Planning for 2003 taxes

Now that your 2002 taxes are done and gone, don't count on new tax cuts to reduce your 2003 tax bill.

Bank instead on tax-saving strategies already on the books, experts say. You have to use the law we know today and plan according to what's real. The best tax planning is good organization.Too many people give up valuable deductions because they don't keep track through good records .

So before filing your 2002 tax papers away, check them again to see how record-keeping can help tax

planning year-round. Keep good asset records starting with your No.1 asset, your house. Additions

and other major improvements add to the basis price when you sell, shielding you from capital gains

taxes. You still have to pay taxes on any capital gains above $250,000 or $500,000 for a couple.

Closing costs you couldn’t write off upfront like attorney fees and transfer taxes also add to a home’s

basis, whether you still have your original mortgage or have refinanced.

Mutual fund statements over the years may show if you have capital losses to write off to lessen

the pain of a bear market. People who automatically reinvest their mutual fund distributions

grow accustomed to owing taxes on them. Double-check to see if you have a loss entitling you to

a write-off up to $3,000 a year.

Start by working with an expert who can help design a financial plan that takes you through the next

10 years. Kick-start it this week before you file your 2002 tax papers away. Take advantage of every

opportunity that currently exists to put money into tax-favored savings programs — the earlier in the

year, the better. Start by contributing regularly to tax-deferred saving plans. A 401(k) retirement account

or Individual Retirement Account on which taxes are deferred until withdrawal in retirement each

has the double benefit of lowering pre-tax income now and building a nest egg for retirement, when

your income — and your tax bracket — may be lower.

Contribution limits for traditional tax-deferred IRAs and for Roth IRAs (on which money

is taxed now for the promise of tax-free withdrawals) have been raised from $2,000 to $3,000, or

$3,500 for people 50 and older.

In 2003, federal tax law lets you put up to $12,000 tax-deferred into your 401(k) plan —

$14,000 if you are 50 and older — but only if your employer approved the higher limits.

Tax-sheltered education savings accounts are another option that lets you put in after-tax

dollars now for tax-free withdrawals for qualified educational purposes.Coverdell

education savings accounts let you invest after-tax dollars of up to $2,000 a

year for a child under 18 to cover the cost of pre-college schooling, including tuition,

room, board, books, computer equipment, uniforms and the like. Earnings and withdrawals

for qualified expenses are tax-free.

State 529 plans, named after their tax-code section, let you save college tuition, room

and board and the like. You pay taxes on the money you put in, but there are no taxes on

the principal or interest as the fund grows and you withdraw the funds tax-free.

Parents or grandparents looking to fund a 529 account can use the annual gift tax

exclusion — $11,000 in 2003 — to fund an account. Or you can combine five years' worth

of gift-tax exclusions into a single year's gift to a 529 account if you want to get it out of

your estate, on which the first $1 million is free of federal estate tax in 2003. One caveat:

If the contributor dies within the next five years the money is subject to gift tax.

Keep an eye on their investment timeline in today's volatile stock market: The closer you

are to needing the cash for education, the less aggressively you should invest.

Make sure you won't need to withdraw money from tax-favored accounts sooner than tax law

allows for reasons other than education or retirement: If you do, you'll face 10 percent early-

withdrawal penalties atop an income tax bill.

Finally, if you get a hefty refund on your 2002 taxes (the average so far is $2,010), you

gave the IRS a free loan of your money instead of putting it to work for you. If your refund

was for more than $500, consider lowering your withholding on the W-4 form on file with

your employer. Alternately, if your tax bill was at least 10 percent more than the amount withheld

from your paycheck, adjust W-4 withholding upward to avoid paying quarterly estimated taxes

plus penalties and interest on any balance due.

More to help you:

Let's review the current tax changes for 2003.

-- Income taxes: Although tax rates aren't scheduled to change until 2004, the brackets have expanded. You can earn a little more before you are pushed into the next marginal tax bracket. Marginal brackets for 2004 and beyond are estimated by using a 3 percent increase per year over 2002 figures excluding the 10 percent bracket.

For planning purposes, you'll want to understand not only how your "marginal" tax bracket is changing, but also how this affects your "effective" tax rate.

Your "marginal" tax bracket is the top tier of tax that you pay on taxable income. The tax tables are structured so that everyone pays the same rate on the first few thousand dollars. So, for example, if you earn $30,000 in 2003, the first $6,000 would be taxed at 10 percent, the next $22,400 ($28,400 minus $6,000) would be taxed at 15 percent. Only $1,600 would be taxed at the "marginal" bracket of 27 percent.

Your "effective" tax rate is found by dividing your "total tax" by your "taxable income." Both of these numbers can be found on Page 2 of your federal 1040 income tax return. Your effective tax rate is the percentage you actually pay of your taxable income. So, for instance, if your marginal tax bracket is 27 percent, your effective tax rate may be only 25 percent. The difference is due to the tiered structure of the marginal tax brackets and any deductions you are entitled to take.

Most people will see their marginal tax bracket go down by a couple of percentage points over the next 10 years. That's not going to make a dramatic difference, but every little bit helps. Knowing how the tax rates change can be an important planning tool for those of you who are thinking about important life changes -- perhaps having only one spouse working or phasing into retirement. Remember that deductions are worth more when tax rates are higher, so take them sooner rather than later. The opposite is true for recognizing income -- if you can defer it to a later year, you may pay less in taxes.

