If ever there was a year when you should estimate your federal tax bill before Dec. 31, this is it. That's because a slew of tax-law changes, from higher standard deductions to new capital-gains rates, have created a minefield for those who haven't analyzed their financial situation since filing last year's return.To reap the greatest benefit from some favorable shifts this year, you or your tax preparer must do a dry run on your taxes soon, so you can still take steps to reduce your tab. Key issues are whether you are obliged to pay the alternative minimum tax (AMT), how close the amount that has been withheld from your salary or handed over in estimated taxes comes to meeting your projected tax bill, and whether you need to make moves to avoid paying the high rates on short-term capital gains.
The conventional wisdom is to defer income, such as yearend bonuses, into the next year, and to search for as many legitimate deductions as possible to take now. But this advice won't work if you're subject to the AMT, warns Steven Hurok, tax director at BDO Seidman tax consultants in Woodbridge, N.J. This year, he says, "that infamous tax is going to hit some people with incomes under $100,000, not just the really wealthy."
Originally intended to ensure that the very richest Americans could not avoid paying taxes, the AMT is based on calculations that exclude personal exemptions and large, common deductions, such as state and local income and real estate taxes. But because the formula has not been adjusted to keep up with rising incomes, the U.S. Treasury predicts 2.7 million filers will have to pay it this year, about 400,000 more than in 2002 and 1.7 million more than in 1998. Among the taxpayers most vulnerable to the AMT are those who live in high-tax states such as California and New York.
Figuring out if you owe the AMT requires two steps. First, calculate your regular income-tax bill, including all the deductions you're ordinarily entitled to. In the case in the table, the family owes $32,213. Then do the AMT math. First you'll have to exclude the deductions you normally would get; then you'll be able to take an AMT exemption (raised a few thousand dollars in 2003, to $40,250 in adjusted gross income for an individual taxpayer and $58,000 for a joint return) before you get to the bottom line that makes you liable -- or not -- for the AMT.
In the example (table), since the AMT doesn't allow the family to deduct its state income tax or real estate and personal property taxes, the result is $34,320 -- and the law says the higher of the two is what's owed. Other factors that could bump you into the AMT include exercising incentive stock options and not selling them in the same year, high medical deductions, or interest on a home-equity loan not used to buy, build, or improve your house.
Your yearend tax-planning changes drastically if you're subject to the AMT. If you aren't, as long as you itemize, you can reduce your tax bill by prepaying such deductible items as real estate, personal property, and state income taxes before Jan. 1. But if you're liable for the AMT, those deductions won't help you in 2003, and you might as well save them in case they can do you good in 2004. Taxpayers who owe the AMT and did not anticipate it, says Hurok, "may be caught in a surprising cash flow problem in April" if they have not withheld enough from their salary.
No matter which tax you must pay, you could be in line for a refund. That's because the new tax law that went into effect on May 28 lowered rates retroactively to Jan. 1, but employers did not start applying the new rates until July 1. As a result, many people may be overwithheld and eligible for a refund. That's a good reason to file early.
Self-employed workers and others who pay estimated taxes each quarter may also be due a refund. Mark Luscombe, principal analyst for the federal and state tax group of CCH, says that if you've made three quarterly payments based on income estimates prepared before the 2003 tax changes, you may have already paid enough. In that case, you can either reduce or cut out your Jan. 15 payment altogether.
A BIT OF CHARITY
Capital-gains tax demands attention, too. Long-term stock gains taken after May 5 "will be taxed at only 15% (vs. 20% last year), but short-term gains will still be taxed at your highest marginal rate" for ordinary income, says Bruce Weininger, a partner in Deloitte & Touche Private Advisory Services in Chicago. That rate could be 28% for an individual with taxable income of $68,800 to $143,500 ($114,650 to $174,700 for marrieds filing jointly) and 35% for those with taxable income of $311,950 or more (it's the same for singles and marrieds). So try to hold on to stocks for more than a year. If you have taken short-term gains, generate losses to offset them by selling some losers before Dec. 31. If your losses exceed your gains, you can claim up to $3,000 in capital losses and carry what's left over into future years.
For higher-income taxpayers who've had a good year in the stock market, a tax-saving strategy is to donate shares with long-term appreciation -- and qualify for a charitable deduction based on the stock's fair market value of up to 30% of adjusted gross income. If you don't want to designate a charity now, you can put the stock into a "donor-advised" fund offered by companies such as Fidelity Investments and Vanguard Group. Later, you can direct the fund to cut checks to charities you choose. You can also deduct cash or in-kind charitable contributions, but be sure you have a receipt for donations of $250 or more.
Finally, don't forget the tried-and-true deductions (table). The standard deduction for joint filers has risen to $9,500 (from $7,950) and for individuals to $4,750 (from $3,975). If you have a 401(k), you must make contributions no later than Dec. 31 to get a tax deferral. Taxpayers with individual retirement accounts have until Apr. 15, or when they file their tax return.
All in all, with the stock market up and tax rates down, this could turn out to be a good tax season, as long as you don't get caught in the AMT net. But you won't know how good -- or bad -- it is for you until you run the numbers. By Ellen Hoffman