Year-End Financial Planning

You can reduce your taxable income and save on taxes for your 2005 tax return — if you act now. On The Saturday Early Show, financial adviser Ray Martin explains every step you need to take.

The fact is that after the end of the year, your tax return is a history report of your taxable income this year. What you do before the year's end can change that before it is final.

Make a few well-timed financial moves before Dec. 31 and you can rack up significant savings. Year-end planning is also about taking actions so that you don't end up losing money or leaving financial advantages on table.

Here is a rundown of some of the financial and investment moves employees, investors and the self-employed should consider.

Spend Flexible Spending Accounts
If you have set aside pre-tax money in a flexible spending account now is the time to check your remaining balance in these accounts. The key thing to keep in mind is that any money not spent that remains in these accounts will be forfeited.

But here's a new wrinkle for 2005 — employers may now amend their flexible spending plans to provide a 2½-month grace period AFTER the end of the year to make reimbursements, so expenses may be incurred and reimbursements could be made as late as March 15, 2006. Be careful to check with your employer. Not all employers have amended their plans and made this change.

No matter what, check with your employer's flexible spending plan and be sure to incur enough qualifying expenses (for out of pocket costs for health care and child care expenses) with receipts dated on or before Dec. 31 (or March 15, 2006) that total as much as or more than what you deposited into these accounts in 2005.

Call or log on to your flex plans contact site now to find out what your unused balance is, and make a plan to spend this on out-of-pocket health care and child-care costs. And now that over-the-counter medicines qualify for reimbursement, it is easier than ever to come up with qualifying expenses to submit for reimbursement.

Start Getting Your Tax Refund Now
If you've experienced an event that will provide more tax deductions than usual this year, such as having or adopting a child or buying a home, you may be pleasantly surprised by a larger tax refund when you prepare and file your 2005 tax return next year. And while a large tax refund next year is nice, more cash flow in your paycheck now will come in handy to pay the rising costs of loans, heating bills and holiday expenses.

Remember, when you get a large tax refund, this simply means that you are overpaying your income taxes and letting the IRS keep this money as an interest free loan. Would you overpay your cable bill or your rent by several thousand dollars just to ask for it back without interest next year?

If you could use the cash instead of giving the IRS a zero percent interest loan, then reduce your tax withholding by increasing your withholding allowances, changing your withholding status or both. Do this by completing a new W-4 form and submitting it with your employer's payroll department. Do it now so that the change will be effective for the remaining pay periods in November and December.

Maximize Deducible Expenses

Teachers Take a Deduction:
Teachers need to save their receipts for Educator Expenses — or out of pocket costs of materials they purchase for the classroom because they can claim a $250 deduction on their tax returns for these. How many teachers could qualify for this deduction? According to the U.S. Census Bureau, there are approximately 6.5 million teachers in the United States.

Timing Your Deductions
Now is also the time to think about your income for this year and in 2006. Maximizing your tax savings from itemized deductions is all in the timing of when you pay these. For example, if you could be receiving more income this year than you expect to receive in 2006, then you could be in a higher tax bracket this year.

Also, if you are not likely to pay the Alternative Minimum Tax this year, but likely to incur the AMT in 2006 (the number of taxpayers getting caught up in the AMT is rising rapidly each year), then it may be advisable to pay more deductible expenses in this year rather than in 2006 as some of your deductions would be disallowed next year under the AMT calculation. Here are some expenses you can pay before year-end to increase your itemized deductions this year:

• Mortgage Payments: Pay the mortgage payment due in January before the end of December, which includes deductible mortgage interest.
• State Income Taxes: Deductible state income taxes should be estimated and paid before year's end.
• Real Estate Taxes: Pay any real estate taxes due early next year (in January, February or March), now before year's end.
• Charitable Contributions you expect to make early next year can be paid this year.
• State Sales Tax Deduction: Again in 2005, taxpayers will have the option of taking a deduction for either state sales taxes OR state income taxes. Residents of the nine states where there is no state income tax may come out ahead if they purchased items in 2005 such as cars, jewelry, furniture, appliances, etc., which would have resulted in state sales taxes that when totaled up exceed their standard deduction ($4,850 for Single and $9,700 for Married filers).

  Taxpayers who could benefit from the state sales tax deduction should consider making any planned purchases of big ticket items, such as cars, remodeling, jewelry, appliances, etc. before year's end to get the most benefit of this deduction. Residents of other states may not get any advantage from this option as their states income tax on their income will in most cases be more than the sales taxes they incurred.

If you turned 50 in 2005 (even on the last day of this year) you can contribute an additional $4,000, for a total of $18,000. Many employers retirement savings plans allow workers who qualify to make Catch-Up-Contributions or CUC's, in whole dollar amounts deducted from a single pay check, so getting the process for doing this is relatively simple.

If you are not on track to maximize your retirement savings plan contributions, change the contribution from your remaining pay this year (salary and bonus) so that you can contribute the maximum allowable into your plan. This accomplishes two things: increases your retirement savings and reduces your taxable income on this year's tax return.

Make Retirement Account Distributions
If you turn 70 and half in 2005 and are no longer employed, the IRS will require you to begin taking withdrawals from your tax-deferred retirement accounts. You've had a tax break for all these years, now they want you to start paying some taxes on this money. Generally these required minimum distributions must begin by April 1 of the year following your age-70.5 year. It's often advised to begin these distributions in the year you turn 70.5 so as to avoid taking two distributions in the following year. After that, these required distributions must be withdrawn from retirement accounts before Dec. 31 each year.

