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The Future of Your TaxesThe top 50% of wage earners pay about 96% of all income taxes collected by the federal government.1 That could be why a whopping 59% of Americans believe their taxes are too high.2 The good news is that the size of your tax bill is not completely outside your control. Indeed, many U.S. tax laws are written to reward taxpayers who make certain financial choices. Although it's possible to take some last-minute steps to help reduce your tax burden before April 15, the most effective measures usually take some forethought and proaction. Be on TimeResearch has shown that the average cost to individuals who delay paying their taxes is about $400 per year.3 So it would seem that one easy way to help ease your tax burden is to pay taxes on time or early. Loan Money to the GovernmentBecause the federal government has a limited ability to tax the activities of other government agencies, municipal bonds issued by state and local governments are typically free of federal income taxes. Municipal bonds are usually issued by state and local governments to raise funds to build roads, schools, and other infrastructure. This type of debt is seen as safer than corporate bonds because it is less likely that a government agency would declare bankruptcy and default on any loans. In fact, history has shown that default rates for investment-grade municipal bonds are less than 1%.4 If a municipal bond was issued by a municipality other than one in which you reside, the interest could be subject to state and local income taxes. If you sell a municipal bond at a profit, you could incur capital gains taxes. Because of these circumstances, the suitability of municipal bonds must be viewed through the lens of your overall tax situation. One caveat: Because of their tax advantages and perceived safety, municipal bonds typically pay lower interest rates than their taxable counterparts. For this reason, the benefits of municipal bonds tend to accrue to individuals who are in the higher marginal income tax brackets. Consider Life InsuranceThe most important reason to own life insurance is to help protect dependents against financial hardship in the event that a wage earner were to die unexpectedly. Assuming that you own (or may purchase) life insurance for this reason, you might be surprised to learn about the tax advantages tucked inside your policy. For example, any premiums paid into a cash-value life insurance policy that are later withdrawn are not subject to income tax. Once all premiums have been withdrawn, the insured may be able to take loans against the policy's cash value. Because the money is borrowed, it is not taxable as income. Be aware that loans from a life insurance policy will reduce the policy’s death benefit. In the case of both cash-value and term life insurance policies, the death benefit paid to the beneficiary upon the death of the insured is not considered income, and thus is not taxable. If the insured person does not own the policy, the death benefit is not considered part of the individual's estate for the purpose of calculating estate taxes. Plus, the death benefit can be used to help pay any estate taxes due on the estate. The cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. Before implementing a strategy involving life insurance, it would be prudent to make sure that you are insurable. As with most financial decisions, there are expenses associated with the purchase of life insurance. Policies commonly have mortality and expense charges. In addition, if a policy is surrendered prematurely, there may be surrender charges and income tax implications. Before you take any specific action, be sure to consult with your tax professional. Convert to a Roth IRAA Roth IRA is a tax-advantaged financial vehicle that can be set up to accumulate funds for retirement. Contributions are not deductible and will not reduce your current income tax burden. However, any earnings you withdraw after you reach age 59½ are typically free of federal income taxes, provided certain conditions are met. And any money contributed to a Roth IRA can usually be withdrawn at any age without income taxes or tax penalties. Although contributions to a Roth IRA cannot exceed $4,000 in 2007 ($5,000 for individuals aged 50 and older), you can roll over much larger sums from a traditional IRA. Starting in 2008, you can roll over assets from an employer-sponsored retirement plan to a Roth IRA. The tax law that prevents anyone with an adjusted gross income of more than $100,000 from converting funds in a traditional IRA or an employer plan to a Roth IRA will be repealed in 2010. If you are you are several years from retirement and believe that you would benefit from owning a Roth IRA after you stop working, you might want to consider converting a portion of your traditional IRA to a Roth IRA each year. Any amount you convert in a given year will count toward your taxable income for that year and will probably raise your current tax burden. But once the money is inside the Roth account, any earnings will grow tax deferred and will be free of federal income taxes upon withdrawal, provided the account has been in place for at least five tax years and the distribution takes place after age 59½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Distributions from traditional IRAs and tax-deferred retirement plans are taxed as ordinary income and may be subject to an additional 10 percent federal income tax penalty if taken prior to reaching age 59½. You should take advantage of every opportunity available to you between now and April 15 to help reduce your income taxes. (Be sure to consult with your tax professional before you take any specific action.) But don't forget that April 15 comes every year. Taking a longer view of your situation may help you find ways to reduce your future tax burden. 1, 2) Tax Foundation, 2006 |
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