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By Roy Lewis
November 16, 2001

A time-honored method of tax planning is to estimate your adjusted gross income (AGI) for this year and for next year. It might be difficult, but in many cases it can save some tax dollars in the long run.

Why? Because if you anticipate being in a higher bracket next year, you might benefit from accelerating income into this year and paying taxes on that income at a lower rate. If you believe that you'll be in a lower tax bracket next year, you can reverse the strategy and attempt to defer income into next year. To make the planning process even a bit more difficult, remember that tax rates will be falling over the next few years. So your planning should be prepared with an eye on the changing tax rates.

Remember also that anytime you mess with your AGI you are also indirectly messin' with other tax items. Deductible IRA contributions, Roth IRA contributions, Roth conversions, medical expense deductions, miscellaneous itemized deductions, taxation of Social Security benefits, and the threshold for various tax credits are just a few of the items that can be affected when your AGI is increased or decreased. So, be aware of how other items on your tax return will be affected.

Moving on up?
If you'll be in a higher tax bracket next year, ways to accelerate income into this year include:

• Year-end bonuses -- If your employer generally pays bonuses early in the year, you might try to negotiate to have your bonus paid to you before the end of this year.
• Retirement plan distributions -- If you are taking money from a retirement plan, consider taking your withdrawals before the end of this year, rather than waiting until next year. Even if you have no immediate use for the money, paying tax this year and simply putting the money in the bank (or other investments) could be a smarter way to go.
• Accounts receivable collection/billing -- If you are self-employed and report your income and expenses on a cash basis, issue year-end bills early to hopefully receive payment by the end of the year. Also, attempt collection on any current or overdue accounts prior to the end of the year. Remember that many of your customers might also be in tax-planning mode and might want to pay their bills (and take their deductions) prior to the end of the year. They might be happy to pay for January's goods or services in advance.
• Roth IRA conversion -- If you convert a traditional IRA to a Roth IRA, you'll be required to report taxable income in the year of the conversion. So you might want to increase your income this year by making a Roth IRA conversion prior to the end of the year.
• Investments -- Review your portfolio now. Determine your gains and losses for the year. See if there are stocks, bonds, or mutual funds you might want to sell in order to take some additional short-term stock gains this year. Your investment portfolio is an area over which you have a lot of control. Don't overlook it.

Slowing things down?
If you expect that your marginal tax rate will be higher this year when compared to next year, you'll benefit by deferring income into next year. You can accomplish this by:

• Investments -- Review your short-term gains and see what you might be able to defer into next year. Additionally, be careful of year-end mutual fund purchases. As we discussed in Part I of this series, mutual funds can throw off income at the end of the year, most of it in the form of ordinary income -- so plan any mutual fund purchases carefully.
• Other issues -- Basically, other techniques simply reverse the items noted above. If you're self-employed, you might want to delay your billing and collection of your bills into next year. Don't make a taxable Roth IRA conversion until early next year. Take your retirement plan distributions next year rather than this year. See if you can talk your employer into delaying your year-end bonus until early next year rather than paying it late this year. I'm sure that you can see how it all works. It all depends on which side of the fence you find yourself.

Deduction planning
This goes hand-in-glove with income planning. If you believe that your marginal tax rate will be greater this year than it will be next year, accelerate deductions into this year's tax return. If you believe that the opposite will be true, then defer deductions into next year.

If deduction planning works for you, and you are a cash-basis taxpayer (which virtually all of us are), please remember these important deduction tips:

1. An expense is only deductible in the year in which it is actually paid. (This is especially important for people trying to "bunch" their deductions into a specific tax year. Remember that you can't bunch expenses paid in different years.
2. If you use a credit card to pay expenses (such as last-minute charitable contributions, medical expenses, business expenses, etc.), the IRS considers the expense deductible in the year that the charge is incurred, not in the year that the credit card bill is paid. So consider using your credit card for those last-minute deductible purchases, services, and charitable contributions.
3. If you make a payment by check, make sure that it is dated and mailed before the end of the year. It's not important whether the check actually clears the bank by the end of the year, just that you made the payment before the end of the year.
4. Remember that a mere promise to pay (making a pledge for a charitable contribution, for example) doesn't constitute an actual payment and is, therefore, not deductible until the year actually paid.
5. If you have a business, don't forget the impact of the Section 179 election relative to various assets purchased. That election allows you to expense (i.e., deduct currently) purchases of business assets and property that you would otherwise be required to depreciate and deduct over a number of years. The total cost of Section 179 property that can be immediately deducted is $24,000 for 2001 and 2002. After 2002, it's $25,000.

Tax credit planning
Tax credits are much more valuable to you than deductions. Don't overlook any of them. And just to sweeten the pot, many of these credits will be increasing in years to come. Here are just a few of the most common credits -- the list is definitely not inclusive:

• Child Tax Credit -- A tax credit of $600 per qualifying child under the age of 17 is available. The credit is phased out when your modified adjusted gross income exceeds $110,000 for married-joint filers, $55,000 for married-separate filers, and $75,000 for all other taxpayers.
• The HOPE Credit  -- This is a credit of up to $1,500 per student for qualified tuition and fees paid by the student, or on behalf of the student.
• The Lifetime Learning Credit -- This is a credit of up to $1,000, and it is not based on the student's class load (which means that part-timers can qualify). Also, the education does not necessarily have to be for the acquisition of a post-secondary degree or specific business purpose.
• Child and Dependent Care Credit -- If you pay somebody else to care for your child under age 13 to allow you to work, this credit could be available to you. The credit is on an inverted scale with respect to your AGI, which means the higher your income, the lower your credit.

Deductions and credits for non-itemizers
Just because you don't itemize your deductions doesn't mean there aren't deductions and credits out there for you. Alimony paid, pension plan deductions (Keogh, SEP, SIMPLE, IRA, etc.), student-loan interest, job-related moving expenses, medical insurance for the self-employed, penalty for early savings withdrawal, and deductions for self-employment taxes are all available to you -- regardless of whether you itemize deductions. This is also true for the many credits available to you even if you don't itemize your deductions.

Catch up your retirement plan contributions
There are limits to how much you can contribute to your retirement plan at work (i.e., 401(k), 403(b), or any other employer-sponsored plan). Generally, your contributions must be made throughout the year, but did you know that some plans allow for "catch-up" contributions in December if your contribution level is less than the maximum allowed? Using your December bonus to add to your plan might be a good way to dodge some current taxes. If your employer matches some of your catch-up contributions, you're in even better shape. Not all plans allow for this "catch-up" provision, so check with human resources or your company's benefits administrator.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.