TAX LAW CHANGES
Some of the changes are provisions from legislation passed years earlier that finally took effect in 2004.
If you're a parent, a student or resident of a state with a high sales tax rate but no income tax, you'll probably find something to like on your current return. On the other hand, if you plan to write off an SUV purchase or donate a car this year, you could be out of tax luck.
Here are 10 tax changes you should know about. Most of them will affect your return due this April. A couple won't matter this filing season, but you need to know about them now so that you won't run into tax trouble when you file next year.
Sales tax break
To claim this tax break you'll have to itemize and then determine which tax amount, sales or income, provides you with the biggest deduction. You can count all the sales taxes you paid in 2004, but since this deduction was created last October as part of the American Jobs Creation Bill, most people probably don't have sales receipts for the whole year. So the IRS created state tables providing an average sales tax deduction amount based on income levels that you can claim. Local levies also can be counted (you'll have to fill out a worksheet to determine how much more you can deduct), as can sales taxes you paid on the purchase of an auto, boat, other vehicles and home building supplies.
But what the tax code gives, it also takes. If you donate a vehicle to your favorite nonprofit in 2005, you might not get as big a tax break on next year's returns as you expect. Previously, you could deduct the fair market value of the vehicle (usually the Blue Book amount). But a new law has scrapped that option. For any donations made this year, exactly how much you can claim on your 2005 taxes will depend on how the charity uses the vehicle and, if they sell it, how much they actually get for it.
This vehicle contribution change took effect Jan. 1, so if you donated a car in 2004, you can still use the earlier, more lenient valuation guidelines on your current taxes.
Easier forms for more filers
Self-employed taxpayers, both those who run a full-time business and those who operate one on the side to supplement a wage-paying job, get some tax-form help, too. If the expenses you claim against self-employment income are $5,000 or less, you can file the less-complicated Schedule C-EZ instead of Schedule C. Last year, the expense limit was $2,500. The IRS says the threshold change means approximately 500,000 more small businesses, a 15 percent increase, will be able to file C-EZ, saving themselves a combined 5 million hours of paperwork.
Educator tax break revived
Larger tuition and fees deduction
Education credits earning limit increased
Environmentally friendly cars
So hybrid drivers who bought their cars last year can still claim the full $2,000 deduction on their 2004 returns (as long as they file Form 1040, that is; the deduction can only be taken on line 35 of that form). And if you're going to buy an alternative-fuel auto this year, you'll also get the full deduction. In 2006, however, the deduction drops to $500 and it will disappear in 2007.
Similarly, the reduction of the tax credit for purchasers of fully electric autos is postponed until 2006. This larger tax break -- a $4,000 credit -- will remain in effect for electric cars bought in 2004 and 2005 before being phased out by 2007.
Expansion of child tax credits
But its companion tax break, the additional child tax credit, could help some parents get a part of that excess back based on a percentage of their earned income. The same law that extended the child tax credit amount through the end of the decade also upped the allowable additional child credit percentage to 15 percent vs. the previous 10 percent limit. This increase should let eligible taxpayers get a bigger tax break.
SUV loophole closed
Previously, business filers could expense up to $100,000 of the cost of a 6,000-pound company vehicle. Many folks took advantage of this law to make Hummers and their heavy-duty brethren official business vehicles. But the American Jobs Creation Act of 2004 that was signed into law last autumn throws a major roadblock into the path of the SUV tax break.
The $100,000 deduction is still around for vehicles bought since the law took effect, but only if they weigh at least 14,000 pounds. A relatively smaller SUV placed in service on or after the law took effect will only get its owner a $25,000 write-off.
What if you purchased your high-dollar, but lighter-weight, SUV on Oct. 21, 2004, or earlier? You're in luck. You can claim the larger, prior-law amount on your 2004 returns.
Remember, regardless of which amount applies to your vehicle, the deduction can only be claimed on vehicles that are used at least 50 percent of the time for business, and then only up to the actual percentage of use that is business-related.
