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It's probably safe to say that most people
enjoy filling out a 1040 about as much as they enjoyed taking the SAT college entrance
exams. In other words, not at all. But, the annual tax preparation ritual at least
forces us to review our finances.
Typically, the big question on everyone's
mind at this time of year is, "What can I do to reduce my tax bill?" Reviewing
their finances may also leave folks feeling guilty for not saving enough. Tax-deferred
savings plans can help in both areas — reducing taxable income and offering extra
incentive to save.
But, you have to use them properly. Here are some tips and
strategies to help you get through the tax season and maybe even have something extra to
show for it.
401(k) Tips
If you save in a 401(k) at work, your tax-deductible
contributions for 2000 for that plan are already set in stone. But, there's still time to
contribute to an IRA and have it count for 2000 (you have to make the contribution before
the tax filing deadline, which falls on April 16 this year). If you meet the IRS income
limits described below, you can make a tax-deductible contribution to a traditional IRA,
which will lower your taxable income for 2000.
If, in 2000, you were single and earned less than $32,000
or married, filing jointly and earned less than $52,000, you can deduct a full $2,000
contribution.
If you were single and earned between $32,000 and $42,000
or married, filing jointly and earned between $52,000 and $62,000, you may be able to make
a partially deductible IRA contribution. The rules for figuring out how much you may
deduct are contained in IRS Publication 590 starting on page 8.
If you were single and earned more than $42,000 or married,
filing jointly and earned more than $62,000, you won't be able make a deductible IRA
contribution at all if you participated in a 401(k). (You could explore a Roth IRA,
though. You won't get the tax deduction now, but your contributions will grow tax-free and
your withdrawals at retirement will be tax-free if you follow the rules.)
Tip: If you can boost your 401(k) contributions now,
it will help reduce your taxable income for 2001. You might want to contribute as much as
possible to your 401(k) before contributing to an IRA because the contribution limit is
higher ($10,500 a year for 401(k)s vs. $2,000 a year for IRAs) and you will benefit from
the employer-matching contribution if your plan offers one.
Got Self-employed Income?
Do you sell crafts on weekends, write free-lance magazine
articles in your spare time or prepare taxes for your friends to bring in extra income?
If you have self-employed income outside of your regular
job, instead of opening an IRA, you could open a simplified employee pension (SEP) plan.
Your contributions to this account can't be more than 15 percent of your compensation or
$30,000, whichever is less. The SEP contributions are only based on the income from your
outside job.
Tip: There's still time to open a SEP for income you
earned in 2000 — the deadline is April 16, 2001.
Do Your Taxes, Today ...
You might be able to save money by preparing your tax
return as soon as possible. You need to know whether you are owed a refund or if you owe
the IRS money.
The earlier you determine whether you owe the IRS money,
the more time you'll have to save enough to make the payment on time and avoid paying
interest.
And, the earlier you determine whether the IRS owes you
money, the sooner you can file your return to claim it. (The IRS should process your claim
as soon as it is received. If you wait until everyone else files, it will probably take
longer.)
Some folks purposely increase their withholdings so they
can get a refund. But, you might be short-changing yourself, said Don Boegel, a
Minneapolis-based certified financial planner. The reason: there's no return on the
savings. "I would rather not give an interest-free loan to the government," he
said.
If you expect to receive a sizable refund or you owe a
significant payment, financial planners say you should review your withholdings.
Tip: If you get a refund, consider using it as an
IRA contribution or as a cushion that enables you to boost your 401(k) contributions this
year.
HCE Minefield
If you were classified as a highly compensated employee
(HCE) for 2000, the time leading up to March 15 is crucial. The reason: If your plan
failed its discrimination test, you could receive a refund by this date.
If your employer operates its 401(k) plan on a calendar
year, it will have to make any HCE refunds by March 15, 2001 or pay a 10 percent excise
tax.
If you receive a refund before March 15, you will have to
count the money as taxable income on your 2000 tax return. So, if you've already filed
your tax return, you'll have to file an amended one with the additional income. (If the
refund comes later than March 15, you can put it on your 2001 return.)
Discrimination tests are required to make sure 401(k) plans
are offered equally to all employees, not just the top earners. Roughly speaking, the test
links contributions of highly paid executives to contributions of lower-paid workers. If
you earned $80,000 or more in 1999 or owned more than 5 percent of the business, you were
considered an HCE for 2000. In 2000, the HCE income limit was raised to $85,000. But, that
will only affect 401(k) plan contributions made in 2001.
Tip: If you suspect you might get a refund, you
might want to delay sending in your return so that you won't have to file an amended
return.
Tip: You can find out from your benefits office how
much you should contribute for 2001 so you can avoid a refund in 2002, said Ted Benna,
creator of the first 401(k) plan and president of the 401(k) Association.
Reduce Your 2001 Taxes, Now
Now is the time to make sure you maximize your tax-deferred
savings for 2001. Review your 401(k) contributions and see if you can increase them for
this year. If you plan to contribute to an IRA for 2001, get started today.
By saving early, you can take advantage of interest
compounding for a longer period of time.
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