From an investment and taxpaying viewpoint, 2006 has been a pretty good year. The stock market is hitting new highs, important tax breaks for education savings were extended. Still, if you haven't done so already, you should take a hard look at your income and investments with an eye toward Apr. 15. Sure, that's months away, but you only have until Dec. 31 to make some smart moves that can produce big savings or avoid a bone-headed, expensive mistake. There weren't nearly as many tax law changes in 2006 as in the past few years, but here are five areas you need to check. In fact, the sooner, the better.
1. Charitable Donations
Before you write that check to your favorite charity, think about making the donation with appreciated stock. Giving shares directly to the institution allows you to take a charitable deduction for their full market value. If you sell stock and then make the donation from the proceeds, you'll have to pay tax on your gains.
Don't wait too long to tell your broker that you want to make such a donation, warns John Gay, a financial adviser at Frisco Financial Planning in Frisco, Tex. "A lot of people intend to do it, but it can take a week or two to complete the transaction," he says. Most religious institutions and well-known nonprofits can easily accommodate a stock donation, but some may have their own red tape. If the transfer isn't completed by Dec. 31, the deduction won't count for 2006.
This year and next also afford an opportunity if you are taking distributions from your individual retirement account (it's mandatory for those 70 1/2 or older). Sums of up to $100,000 from your IRA donated to charity won't count as income to you. That can help you avoid triggering other problems, such as getting pushed into a higher tax bracket.
2. Retirement Plans
You can make contributions to IRAs for 2006 up until Apr. 15, but there may be better plans for you--and those require you to act before yearend. For instance, if you're self-employed, a 401(k)-like tax-deferred account known as the Single K has the same pretax contribution limit as a 401(k)--for 2006, $15,000 a year withheld from salary (or $20,000 for people over 50). But it also adds a profit-sharing element that can exceed those amounts, allowing the self-employed to make contributions of up to 25% of the business' profits. The trick is that the salary portion must be contributed before Dec. 31. "It's a much better option for many sole proprietors," says Sacha Millstone, senior vice-president at the Millstone Evans Group of Raymond James & Associates.
If you've changed jobs this year you also need to do an immediate check on how much has been withheld in pretax retirement accounts. Because two employers may have withheld salary for a 401(k), it's possible you may have accidentally exceeded the annual limit. If you've made excess contributions, you need to get your employer to withdraw them by Apr. 15. Otherwise, you, in effect, end up with double taxation. The excess gets reported as income for 2006, and it will be taxed again when you start tapping the funds in retirement.
3. Expenses and Income
It's often a good idea near the end of the year to accelerate deductible expenses and defer income, but there are a few caveats. You may want to pay property tax bills in December that aren't due until January or February. That allows you to claim the deduction for property taxes in the current year. But watch out if your property taxes are held in escrow. Your mortgage company may not be as diligent about getting a check out on time as you would be. If the escrow holder pays even a few days late, you don't get the deduction until next year.
Unfortunately, this accelerated payment ploy doesn't work for interest on mortgages or loans, or for rent. The IRS won't consider it deductible for 2006.
It's also dicey to shift income into next year for work already done. Even arranging to have current salary deferred without risk and at your behest doesn't delay the tax liability, according to the IRS. Financial advisers warn that the IRS doesn't look kindly on delayed invoicing that appears out of the ordinary. Things get especially tricky for owners of small businesses that operate on an accrual basis. Under the accrual method, income is credited when services or sales occur, regardless of when the money is received.
4. Paying for Education
Congress finally got around to making permanent the tax advantage of 529 savings plans, making these tax-deferred education accounts a smarter choice for many parents. The tax change also prompted some plan providers like Fidelity and Vanguard to cut fees and offer additional investment choices, so it's worth revisiting the question of whether these plans are the most appropriate way to save for college.
If your youngster plans to start college next year, then you need to look again at your income and expenses for this year. That's because financial aid applications will focus on the full calendar year before a student matriculates. Even if there is no tax reason to defer income, keeping your income down could improve the prospects for a financial aid award. Online calculators such as FinAid (finaid.org/calculators) can show you the effect of different incomes on aid.
Going back to school for professional development in 2007? You may be able to take advantage of the lifetime learning credit, which pays a maximum of $2,000 per year. You can even collect the credit in two consecutive years for a hefty tuition bill in one year. Here's how: Prepay part of the tuition in 2006 for classes that start by Mar. 31, 2007, and you get the credit for 2006. Amounts paid in 2007 will apply to next year's taxes.
5. The AMT
Some tax moves may become irrelevant or even counterproductive if you wind up paying the alternative minimum tax. Created in the 1960s to prevent millionaires from avoiding taxes altogether, the AMT calculation disallows many popular deductions, such as state and local taxes. Your tax is whichever method produces the higher tax bill.
About 3.6 million taxpayers are expected to get hit by the AMT this year. Are you one of them? If you paid the AMT last year and your financial situation is similar this year, you're likely to get hit again. If you didn't, you may get hit if you live in a high-tax state and have several dependents. The IRS offers an "AMT Assistant" (apps.irs.gov/app/amt/index.jsp) to help you determine your exposure.
One of the biggest pitfalls with the AMT is that the tax applies to gains on incentive stock options that have been exercised even if the acquired stock hasn't been sold. If this applies to you, remember to take it into account when figuring your AMT.
Politicians in both parties have said they want to fix the AMT before it snags some 18 million taxpayers in 2008. What the pols haven't figured out is how to replace the cash it raises.
By Aaron Pressman