Saturday, February 12, 2011

Desperate for tax deductions? Consider an IRA

You can't deduct food as a medical expense, even though you get sick if you don't eat. And your dogs may be like children to you, but you can't claim them as exemptions. Knock it off. There's little you can do now to reduce your 2010 taxes. But you can do plenty to reduce your 2011 taxes, if you start now. At some point while doing taxes, people start getting frantic for deductions. "I had a client ask if he could use the time he spent helping his dad remodel his basement as a charitable contribution," says Terrence Rice, a CPA in Milwaukee. He also had one client try to deduct the cost of four boxes of Girl Scout cookies. (No, says the Girl Scouts, you can't deduct the cookies unless you donate them to charity. And come on: four boxes of Thin Mints?)
The only thing you can do now to reduce your 2010 taxes is contribute to a deductible individual retirement account. You have until April 15 to make your 2010 contribution. If you're not covered by a retirement plan at work, you can make a fully deductible contribution.
Tax law limits your ability to contribute to a deductible IRA if you do have a retirement plan available. It also limits how much you can contribute. A person under age 50 at the end of 2010 can contribute up to $5,000 to an IRA. If you're 50 or older, you can contribute $6,000. Your contribution reduces your taxable income, which, in turn, reduces your taxes.
If you can't open a deductible IRA, you're pretty much limited to scrounging around for additional deductions if you want to reduce your 2010 taxes.
As long as you have your finances spread out on the table around you, however, why not look to see what steps you can take to reduce this year's taxes?
Start with the proposition that the higher your tax rate, the less you're going to like anything taxed at the same rate as income. True, the taxes on interest from a CD wouldn't buy a rivet on an aircraft carrier, but sooner or later, rates will go up.
So make sure that most of your income-generating investments, such as CDs, bonds and money market funds, are in tax-sheltered accounts, such as IRAs and 401(k)s. As much as possible, keep stocks and stock mutual funds in taxable accounts. "It would be foolish to put stocks in retirement accounts and bonds in a taxable account," says Rice. "You'd be passing on spectacular opportunities that our tax code offers."
You normally don't hear "spectacular opportunities" and "tax code" in the same sentence, but Rice has a great point. If you put your stocks in a retirement account, such as a 401(k), your withdrawals will be taxed at ordinary income tax rates.
But, as any CEO knows, long-term capital gains are taxed at a maximum 15%, as are most dividends. Someone who makes $1 million in profit from a stock sale pays 15% on his gains if he has held them for a year; someone who gets income of $1 million pays a maximum 37.5%. Furthermore, stocks offer multiple ways to reduce your tax bill.
Losses. You can use a capital loss to offset any amount of gains. If you have more losses than gains, you can deduct up to $3,000 of your losses from your income and carry forward any unused losses to the next tax year.
If you're sitting on a big loss, but are hoping the stock market will turn around, you can buy another fund the same day, provided it's not substantially similar. For example, you could sell an equity-income fund and buy an S&P 500 index fund and get the loss. If you buy a substantially similar fund within 30 days, the IRS will disallow your losses.
Gains. You won't owe any taxes on a winning fund until you sell it. (The one exception is the annoying capital gains distribution that most funds make late in the year, but you can use losses to eliminate the taxes on those.)
Taxable accounts offer other ways to get rid of gains. If you donate appreciated stock to charity, you can deduct the market value of the stock and pay no taxes on the gains. If you're especially tax-averse, you can die. Your heirs will be able to calculate their gains based on the stock's price when you die — which, one hopes, is higher than when you bought it. Not that you'll care. True, you could put your stocks in a Roth IRA, in which case withdrawals won't be taxed. But you still won't be able to take advantage of your losses.
As always, don't let the tax tail wag the dog. If your employer offers a 401(k) match, contribute at least as much as the match, even if your overall allocation dictates that some of that money be invested in stocks. You'll reduce your taxable income and get free money — which certainly beats trying to find extra deductions in your shoebox.

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