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Use Income Tax Reductions To Fund Your Goals

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Americans are about to receive some serious tax relief. Tax reduction was a prime concern of the Bush Administration, and the new president got just about all that he was asking for.

The law provides a grab bag of measures to directly reduce taxes. Direct income tax relief is accomplished through:

  • A systematic reduction of marginal tax rates,
  • Creation of a new 10% bracket carved out of the present 15% bracket,
  • Increased child credits,
  • Specific measures to reduce the marriage penalty,
  • Reduction and elimination of the limitations on deductions and exemptions for higher income individuals,
  • Increases in earned income tax credits for lower income individuals, and
  • Other miscellaneous changes.

All these provisions have been widely reported and will not be examined here. For complete discussion and scheduled effective dates see links below.

Convert tax savings into financial goals – These above changes that simply affect tax preparation happen automatically and benefit even the most unwitting. As such they don’t offer direct planning opportunities. The big advantage comes from using the tax savings to fund your financial goals. Here’s how:

You should notice some difference immediately. A retroactive credit for 2000 will speed a check to most taxpayers ($300 single/$500 head of household/$600 married). Additionally, employers are required to adjust withholding for earnings after July 1 that will put more bucks in high-income wage-earners pockets. A one half percent reduction for the 28%, 31%, 36%, and 39.6% brackets takes place this year. Initially these amounts will be trivial. For instance, according to H&R Block, a single taxpayer paid $1,300 twice a month will receive about $2 more in each paycheck. A similar person paid $2,500 twice monthly will get about $13 more in each check. But in later years, the amounts will be substantial.

The government would like for you to blow this money foolishly to boost demand and jump-start a recovery. You, on the other hand, should consider this largess as a source for badly needed savings. Why not consider increasing your 401(k) deductions or IRA contributions by the amount of your tax reduction? Since you are not used to having this money now, you shouldn’t miss it. And an additional deduction for your contribution will generate even further tax savings! Reasonably invested, these almost painless savings could provide a healthy increase in your standard of living post retirement. Or, use the savings to fund other non-retirement goals. The important thing is not to squander this “found money”.

Tax Rate Arbitrage – Any time you expect your marginal tax rate to fall in the future, it makes sense to consider deferral techniques. Deferring income will generate modest incremental savings due to the tax rate arbitrage. But, as always, the chief benefit of deferral is the opportunity to invest the funds that you would otherwise have to pay in taxes now. The profits, or at least the after tax profits, are yours to keep after you ultimately settle up with the IRS later.

Because deductions are more valuable at higher marginal rates, accelerating deductions makes sense. You and your accountants will want to be alert to possibilities to shift income to later years, and report expenses in earlier years.

Words of caution – Don’t go spending all your scheduled tax reductions right away. Because the cuts are based on projected budget surpluses that may or may not appear, they are phased in slowly over ten years and heavily loaded toward the back end. Most of the savings will not appear for several years. Tax acts have a short half-life, and with a sputtering economy those fat revenue predictions may evaporate. For instance, the haul from corporate taxes is already fizzling due to declining profit levels.

You can count on continued pressure for new projects for military, education, social engineering, and infrastructure maintenance. Finally, over the law’s ten-year life, awareness of the Social Security and Medicare/Medicaid shortfalls will spawn searches for additional revenue sources. In short, the temptation to freeze or increase rates may be irresistible for future legislators. So, don’t bet the farm that you will get everything the act promises now.

Coming up:

Exciting changes in the pension and IRA provisions offer real financial planning opportunities for informed tax-payers.

References:

Deloitte & Touche, Seeds of Change: The 2001 Tax Cut

http://www.dttus.com/pub/taxcut/2001TaxBook.pdf

The Economic Growth and Tax Relief Reconciliation Act of 2001 Summary by
James Lange, Esq., CPA

http://www.rothira-advisor.com/articles/roth21.pdf

Joint Committee on Taxation Summary of Tax Act:

http://www.house.gov/jct/x-50-01.pdf