Even after a succession of federal tax cuts since 2000, Americans still bear a substantial tax burden. In fact, the nonprofit Tax Foundation estimates that the average person will still need to work 70 eight-hour days this year to pay federal taxes alone, compared to the 84 days they had to work in 2000 to cover federal tax obligations. State and local taxes are expected to cost the typical taxpayer an additional 37 days of work in 2005, versus 39 days in 2000. As these numbers indicate, lower tax rates may put more money in your wallet, but they do not negate the need for careful tax planning throughout the year.
What to Consider Before Year-End
Some of the smartest tax planning decisions can be made long before 2005 returns are due on April 17, 2006, with a few of them only possible before December 31. For example, investors reviewing their investments before December 31 can look for possible opportunities to offset capital gains in some securities with losses realized in others. Losses in a given tax year must first be used to offset realized capital gains. Any leftover losses can be used to offset up to $3,000 in ordinary income in that year, with any remainder carried forward to offset capital gains or income in future years. However, the decision to sell a security should not be driven by tax considerations, but rather based on an assessment of its long-term potential and role in an individual's investment strategy.
Before the year ends, look for additional deductions, such as charitable donations and deductible contributions to a traditional IRA, that can be claimed for 2005. The maximum contribution to a traditional IRA is $4,000 for 2005, an increase of $1,000 from last year, and deductibility is based on income and other factors. An additional catch-up contribution of $500 is available for those aged 50 and older. The deadline for IRA contributions for tax year 2005 is April 17, 2006.
Some taxpayers may also decide to make use of the annual gift tax exclusion. In 2005, gifts of up to $11,000 ($22,000 if filing jointly) may be made to any single individual without any gift tax consequences, if done so prior to December 31.
Managing Taxes Over the Long Haul
Beyond current year tax considerations, it can be worthwhile to focus on broad strategies for reducing tax liability over the longer run. These include investing in tax-advantaged retirement accounts, such as employer-sponsored 401(k) and 403(b) plans and traditional and Roth IRAs. In some cases, contributions to these vehicles may be made on a pretax basis or may be tax deductible, which can help reduce taxable income. More important, investment earnings compound tax deferred until withdrawn, typically in retirement when an investor may be in a lower tax bracket. Contributions to Roth IRAs are not deductible. However, withdrawals from a Roth IRA are tax-free provided the account has been held for at least five years and the account owner is at least age 59.
Whatever your personal tax situation and financial goals may be, keep tabs on how taxes affect your investments and take advantage of the various tax saving mechanisms that are available to you. Doing so may help improve your overall financial bottom line. For more information about the tax ramifications of managing your finances, contact a qualified tax professional.