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4 tax traps to avoid in 2007

Your 2006 tax return is telling you something. Are you listening?

By Penelope Wang, Money Magazine senior writer

NEW YORK (Money Magazine) -- Still smarting over the shocking sum you doled out to Uncle Sam for 2006? If only you'd known at the start of last year what you know now.

Well, at least it's not too late to save 2007. "You have time to make adjustments that can reduce taxes for the current year," says American Institute of Certified Public Accountants vice president Tom Ochsenschlager.

Read over your 1040 to see if you got snagged by any of these common traps - and learn from experience.

Lines 8, 9 and 13

You hit the jackpot on interest, dividends and capital gains. Too bad.

In 2006, for the fourth consecutive year, most stock funds made money - the average domestic equity fund was up 12.5 percent. At the same time, many of them used up the losses they'd been carrying forward from the 2002 bear market, which had offset previous years' gains.

That means you were probably hit with a bigger investment tax bill than you'd seen in years. Interest income and short-term gains were levied at your federal tax rate, up to 35 percent depending on your income.

Granted, long-term capital gains and qualified dividends were taxed at a modest 15 percent. But even that's a lot if you weren't expecting it.

Lesson On your equity funds, switch to tax-efficient entries, such as tax-managed or index funds. For the fixed-income portion of your portfolio, move to tax-exempt municipal bond funds. (Recently a five-year muni was yielding 3.7 percent, equivalent to 5.1 percent for someone in the 28 percent bracket, at a time when five-year T-bonds yielded just 4.6 percent.)

These changes may trigger a gains bill for 2007, but they'll almost certainly help you pay less in 2008.

Line 44 (of your 1040 or your child's)

Your kids earned a lot of interest. For decades, parents stashed cash for their kids in custodial accounts, since investment income earned by children was taxed at a lower rate. But starting in 2006, kids up to age 18 began paying taxes at their parents' rate on amounts of more than $1,700.

The result: a bigger tax bill for those who amassed accounts in the mid-five figures.

Lesson Reduce the tax bill by spending down the account in ways that benefit your kid -camp, say, or college visits. Then use the money that would've gone to those expenses to fund a 529 college savings account, which is tax-free if used for higher education.

Bonus: Your state may let you deduct your 529 contributions.

Line 45

Surprise! You get to pay the rich man's tax. The alternative minimum tax, or AMT, is a complex parallel tax code originally designed to prevent the richest households from dodging Uncle Sam. All taxpayers are technically supposed to calculate their bill two ways (the regular way and the AMT way) and pay the higher amount.

But the AMT isn't indexed to inflation, so many middle-class Americans end up in its grip. They pay considerably more, since the AMT caps or disallows favorite breaks, like the deduction for state taxes or the exemption for kids. Alas, once the AMT has you by the ankle, it's hard to shake loose.

Lesson Get a sense of whether you'll be hit again using H&R Block's AMT calculator (hrblock.com; click on Calculators). If you may fall victim, set aside some money to cover yourself. And book an appointment with a C.P.A. While you usually can't avoid the AMT, a pro may be able to help you reduce its impact.

Line 73

You got a really huge refund. What's so bad about that, you ask? By overpaying, "you made a free loan to the government," says Mark Luscombe, principal analyst at tax law publisher CCH. "And you missed out on the interest you could've earned on that money."

Lesson Ask your HR manager for a new W-4 and reduce your withholding. Remember, more exemptions means more cash in your pocket - and less in Uncle Sam's. Top of page