This is the opposite side of the defer-income coin for year-end planning. It can be just as effective in trimming taxable income-and your tax bill-for the current year.
Before going on a spending spree to hike your deductible expenses, be absolutely certain that you’ll be itemizing. Thanks to higher standard deductions-$4,700 for singles and $7,850 for joint returns in 2002 and $4,750 for singles and $7,950 for marrieds in 2003-fewer taxpayers than in the past get any benefit from itemizing. (The standard deductions are even higher for taxpayers age 65 and older and those who are legally blind.) Itemizing pays off only if your qualifying expenses total more than the standard deduction for your filing status.
If you are on the itemize-or-not borderline, your year-end strategy should focus on bunching. This is the practice of timing expenses to produce “lean” and “fat” years. In one year, you cram in as many deductible expenses as possible, using the tactics outlined above. The goal is to surpass the standard-deduction amount and claim a larger write-off.
In alternating years, you skimp on deductible expenses to hold them below the standard deduction amount-because you get credit for the full standard deduction regardless of how much you actually spend. In the “lean” years, year-end plans stress pushing as many deductible expenses as possible into the following “fat” year when they’ll have some value.
Contributing to Charity
You have great flexibility in timing your deductible gifts to charities. If you’re thinking of making a substantial gift to your alma mater, for example, doing so before the end of the year locks in the deduction for the current year. If you normally give $100 a month to your church, making the January contribution by December 31 boosts your write-off by that amount. If you make a pledge to make future contributions, however, you don’t get the deduction until you actually make the gifts.
There’s a special advantage to giving away appreciated property-such as stock-rather than cash. You can earn a write-off for the current value of the stock rather than what you originally paid for it, and you avoid having to pay tax on the profit that built up while you owned it.
If you routinely go through closets for used clothing to give away, find time for a year-end sweep. Making the donation by New Year’s Eve earns you a deduction for the current year.
For 2002, you can give away as much as $11,000 a year to any number of people without triggering the federal gift tax. The tax-free amount doubles to $22,000 if your spouse joins you in making the gift. You don’t get a tax deduction for such gifts. But there’s an important advantage: Assets given away during your life-and any future appreciation-won’t be in your estate to be taxed after you die. And income generated by the gift is taxed to the new owner, not to you. (If you give assets to your own children, however, the income from those assets can be taxed in your tax bracket until the children reach age 14.)
This issue is raised here, among possible year-end maneuvers, because if you’re planning to make substantial gifts, you face a December 31 deadline. If you don’t use your $11,000 annual exclusion by that date, you lose it. Each new year presents you with a new exclusion, but you can’t reach back to benefit from a previous year’s unused allowance.
Assume, for example, that a couple plans to give $40,000 to their son. If they give it all during one year, $22,000 of the gift would be sheltered from the gift tax, the other $18,000 subject to it. However, if half the gift was given in December and the other half in January, the full $40,000 would be protected. (In fact, few people really have to pay the federal gift tax because the law includes a credit that pays the tax on the first $1 million worth of gifts that go over the $11,000 limit.)
If you make the gift by check, be sure the recipient cashes the December check before the end of the year. Unlike the rules for itemized deductions-which allow a deduction for the year you give the check regardless of when it is cashed-when a gift is involved, it is considered given in the year the check is cashed.
Since medical bills are deductible only to the extent that they total more than 7.5% of your adjusted gross income, timing your payments may be the only way to garner a tax benefit from these costs. By early December, you should have a good idea whether you’ll pass the 7.5% test. If it’s doubtful, try to hold off paying any medical bills until the following year, when they might have some tax-saving power. On the other hand, if you are close to or already over the threshold, see what you can do to pump up the deduction.
One sure way, of course, is to pay any outstanding medical bills-including health insurance premiums-by December 31. If you charge expenses to a bank credit card or borrow money to pay the bills, you get the deduction for the current year when you pay the bill, regardless of when you repay the debt.
Taxpayers who know they’ll get to deduct medical expenses should also consider scheduling, being billed for and paying for elective medical and dental work before the end of the year. That locks in Uncle Sam’s subsidy. The same goes if you need new glasses, contact lenses, dentures, a hearing aid, or modifications to a car to enable a handicapped person to drive.
If you make estimated income-tax payments, mailing the fourth-quarter installment by December 31 earns you the deduction in the current year-even if part of the payment is returned to you via a state tax refund the following spring. However, the payment has to be based on a reasonable estimate of your actual state-tax bill. You can’t inflate your fourth-quarter payment just to hike the write-off on your federal return.
You may have similar flexibility with state and local property-tax bills. In some areas of the country, these bills are mailed out in the fall, for example, but they don’t have to be paid until January of the following year. Beating the deadline by paying before year-end lets you claim the tax savings a year earlier.
Tax-Free Fringe Benefits
Fringe benefits often deliver double benefits. Not only does your employer foot all or part of the cost, but the value of most of these benefits comes to you tax-free. Even when that value is included in your taxable income, you come out ahead.
