Five Tax Strategies for 2006 Returns

Now that the April 17 tax deadline has passed, you probably want to dismiss all thoughts of the IRS for another year. But whether you received a large refund on your 2005 taxes—meaning you effectively gave the government an interest-free loan—or had a hefty tax liability, now's a good time to help start minimizing your 2006 taxes. Here are five things you can do to try to prevent getting too much back or owing a lot next year.

Strategy #1: Take a look at your payroll withholding. If you're like most working Americans, you pay the lion's share of your taxes through payroll withholding. Now is the time to make sure your employer is withholding the right amount from your paycheck—not too much or too little.
If the amount withheld is too high, you'll end up getting a big tax refund. That can feel pretty nice—but it's an expensive thrill. In effect, you gave the IRS an interest-free loan equal to the refund amount. In that case, you may want to fill out a new W-4 form and submit it to your employer. If you aren't claiming the maximum number of allowances, you may be able to claim more to decrease your withholding amount.

If the amount withheld last year was too low, you might end up with a surprise tax bill that could disrupt your finances—perhaps forcing you to dip into emergency reserves or even borrow money. In certain cases, you could also face IRS penalties. Consider revising your W-4 form and submitting it to your employer to claim fewer allowances. You can also enter an additional amount that you want withheld from each paycheck. For example, you might want to take the amount you owed last year, and divide it by the number of pay periods remaining this year.

Strategy #2: Consider increasing contributions to retirement savings accounts. Pre-tax contributions to a 401(k) account come out of your paycheck before taxes, and are not included in taxable income for that year. In 2006, you can make pre-tax contributions of up to $15,000 ($20,000 if you will be 50 or older by Dec. 31). "In effect, the government is supplementing your savings," says David Little, vice president of Eclectic Associates, a financial planning firm in Fullerton, Calif. "Assuming you're in the 25% federal tax bracket, every additional dollar you put into a 401(k) only reduces your take-home pay by about 75 cents."

You may also be able to deduct contributions to a Traditional IRA, depending upon your adjusted gross income (AGI) and whether you or your spouse are covered by a retirement plan at work. Moreover, you can defer taxes on any earnings within a 401(k) or Traditional IRA. Earnings on Roth IRAs are federal income tax free providing certain requirements are met. This year you can contribute the lesser of your compensation or $4,000 ($5,000 if you will be 50 or older by year end) in total to an IRA—either Roth, Traditional, or a combination of both. Contributions can be made to a non-working spouse's IRA as long as the couple files jointly and the total of the contribution to each spouse's IRA doesn't exceed the working spouse's compensation.

While there are no income limits for making non-deductible Traditional IRA contributions, there are income limits for Roth IRA contributions. Your AGI must be below $95,000 if single ($150,000 if married, filing jointly) to make a full Roth IRA contribution. Partial Roth IRA contributions are allowed if your AGI is between $95,000 and $110,000 if single ($150,000 to $160,000 if married, filing jointly).

Some people postpone IRA contributions until the last minute—but that can actually cost them. The sooner you make your contribution, the longer time it has to potentially generate earnings. Over time, that head start, combined with the tax-deferred compounding of any earnings, may make a sizeable difference in your retirement assets. "It comes down to a very basic rule of investing, which is the time value of money," says Jackie Perlman, senior tax research coordinator at H&R Block. "The longer you invest money, the more time it has to potentially grow."

Strategy #3: Get more energy efficient. High fuel prices are a reminder of the need to conserve energy—and the tax breaks that come along with such conservation. The 2005 energy bill includes tax credits—dollar for dollar reductions in your taxes—for money you spend on certain energy-related home improvements.

Jackie Perlman of H&R Block says manufacturers of eligible products, which range from insulation and replacement windows to oil-burning furnaces and solar panels, should provide consumers with proof that the product meets IRS guidelines—but you should make sure to obtain such proof before you buy. "We've seen a lot of advertising hype about products that aren't actually eligible for the credit," warns Perlman.

Buyers of hybrid cars and light trucks may also be eligible for a tax credit of up to $3,400 this year. Only certain models qualify for the tax credit, so you should double check that the one you're interested in is one of them. The credit will decline once your car's manufacturer sells more than 60,000 hybrids. So if you're considering buying a hybrid, it makes sense to act sooner rather than later.

Strategy #4: Keep better records of charitable contributions. One way to potentially lower your federal taxable income is to increase your donations to qualified charities. (There are limits on deductions, depending on, among other things, your adjusted gross income, the type of items donated, the type of charity, and how the charity will use the item.) However, you may also find tax savings opportunities when you donate goods—such as old clothes or household appliances—to a qualifying nonprofit by simply documenting donations valued over $250. You'll have to figure out how much that bag of last season's clothes is worth, but many tax-preparation software programs include modules to help you estimate the value of commonly donated goods. You can also find worksheets online at personal finance Web sites. "A lot of people lose track of what they donate over the course of the year," says Modly. "It doesn't take much time to keep good records, and the tax savings will be worth it."

Also consider donating securities with unrealized long-term gains. If you held the securities longer than one year, you can usually take a deduction for the fair market value of the securities at the time they are donated, subject to certain limitations, and you generally should be able to avoid paying taxes on the appreciation. If the securities were held one year or less, your deduction would generally be limited to the cost basis of the security.

Strategy #5: Consider taking advantage of stock losses.You'll need to monitor your portfolio closely, but Helen Modly, CFP, of Focus Wealth Management in Middlebury, Virginia, says tax-loss harvesting may be worthwhile if you can use the realized losses to offset realized gains in your portfolio throughout the year. The strategy involves selling securities at a loss in order to offset other capital gains realized elsewhere in your portfolio. For a given tax year, if you end up with a net loss, you can generally use it to offset up to $3,000 of ordinary income ($1,500 if married, filing separately). And unused losses can generally be carried forward to use against gains realized in future years.

For example: Let's say you own 100 shares of stock X, a major auto maker, and so far this year it's chalked up a $1,000 loss. Nonetheless, you want to keep the stock in your portfolio because you like its long-term prospects. You could sell stock X and immediately replace it with shares of stock Y, another auto maker that is similar to stock X. (We are also assuming that you didn't buy or sell an identical or substantially identical stock in the 30 days before selling stock X.) You could then hold stock Y indefinitely or sell it after at least 31 days to repurchase stock X. Or you could simply wait the 31 days and repurchase stock X without ever buying stock Y. In determining the best way to replace the stock, you should factor in any commissions and the fact that capital gains on securities held for one year or less are generally taxable at the higher ordinary income tax rates.

The time period is important because of wash sale rules. A wash sale may occur if you sell shares of a security at a loss and, within the 61-day window beginning 30 days before and ending 30 days after the sale, purchase shares of the same (or a substantially identical) security. It makes no difference if the buy or sell is in the same or different accounts. If a wash sale occurs, the loss from the transaction should be "disallowed" for tax purposes, and the amount of the loss should be added to the cost basis of the newly purchased shares. Effectively, the loss is deferred until the new shares are sold. "If market prices allow you to utilize this stratetgy and you execute it correctly and periodically over the course of the year, you should be able to generate various losses you can use to offset other realized gains or a small amount of ordinary income at the end of the year," says Modly.