Tax-Savvy Money Moves

Question of the week:I have to cut costs wherever I can this year and by far one of my biggest costs is my tax bill. What should I be doing to lower it? --Rebecca C.

Dear Rebecca,

It's December, that time of the year when so many of us start dreading the inevitable April 15 date with the tax man. You only have from now until the end of the year to do everything you can to cut your 2003 taxes, but fortunately you have plenty of options.

When we asked members of the Armchair Millionaire community recently about what they'll be doing, we heard an entire laundry list of tax-cutting moves. Here are just some:

"My wife and I are maxing out our 401(k) and 403(b) plans, have stretched our mortgage out to 30 years at 5.375 percent, and make sure the monthly extra goes into something tax-free." --ivroom2

"I've maxed my 401(k) contributions, as well as using the flexible spending accounts at work. I'm also donating used clothing, household articles, and toys to local charities before the end of the year to get the deduction in 2003." --Howard

"Both my husband and I max out our 401(k) accounts. I contribute to a pre-tax transit reimbursement program and to a pre-tax flexible spending account through work. We bought a home and deduct the mortgage interest and I started a small web-based business with my husband. Also, I defer a portion of my bonus into my 401(k)." --Pug Mom

While every one of these tax moves will help cut your tax bill, you should also manage your investment portfolio year-round with an eye towards reducing your taxes-and effectively increasing your investment returns. Even though the tax law passed last spring reduced the tax rates on most stock dividends and long-term capital gains, it still pays to heed the impact of taxes on your portfolio. My guide provides some basics.

The Armchair Millionaire's Guide to Tax-Wise Portfolio Management

• Invest in the most tax-advantaged accounts first. Prioritize your investments according to which vehicles offer the best tax breaks. An investment in your 401(k) that is matched by your employer is hands-down the best place. After that, a Roth IRA is probably the best choice, followed by an investment in your 401(k) above and beyond your employer's match.
• Treat taxable accounts with care. Different types of investments have far different tax implications. For example, an index fund is generally much more tax efficient than the average actively managed mutual fund. And a stock that you hold for less than a year will cost you much more in taxes when you sell than one you hold for five years. So whenever you invest in a taxable account, consider those investments that will keep your taxes in check.
• Harvest losses. Tax law allows you to use up to $3,000 of capital losses each year to offset capital gains or "ordinary" income, like your salary. So if you have an investment that has dropped in value over the last several years (who doesn't?), you can sell it and receive a deduction for the loss. If you have more than $3,000 in losses, you can carry them over to future years. Just be sure to not buy the same or substantially similar investment within 30 days of selling. If you do, the tax deductibility of your capital loss will be disallowed under the IRS's "wash sale" rule.
• Don't buy the distribution. Planning to buy a mutual fund between now and the end of the year? Check the "record date"--the day (typically in December) when funds determine which shareholders will receive a distribution of its capital gains for the year. You'll need to pay tax on these capital gains (unless you hold that fund in a tax-advantaged account), even if you've only owned the fund for a few days. You can avoid paying that tax simply by waiting to buy the fund after the record date.

THE BOTTOM LINE: Taxes are unavoidable, but paying more than your fair share is not. Whenever you make a financial decision of any kind, consider the tax implications. More often than not, you can find a way to lower your tax hit.

