Tax Savings for Empty-Nesters
Roll over an inherited 401(k), help your children earn a credit for retirement savings -- and rack up tax savings in the process.
April 2009
Advertisement
Empty-nesters should make these moves throughout the year to keep their bill low at tax time. Here are the areas where you should look for savings:
At work
Car and home
Charitable contributions
Inheritance
Investments and retirement savings
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.
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.
Don't be afraid of home-office rules. If you use part of your home regularly and exclusively for your business, you can qualify to deduct as home-office expenses some costs that are otherwise considered personal expenses, including part of your utility bills, insurance premiums and home maintenance costs. Some home-business operators steer away from these breaks for fear of an audit. But if you deserve them, claim them.
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.
Pay back a 401(k) loan before leaving the 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, hit with a 10% penalty, too.
Choose the right kind of business. Beyond choosing what business to go into, you also have to decide on the best form for your business: a sole proprietorship, a subchapter S corporation, a C-corp or a limited-liability company (LLC). Your choice will have a major impact on your taxes.
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.
Save energy, save taxes. Home improvements designed to save energy can shave your tax bill, too. One 2009 tax credit is worth 10% of the cost of new insulation, doors, windows and high-efficiency furnaces water heaters and central air conditions. The maximum credit is $500, with no more than $200 attributable to windows. A bigger credit is available if you install a solar energy system.
Second homes can offer a vacation from taxes. If you're trying to figure whether you can afford a second home, remember that you'll get some help from the IRS. Mortgage interest on a loan to buy a second home is deductible just as it is for the mortgage on your principal residence. Interest on up to $1.1 million of first- and second-home debt can be deducted. Property taxes can be written off, too. Things get more complicated -- and perhaps more lucrative -- if you rent out the place part of the year to help cover the bills.
Watch the calendar at your vacation home. If you hope to deduct losses attributable to renting the place during the year, be careful not to use the house too much yourself. As far as the IRS is concerned, "too much" is when personal use exceeds more than 14 days or more than 10% of the number of days the home is rented. Time you spend doing maintenance or repairs does not count as personal use, but time you let friend or relatives use the place for little or no rent does.
Take advantage of tax-free rental income. You may not think of yourself as a landlord, but if you live in an area that hosts an even that draws a crowd (a Super Bowl, say, or the presidential inauguration), renting out your home temporarily could make you a bundle -- tax free -- while getting out of town when tourists overrun the place. A special provision in the law lets you rent a home for up to 14 days a year without having to report a dime of the money you receive as income.
CHARITABLE CONTRIBUTIONS
Tote up out-of-pocket costs of doing good. Keep track of what you spend while doing charitable work, from what you spend on stamps for a fundraiser, to the cost of ingredients for casseroles you make for the homeless, to the number of miles you drive your car for charity (worth 14 cents a mile in 2009). Add such costs with your cash contributions when figuring your charitable contribution deduction.
INHERITANCE
Pinpoint the stepped-up basis of property you inherit. In most cases, the tax basis of inherited property -- that's the value from which you will figure gain or loss when you sell -- is "stepped up" to the value on the day the previous owner dies. Tax on all appreciation during his or her lifetime is forgiven. If you will inherit assets in 2009, be sure you pinpoint your basis so you don't overpay your tax later. Taxpayers who know about this break save billions of dollars each year.
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.
Scour your portfolio for paper losses. Never make investment decisions solely for tax reasons, but the prospect of realizing a money-saving tax loss might be the impetus you need to unload a loser. If you incur losses during the year, ask yourself if it's time to take some money off the table by selling stocks or mutual funds that have enjoyed healthy run-ups in value. Offsetting losses could make your gains tax-free.
Consider tax-free bonds. It's easy to figure whether you'll come out ahead with taxable or tax-free bonds. Simply divide the tax-free yield by 1 minus your federal tax bracket to find the "taxable-equivalent yield." If you're in the 33% bracket, your divisor would be 0.67 (1 - 0.33). So, a tax-free bond paying 5% would be worth as much to you as a taxable bond paying 7.46% (5/0.67).
Keep a running tally of your basis. For assets you buy, your "tax basis" is basically how much you have invested. It's the amount from which gain or loss is figured when you sell. If you use dividends to purchase additional shares, each purchase adds to your basis. If a stock splits or you receive a return-of-capital distribution, your basis changes. Only by carefully tracking your basis can you protect yourself from overpaying taxes on your profits when you sell.
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.
Undo a Roth conversion gone bad. When you convert a traditional IRA to a Roth, you must pay tax on the amount you convert. But what if the investments in the new Roth IRA fall in value? You get a chance for a do-over. You have until October 15 of the year following the conversion to "unconvert" and avoid paying tax on the money that evaporated. You can then redo the conversion the following year.
Help your children earn a credit for retirement savings. This credit can be as much as $1,000, based on up to 50% of the first $2,000 contributed to an IRA or company retirement plan. It's available only to low-income taxpayers, who are often the least able to afford such contributions. Parents can help, however, by giving an adult child (who can not be claimed as a dependent) the money to fund the retirement account contribution. The child not only saves on taxes but also saves for his or her retirement.
See All Tax Savings Strategies