You would think it would be hard to persuade someone to put hundreds or even thousands of dollars into a savings account that didn't pay interest and would allow withdrawals only once a year. Yet that's what millions of taxpayers do when they overpay on their income taxes and receive a refund check.
Evaluating the accuracy of your income tax withholding is just one of the smart tax moves that accountants strongly recommend for taxpayers doing their mid-year tax planning, because it's early enough to be the most effective.
"The longer you wait, the harder it is to do any significant planning," says Peter Diaz, a certified public accountant in Redwood City, Calif. "I tell my clients to get a baseline on their tax situation early so they don't have any surprises when it's too late to do anything about it."
Diaz says a mid-year tax review should target:
- How much you overpaid or owed on your 2007 tax return;
- Changes in personal circumstances that may affect your taxable income and deductions;
- Tax code changes that may impact the amount of tax you owe; and
- Strategies to lower your taxable income that you haven't taken full advantage of in the past.
Step 1: Revisit your withholding
Getting a big refund or having to write a big check at tax time are both consequences of the same problem -- failing to accurately estimate how much tax you owe for the year. And neither works to your advantage, Diaz says.
"It's not smart to get a big refund," he says. "Ideally, you want to owe a little at the end of the year, but not so much that you would have a penalty for underpayment."
Most taxpayers can avoid a penalty for under-withholding if they pay enough during the course of the year to cover at least 90% of their tax bill, or if they pay at least 100% of the tax shown on the return for the prior year, according to the Internal Revenue Service.
To change your withholding amount, have your employer revise your IRS Form W-4. If you're self employed, adjust your quarterly estimated tax payments.
Learn more
Get withholding help from IRS Publication 919, How Do I Adjust My Tax Withholding?
Step 2: Evaluate changes in circumstances
If you have already made or are planning to make major changes in your life, remember that they may have tax consequences. For example, says Diaz, buying a new home will likely lower your tax bill, because you'll be able to deduct your mortgage interest and any "points" you paid when you took out your loan.
Similarly, a new child in the family typically generates an additional dependency exemption of $3,500 for 2008, up $100 from 2007.
Another event with significant tax consequences is a child starting college. You might be eligible for a Hope scholarship credit of as much as $1,800 for each enrolled child or a Lifetime Learning credit of up to $2,000 per tax return. If your income is too high to qualify for one of the credits, you might be able to claim a tuition and fees deduction of up to $4,000.
Learn more
See IRS Publication 970 for details of the education credits and deductions.
Conversely, you could incur a significantly higher tax bill if you sell stocks that have greatly increased in value, get a big promotion at work, or receive an inheritance.
Whatever the event, you should incorporate it into your tax planning as soon as possible.
Step 3: Be aware of tax code changes
Tax code changes can significantly impact how much tax you owe, yet many people aren't aware of them until it's too late to benefit -- or to avoid their consequences.
Two items that taxpayers should look at closely in 2008 are the "kiddie tax" rules and the sales tax deduction, says Cynthia Dulworth, a certified public accountant at Sanford, Baumeister and Frazier in Fort Worth, Texas.
The new kiddie tax rules for 2008 make it much harder for parents to shift a large amount of investment income into a child's account so that it will be taxed at the child's lower rate. The new rules specify that a child with unearned income of $1,800 or more will have to pay tax at the parents' rate on the amount of the income that exceeds $900 (the dependent child's standard deduction). The new rule even applies to children ages 19 to 24 if they're full-time students.
There is an exception, Dulworth points out, for children who have earned income that covers half of their support. (For purposes of the kiddie tax, support includes the fair rental value of lodging, clothing, education, medical care, transportation, entertainment, etc.) So parents with small businesses who can employ their children and legitimately pay them enough to satisfy the threshold may be able to limit the impact of the kiddie tax.