IRA deduction phase-out range is bigger
For 2004 taxes, more traditional-IRA holders should be eligible for at least some deduction of their contributions because the adjusted gross income limit has been raised. Single and head-of-household filers covered by a company retirement plan can make up to $45,000 and still get a full IRA contribution deduction. They're allowed a partial deduction if their income falls between $45,000 and less than $55,000.
Married couples filing joint returns can make up to $65,000 modified adjusted gross income and get the full deduction; a partial deduction is available when income falls between $65,000 and up to $75,000. Your tax form instructions have worksheets to help you determine just how much of your contribution can be used to reduce your tax bill.
You can put up to $3,000 ($3,500 if you're 50 or older) in your IRA for the 2004 tax year. You have until April 15 to make the contribution, regardless of whether you deduct it.
So with the new tax laws, what should I do to get a better break on my taxes?
With much fanfare on June 7, 2001, President Bush signed into law one of the largest tax cuts seen in years. But what did this sweeping tax cut do for you? The short answer is that if you plan wisely, you'll reap significant savings from these changes. Here are ten tips for taking advantage of the tax cuts.
1. Increase your 401(k) or 403(b).
These retirement plans allow you to defer taxes on the money you put into them. Starting in 2002, the maximum amount you can put into your employer's 401(k) or 403(b) plan starts increasing. The limit is now $13,000, and it sharply increases for the next three years according to the following schedule:
Every dollar you shift from your salary into the plan saves you tax dollars. For example, if your annual salary for 2004 is $80,000, a deferral of $12,000 will save you $3,000 in taxes if your marginal tax rate is 25 percent. If it makes sense for your overall financial picture, defer as close to the maximum as possible, especially if your employer matches a portion of your contribution.
2. Shift Your Income to Your Children.
The new 10 percent rate bracket in effect for 2002 and thereafter will provide greater tax savings to your entire family if you shift income-producing assets to your children. A child age 14 or older will be able to take advantage of this 10 percent rate, just as you will.
Example: If your child reports $7,800 in income in 2004 that you would otherwise report, your child would pay $700 in tax on that income ($7,800 less the child's $800 exemption is $7,000, taxed at 10 percent). Contrast this with what you would pay on the same income at, say, 35 percent: $2,730.00.
So now when you move income-producing assets to your children you take advantage of the lower income tax rates. While this general strategy has always been attractive, the new 10 percent rate makes this strategy even more appealing.
3. Think Twice about Exercising Nonqualified Stock Options.
If you received nonqualified stock options from your employer, consider your other income before exercising them. Try to exercise them during a year when your income keeps you in the new lower brackets.
4. Make Those Charitable Donations during the year they will be most effective.
If you're planning on making a sizeable charitable contribution, make it during the year you are projecting the most income. The higher your tax bracket, the more benefit you will get from your deduction.
If you're in the 35 percent tax bracket, a donation of $15,000 in 2004 saves you $5,250 in tax dollars. The same donation in a 25 percent tax bracket would save you only $3,750 -- a $1,500 difference.
5. Keep your Eye on the AMT.
The alternative minimum tax (AMT) rates didn't change along with the lower income tax rates. What did change, at least for years 2001 through 2005, is the AMT exemption amount.
In an effort to delay application of this parallel minimum tax to more and more taxpayers, Congress increased the exemption amount by $9,000 for married couples and by $4,500 for all others for this four-year period.
Most experts agree that the AMT laws must be revisited soon. This taxing system was originally developed to prevent certain people with high gross income and a lot of deductions from paying much less in tax than lower-income people with few deductions.
The best action you can take is to be proactive about your tax planning: evaluate the year's income tax liability before the end of the year and determine whether you're subject to (or close to) AMT before you accelerate your mortgage or tax payments. Remember: Many of the expenses that you can claim as deductions on your regular tax return disappear on the AMT, making your income look a lot more substantial, and, possibly, increasing your taxes.
6. Buy Business Equipment Now.
If you have been planning to buy some equipment for your business, make those purchases this year. You'll get an additional 50 percent depreciation in the first year, on top of any Section 179 deduction you can take on your purchase. Here's an example:
Your business purchases, and starts using, office equipment for $150,000 in May 2004. You may take in 2004:
Beware: the 50% bonus depreciation expires after 12/31/04.