Surviving an Audit

Question of the week:I just received a letter from the IRS telling me that my tax return is going to be audited. I was completely honest on my return, but I'm still really nervous. What should I do to make everything turn out right? --Nik B. Dear Nik, I'm afraid you're one of the unlucky few. According to the IRS, only 0.57 percent of income tax returns were audited in 2001 (the most recent year for which stats are available). However, you should look on the upside: Not all audits turn out badly, as evidenced by these stories from members of the Armchair Millionaire community: Smooth sailing. "We've been audited, but no problems. We keep good records (receipts, etc) and had no problem supporting amounts and calculations." --Alan and Kay Coming out ahead. "I was audited a few years ago. All went well for me, but not so the government. I was looking at a $2,782 liability, but when the audit was over the IRS owed me $763." --Ted B. The reason the IRS conducts an audit is to figure out if you accurately reported your income, deductions and/or tax credits. This means that the best defense is to file your return correctly in the first place. And if you're in a group that the IRS just loves to audit--self-employed people are a prime example--keep meticulous records of all of your income and expenses. Even armed with an accurate return and complete records, you'll still need to be ready to face that audit. My guide provides the essentials on minimizing the pain. The Armchair Millionaire Guide to Surviving an Audit Prepare. Re-visit the return in question so that you're completely familiar with it. If any supporting evidence is missing, dig it up. If you can't find it, consult with a tax professional about reconstructing it. Provide complete information, but don't go overboard. Give exactly the information requested, and stop there. Your audit notice will tell you the issue that is in question. Bring only the documentation related specifically to that issue. When you're asked questions, be as brief as possible--especially when you're nervous, it's easy to talk too much and give away unasked for information. Don't be intimidated. The IRS must follow a clearly established set of rules when it conducts an audit. According to the Taxpayer bill of rights, you have the right to record the audit, to have it conducted at a time and place that is convenient to you, to limit its scope to the issues that are directly related to the items in question, and to appeal the findings if you disagree with them. For full details, get IRS publication 1, Your Rights as a Taxpayer, from the IRS Web site at www.irs.gov. Call in a professional. Especially if the issues are complicated, seriously consider hiring a pro to represent you. When possible, use the person who prepared your return. In many cases, your representative will really make it easy on you by requesting that you not even attend the audit. Never, ever: Leave your only copy of documentation with the IRS. Give the IRS your records to sift through. Sign anything you don't understand. THE BOTTOM LINE: You can and will survive an audit. But knowing what to expect, being fully prepared and having a pro by your side will all help make the experience less stressful.

The Tax Man Cometh

Question of the week:I'm debating this year about whether to do my taxes myself on my computer or hiring a tax return preparer. Which do you think is best? --Sarah S.

Dear Sarah,

The time alone required to complete a Form 1040 these days can be daunting, not to mention the amount of anxiety and stress that a lot of people go through when preparing their returns. So you're wise to think before choosing a tax preparation path.

When we asked members of the Armchair Millionaire community recently about the ups and downs of tax prep, we heard a range of responses:

Do it yourself. "I prepare my own taxes using TurboTax, which walks me through everything and then flags anything that might make the IRS audit. It's a lot easier than people think--you just have to focus and take the time to do it." --Kristi

Go with a pro. "It's a full time job trying to keep up with all the changes in tax law, so I've always turned to professionals." --Ryan

In general, I think it's a good idea for most people with relatively simple tax situations to prepare their own returns. It keeps them in touch with their situations, and with the range of tax prep software now available, it can be a snap.

For taxpayers with more complex situations--for example, anyone who is self-employed, going through a divorce, or facing the alternative minimum tax--I believe that a professional can be invaluable. If you chose this route, my checklist will help you get the most from it.

The Armchair Millionaire Checklist for Getting Professional Tax Help

• Choose the right type of preparer. There are many different kinds of preparers, each with a different level of expertise (and accompanying cost). These are the major types:
  • Return preparers at national chains or local outlets. While convenient and fairly inexpensive, the knowledge and experience from one preparer to the next may vary widely. I would recommend this option only if you have a fairly simple tax situation.
  • Enrolled agents. These folks must pass a rigorous IRS exam, pass a background check and complete continuing education requirements every year. If needed, an enrolled agent can represent you with the IRS if it questions your return.
  • Certified Public Accountants. CPAs must undergo rigorous training and licensing requirements and are highly skilled in accounting matters. However, not all handle tax matters, so be sure to ask. CPAs may also represent you before the IRS.
  • Tax attorneys. An attorney specializing in taxation may be appropriate if you have a highly complex or specific situation on which you need expert guidance in completing your return.

• Check them out. Before you work with any preparer, ask them about their training and qualifications, continuing education, experience dealing with your type of tax situation, and if they would represent you in case of an audit.

• Organize your stuff. Your preparer can do a better job (and will charge you less) if you don't dump a shoebox full of unorganized tax records on their desk. Provide copies of previous years' tax returns, but make sure you send copies, not originals. And don't wait until April 10 before making an appointment with your preparer.

• Check your return carefully. Don't sign your return without reading it through carefully to ensure you understand it and that there are no glaring inaccuracies or omissions.

THE BOTTOM LINE: The old cliché says, taxes are one of two things you can be certain to face. But you can certainly make them less painful by choosing the right path for your tax preparation needs.

