Tax Planning Basics

Short of breaking the law by not filing – and ending up like Al Capone – there isn't much you can do to avoid taxes altogether. But you can take advantage of several strategies to pay less tax.

Making tax-deferred and tax-exempt investments,doing year-end tax planning, and taking full advantage of the tax laws can help you on April 15.

Tax exempt means no tax is due, now or ever. Earnings in a Roth IRA, for example, are tax exempt if you're at least 59½ when you withdraw and your account has been open at least five years. So is interest on municipal bonds. If you live in the state or city that issues a municipal bond that you buy, you will avoid state and local income tax as well as federal income tax on your earnings.

Earnings on 529 college savings plans and Coverdell education savings accounts (ESAs) are also federally tax exempt if you use the withdrawals to pay qualified educational expenses. Withdrawals from 529 savings plan may or may not be state-tax exempt, depending on the state where you live and the plan you are using.

Tax deferred means you don't owe tax on your earnings now. Tax-deferred investments include money in 401(k), 403(b), and other employer sponsored retirement plans, as well as traditional IRAs and deferred annuities. But when you withdraw, you'll owe tax on the earnings and on any contributions on which you haven't already paid tax . In theory, your marginal tax rate will be lower when you retire, so you'll owe less tax than you would if you took that income now.

You can also defer taxes on investments that appreciate in value, as long as you hold onto them. For example, if you buy a stock for $5 a share and it goes up to $50 a share, you don't owe any tax on your paper profit – until you sell and realize the gain.

Selling Capital Assets

You can avoid taxes on some or all of your long-term capital gains by selling securities on which you are losing money – especially if you think they're not worth holding on to. You can use capital losses to offset your capital gains and, in some cases, a certain amount of ordinary income as well. You are also exempt from paying capital gains tax on up to $250,000 in profit on the sale of your home (or $500,000 if you're married and file a joint return), provided it's been your primary residence for at least two years. In fact, you may qualify for a partial tax deduction under certain other circumstances, such as moving to take a new job. You may want to consult your tax adviser if you have questions about these potential investments.

Home Equity Loans

Since interest on many home equity loans is often deductible – while interest on consumer loans and credit cards is not – it may pay to tap your home equity if you need to borrow money. The danger is owing more than you can repay comfortably and putting your home at risk from your creditors.

Shifting Income to Children

If your children are over 14, their tax rate is determined by their individual incomes. If the rate is less than yours, you can shift cash or investments to them and save tax on the earnings, or on the sale of property that has increased in value.

Children under 14 pay tax at their parents' rate if they have $1,900 or more of unearned income, but no tax before reaching that amount. Since they'd need a substantial portfolio to earn more than $1,900 annually, it may pay to shelter some investments by putting them in a child's name.

Shifting Income and Deductions

Sometimes you have the option of postponing income to next year, accelerating it into the current year, or bunching deductions so that your miscellaneous expenses exceed 2% of your adjusted gross income (AGI) in alternate years. By planning those moves ahead of time, you can often save on your tax bill. But you should get tax advice when you use these strategies.

Planning Now to Avoid Taxes Later

By planning ahead, you may also reduce the amount of tax the government will collect from your estate when you die. One reliable approach is to reduce the size of the estate by giving away some of your assets or setting up one or more trust funds for your heirs.

Giving to Charity

If you make a contribution of stocks or other securities that have appreciated, or increased in value, you get the same deduction as you would for giving cash, but you avoid the capital gains tax and the value of what the charity receives may turn out to be higher.

Paying Expenses with Pretax Dollars

Many employers offer flexible spending plans that let you contribute money from your pretax salary to pay certain medical and dependent-care expenses.

Under these plans, you usually pay for the expenses and are then reimbursed from your flexible spending account. Since this money is not included in your salary for tax purposes – hence the term pretax dollars – you may pay less tax. As a rule, the higher your tax bracket and the more you contribute, the greater your investments potential will be.

2004 by Lightbulb Press, Inc. All Rights Reserved.
This information is provided by Lightbulb Press, Inc. and does not express the views of Wells Fargo, Inc. or any of its affiliates. Wells Fargo is not responsible for the accuracy, completeness, or correctness of the information provided by Lightbulb Press, Inc. or other third parties.

Any tax or legal information in this website is merely a summary of our understanding and interpretations of some of the current income tax regulations and is not exhaustive. Investors should consult their tax advisor or legal counsel for advice and information concerning their particular situation. Wells Fargo Funds Management, LLC, Wells Fargo Funds Distributor, LLC, nor any of their representatives may give legal or tax advice.

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