Even though Tax Season 2004 is over, next April 15 will be here sooner than you might think.
To help get a jump on next year, baltimoresun.com's tax experts -- Jim Dupree of the Maryland office of the Internal Revenue Service in Baltimore; Nicole M. Harrell, head of her own accounting firm in Baltimore; and Gregory S. Horning of Stout, Causey & Horning in Hunt Valley -- respond to one reader's e-mail, adding tips that could apply to most filers.
I am single with no children. My tax preparer suggested that I borrow from my 401(k) immediately, since the interest rates are so low, and buy a house. I told him I was on a debt-reduction plan right now, and was not ready to buy.
Is there anything else I can do for the next year or two to reduce my taxes, while I work on lowering my debt?
Dupree: While it is not the purview of the Internal Revenue Service to give financial planning advice, financial decisions should never be made solely based on their tax consequences.
However, borrowing from your 401(k) may be a problem if you quit your job or retire before repaying what has been borrowed. Usually, the unpaid amount must be repaid immediately or it will be considered a taxable distribution and could be subject to a penalty if you are younger than 59.5.
That said, here is some general advice toward helping your tax situation next year:
Adjust your W-4 or estimated tax payments (on the 2004 Form 1040ES) so that the proper amount of federal and state withholdings is reflected. Claiming no allowances will cause more taxes to be withheld from your earnings each pay period, while one or more allowances will cause fewer taxes to be withheld. With 10 or more allowances, the IRS receives W-4 notification from your employer.
You also could consider designating an additional amount withheld for non-wage income or you can make estimated tax payments quarterly.
You can increase your contributions to your 401(k) plan. Such contribution limits have increased to $13,000 -- or $16,000 for those 50 and older -- for tax year 2004. (The deduction for tuition and fees for yourself, your spouse and your dependents also has increased to $4,000 for 2004.)
For 2004, the business mileage deduction increases, and so has medical mileage, an often overlooked deduction for transporting someone for treatment. It is 37.5 cents per mile and 14 cents, respectively.
For 2004, the problems many taxpayers experienced with the Advance Child Tax Credit will not occur next year; it was an issue in 2003 only.
Set a date on your calendar for early February to do your taxes for tax year 2004.
Avoid headaches by keeping track of your receipts and other records over the next year. Good record-keeping will help you remember the various transactions you made during the year, which will help greatly when preparing your taxes.
Records also help you document the deductions you've claimed on your return. You'll need this documentation should the IRS select your return for examination. Normally, tax records should be kept for three years, but some documents -- those relating to a home purchase or sale, stock transactions, IRA and business or rental property -- should be kept longer.
In most cases, the IRS does not require you to keep records in any special manner. Generally speaking, however, you should keep any and all documents that may affect your federal tax return. Such items would include bills, receipts, invoices, mileage logs, canceled checks or any other proof of payment -- and any other records to support deductions or credits you may claim on your return.
Good record-keeping saves time and effort at tax time when organizing and completing your return. If you hire a paid professional to complete your return, the records you have kept will help your preparer complete your return quickly and accurately.
Harrell: Deborah, as a single person with no children, there still are some other considerations that may affect your decision:
Have a tax preparer review your tax returns from the past two years to ensure that you have deducted all that is allowed to you. Take into consideration any student loan interest paid, Individual Retirement Account contributions, educational tuition and fees paid.
Many times, single individuals do not think they qualify for itemized deductions because their standard deduction, totaling $4,750 for the 2003 tax year, is greater. Remember that your Maryland state withholding, cash and non-cash charitable contributions, as well as miles traveled for charitable purposes, are deductible on Schedule A of Form 1040. This is in addition to unreimbursed employee expenses and medical expenses that you paid.
If you have investments that are doing poorly, and your financial adviser doesn't foresee a turnaround in the immediate future, you may want to consider selling the investment and take a capital loss. A maximum of $3,000 may be deducted on your return in any tax year, but any excess may be carried over to future years. This doesn't, however, include your 401(k) investments.
For other taxpayers, here are some other tips to keep in mind now for next year:
Expect to receive all of your tax documents by Jan. 31, 2005. This includes your mortgage interest statements; Forms W-2 and 1099; and interest and dividends statements. Make sure that you have not only the dependent-care amount paid, but also the address and federal identification number. If you do not receive all of your appropriate tax information, please contact the various sources when you determine the information is missing.
Many times, taxpayers forget to include relevant tax information that may be deducted on their tax return. Make sure that you have received charitable statements and mortgage interest statements from all sources. If you purchased or sold a home during the year, please do not forget to give your tax preparer your settlement sheet so that all relevant expenses can be included in the calculation of your income tax return.
