If you're looking for ways to reduce your income tax bill, consider the following strategies:
Contribute the maximum amount to your 401(k) plan.
Your contributions, up to a maximum of $14,000 in 2005 (individuals over age 50 may also be able to make an additional $4,000 catch-up contribution), are deducted from your gross pay, so you won't pay current income taxes on the contributions (although you still pay Social Security and Medicare taxes). In addition, earnings and capital gains on your investments grow tax deferred until withdrawn. When you make withdrawals, you'll have to pay taxes on the contributions and earnings (and a 10% early withdrawal penalty if withdrawals are made before age 59 1/2), but this tax-deferred growth typically means you'll have a larger retirement fund than if you had been paying taxes currently during the years.
Decide which type of individual retirement account (IRA) to contribute to.
Find out whether you're eligible to contribute to a traditional deductible or Roth IRA and then decide which is the better alternative for you. Make your contribution early in the year to allow your funds to compound tax deferred or tax free for a longer time.
Consider investing in municipal bonds if bonds comprise a portion of your investment portfolio.
Interest income from municipal bonds is generally exempt from federal, and sometimes state and local, income taxes. In general, the higher your marginal tax rate, the more advantageous you'll find investing in municipal bonds. Before investing, compare the yield on the municipal bond to the after-tax yield of other types of bonds. Keep in mind that municipal bonds are subject to market risk, interest rate risk, and credit risk. Also, the income from certain municipal bonds may be subject to the alternative minimum tax (AMT).
Investigate investments that generate capital gains, such as growth stocks.
Capital gains on investments held over one year are subject to the 15% capital gains tax rate (5% if you are in the 10% or 15% tax bracket), compared to the highest ordinary income tax rate of 35%. Also, you do not pay any tax until the investment is sold, allowing you to decide when to recognize the gain. You may also want to consider stocks that generate dividend income, since that income would now be subject to the capital gains tax rate.
Replace loans that generate personal interest with mortgage loans or home-equity loans.
Personal interest cannot be deducted on your tax return, while mortgage and home-equity loan interest typically can, as long as your mortgage does not exceed $1,000,000 and the home-equity loan does not exceed $100,000.
Make annual gifts (up to $11,000 in 2005 or $22,000 if the gift is split with your spouse) to your children tax free.
Doing so shifts the income from the assets to your children, who may be in a lower tax bracket. If your child is under age 14, be aware that the "kiddie tax" rules apply. In 2005, the first $800 of investment income is tax free, the second $800 is taxed at the child's tax rate, and any remaining income is taxed at the parents' marginal tax rate. Thus, you may want to utilize tax-free or tax-deferred investments for at least a portion of the child's investments until he/she turns 14. All investment income of children age 14 or older is taxed at the child's marginal tax rate.
Take advantage of education tax breaks.
If eligible, make sure to document and claim the above-the-line deduction or Hope or Lifetime Learning credit. Be aware that you may be able to deduct a portion of the interest paid on student loans. Also, decide whether you want to save for college with a Coverdell education savings account or a Section 529 plan.
Obtain a receipt for any household goods donated to charity.
You can deduct those contributions on your tax return. Also, keep track of any out-of-pocket expenses incurred while you are performing charitable activities; those can also be deducted.
Keep track of expenses incurred while searching for a new job.
Items like resume preparation, mileage, airfare, and hotels can be deducted as miscellaneous itemized deductions. If you get a new job in the same field and relocate more than 50 miles from your current home, you can also deduct all unreimbursed moving expenses. You don't even have to itemize to claim the expenses.
Review your tax situation now.
This gives you time to consider various tax planning strategies and ensure you have adequate time to implement them before year-end.