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.

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