Take the "Ouch" Out of Next Year's Tax Bite

Question of the week:I'm dreading April 15th already. I know I'm going to owe--is there anything I should be doing now to lower my taxes? --Philly76

Dear Philly76,

We feel your pain. The economy is down and its future is uncertain, but we still have to pay the tax man. When we recently asked members of the Armchair Millionaire community about what they're doing to cut their taxes, we heard a few grumbles and some good suggestions:

"I'm going to sell one index fund that I've had forever that is down 30 percent overall, and then use the money to buy shares in another index fund. I'll get a nice capital loss to write off, plus get somewhat better diversification than I had before." --MBL

"I'm paying all my property taxes before the end of year, increasing my 401(k), and taking capital losses, but my taxes will be still be high this year ..." --SM

My suggestion is that you step back and take a good look at your overall financial picture. Ask yourself: Can I save more in tax-deferred accounts? How much can I afford to give away? How can I adjust my investments to reduce my tax liability? My checklist will guide you on some of the specific moves you can make.

The Armchair Millionaire Checklist of Tax-Busting Moves

• Give to a good cause. It's no coincidence that you receive most of your charitable solicitations at this time of the year. Haul out your checkbook and donate to those less fortunate than yourself and get a tax deduction at the same time. And don't overlook non-cash donations. That old clunker sitting in your driveway, for example, might be worth more as a write-off when you donate it to a local charity than it would be if you sold it to your 16-year-old nephew.

• Harvest your capital losses. There is one advantage to selling when the market is down: You can use up to $3,000 of capital losses to offset any capital gains or "ordinary" income, like your salary. (If you have any capital gains this year, by the way, I congratulate you.) If you have more than $3,000 in losses, you can carry them over to future years. To not truly "lock-in" your losses, I suggest selling one investment and immediately reinvesting your proceeds in another investment that is similar enough to fit in with your overall investment goals.

• Max out your 401(k). Every buck you stash away for retirement is a buck that won't be taxed. The maximum most people can contribute this year is $11,000, a figure that will go up by $1,000 every year until it hits $15,000 in 2006. If you're over 50, take advantage of the new "catch-up" provision, which lets you contribute even more: $12,000 this year, going up to a sweet $20,000 by 2006. See your HR folks for details.

• Take advantage of flexible spending accounts. Many employers these days offer these accounts (also called "cafeteria plans") that allow you to have a set amount of money withheld from your paycheck that you can use later for medical expenses or childcare. Your contributions come out pre-tax, so you get to save a few bucks on these basic expenses. Fall is often the time when employers let their employees begin or change their contributions, so check with your HR department.

THE BOTTOM LINE: There are plenty of ways to lower your taxable income, and you'll find that many of them will not just cut you tax bill, but improve your overall financial picture, to boot.

How To Turn Your Tax Refund Into Half a Million Bucks

Question of the week: This year for the first time I'll be getting a very nice tax refund check-about $4,000. I'd really like to make the most of this unexpected windfall. What do you suggest I do with it? --Miami Taxpayer

Dear Miami,

We asked the members of the Armchair Millionaire community what they'll be doing with their refunds. Here's what they told us:

Start saving. "I'm receiving just over $1,000 back and am planning to finally get an emergency fund established." --Professor G.

Pay off debt. "My wife and I already received our tax refund of $4,149, which we have used to pay off our two car loans." --James B.

Spread it around. "I will be getting over $8,000 back this year and plan to equally divide it between investing for my children's education and refinishing my basement." --Gregor

Of course, the biggest bang of all from your tax refund check would be to put it to work in the stock market. If you invest your $4,000 in an index fund achieving the historical average annual return of about 11 percent, and then add another $2,000 to the account each year, it will grow to over $500,000 over the next 30 years. My checklist will guide you on this route.

The Armchair Millionaire Checklist for Sensible, Long-Term Investing

• Choose diverse, low cost investments. You want a balanced investment that will track the overall stock market. At the same time, you don't want to see your money drained away by high the high fees or loads that some mutual funds charge. To achieve both these goals, a no load index fund is your very best bet.

• Minimize your taxes. Taxes on your investment do nothing but drag down your overall returns, so take full advantage of tax-advantaged accounts. You can defer your taxes by using a traditional IRA, or steer clear of them altogether by using a Roth IRA.

• Reinvest all returns. Over time, you'll get the most growth in your portfolio from compounding returns, so be sure to have all interest and dividends automatically reinvested.

• Start now. Compounding returns need time to work, so give your portfolio as much as you possibly can. Don't delay in starting to invest.

THE BOTTOM LINE: Building a powerful portfolio doesn't require special genius or a huge amount to begin. All you need is a modest amount--like your tax refund--and the commitment to stick with a long-term plan. Get started now.