Believe it or not, now is the perfect time to start thinking about taxes. That's right, even though tax time is another six months away, this is the time to save big bucks for when April 15 rolls around.
Here are some ways you may be able to reduce your taxable earnings for the current year:
Hire your child
A child with income from a summer or part-time job is eligible to put up to $2,000 in a Roth IRA, which lets assets grow tax-free. Except for certain education costs or to buy a first house, your child generally can't access the money until he or she is 59-1/2, or the money will be subject to income taxes.
If you own a business, including your farm, and put your child on the payroll, you get a tax deduction for the amount you pay.
But the child must be doing legitimate work. The IRS is likely to frown on hiring, for example, a 6-year-old to make photocopies, given that someone that age is unlikely to have the skill or discipline for office work.
Remember, too, that a dependent child must file a federal tax return if his or her earned income exceeds $4,400 for the year, and the source of the earned income makes no difference. The child also must file if unearned income, such as dividends or interest on investments, exceeds $700.
Adjust taxes withheld
If your personal situation has changed by marriage or divorce, or the birth of a child, you may want to adjust the taxes being withheld. To make withholding changes, obtain a new W-4 form from your employer and then return it after making the changes.
Consider making gifts to children and grandchildren age 14 and older to reduce family income taxes and future estate taxes. You can make tax-free gifts of up to $10,000 to any person each year or $20,000 when gifts are made jointly with a spouse.
Give property with a high appreciation potential, such as stocks, growth mutual funds, or real estate. None of the appreciation in value after the date of the gift will be part of the donor's estate at death, and most of the capital-gains tax will be attributed to an increase in the value of the property while in the recipient's hands.
Payments that are made on another person's behalf directly to an educational or medical institution are exempt from gift tax.
Therefore, you can pay a child's tuition or medical bills in addition to making the direct gift.
But don't make the mistake of letting the 'tail wag the dog' by seeking short-term tax savings while neglecting basic financial-planning principles. All major tax strategies should be examined in the context of your larger financial situation.
One popular tax-saving idea has been to put college savings in the name of a child over age 13, so investment earnings will be taxed at the child's low rate rather than the parents' higher rate.
But this risks losing future college financial aid for the child because standard formulas used by colleges to determine need for aid assume that a student's own funds are available to pay tuition. So, a small tax savings could cost a lot in tuition assistance.
It may make sense to put college savings in a child's name, but this will depend on larger financial circumstances, such as your child's likely need for college aid and how aid formulas apply at your income level.
Try to sell stocks you've held for more than 12 months so that you'll qualify for the more favorable 20 percent capital-gains rate (10 percent for taxpayers in the 15 percent bracket).
Also, if your investments have done well this year, search your portfolio for offsetting losses. Conversely, if you expect high losses next year, try to postpone realizing gains until then. In addition, you're allowed to write off dollar-for-dollar against your gains plus $3,000 of ordinary income. If you have no gains, you can still deduct the losses against up to $3,000 of ordinary income.
However, resist the temptation to switch to "better" stocks or mutual funds
- unless yours performed poorly long-term.