Forget to take this required distribution and you can get stuck with a stiff penalty of up to 50 percent of the amount not withdrawn. Using the IRS's applicable divisor for individuals who are age 70.5, the amount required to be distributed in the first year of required minimum distributions is about 3.65 percent of the value of the retirement accounts at the end of the prior year (the December 31, 2004 value).

Click on page 2 for Year-end moves for the Self-Employed and Investors

According to the U.S. Census Bureau, the number of self-employed workers in the United States is approximately 10.3 million. But add to that the number of small business owners and the number is significantly higher. The Small Business Owners and the Self-Employed have great flexibility over the timing of their income and expenses and should consider the following year-end financial strategies:

• Defer Income into next year by waiting until January to send December bills to customers.
• Employ and Pay Family: For 2005, small business owners can deduct and pay each employee who is their child as much as $8,850 and they may pay NO income taxes on this amount. If the employee-child is under the age of 18, they may not even owe any Social Security or Medicare taxes.

  This works because each income earning individual can claim a standard deduction of $4,850 and can also contribute up to $4000 to a deductible IRA in 2005. And parents who own a business and employ and pay their children more than $8,850 can save more: the employed child has earnings in their lower tax bracket and can contribute to a deductible or Roth IRA while the parents business gets a deduction for the income paid out at a higher tax bracket.

• Open a Retirement Plan Account: My favorite tip for small business owners and the self-employed is to open a retirement plan before year's end. One of the best types of retirement plans to consider is the Self-Employed 401(k) plan. These plans allow the self-employed to contribute and deduct up to $46,000 by making a combination of a profit sharing contribution of 25 percent of adjusted net income and a $14,000 pre-tax 401(k) contribution (or $18,000 if you are 50 or older). The catch is that the plan account must be established and opened before December 31st.

  Contributions don't have to be made by then but to take a tax deduction on your 2005 tax return; you must have established the account and have an account number before the end of 2005.

  Small business owners who are older, with high incomes and few employees can also consider a defined benefit pension plan that may allow them to contribute and deduct a much larger amount that's based on their age and income. One caveat: you will have the flexibility to fund other types of retirement plans but you must make an annual contribution to a defined benefit plan.

• Deduct Business Property: Small Business Owners can also buy up to $105,000 of computers, office furniture and software in 2005 to qualify for a Section 179 deduction of this amount against their net income. This is a use-it-or-lose-it deduction, as any unused amount cannot be carried forward to future years. But don't worry — unless the tax code changes, you'll have this deduction again in 2006 and 2007, but after that, this deduction is scheduled to decline to $25,000. Small business owners and the self employed who use expensive medical or construction equipment in their businesses will have no difficulty coming up with $105,000 in eligible expenses.

Investors need to take inventory of their capital gains and losses for the year. Take a measure of all realized and unrealized gains and losses on investments in taxable investment accounts. Also remember to include gain realized from real estate sales too. If you have realized net capital gains so far this year, then look for any potential losses that could be realized to offset the gains.

Start with pulling out your 2004 U.S. Individual Income Tax Return and review the Schedule D, Capital Loss Carryover Worksheet, to find out if you have any unused capital losses that have been carried over to 2005 and can be used to offset gains this year.
Once you've determined your net capital gains, it's time to go to work, identifying a plan to sell investments that result in realizing enough losses (or gains) to offset the gains (or losses) from investments sold or mutual fund distributions.

Remember, the rule for using capital losses is:
Excess Long-term Capital Losses:

• First used to offset long term capital gains, then
  
• Used to offset short-term capital gains, then
  
• Use $3,000 to offset ordinary income, then
  
• Carry over the remaining amount to the next year.

• First used to offset short-term capital gains, then
  
• Used to offset long term capital gains, then
  
• Use $3,000 to offset ordinary income, then
  
• Carry over the remaining amount to the next year.

Reducing Capital Gains Taxes
Gifts to Charity: As a general rule the market value of stock owned at least a year or more that is donated to charity is deductible. Neither you nor the charity will pay taxes on the gain when the charity later sells it. Essentially you are giving away the tax liability on your gains and getting a tax deduction for the gift! But don't make the mistake of giving away stock that is worth less than you paid for it. You can only deduct current market value of the shares and cannot take the loss.

Gifts to Children: Also, don't give your children cash as gifts. Instead, give them shares of appreciated stock or mutual funds. When they sell the shares, the gains could be taxed at their lower capital gains rate (five or 10 percent) versus the parent's higher rate (15 percent).

Gifts to Anyone: Also, remember that you can give any individual up to $11,000 in 2005 and the gift will be excluded from the US Gift Tax and will be received tax-free by the recipient. If you make these gifts each year, make sure that you have fully used your annual gift-tax annual exclusion amount.

Stock Option Planning
When stock options are exercised, the gain realized between the grant price and the market price will be included in W-2 income and taxed as ordinary income. Therefore, consider delaying the exercise of any more nonqualified stock options until after year-end. Of course ignore this for any options that may expire this year and exercise the options that are in-the-money before they expire. Also, taxpayers who are subject to the alternative minimum tax should consider exercising non-qualified stock options to generate more taxable income which can help to avoid the AMT.