But, Dulworth adds, "Many people are going to have to restructure how they transfer money to their children." That might include:
- Opening a Coverdell Education Savings Account or 529 plan college savings account, in which the earnings are not taxed if they're used for qualified higher education expenses;
- Investing in equities more likely to generate long-term capital growth than current-year income; or
- Choosing tax-exempt or tax-deferred bonds.
How Fidelity can help
Learn more about Fidelity managed 529 accounts.
Another big tax change to watch, Dulworth says, is the scheduled expiration in 2008 of the option to deduct state and local sales tax instead of state and local income tax. That's significant for people in Texas and other states without an income tax. For example, a family of four in Fort Worth with income of $90,000 to $100,000, would have been able to claim a sales tax deduction of $1,566 in 2007, according to the IRS sales tax deduction calculator.
Still, Dulworth is hopeful that Congress will reinstate the option before the end of the year, and she advises taxpayers to continue monitoring tax law changes. Last year, Congress made its last major adjustments just before Christmas.
Another action that many taxpayers are hoping Congress will take before the end of the year is once again "patching" the alternative minimum tax, or AMT.
Originally intended to prevent the wealthy from avoiding paying any tax, the AMT in recent years has resulted in millions of taxpayers, many of them in the middle class, owing more in taxes. Last year's last-minute patch raised the AMT income exemption to $66,250 for joint filers and $44,350 for individuals -- but only for 2007. Unless further action is taken, the exemption levels would revert to $45,000 for joint filers and $33,750 for individuals.
Dulworth notes another popular tax credit expiring this year is one for making energy-efficient home improvements, such as improved storm windows and doors. "It wasn't a huge tax break, but a lot of people took advantage of it," she says.
On the good news side, Peter Diaz notes that the long-term capital gains tax rate is reduced to zero for tax years 2008 through tax year 2010 for taxpayers in the 10% and 15% tax brackets. People in those brackets have taxable income below $65,100 for joint filers and $32,550 for individuals.
Therefore, Diaz suggests that "It's a real advantage for taxpayers who don't have a lot of salary income but have a lot of stock -- like someone who has been laid off and has a lot of stock options." He says, "We have a lot of people like that in the Silicon Valley. If you're in that situation, you can cash out some of the stock that would otherwise have been taxed at higher rate."
Step 4: Take advantage of opportunities
If you find that you make a promise to yourself every year at tax time that you will put more income into tax-deferred accounts -- but never following through -- now is the time to make good on the promise for 2008.
"I encourage clients to take full advantage of their 401(k) plans and IRAs to reduce their taxable income," Diaz says. "At a minimum, it's silly not to at least put enough in your 401(k) to get the full employer match."
Participants in 401(k) and 403(b) plans can contribute up to $15,500 ($20,500 if they're age 50 or older by the end of the tax year) in 2008 and reduce their current-year taxable income by that amount. But it's hard to get there, Diaz says, if you wait too long into the year to increase your paycheck contributions. Check in with your employer now to increase your payroll deduction.
Also in 2008, the amount of qualified contributions to a Traditional IRA or a Roth IRA increases $1,000 to $5,000 per eligible taxpayer ($6,000 for people 50 and older).
Furthermore, Diaz is encouraging clients who cannot contribute to a Roth IRA -- because their income exceeds the contribution limits -- to make nondeductible contributions to a Traditional IRA this year and next. Because in 2010, the income limit for converting a Traditional IRA to a Roth IRA disappears -- currently only those with modified adjusted gross income below $100,000 could convert. So those nondeductible Traditional IRA contributions can be converted to a Roth, giving his clients "a nice jump start," because they will only have to pay tax on the earnings, not the principal.
How Fidelity can help
Learn more about IRAs.
One thing that all of the mid-year tax planning strategies have in common is that if you don't start early, their value will diminish over time. The best tax plan, the experts say, begins long before the end of the year.
How Fidelity can help
Visit the Fidelity Online Tax Center for tax tips, tax planning tools, and tax-saving opportunities with Fidelity products, services, and investment options.
(Please e-mail any comments to Investor's Weekly at Investors.Weekly@fmr.com.)
