February 2007

April 17th (yes, two extra days to file this year) is still a couple of months away, but it's time NOW to "GEAR UP" for tax savings for your 2006 and 2007 returns.

Yes, this is normally a "real estate and mortgage" based newsletter each month, but we thought we'd devote this month's issue to helping you save some of your hard earned money from the claws of the IRS.

By now, you probably received your W-2's and your 1099's (or will over the next few days) and you may be eager to start on those taxes so you can pocket that refund.  But give yourself plenty of time because Congress revived several deductions last year that could reduce your tax bill… IF you know where to find them.  Let us suggest a few places to look:

Expanded Kiddie Tax

Parents who use custodial accounts to save for their children's education may be blindsided by a change in the law that expands the "kiddie tax" on children's investment income.  Custodial accounts, also known as Uniform Gifts to Minors Act or Uniform Transfers to Minors Act accounts, permit parents to invest on behalf of their children until they're 18.

The kiddie tax was intended to prevent parents from using these accounts to dodge taxes by sheltering money in their children's names.   Under the kiddie tax rules, children's unearned income — interest, dividends and capital gains — is taxed at their parents' top rate once that income exceeds a certain threshold.

In the past, the kiddie tax expired when a child turned 14. After that, the income was taxed at the child's rate.  But in May 2006, Congress expanded the kiddie tax to age 18 and made the change retroactive to the beginning of 2006.

The new law could trigger higher-than-expected tax bills for parents who transferred investments to their 14-year-olds last year, believing the income would be taxed at the child's lower rate.

It could also create tax headaches for parents who sold stocks in their teenagers' accounts to pay for college tuition.  Instead of paying a 5% long-term capital gains rate, those parents could owe a 15% rate on the sales.

Not all of a child's investment income will be hit by the higher rate.  For 2006, the first $850 of a child's unearned income is tax-free.  The next $850 is taxed at the child's rate, usually 10%.

If your teenager's investment income exceeded $1,700 last year, there's nothing you can do now to lessen the damage.  But you may want to consider other ways to save for your children's future.

If you're saving for college, a 529 college savings plan lets you save up to $12,000 a year, per child, without filing a gift tax return.  A married couple can contribute up to $24,000 a year to a child's 529 savings plan.  As long as the money is used for college expenses, withdrawals are tax-free.

Deductions for college tuition, educators' classroom expenses and state and local sales taxes expired at the end of 2005.  In December, President Bush signed a bill extending them through 2007.  But by then, the IRS had already sent 2006 tax forms to the printer.

As a result, the deductions don't appear on tax packages mailed to taxpayers who have filed on paper in the past.  The IRS has provided instructions on its website, www.irs.gov, explaining how to wedge them into your tax return.  But a better strategy is to use tax software. Tax preparation companies have updated their programs to reflect the changes.

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Here's a Look at the Revived Deductions and Who Can Benefit:

•State and local sales-tax deductions.  Taxpayers who itemize can choose to deduct their state and local sales taxes, instead of their state and local income taxes.  This tax break is particularly popular with taxpayers who live in states with no state income tax, because it gives them a new deduction.  But some taxpayers in states with income taxes may also benefit.

If, for example, you live in a low-tax state and bought a car last year, you might receive a bigger tax break by deducting sales taxes instead of income taxes.  Likewise, retirees in states with income tax exemptions for seniors might benefit from the sales-tax deduction, as long as they itemize.

You can claim this deduction even if you didn't save all your sales receipts.  The IRS provides state sales-tax tables in Publication 600, available at www.irs.gov.  The tables assign an amount based on income, filing status, dependents and your state of residence. If you bought a big-ticket item, such as a car or boat, you can add the actual sales tax for that purchase to the amount provided in the IRS tables.

•Tuition tax deduction. Taxpayers can deduct up to $4,000 in college tuition and fees. This tax break benefits families who earn too much to qualify for the Hope and Lifetime Learning credits.  Those tax credits provide bigger tax breaks than deductions because they represent a dollar-for-dollar reduction in your tax bill.  But married couples whose 2006 modified adjusted gross income exceeded $110,000 can't claim the credits.  For singles, the income cutoff is $55,000.

The income limits for the tuition tax deduction are higher.  Married couples with 2006 adjusted gross income of up to $130,000 can claim the full deduction; those with AGI of up to $160,000 can claim a $2,000 deduction. Single filers with AGI of up to $65,000 can claim the full deduction; those with AGI of up to $80,000 can deduct $2,000.

The tuition deduction is an above-the-line deduction, which means you don't have to itemize to claim it.

•Teacher's classroom expense deduction. Educators who teach grades K-12 and spend their own money on classroom supplies can deduct up to $250. This is also an above-the-line deduction.

New Donations Guidelines

Donations of used clothing and household appliances to charity can free up room in your closets and reduce your tax bill.  But under a provision in the Pension Protection Act enacted last year, used clothing and household goods must be in good or better condition to qualify for a tax deduction.

The law applies to any donations made after Aug. 17, 2006.  It doesn't define "good or better," but the IRS says it will deny deductions of "minimal monetary value."  The law suggests that used underwear and socks fall into that category.

The new pension law also tightened requirements for deductions of cash contributions, starting this year. When you file your 2007 tax return, you'll be expected to document all cash donations with a canceled check, credit card bill or receipt from the charity.  So instead of dropping a couple of dollars into the church plate every Sunday, consider writing a check to your church.

Free File

For the fifth year, the IRS and a group of tax preparation companies are offering the Free File program, which allows eligible taxpayers to prepare and file their federal tax returns electronically for free.

What's new for the 2006 tax year:

•Taxpayers with adjusted gross income of $52,000 or less are eligible, up from $50,000 last year.

•Companies that participate in the program are barred from pitching refund-anticipation loans and other products. In the past, some Free File participants promoted these products.  

•Two companies are offering Free File in Spanish.

•Taxpayers can use Free File to file a claim for the telephone tax refund, even if they're not required to file a federal tax return. After several federal courts ruled that the tax had been illegally applied to long-distance service, the Treasury Department announced it would refund taxes billed from Feb. 28, 2003, to Aug. 1, 2006.

Taxpayers who claim the standard amount are eligible for $30 to $60, depending on the number of exemptions on their tax returns. The IRS has created a form, 1040EZ-T, for low-income taxpayers who aren't required to file a tax return, to claim this refund.

To use the program, go to www.irs.gov and click on the Free File link. If you go through a participating company's website, you may be charged a fee.

Preparing and filing your taxes electronically is faster than filing on paper, and you're less likely to make mistakes.  But even the best software program is only as good as the information you provide.

If you spent a lot of time hunting down 1099s and charitable receipts this year, develop a record-keeping system for documents you'll need for your 2007 return.

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Planning Moves to Make Now for 2007 Returns