>

Savings & Spending Tips Reducing Taxes Regardless of your age or where you are in the financial lifecycle, always look for opportunities to avoid or reduce income taxes. A key part of successful cash management is determining — in advance — the tax implications of all your financial activities. This might involve: Consolidating deductions into one year rather than taking them over two years Spreading income over several years rather than taking it all in one year Waiting a few months to sell an asset in order to take advantage of lower long-term capital gains rates Borrowing against the equity of your home to purchase a car, for example, to generate interest payments that are deductible   Quick Question What is the difference between tax avoidance and tax evasion? A. You win a free trip to Hawaii. B. You get back a lot of money at the end of the year. C. You can spend up to 20 years in the federal penitentiary. D. You are in a different tax bracket. Marginal tax brackets Do you know what marginal tax bracket you're in? Take a look at how you file (Single, Joint, or Head of Household) and determine your taxable income (not your gross income). Then refer to the chart below: You don't need to be earning a tremendous sum of money before you're in the higher 25% (or more) federal tax bracket. For instance, if you file taxes as a single person, the first $7,825 of your taxable income is taxed at the rate of 10%. The taxable income between $7,825 and $31,850 is taxed at 15%. Each additional dollar is taxed at the rate of 25% or more, so your marginal federal tax rate almost doubles! (If you are married and file taxes jointly, the 25% break point for you is $63,700.) And don't forget to add state income tax on top of your federal income tax, if applicable.   Tax Planning Tip It's important to be aware of what taxes are doing to your income. Example: You're in the 25% federal marginal income tax bracket, and you have a certificate of deposit paying 3.0%. Your after-tax return is only 2.25%. The other 0.75% is being taken out in the form of taxes.   Before-Tax Return After-Tax Return Certificate of Deposit 3.0% 2.25% Don't look at what you're getting paid — look at what you're getting to keep! Take the Investment Strategies Course to learn how to maximize your investments and minimize taxes. Tax-deferred plans If you're in the 32% combined federal and state marginal tax bracket, each $100 that you contribute to your employer's tax-deferred plan saves you 32% or $32 on your tax bills. This means that if you're putting away $100 that will grow tax-deferred for your future, it's really only costing you $68 after taxes! If your federal marginal tax bracket is 25%, a $1,000 contribution reduces taxable income and saves approximately $250 in taxes. Refer to the Investment Strategies Course for more information. One objection to tax-deferred growth is that distributions are eventually subject to income taxes when withdrawn, and marginal tax rates frequently may be just as high during retirement as during the accumulation phase. However, tax-deferred growth may still accumulate more for retirement. It's important to be aware of what taxes are doing to your income.   Example Ms. Gotrocks has $100,000 accumulated in her tax-deferred plan at age 62, when she retires. Ms. Lessing, using the exact investment plan as Ms. Gotrocks but in a taxable account, only has about $70,000 at age 62 because her investments have been eroded all along by income taxes. Both retirees invest their lump sums in conservative portfolios that earn 6% each year during retirement. Distributions on both are taxable. $100,000 @ 6% $6,000/year before tax $4,5000/year after tax* $ 70,000 @ 6% $4,200/year before tax $3,150/year after tax* * Assumes 25% federal marginal income tax bracket In contributing to your employer's tax-qualified plan, you are also practicing one of the most important habits of sound financial planning, which is to Pay Yourself First! Lower maximum capital gains rates may apply to certain investments in a taxable account, which would reduce the differences between the performance in the accounts shown in the chart. You should consider your personal investment horizon and current and anticipated income tax brackets when making investment decisions as they may further impact the results of the comparison. Take advantage of tax deductions and credits Many tax advisors will suggest that you may be able to reduce your taxes by itemizing your deductions, rather than taking standard deductions. For example, your joint income may be $65,000 in 2006, but by itemizing your mortgage interest, property taxes and charitable contributions you reduce your taxable income below the $63,700 mark, which would lower your marginal federal tax bracket from 25% to 15%. Finally, take advantage of any deductions and tax credits that may be available to you. Deductions will reduce your taxable income. This, in turn, reduces the amount of taxes you pay depending on your tax bracket. Tax credits are taken after your taxable income is computed, and represent a dollar-for-dollar reduction of taxes you pay. For more information on these tax savings ideas, please consult your personal tax preparer. Tax-advantaged investment strategies Another way to save money in taxes, is to invest using tax-advantaged strategies. To learn more about these strategies please refer to the Investment Strategies Course. Municipal bonds A bond issued by a state, state agency or authority, or a political subdivision (county, city, town). Interest is exempt from federal income taxes (and from state income taxes within the state of issue).   Before-tax Return After-tax Return Taxable account/investment 3.0% 2.25%* Municipal bond 3.0% 3.0% * Assumes 25% combined federal and state marginal income tax brackets Don't compare what you're getting paid; compare what you get to keep after taxes! For more information on municipal bonds, see the Investment Types Course. Education funding plans There are several ways to save money for education on a tax-preferred basis, including: Custodial accounts Coverdell education savings accounts 529 plans How much do you need to save for your child's education? What will be the cost of your child's education in five years? In 10 years? Find answers to these important questions by creating a personalized Education Funding Report. For more information about these and other types of investments, see the Investment Strategies Course. IRAs Individual Retirement Accounts (IRAs) grow tax deferred* and they may provide an initial tax break through deductible contributions. The traditional IRA is the most familiar type, but a Roth IRA (where distributions may be tax-free, if certain conditions are met) may provide an attractive option for you if your income exceeds the limits for deducting your contributions to a traditional IRA. * Income taxes are payable upon withdrawal. A 10% federal tax penalty may apply to withdrawals taken before age 59½. For more information on IRAs, see the Investment Strategies Course. < PREVIOUS NEXT > #40213