October, 2005 Tax Tip
Get a Head Start on 2005 Year-End Tax Planning
I normally write my Tax Tip on year-end tax planning later in the year. However, when I meet with clients for their tax interviews during the filing season, I often discover, all too late, that some of the things they did during the tax return year could have been done far better from a tax standpoint had I known about them in advance. If you wait until December, as most people do, it may be too late to implement many tax-saving strategies. Hence that is my purpose in writing this Tax Tip ahead of schedule - it’s far enough into the year that good tax information is available, and yet early enough to put a good tax plan into operation.
The optimum tax plan doesn’t just focus on saving tax in 2005, but also looks ahead to 2006 and sometimes later years to achieve a maximum savings over a longer time frame. Here are just a few pointers to keep in mind:
Know Your Tax Bracket - I have stressed in previous tax tips the importance of staying on top of your tax situation by knowing your tax bracket, specifically the percentage at which your last dollar of taxable income is taxed. Tax brackets, range from 10 percent to 35 percent. Where you fall depends on your taxable income and filing status.
Hopefully, by now, most of you should be able to make a reasonable estimate of your taxable income for 2005. Knowing that, you can look up your tax bracket by going to the Links tab at my website, www.rontaxcpa.com.
Pay Your Tax on Time, Not Early – There is generally a time-money value in deferring the payment of taxes – the longer you have the money, the more it can work for you. That is why a common tax strategy at year-end is to postpone income and accelerate deductions to the extent permitted by law. If you are paid a year-end bonus, you may be able to arrange with your employer to have it paid to you in 2006. You need to be careful how you do this, or it may be considered 2005 income anyway. If you are self-employed, you could control when you receive the income by not billing your customers or clients until 2006.
However, like any general rule there are exceptions. For example, if you know that you will be in a higher bracket in 2006 than you are in 2005, it would probably be advisable to accelerate income into 2005.
Reap Full Benefit From Your Deductions - If your itemized deductions for 2005 already exceed your standard deduction, plan to incur more deductible expenses this year. If you see that your itemized deductions won't come close to matching the standard deduction you would get anyway, postpone deductible expenses you can control until 2006 (for example, wait to pay the 2005 property tax bill or to make a large charitable donation until January 2006), when you may be able to itemize your deductions. This strategy is called “bunching” your deductions. It provides you with a two-year optimization.
Take Advantage of Retirement Plan Benefits - Even if you feel that your income and deductions are pretty well set for 2005, contributions to certain retirement plans can significantly reduce your tax bill. If you are eligible, a contribution to a deductible individual retirement account (up to $4,000 in 2005, or $4,500 for people 50 or over) will reduce not only your taxable income but also your adjusted gross income. A SEP can potentially give self-employed individuals an even larger deduction.
Contributions to 401-k plans, subject to a $14,000 maximum in 2005 or $18,000 for people 50 and over, as well as employer-set limits, also lower both taxable income and adjusted gross income. The lower the AGI, the more tax credits and deductions are available to you.
An IRA or SEP for 2005 does not have to be established this year. As long as it is in place and the money is contributed by April 17, 2006 (the filing deadline for 2005), you can take the deduction. But funding it early gives you more months of tax-deferred earnings. In the case of a SEP, the contribution does not have to be fully paid in until the extended due date of the return.
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