Assume, for example, that your firm has a vacation resort that you can use free of charge. If you take advantage of such generosity, the law demands that you include in taxable income the fair market value of the accommodations. If the value is set at $1,000 for your two-week stay, for example, an extra $1,000 will show up on the W-2 form for the year and you must pay tax on the extra “income.” For someone in the 30.5% tax bracket, the tax cost of the vacation would be $300 (30% of $1,000).
That’s a good deal, compared to the $1,000 it would have cost you otherwise. But it’s even better than it appears. If you had to pay the $1,000 out of pocket, it would really cost you more because you’d be spending after-tax dollars. In the 30% bracket you must earn almost $1,430 to have $1,000 left after the IRS gets its share.
The tax appeal of fringe benefits can even make it a smart move to ask your employer to cut your salary, with the pay cut being diverted to pay for fringe benefits. Suppose your company has a plan that permits you to shift $300 a month into an account that will be used to reimburse you for $3,600 you have to pay for child-care expenses. You more than break even by funneling money through the company plan. It would take almost $5,000 of taxable earnings, in the 27% bracket, to have the $3,600 after taxes you need to pay for child care.
Remember, too, that the tax-saving value of fringes is often boosted when you take state income taxes into account.
Take advantage of these tax-free benefits.
These allow employees to select from a menu of fringe benefits-which often includes the choice of cash as an entree-to tailor a personalized package of benefits. The plans have become increasingly popular as husbands and wives with duplicate benefits seek ways to trade in unnecessary items, such as double medical coverage, for more desired benefits, such as additional life insurance or dental coverage.
If you choose cash under such a plan, it is taxable income. If you choose tax-free benefits, their value is not included in your salary, and you therefore avoid the extra tax.
A popular selection on some menus-and sometimes a stand-alone benefit-is a reimbursement account. Also known as a flexible-spending account, these plans are funded through employee salary reduction, with the money going to pay certain expenses, such as medical and child-care costs. The advantage is that money going through the account is invisible to the IRS, so there’s no income tax, no social security tax and, in nearly all states, no state income tax either.
These plans require an employee to elect in advance how much salary to deflect for designated benefits. Another condition is that any amount left in the account at year-end must be forfeited. Using such an account for uncertain expenses-such as medical and dental bills-is somewhat risky. But there’s little danger for such predictable costs as child-care expenses. Also, the tax benefits are so great that, depending on your tax bracket, you could forfeit 20% or more of the salary diverted to the plan and still come out ahead.
Expenses paid by your employer-whether for a care provider you hire or for the value of care at facilities provided by your employer-are tax-free, up to $5,000 a year. Even if you can’t persuade your employer to institute a child-care-assistance program that offers this tax-free benefit, you may be able to garner tax help through a flexible spending account-see Cafeteria plans above.
You are taxed on the value of your personal use of the vehicle, but the value assigned to your business use of the car is tax-free. Your employer has to include the value assigned to your personal use of the car on your Form W-2 as income.
De Minimis Fringes
These are little things, the cost of which is so small that it’s unreasonable to keep track. Included in this tax-free category: use of the office copying machine, supper money or taxi fare paid in connection with overtime work, the value of office parties and employer-provided sports or theater tickets.
Educational Assistance Programs
Company-provided educational expenses are tax-free if the course is designed to maintain or improve skills for a job you already have (rather than to qualify for a new job) or is required by your employer. The law also allows employers to pay up to $5,250 worth of non-job-related educational expenses as a tax-free fringe. Until 2002, the break covered only undergraduate courses, but now it covers graduate level courses as well.
Discounts of as much as your employer’s profit on products and as much as 20% on services are tax-free to you.
Employee Stock-Purchase Plans
Options granted under these plans, which are similar to ISOs, let employees buy company stock at a discount, often 15% below market value. You don’t have to report any income until you sell the stock, when you are taxed on the difference between what you paid and what you get.
What your firm pays for airline tickets and hotel and restaurant bills while you’re on assignment is not taxable income. That remains true even if you tack a vacation on to the end of your trip. If you go to the coast for a three-day meeting, your airfare is the same whether you rush back to the office or hang around for a holiday.
If you take the family along, you have to pay for your spouse’s fare and the kids’, but working things so you get a tax-free trip from the firm could significantly cut the cost of the trip. Since many hotels let spouses and children stay for reduced or no cost, the time you’re on business with your company footing the hotel bill can produce tax-free accommodations for the whole family.
Congress has slapped a limit on how generous your employer can be when providing free parking. For 2002, if the value of parking is over $185 a month, the excess is considered taxable income. If your employer won’t pay for parking, you may still get a tax break here by volunteering for a pay cut to cover the cost. The law now allows employers to reduce an employee’s pay and use the money to pay for parking (or mass transit fares). The advantage: This would allow you to pay for parking with pre-tax dollars. In the past, if an employee had a choice between cash and a parking fringe benefit, he or she was taxed on the value regardless of which was chosen. Now, if you choose parking, the value is tax-free.
