One of the most important and complex areas of financial planning is taxation. The manner in which a taxpayer fills out the annual revenue forms can go a long way in determining how much money is left over for other things.
The past couple of years have seen the arrival of new tax breaks. The Taxpayer Relief Act of 1997 produced a crop of them, including provisions that deal with education expenses, individual retirement accounts and child tax credits.
These breaks are still relatively new, and not always well-understood or fully used by the taxpayers who are eligible for them.
But they can add up. Steven L. Wiseman, chairman of the federal taxation committee of the Maryland Association of Certified Public Accountants and vice president of Wiseman Associates Inc. in Bel Air, said he "could definitely see an impact" on the tax liability of his mainly middle-class clients.
Perhaps the most famous and misunderstood of the 1997 tax changes is the Roth IRA. This is a retirement account on which the gains, dividends and interest are not taxed. In certain circumstances, you may be able to switch funds from a traditional IRA to a Roth IRA to avoid taxes on future interest. Unlike a traditional IRA, a Roth IRA does not require minimum distributions when you reach a certain age.
No income tax is paid on money that is withdrawn from the Roth IRA, though you generally must be at least 59 1/2 years old (leave it to the tax laws to give even the simple issue of age an added layer of numerical complexity) in order to make a withdrawal.
In short, it's a tax-free way to build up a retirement fund. However, a Roth IRA is not deductible from income tax. The most you can put into your IRAs each year is $2,000.
For a sense of how the Roth IRA differs from the traditional IRA, consider this example:
You pay $2,000 a year into your retirement account for six years, resulting in $12,000. During that time, your account earns an additional $8,000, so you have a total of $20,000 in your IRA.
With a traditional deductible IRA, there is no tax on the amount you put in during those six years -- it's a deductible account, after all. However, the whole $20,000 amount is taxable when it is pulled out at retirement.
A traditional nondeductible IRA, as the name suggests, allows no deductions up front on the $12,000, but that money is not taxed when it is pulled out of the account. On the other hand, the $8,000 that money earns is not taxed as it builds up, but is taxed when it is withdrawn.
Now for the Roth. The full $20,000 amount may be taken out tax-free. As with the traditional nondeductible IRA, the $12,000 contribution enjoyed no deductions. However, the Roth IRA differs from the traditional nondeductible IRA in at least one important sense; the $8,000 in earnings is not taxed.
"If you're not eligible to get a deductible IRA, there's no reason to do [a nondeductible traditional IRA] as long as you're eligible for a Roth," Wiseman said.
As of last year, taxpayers may withdraw limited amounts from Roth or traditional IRAs to buy or build a first home, or to pay higher-education expenses.
Abatement of education costs is a theme that links many of the new tax breaks. A new education IRA permits contributions of up to $500 per year, per child. While this is a nondeductible contribution, the earnings will be tax-deferred and withdrawals are tax-free so long as they do not exceed education expenses.
The HOPE Credit allows you to shave up to $1,500 per year from your tax bill for the first two years of post-secondary education.
The Lifetime Learning Credit subtracts up to $1,000 per year for undergraduate or graduate education expenses, and may be used for an unlimited number of years. The HOPE and the Lifetime Learning Credit cannot both be claimed in the same year.
Whether or not you itemize your deductions, you may deduct up to $1,000 for interest on student loan payments.
"It's not just people who are in college," said Wiseman. "It can be for graduate and other classes, so it's for adults as well."
Even before kids start racking up tuition bills, they can still warrant a few tax breaks. The Child Tax Credit will be $500 per qualifying child on the 1999 tax forms, a figure that declines in stages for taxpayers with modified adjusted growth incomes higher than $75,000 for single filers and $110,000 for joint filers.
Since 1997, there have also been changes in the treatment of capital gains. The top rate has been cut to 20 percent for any gains on the sale of property held for more than a year, if those gains would be taxed at a 28 percent or higher rate as ordinary income.
The rate has been cut to 10 percent for gains that would be taxed at the 15 percent level as ordinary income.
There is also a simplified home-sale exclusion, which allows anyone selling a personal residence to exclude up to $500,000 of the gain ($250,000 for single filers) from taxation.
Barbara Pietrowski, president of Financial Planning Concepts Inc. in Kensington, said the home-sale exclusion is a key aspect of the 1997 legislation.
"It is probably, except for the Roth IRA, the single greatest benefit that came out of that bill. It's incredible. Before, you had to be over 55 to exclude $125,000 of gain. It severely limited mobility," Pietrowski said. "There's no age limit now. It's a huge benefit, just huge."