdens and save for retirement in the process. One advantage? The money you invest can be deducted from your tax bill if you meet IRS requirements: If you’re not covered by an employer savings plan, your contribution generally is deductible; if you are covered, your deduction is limited once your 2007 adjusted gross income exceeds $52,000 for single filers, or $83,000 for married couples filing jointly ($53,000 for single filers or $85,000 for married couples in 2008). You have until April 15, 2008, the day taxes are due, to make a 2007 contribution and still deduct it on your 2007 return.

Starting in 2008, the IRS allows individual taxpayers to contribute and deduct $5,000 every year in IRA contributions, and $6,000 if they’re 50 or older. They still must meet the requirements mentioned previously to deduct the contribution.

Consider a Roth IRA

For a longer-term tax benefit, consider the Roth IRA. This investment has different income requirements than a traditional IRA and doesn’t provide the tax savings now. But, if you qualify, it allows your money to grow tax free until you reach retirement age and to be withdrawn tax free later. Meanwhile, you pay tax on the money at today’s rate instead of at the future’s unknown rate when you withdraw it.

“I advise many clients to convert their traditional IRA to a Roth,” says Ronald Park, managing partner of a Texas-based accounting firm. “The savings are usually very dramatic.” Taxes will be due upon conversion. However, the benefit of the future tax-free growth on a Roth may outweigh holding a traditional IRA. Discuss this option with a financial or tax advisor.

You can also use a Roth IRA to start your children on the right financial foot. “If your child works, you can make the contribution to an IRA in his or her name,” says certified public accountant Kathryn Mendicki. “A 4,000 contribution at age 15, with an average return of 10 percent, can grow to nearly $300,000 by age 60 — all tax free when your child withdraws it.”1

Footnote: 1This is a hypothetical assumption that assumes tax laws will remain in effect for the entire period and does not take into account the fluctuating nature of investment returns.

Don’t forgo your 401(k)

If you’ve ignored your company’s 401(k) plan, start paying attention. This and other work-based savings plans reduce your tax burden each year and often offer employee matches — in other words, free money. This year, the 401(k) limit is $15,500, but those older than 50 may contribute that amount plus an additional $5,000.

Many employees are now taking advantage of Roth 401(k)s, which began in 2006. They work like this: Employees can make contributions from their paycheck, but as an after-tax contribution. You don’t get a tax break for contributions made that year, but you may benefit from increased tax savings over the lifetime of the Roth 401(k) since your withdrawals may be entirely tax free. Employers can still match a certain percentage of your contributions, but the employer contributions and earnings will be taxed upon withdrawal.

Make tax-savvy investments

Two relatively conservative investments can help give tax relief.

A municipal bond fund is similar to a taxable bond fund, but all of the bonds in the fund are issued by a state, city or local government, and the
fund generates income that is not subject to U.S. income tax. Some funds hold only bonds issued in one state, and if you live in that state, produce income that is exempt from both federal and state income taxes. This type of investment typically is suitable for someone in a higher tax bracket.

A fixed annuity is a guaranteed investment. Similar to a certificate of deposit, or CD, a fixed annuity will pay a set, fixed interest rate. Depending on the annuity, the interest rate may reset or fluctuate periodically. From an income tax standpoint, the perk is that you will not pay income tax on the earnings until you withdraw them from the annuity.

Give and receive

Donating old clothes, tools, books and items collecting dust to qualified charities may entitle you to a charitable contribution deduction. A recent change in the rules now requires that in order to take the deduction you must get documentation of the donation from the recipient organization, which also must be eligible for tax-deduction donations. “Most clients forget that non-cash donations are eligible,” Park says. “Cleaning out the closet once a year can save you not only space, but money.”

Give to family

For 2007, the annual gift tax exclusion per person is $12,000. Parents can combine their gift to each person for a total of $24,000, without gift tax consequences. For example, parents can give a child $24,000 and $24,000 to a child’s spouse, for a total of $48,000. One hundred percent of that gift is tax-free to the recipients, and the gift could help reduce the estate bill for the givers.

Deduct moving expenses

If you’re a member of the armed services, you probably know that you’re entitled to deduct unreimbursed moving expenses. But make sure you do it. Civilians generally need to meet certain time and distance requirements to deduct moving expenses, but if you’re active duty and you move, those requirements can be waived.

Be smart about college savings

Many savings plans don’t have great tax advantages. If college savings is the primary goal for any savings account you open for a child, a 529 plan or Coverdell education savings account might be the best bet. “Forget savings accounts and bonds,” says Beth Wiggins, a Texas certified public accountant with tax and accounting firm BKD LLP. “Income from these accounts may be taxed at the parents’ tax rate until the child is 24. Instead, focus entirely upon college savings plans, such as Coverdell accounts or 529s, where earnings are never taxed if used for educational expenses.”

File early and enjoy your refund sooner

If you’ve had too much money deducted all year and you file early, you’ll receive your refund earlier, too. “The money is better off in your pocket than Uncle Sam’s,” says Allan Pearlman, a tax lawyer based in New York. But remember that when you get a refund, you’re really just getting your own cash back after you loaned Uncle Sam the money all year long, interest free. Adjust your withholding this year to make sure you’re not paying more in taxes instead of using that money to pay down debt or for investments or savings.

Think about e-filing

“Electronic filing and direct deposit will normally get you your refund in 10 days, versus six weeks for a paper-filed return and paper check sent in the mail,” says James Smith, chairman of the Texas Society of CPAs. That’s money that could be earning interest in your hands more quickly, as opposed to being held up at the IRS.

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