Group Term Life Insurance
The cost of up to $50,000 of coverage provided by your employer is tax-free. Coverage above that level results in taxable income, but it’s still usually a real bargain.
Incentive Stock Options (ISOs)
ISOs offer the opportunity to buy company stock at a set price over a period of time as long as a decade. You can wait for the price to rise before exercising the option, thus locking in a sure profit. You are taxed only when you ultimately sell the shares. To get gentle long-term gain treatment of any profit, you must not sell the stock until more than two years have passed since the option was granted and more than one year has passed since you exercised the option to buy the stock. (Different rules apply if you’re subject to the alternative minimum tax.)
Interest-Free or Bargain-Rate Loans
The option to borrow from your employer-not from the pension plan-is a rare but sweet perquisite. To the extent that you get a break on the interest rate, though, the IRS says you have taxable income.
Meals and Lodging
Your employer can provide food and housing tax-free if specific conditions are met. Meals must be offered at your employer’s place of business-a company cafeteria, say, or at the restaurant where you are a chef or waitress. The meals must also be for your employer’s “convenience,” a test that can be met if, for example, a short lunch hour or lack of local eateries makes it unreasonable for you to eat elsewhere.
Housing must be a condition of your employment-as it might be if you are a motel manager, for example, or a ranch foreman. Special rules apply to members of the clergy who are given a house or a housing allowance as part of their pay. That value is not taxable. There are also special rules for the tax treatment of on- or near-campus housing provided for professors and other employees of educational institutions.
Medical and Dental
Insurance premiums paid by your employer for you and your family are tax-free, although it’s possible that Congress will impose a limit on how much an employer can pay, with excess amounts considered taxable income to the employee.
You are not taxed on services that have value to you but don’t cost your employer anything. Included are such benefits as free space-available air or train travel for airline or railroad employees. If your employer operates a subsidized eating facility, the difference between what you have to pay for meals and what they would cost at an independent cafeteria or restaurant is a tax-free fringe as long as the employer charges at least enough to break even. And, apparently in an effort to encourage physical fitness, the law includes the use of an on-site athletic facility on the list of tax-free perks.
The value of services paid for by an employer who is letting you go-such as motivational seminars, resume writing and counseling aimed at helping you find a new job-is a tax-free fringe.
Often the most valuable and most important fringe benefit, money set aside for your retirement is not taxed until you actually get your hands on it. If the plan permits employee contributions, give careful consideration to the tax value of signing up.
Stock Bonuses and Bargain Purchases
If your company gives you stock or lets you buy it for less than market value, you receive taxable income to the extent that the stock is worth more than you pay for it. However, if there is a risk that you might have to forfeit the stock-such as a requirement that you return it to the company at the price paid if you quit your job within a certain number of years-you don’t have to report any taxable income until those restrictions expire. At that time, you would report as income the difference between what you paid for the stock and its value when the restrictions expired.
Employees can get up to $100 a month tax-free to cover the cost of getting to and from work via public transit. This benefit can take the form of bus, subway or train passes or tokens or reimbursement. If your employer doesn’t offer free mass-transit passes, you may still get a tax break here by volunteering for a pay cut to cover the cost. The law now allows employers to reduce an employee’s pay and use the money to pay for mass transit fares (or parking). The advantage: This would allow you to pay $100-a-month of your commuting expenses with pre-tax dollars. In the past, if an employee had a choice between cash and a mass transit fringe benefit, he or she was taxed on the value regardless of which was chosen. Now, if you choose the fringe benefit, the value is tax-free.
Working-Condition Fringe Benefits
You are not taxed on such benefits as the value of a company car provided for business use or the cost of subscriptions to professional journals paid by your employer.
Alimony Payments and Income
The way the IRS treats various parts of the financial arrangements that accompany a divorce can play a major role in the structure of those arrangements. Payments that qualify as alimony are deductible by the ex-spouse who pays them and taxed as income to the one who receives the money. Child support, on the other hand, is neither deductible nor taxed.
Stocks or other property received as part of a divorce settlement retain the same basis they had when owned by your ex-spouse. In other words, the paper gain or loss that built up while your spouse owned the property and any tax liability for it are transferred to you.
Careful tax planning can produce a settlement with the most favorable tax consequences for both parties-leaving more for each of you by limiting the government’s share. If your differences keep you from addressing the tax issues, the only winner on this front will be the IRS.
Miscellaneous Expenses As with medical costs, you get a deduction in this catchall category only if your expenses exceed a threshold: 2% of your adjusted gross income in this case. The list of qualifying expenses is long, but you get no tax savings unless you pass the 2% test.
As you get your bearings in November, see how close you are to the threshold. If it is certain you’ll fall short, hold off paying qualifying expenses, such as professional dues and the cost of subscriptions to tax or investment publications, or postpone buying small tools for use in your job. If it’s likely your expenses will pass 2% of AGI, speed up such spending to exploit the tax subsidy.