7. Take Advantage of the Expanded College Savings Vehicles.
Beginning in 2002, you can contribute $2,000 to an Education Savings Account each year for each student, which is a significant boost from the $500 per-year contribution limit in 2001.
If you contribute $2,000 to an Education Savings Account for 18 years and you earn an average investment return of 8%, you'll have over $80,000 saved for college costs!
The contribution isn't deductible on your tax return, but on the other side of the coin, distributions from the IRA at tuition payment time are tax-free as long as you have qualified educational expenses at least as much as the distribution.
In addition to the Education Savings Account, you can choose from among section 529 college tuition plans. These plans, typically offered in various forms by states, are now offered by private institutions. As with Education Savings Accounts, contributions to the plans aren't deductible, but withdrawals of funds to pay for educational expenses won't be taxable income either.
The year 2002 also brought a new deduction for educational expenses. The deduction will be around for four years, and can be as much as $4,000, depending on the tax year and your income level.
Both the Education Savings Account and the new deduction are available only to taxpayers with incomes that don't exceed certain limits.
8. Rollover Your Pension Plan When Changing Jobs.
If you may be changing jobs this year, your options for moving your retirement funds have been expanded. Individual plans permitting; you are now allowed to roll your retirement funds over from one qualified plan, 403(b) annuity or section 457 plan to another such plan.
It’s tempting just to cash out retirement funds, but you will be faced with a steep early withdrawal penalty tax of 10 percent, plus regular income tax on the taxable portion of those funds if you do.
Transferring funds to an IRA is an attractive option, but if you’re set on having all of your funds in one place, check with the plan administrator of your new company’s plan to see if the new plan will accept rollover contributions.
You can also roll over after-tax contributions to qualified plans or IRAs (via direct transfer only). Previous law permitted only rollovers of pre-tax contributions.
Caution: Your after-tax contributions in an IRA account can't be rolled over to a qualified plan, 403(b) annuity, or a section 457 plan.
9. Consider an IRA With the New Increased Contribution Limits.
The IRA contribution limit increases to $3,000 for 2002 through 2004, then $4,000 for 2005 through 2007, topping out at $5,000 in 2008.
If you're 50 years old or over, the news gets better. The new contribution limits are increased and extra $500 for 2002 through 2005 and an extra $1,000 for years 2006 through 2008.
So it might be time to open an IRA account if you haven't done so before. The increased limits apply to both traditional IRAs and Roth IRAs, meaning that you have just as much flexibility as before, but more savings opportunity. However, if you have a limited amount of funds to put toward a retirement vehicle and you can choose between an IRA and your employer's 401(k) plan, consider whether your employer has a matching feature. You may want to channel contributions to the 401(k) plan to obtain the maximum matching possible first before making contributions to an IRA.
10. Re-Evaluate your Estate Plans.
Estate taxes, otherwise known as "death" taxes, now start phasing out in 2002, and disappear completely in 2010, only to come back in full force in 2011.
The phase-out is accomplished by increasing the estate tax exemption, which is the value of your estate that can pass to your heirs free of federal estate taxes. The exemptionÂ was $1 million for 2002 and 2003, increasing after that to $3.5 million before the estate tax is repealed.
So the estates of more and more individual taxpayers will escape estate taxation over the next ten years -- almost 40 percent in the first year of phase-out alone.
To get an idea of the magnitude of this change, consider that in 1997, the most recent year for which statistics are available, almost 43,000 estates paid over $16 billion in taxes.
The reduction and eventual elimination of estate taxes doesn't necessarily mean that you shouldn't think about setting up a living trust. Living trusts help to avoid costly and lengthy probates of estates, and while the value of your assets may not subject you to estate taxes, a living trust can ease the transition of your property to your heirs.
Remember that these trusts alone do not save you estate taxes. You need to take certain steps to evaluate your estate and plan for the transfer of your assets to your heirs, especially if you're married. Traditional A-B trust provisions for married couples can be a valuable planning alternative. Consider investing some time and money in estate planning this year to determine what the best alternatives are for you.