Tax Savings for Young Families
Take advantage of your flex account, save for college in a 529 plan and hire your children to lower your tax bill.
April 2009
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Young families should make these moves throughout the year to keep their tax bills low at tax time. Here are the areas where you should look for savings:
At work
Car and home
College savings
Deductions for non-itemizers
Inheritance
Investments and retirement savings
Your children
AT WORK
Give yourself a raise. The odds are high that you're having too much tax taken out of your paycheck every payday. The evidence is clear if you have a big refund coming. In 2008, the IRS issued nearly 107 million refunds averaging $2,400. So far this year, the average refund is even more: $2,700. Filing a new W-4 form with your employer (get one from your payroll office) will insure that you get more of your money when you earn it. See our easy-to-use withholding calculator to help you figure how many allowances you should claim. Suggest that your husband or wife do the same. If you're just average, you deserve almost $225 a month extra.
Take advantage of your flex account. Be aggressive if your employer offers a medical reimbursement account -- sometimes called a flex plan. It lets you divert part of your salary to an account, which you then tap to pay medical bills. The advantage? You avoid both income and Social Security tax on the money -- and that can save you 20% to 35% or more compared with spending after-tax money.
Change in family = change in flex plan. If you get married or divorced, or have or adopt a child during the year, you can change the amount you're setting aside in a medical reimbursement plan. If you anticipate more medical bills, steer more pretax money into the account; if you anticipate fewer, you can pull back on your contributions so you don't have to worry about the use-it-or-lose-it rule.
Make the most of a child-care reimbursement account. If Mom and Dad both work and have access to a flex plan, it’s worth more to a spouse whose salary is below the Social Security wage base ($106,800 for 2009) than to one who exceeds it. Money you run through a reimbursement plan avoids the Social Security levy as well as the income tax. That saves an extra 6.2% for those whose earning are under the wage base.
Switch to a Roth 401(K). If your employer offers the new breed of 401(k), seriously consider opting for it. Unlike the regular 401(k), you don't get a tax break when your money goes into a Roth, but younger workers are often in lower tax brackets ... so the break isn't so impressive anyway. Also unlike a regular 401(k), money coming out of a Roth 401(k) in retirement will be tax-free ... at a time you may well be in a higher bracket.
Stash cash in a self-employed retirement account. If you have your own business, you have several choices of tax-favored retirement accounts, including Keogh plans, Simplified Employee Pensions (SEPs) and individual 401(k)s. Contributions cut your tax bill now while earnings grow tax-deferred for your retirement.
Pay tax sooner than later on restricted stock. If you receive restricted stock as a fringe benefit, consider making what's called an 83(b) election. That lets you pay tax immediately on the value of the stock rather than waiting until the restrictions disappear when the stock "vests." Why pay tax sooner rather than later? Because you pay tax on the value at the time you get the stock, which could be far less than the value at the time it vests. Tax on any appreciation that occurs in between then qualifies for favorable capital gains treatment. Don't dally: You only have 30 days after receiving the stock to make the election.
Hire your children. If you have an unincorporated business, hiring your children can have real tax advantages. You can deduct what you pay them, thus shifting income from your tax bracket to theirs. Because wages are earned income, the "kiddie tax" does not apply. And, if the child is under age 18, he or she does not have to pay Social Security tax on the earnings. One more advantage: The earnings can serve as a basis for an IRA contribution.
Pay back a 401(k) loan before leaving your job. Failing to do so means the loan amount will be considered a distribution that will be taxed in your top bracket and, if you’re younger than 55 in the year you leave your job, hit with a 10% penalty, too.
Ask your boss to pay for you to improve yourself. Companies can offer employees up to $5,250 of an educational assistance tax-free each year. That means the boss pays the bills but the amount doesn't show up as part of your salary on your W-2. The courses don't even have to be job-related and even graduate-level courses qualify.
Track the costs of a job-related move. . If the new job is at least 50 miles farther from your old home than your old job was, you can deduct the cost of the move . . . even if you don’t itemize expenses. If it’s your first job, the mileage test is met if the new job is at least 50 miles away from your old home. If you drive your own car, you can deduct 24 cents a mile for 2009 moves, plus parking and tolls.
Tally job-hunting expenses. As long as you're looking for a new position in the same line of work, you can deduct job-hunting costs including travel expenses such as the cost of food, lodging and transportation, if your search takes you away from home overnight. Such costs are miscellaneous expenses, deductible to the extent all such costs exceed 2% of your adjusted gross income.