In addition, many people wait until the last minute to file their taxes because they have owed money in the past. You should make the appropriate estimated tax payments to the IRS and state taxing agencies throughout the year. Penalty and interest will accrue if you have not made the required deposits.
Examine your withholding. I generally discourage taxpayers from receiving large tax refunds. This usually means that you had too much money withheld from your compensation for taxes during the year. Change your federal and state withholdings to better reflect what is truly due the IRS and the state.
Using Form 1040ES can assist you in determining how much should be withheld for federal tax purposes.
If you are thinking about incorporating a new business in 2004, consider whether you are actually going to conduct business this year. Many individuals incorporate a business before they are truly ready -- forgetting that there are still corporate returns that will need to be prepared. This can be expensive. Consult your accountant and attorney before you start this endeavor.
You should amend your tax returns for 2001, 2002 and 2003 if you are entitled to a refund. If you need to amend your returns, and it will require you to owe additional taxes, you should file the returns as soon as possible and for all of the appropriate years.
Remember that after April 15, 2005, you cannot amend the 2001 tax return to get a refund.
Many people think being an independent contractor is better than an employee because they receive their compensation without taxes being withheld. You may have not paid taxes then, but you will have to pay income tax and self employment tax in the calculation of your tax returns.
Make sure that estimated taxes are paid on the net income (income after deducting allowable business expenses).
Horning: I suggest, Deborah, that you trust your instincts on the 401(k) loan.
Many participants borrow from their 401(k) plans, believing that the loan is a "good deal" since they are paying themselves back, with interest. What they fail to realize is that 401(k) loans carry two significant drawbacks:
If you leave your employer, most plans will require you to repay the outstanding loan in full by the end of the next quarter. If you fail to do so, you will be taxed on the defaulted loan and may be subject to a penalty equal to 10 percent of the defaulted loan.
While the interest you pay on the loan is deposited into your 401(k) account, this interest is generally not tax deductible, and is paid with after-tax dollars. In the future, you will pay tax again on these same dollars when they are distributed to you in retirement.
For these reasons, I suggest that you maintain your current course of debt reduction and only purchase a home if, and when, you can afford to and are able to qualify for a traditional mortgage loan.
More broadly, here are some tips that taxpayers can use to save time and money on taxes next year and beyond:
Create a tax year 2004 folder to store receipts and related information. It is much easier to gather this information over the course of the year rather than scrambling next spring. Many opportunities for tax savings are missed when facing the pressure of a looming deadline.
Consider adjusting your withholding by changing your Form W-4 with your employer. As enjoyable as those healthy refund checks are, this money represents an interest-free loan to the IRS. Investing during the year makes better financial sense.
Alternatively, those who owe taxes at the end of the year may want to increase withholdings. This step will reduce the burden of writing a large check next April and can eliminate penalties and interest. Another option for those who owe is to pay quarterly estimated taxes.
Taxpayers who pay estimated taxes should mark their calendars with the due dates. Avoid the dreaded interest and penalties caused by missing these quarterly deadlines.
Review your 2003 tax return for carry-forward information. Capital losses, charitable contributions, equipment expensing under Section 179 of Form 1040 and various credits may be carried from previous tax years. Proper tax planning can maximize these carry-forwards for your benefit.
Finance your retirement! With a checking account replenished by that healthy tax refund, taxpayers should consider saving for retirement. Setting up and contributing to an Individual Retirement Account is an easy process.
Taxpayers also should take advantage of any employer-sponsored plans that may be offered. The most prevalent, the 401(k), combines tax-deferred growth with an employer-matching feature. Generally, taxpayers should try to maximize the employer match.
The tax-favored status of IRAs and 401(k)s makes them ideal investment tools for retirement. Speak with your tax adviser to determine which plan makes the most sense.
Parents and grandparents concerned with financing a child's education should consider starting college savings plans, often called 529 plans. Many people are attracted to the excellent tax benefits and flexibility these plans offer. There is no time like the present to begin saving for the skyrocketing cost of education.
"I'm not rich! Why am I subject to the alternative minimum tax (AMT)?" An increasing number of taxpayers are surprised to learn that they are subject to the AMT. Completing a tax projection during 2004 can eliminate the surprise next April. Often, tax planning can remove the AMT burden entirely.
Closely monitor securities transactions to qualify for favorable long-term capital gains rates.
Review the tax efficiency of your portfolio with your financial adviser. Consider the favorable rates applicable to qualified dividend income. Also, consider whether taxable or tax-exempt bonds are beneficial, based on your tax bracket and the applicability of the AMT.
Businesses contemplating new equipment purchases should bear in mind the expiration of the 50 percent bonus depreciation rules at the end of this year. Don't miss your last chance at this valuable tax break.
But the most important tip is to plan. The decisions you make today will affect you in the future. Talk to your tax and financial advisers, make a plan -- and stick to it.