Mellody's Math: Last Minute Tax Tips For 2001

The Internal Revenue Service would not call them taxes if they weren't quite so taxing, but there are some smart moves you can make in the last few days of 2001 to make paying them easier.

The IRS expects more than 130 million individual tax returns to be filed for 2001. This year, Congress passed legislation to cut taxes by $1.35 trillion between now and 2011, the largest tax cut since 1981.

The new tax plan lowers the top tax rate, repeals the estate tax in 2010, doubles the child tax credit, provides tax relief for married couples and expands education and retirement saving tax incentives. While many of these tax relief measures kick in over the next several years, here is what you can do right now, before the end of 2001, to ease your tax burden:

1. Defer Income: Basically, you should work now, but get paid later. Next year, tax rates above the 15 percent tax bracket are scheduled to drop by one-half a percentage point. This means any income you can defer into the New Year will be taxed at a lower rate, leaving you with more money. If you can, defer any and all added income owed to you this year into 2002. For example, if you are scheduled to receive a holiday bonus before year-end or you are owed consulting fees for completed work, have the check dated after Dec. 31, 2001. That allows you to save on 2001 taxes, and it gives you more cash as a result of lower tax rates in 2002.

2. Max out your 401(k): Since company retirement plan contributions are made on a pre-tax basis, you might want to contribute more to your 401(k) plan to lower your taxable income by the same amount. (In 2001, the maximum 401(k) contribution allowed is $10,500.) As an extra incentive, if your company matches contributions, you will capture an additional benefit of putting more, tax-deferred income towards retirement. If you receive a bonus before year-end that cannot be deferred into 2002, you may want to apply as much as you can to your 401(k) to help decrease your taxable income and ultimately this year's tax bill.

3. Maximize Deductions: The key here is pre-pay, pre-pay, pre-pay, as much as possible. If you are one of many taxpayers who itemize your deductions, consider pre-paying deductible items now such as mortgage payments, state income taxes, medical bills, health insurance and property taxes due in January. Why now? These deductions are worth slightly more this year than they will be next year when tax rates fall. But be warned: this strategy does not work for taxpayers subject to the Alternative Minimum Tax (AMT). Such can be the case for individuals who live in a high tax state, have many dependents, or have exercised stock options in 2001.

4. Losing is winning: For the first time since 1974, U.S. stocks are likely to be down for a second year in a row. While no one likes losses in their investment portfolio, there is one saving grace: those losses can help reduce your tax bill. Therefore, you may want to consider selling poor performing issues before year-end. Do not sell just any stocks where you have lost money, but strictly the investments that you believe will continue to lose money.

Assets held for one year or less are considered short-term and assets held for more than a year are considered long-term. Short-term gains are taxed at your marginal income tax rate, which can run as high as 39.1 percent, whereas long-term gains are taxed at 20 percent or 10 percent depending on your income. In an optimal situation, you want long-term gains and short-term losses. If you have more losers in your portfolio than winners, you may deduct up to $3,000 of losses against your ordinary income each calendar year until all losses are fully "spent."

Mellody's Math: Here are two examples that can help you understand why.

Example 1: Assume you have a short-term gain of $10,000, a long-term gain of $10,000 and a $9,000 short-term loss. When you net your short-term gains and losses, you realize a $1,000 short-term gain and a $10,000 long-term gain.

The short-term gain is taxed at up to 39.1 percent and the long-term gain is taxed at a maximum of 20 percent. On the flip side, if you have a $10,000 short-term gain, $10,000 long-term gain and $9,000 long-term loss, you end up with a $10,000 short-term gain and a $1,000 long-term gain. In this scenario, you are forced to pay more in taxes-up to 39.1 percent of $10,000 instead of 39.1 percent on the $1,000 if you exercised the loss before or on the one-year anniversary of your purchase of the securities. The Moral: Consider taking short-term losses before they become long-term to offset any gains.

Example 2: Assume you have a short-term gain of $10,000, a long-term gain of $10,000 and a short-term loss of $35,000. Net the short-term gain and loss to realize a $25,000 short loss. Offset this loss with the $10,000 long-term gain which leaves a $15,000 net short-term loss. You may use $3,000 this year and carry forward the remaining $12,000 loss to offset short-term gains first then long-term gains in future years. As always, you want to eliminate the short-term gains first, then apply the losses to any future gains.

5. To Give Is Divine: Contributions to charities are fully deductible if you itemize them on your tax forms. Americans have reportedly donated an estimated $1.3 billion to non-profit organizations providing aid for those affected by the Sept. 11 attacks. As a result, many other charities have been left in the cold, making your year-end donation all the more meaningful. In lieu of cash, you can also donate appreciated stock or mutual fund shares before the close of 2001. If you have owned the shares for more than one year, you can deduct the full market value on the date of the gift, and avoid paying capital gains taxes on the appreciation, saving you money. The maximum deductible contribution allowed is 50 percent of your adjusted gross income (AGI). The 50 percent rule applies to most contributions, but it may be lower for contributions to certain organizations or for certain kinds of contributions.

Mellody's Math: If you bought $500 worth of stock several years ago that is now valued at $1,500 and sold it, you would owe $200 in capital gains (20 percent of your $1,000 gain). If after selling the stock you donate the $1,300 after-tax profit to your favorite charity, you would shave $403 off your income taxes (assuming a tax rate of 31%) for a net tax savings of $203 after the capital gains tax that you already paid is taken into consideration. However, if you donate the fully appreciated stock instead of selling it and donating the after-tax proceeds, you not only avoid paying a $200 capital gain tax, you will also be able to deduct the full value of the donated shares-$1,500-instead of just $1,300. In total, your taxes would be reduced $465.

It is worth noting that donations to charity can be given in forms other than money or securities. For example, do your spring-cleaning this December and donate those clothes that are just sitting on hangers. Or if you purchased a new computer this holiday season, consider donating your old one to a school or charitable organization. Not only will a needy organization benefit, you will also get a tax break.

6. Convert to a Roth IRA: In a traditional IRA, you have until April 15 to make deductible 2001 contributions. If you are in a qualified tax bracket, contributions made to your IRA are tax-deductible. Even if the contribution is not deductible in your tax bracket, you will benefit from having your money compound longer — tax deferred.

If your gross income is $100,000 or less, consider converting your regular IRA to a Roth IRA. Although you have to pay income tax on the amount you convert (from a regular IRA), in light of this year's market decline, a lower balance makes for a lower tax bill. With a Roth IRA, when you retire, all of your withdrawals will be tax-free.

7. For Now, Don't Touch College Savings Plans: As of January 2002, all distributions from 529 college savings plans are exempt from federal taxes if used for qualified educational expenses like tuition. If you tap into the plan before 2002, earnings will be taxed at the child's tax rate of 15 percent.

Mellody Hobson, president of Ariel Capital Management in Chicago, is GoodMorning America's personal finance expert. Click here to visit her Web site, Ariel Mutual Ariel associates Matthew Yale and Anne Roche contributed to this report.