Now's your chance to make some last-minute moves that could save you money on your 2001 taxes.
And this year is going to present some special opportunities for taxpayers to save not only on their 2001 returns, but also for 2002.
"Extraordinary circumstances overshadow tax and financial planning for the balance of 2001," said Bob Trinz, an editor at RIA, a New York-based provider of tax information and software to accountants and professionals. "The nation was hit hard by the terrorist attacks of Sept. 11, which had a severe, negative impact on an already weakened stock market and the economy in general.
"On the plus side of the ledger, the 2001 Tax Act ushered in lower tax rates for 2001 and even lower rates in 2002 and in the years to come."
What's more, the new tax law is packed with more generous tax credits, exclusions and other expanded tax breaks that will take effect in 2002.
"To take advantage of these new breaks, it may make sense for some taxpayers to defer some types of expenses until next year," Trinz said.
The first thing to do in your year-end tax planning is to get a big-picture perspective of where you stand.
"Get involved in the process," said Richard Joyner, a partner in personal financial counseling at Ernst & Young in Dallas. "Make sure you take time to look at your tax situation and estimate where you might be. Use pay stubs, investment statements and the like to estimate your current tax situation.
"Only by doing that can you know what needs to be done to improve the situation. You might also avoid a nasty surprise like an unexpected tax liability."
Many of the time-tested tax-planning moves still apply.
First step: Defer income
If you can afford to, defer income, such as a bonus, to 2002.
"Specifically, deferring taxable income from 2001 to 2002 will turn out to be the best move for those who will benefit from reduced tax rates next year, as well as those who will be taxed at a lower bracket in 2002 because of reduced investment or compensation income," Trinz said.
The new tax law created a 10 percent tax rate and lowered the top tax bracket for 2001 to 39.1 percent. The individual tax rates will drop slowly until 2006, when the top rate will be 35 percent.
One way of deferring income is to participate in your employer's deferred compensation program or by buying tax-deferred U.S. Treasury securities.
Turn around losses
If you've got investment losses as many investors do this year turn those lemons into lemonade.
"The many taxpayers who have paper or realized losses in the stock market and other investments must plan their year-end selling carefully to make the best tax use of capital losses," Trinz said.
Here's how handling of capital gains and losses works:
If you incur losses from the sale of investments, you may deduct those losses to the extent they equal your capital gains.
Long-term capital losses losses on the sale of investments held for more than a year are used to offset long-term capital gains before they're used to offset short-term capital gains gains on the sale of investments held for a year or less. Similarly, short-term capital losses must be used to offset short-term capital gains before they're used to offset long-term capital gains.
If your capital losses exceed your capital gains, you can only deduct up to $3,000 of those losses in a tax year against ordinary income. Any excess will be carried over until it can be offset against future capital gains or be deducted as a loss against ordinary income, with a limit of $3,000 a year.
"Be extra diligent about looking at your investments this year," Joyner said. "Many mutual funds lost money, but this sometimes leads them to distribute built-in capital gains accumulated inside the fund. If you are getting capital gains distributions from a fund, they can be offset by selling mutual funds that might have lost their value in this year's market turmoil. The capital gain distributions and losses from the sale will offset and can help you avoid paying an unexpected tax."
Investments come first
One crucial piece of advice: Don't let tax issues influence your investment decisions.
"You make your investment decisions first and you try to do the best tax planning you can around your investment decisions," said William J. Goldberg, Southwest partner in charge of personal financial planning at KPMG LLP in Houston. "You don't want to get out of a (investment) position when you're on the verge of a big move upward."
Consult with your tax adviser to ensure that you won't owe the dreaded alternative minimum tax or AMT. The AMT is a tax system with its own tax brackets that's parallel to the regular federal income tax system.
Congress created it about three decades ago to ensure that the wealthy pay at least some tax.
But because the AMT isn't inflation-adjusted, it's been ensnaring more and more average-income taxpayers. The AMT ensures that people who take many deductions and credits still pay a minimum amount of taxes.
"Before you make any tax moves, check your status under the AMT," Joyner said. "If you have exercised and held incentive stock options during 2001, have nontraditional investments that generate AMT preference items (income and expense items that receive special treatment under the tax laws) or anticipate that long-term capital gains will be a substantial portion of your total income, evaluate your exposure to AMT."
There's a good reason to stay far away from the AMT. "The big issue that arises is once you're in the alternative minimum tax, you are losing the benefits of some of your deductions," Goldberg said.
Consider "bunching" itemized deductions in alternating years if you're close to claiming the standard deduction. For example, you can make charitable contributions this year, but not again until 2003.
"That way, you can itemize in alternating years and still get the benefit of the standard deduction in others," Joyner said.
For charitable deductions, consider gifting a stock held for more than a year instead of giving cash.
You'll get a charitable-contribution deduction based on the stock's fair-market value and avoid taxes on the accumulated gain.
"If you have a stock purchased for $10 and you hold for more than one year and give it away when it's worth $100, you get a charitable deduction for $100 and never pay the tax on the $90 gain," Joyner said.
Consider accelerating tax-deductible expenses to take deductions this year, when tax rates are higher, instead of in future years, when rates will be lower.
If you have a child, consider funding a 529 plan. A 529 plan is an investment plan operated by a state to help families save for college.
The new tax law greatly increased the benefits of 529 plans. Now, anyone can establish an account for a beneficiary, regardless of income levels. Beginning in 2002, assets in a 529 plan will grow tax-free instead of only tax-deferred if used for qualified education expenses.
Finally, don't forget to max out contributions to your 401(k) retirement plan.
"Sometimes if you have a year-end bonus, you can put more of that into the 401(k)," Joyner said. "Not only do you get the tax deferral, but you may also get a company match on some or all of the funds."