The government has taken the fun out of the year-end tax dodge.
Years ago, avoiding taxes could be exciting. It caused people to invest in wind farms, cattle ranches and oil wells. Some would hire their 3-year-olds and pay them exorbitant salaries. Others might claim their dogs as dependents.
OK, so some of it was shady. At least it was interesting.
Now, because of tax legislation passed by Congress and stricter rules enforced by the Internal Revenue Service, the choices are less lucrative--and far less dicey.
You can give money to charity, prepay a few bills, sell some investments and put money away for retirement. Still, the chance of dramatically reducing your tax is slight.
"People who tell you they can solve all your year-end tax problems are probably going to charge you more in fees than they'll save you in tax," sighed Gregg Ritchie, partner with the accounting firm of KPMG Peat Marwick.
In fact, because of new tax rules that go into effect next year, you might want to avoid tax avoidance altogether this year.
"Normally you would want to defer income and accelerate deductions to postpone tax liability," said Tim Kochis, national director of personal financial planning at Deloitte & Touche in San Francisco. "But since the top marginal rate goes up to 31% next year from 28% this year, that logic often reverses itself."
Some people might at least think about paying more tax this year to pay less next year, Kochis added.
Given all this, there are still a few things you can do to reduce your 1990 tax bite.
One of the best options is to put money aside for retirement, Kochis said. How you do this will depend on a variety of factors, including how much you earn annually and where you are employed.
If your company has a 401(k) plan, you should consider contributing the maximum amount allowable, which is $7,979 in 1990. (The allowable amount is indexed for inflation.) These plans have two advantages: Money contributed is taken out before tax, and interest earned on the account accrues tax-free until the money is withdrawn at retirement.
What does that mean in dollars and cents?
Consider a couple earning $100,000 annually. They are in the so-called bubble bracket, which means that they pay 33% in federal tax for every dollar earned over a certain amount. If they contribute the maximum amount to a 401(k) plan, they will save $2,633 in federal tax and $742 more on their California return, said Phil Holthouse, partner at the West Los Angeles accounting firm Parks Palmer Turner & Yemenidjian. In other words, the government is paying for nearly half of their retirement savings.
If you are self-employed, or have at least some self-employment income, you can also start a Keogh plan, Holthouse added. These plans are similar to a 401(k) but may allow larger contributions. The IRS limits deductions to the lesser of 13% of self-employment income or $30,000 annually.
And many taxpayers can take advantage of individual retirement accounts. These accounts allow for tax-deductible contributions of $2,000 annually if your income is less than $25,000 individually or $40,000 for a married couple. And taxpayers who have no pension plan at work may contribute to an IRA at any income level.
Another tax-saving strategy: Pay your January mortgage in December. This allows you to deduct the interest expense in 1990 instead of 1991.
Some individuals might consider prepaying property and state taxes, too. However, the advantage of getting a deduction for these payments needs to be weighed carefully against the disadvantage of losing the use of that money for the three or four months between the time you pay the bill and the actual due date.
For example, say you needed to pay $5,000 in state taxes in April. If you paid that early, you would save $1,400 in 1990, assuming a 28% federal tax bracket. However, since you are using up 1991's deduction in 1990, you are only deferring the tax payment for one year, not avoiding it altogether. So in reality, your only real gain is the interest you've earned on the $1,400 deferral. Assuming an 8% rate of return, you would have earned $112 on your $1,400. But, had you invested the whole $5,000 for four months, you would have earned slightly more--about $133.
If, however, you are now in the 33% "bubble" bracket, accelerating these deductions could make sense again because your tax rate may drop slightly next year, said Mark Collins, partner at Arthur Andersen & Co. in Los Angeles. In other words, this year's deductions are worth comparatively more and next year's comparatively less.
Of course, if you are like most middle-income individuals and your tax rate is set to climb next year, the opposite is true. The deduction would be more valuable in 1991, Kochis said.