-- Estate taxes: Estate tax rates will come down dramatically. In fact, in 2010 they're scheduled to go away completely. But before you make any changes to your estate plan, you should know that the "sunset" provision of the new tax act allows for all the current estate tax to come back in 2011. Quite a dilemma from a planning perspective!

Most people think there will still be some type of estate tax in the future. So you want to structure your estate documents for maximum flexibility over time.

Many of you are familiar with the concept of passing a certain amount of money tax-free to your heirs. The amount that you're allowed to pass is called an "exemption equivalent." Right now that amount is $1 million per person (2002-2003). That will increase over time to $3.5 million. Only amounts over these thresholds will be taxed.

While the estate tax rates are going down and the exemption equivalents are going up, you'll also want to be aware of what's happening with the "step-up" in basis. Right now your heirs are able to value their inherited assets at the fair market value on the date you die (or alternatively six months later if the property has not been sold). In 2010, when the estate tax is due to be phased out completely, the step-up in basis also changes, and a new "modified" step-up in basis goes into effect.

The modified step-up in basis divides heirs into two groups: spouses and nonspouses. Non-spouses will be allowed to step-up the basis up to $1.3 million. So, for example, if your total estate is valued at $500,000, your nonspouse heirs will be able to step-up the full amount. When they sell those assets, they'll pay capital gains only on any amount above $500,000. If your estate is valued at $1.5 million, your nonspouse heirs could step-up the basis to $1.3 million. The other $200,000 would carry over the basis of the deceased. If accurate recordkeeping is unavailable, it could hold up the settling of the estate.

If the spouse is the beneficiary of the estate, he or she will get to step-up the basis to a higher amount: $3 million plus the $1.3 million. So, if your estate is under $4.3 million, your spouse would be able to step-up the full amount. If it is over that amount, the incremental amount will retain the deceased's basis.

For the average person, much of the hoopla over estate taxes is much ado about nothing. If your estate will be less than $1 million, your heirs will get a full step-up in value, and they won't have to pay any estate tax -- not now and not in the future. But you might be surprised at just how many people will have an estate worth more than $1 million. There is talk of making the elimination of the estate tax permanent. Don't believe it until you see it. The need for careful recordkeeping of cost basis will be one of the most important gifts you can leave for your heirs.

-- Gift tax: You can gift $11,000 a year each to as many people as you'd like without owing the gift tax. If you're married, you can "gift-split" (that just means you and your spouse split the amount gifted between you) up to $22,000 a year to whomever you'd like with no gift tax problems. If you gift more than those thresholds, you will have to file a gift tax return and pay tax at the same rates as estate tax. (Technically, you also need to file a gift tax return if you gift-split up to $22,000, but no tax would be due.)

We all are allowed a unified credit for estate and gift tax. The credit offsets gift or estate taxes so that you can pass the exemption equivalent amount (see above) to your heirs. In 2003 the exemption equivalent amount is $1 million for both the gift and estate tax for your lifetime. However, while the estate tax exemption equivalent continues to increase to $3.5 million in 2009, the gift tax exemption equivalent remains constant at $1 million (without any increases for inflation).

Say, for example, you gift $100,000 to your kids in 2003 for the down payment on a house. If you are married, you'd be able to gift-split $22,000 without incurring the gift tax. You could also offset the gift tax on the remaining $78,000 ($39,000 each) by using part of your unified credit. Your remaining gift tax exemption equivalent would then be $1 million minus $39,000, or $961,000 for the rest of your life.

Unlike the estate tax, the gift tax is not scheduled to phase out in 2010. You'll still be able to gift up to your exemption equivalent amount, but once you've exceeded that amount, you'll pay tax on the incremental amount at individual tax rates.

-- Retirement plan changes:

2003 brings more increases for retirement plan contributions. People over age 50 will be able to make "catch-up" contributions. For IRAs, the catch-up amount for 2003 to 2005 is $500, and for 2006 and on it is $1,000. For example, in 2003 you can contribute a maximum of $3,500 to your IRA if you are age 50 or older.

Salary-reduction plans, such as a 401(k) or 403(b) plan, will allow even more generous catch-up contributions. In 2003, you can contribute $12,000 to these plans and another $2,000 if you are over age 50.

With a little planning, you can maximize the way you put your money to work. Think about the following:

-- Plan your cash flows over the next 10 years. Defer income to future years as tax rates go down. Accelerate deductions as much as possible. They are more valuable when tax rates are higher.

-- Compare the capital-gains tax rates (not scheduled to change so far) to ordinary income tax rates. As the spread between them narrows, you may find there is less of an advantage to holding investments over a longer period so that they will be taxed at capital-gains rates. Although tax considerations shouldn't drive your investment decisions, they can be an important factor in your returns.

-- Make sure you've calculated the basis on your investments and re-evaluate when you plan to sell your investments. For example, right now there is an incentive to hold a stock with a low basis until death, so the heirs will get the step-up. Without the full step-up in basis, we may see people trading more frequently. Correctly calculating basis becomes even more important if your heirs will have to carry that forward.

-- If you feel you're behind on saving for retirement, do some planning to include higher contributions, especially if you're older than 50 and can take advantage of the "catch-up" benefits.

-- Think about the timing of gifts. For those people who expect to exceed the $1 million gift tax exemption equivalent amount, there will be an incentive to slow or stop gifts so that property passes at death when the exemption equivalent increases.