CAR AND HOME
Take Uncle Sam for a ride. You can drive away with a credit that will reduce your tax bill dollar for dollar if buy a gasoline/electric hybrid or qualifying clean-diesel vehicle in 2009. The size of the tax credit depends on how fuel-stingy your new car is, but the savings can range from several hundred dollars to over $3,000.
Use a Roth to save for your first home. Sure, the “R” in IRA stands for retirement, but a Roth IRA can be a powerful tool when you’re saving for your first home. All contributions can come out of a Roth at any time, tax- and penalty-free. And, after the account has been opened for five years, up to $10,000 of earnings can be withdrawn tax- and penalty-free for the purchase of your first home. Assume $5,000 goes into a Roth each year for five years, and the account earns an average of 8% a year. At the end of five years, the Roth would hold about $31,680—all of which could be withdrawn tax- and penalty-free for a down payment.
Let Uncle Sam help pay for your home. A new home, whether it's your first or a trade-up, usually means a bigger mortgage. And that means a bigger mortgage interest deduction and maybe higher property taxes, too. You can adjust tax withholding from your salary to account for the new tax breaks, and beef up your take-home pay to help pay the bills.
Attention first-time itemizers. If the purchase of your first home means you'll be itemizing for the first time, start saving the records you'll need to get all the breaks you deserve. In addition to mortgage interest and property taxes, you can now deduct charitable contributions, state income or sales taxes, casualty and theft losses, and medical expenses to the extent such costs exceed 7.5% of adjusted gross income and some miscellaneous costs.
COLLEGE SAVINGS
Save for college the tax-smart way. Stashing money in a custodial account can save on taxes. But it can also get you tied up with the expensive "kiddie tax" rules and gives full control of the cash to your child when he or she turns 18 or 21. Using a state-sponsored 529 college savings plan can make earnings completely tax free and lets you keep control over the money. If one child decides not to go to college, you can switch the account to another child or take it back.
DEDUCTIONS FOR NON-ITEMIZERS
Deduct expenses even if you don't itemize. Taxpayers who claim the standard deduction often complain that itemizers get the better deal. But that’s not true. The only reason to use the no-questions-asked standard deduction is if it’s bigger than the total you could deduct if you itemized. And, you can deduct a lot of things even if you don’t itemize, including student loan interest, job-related moving expenses, costs incurred by reservists and performing artists and contributions to health savings accounts and IRAs. Also, in 2009 homeowners who don’t itemize can boost their standard deduction amount by up to $500 (single) or $1,000 (joint returns) for property taxes they paid. And, casualty losses -- which used to be deductible only by those who itemize -- can also be added to the standard deduction. Keeping good records will save you money.
INHERITANCE
Roll over an inherited 401(k). A recent change in the rules allows a beneficiary of a 401(k) plan to roll over the account into an IRA and stretch payouts (and the tax bill on them) over his or her lifetime. This can be a tremendous advantage over the old rules that generally required such accounts be cashed out, and all taxes paid, within five years. To qualify for this break, you must name a person or persons (not your estate) as your beneficiary. If your 401(k) goes through your estate, the old five-year rule applies.
INVESTMENTS AND RETIREMENT SAVINGS
Check the calendar before you sell. You must own an investment for more than one year for profit to qualify as a long-term gain and enjoy preferential tax rates. The "holding period" starts on the day after you buy a stock, mutual fund or other asset and ends on the day you sell it.
Don't buy a tax bill. Before you invest in a mutual fund near the end of the year, check to see when the fund will distribute dividends. On that day, the value of shares will fall by the amount paid. Buy just before the payout and the dividend will effectively rebate part of your purchase price, but you'll owe tax on the amount. Buy after the payout, and you'll get a lower price, and no tax bill.
Beware of Uncle Sam's interest in your divorce. Watch the tax basis -- that is, the value from which gains or losses will be determined when property is sold -- when working toward an equitable property settlement. One $100,000 asset might be worth a lot more -- or a lot less -- than another, after the IRS gets its share. Remember: Alimony is deductible by the payer and taxable income to the recipient; a property settlement is neither deductible nor taxable.
Make your IRA contributions sooner rather than later. The earlier in the year your money is in the account, the sooner it begins to earn tax-deferred or, if you use a Roth IRA, tax-free returns. Over a long career, this can make an enormous difference.
YOUR CHILDREN
The stork brings tax savings, too. A child born, or adopted, during the year is a blessed event for your tax return, too. An added dependency exemption will knock $3,650 off your 2009 taxable income and you’re almost sure to qualify for the $1,000 child credit, too. You don’t have to wait until you file your 2009 return to reap the benefit. Add at least one extra withholding allowance to the W-4 form filed with your employer to cut tax withholding from your paycheck. That will immediately increase your take-home pay.
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