(MONEY Magazine) – Tax planning is your single best hope of reducing your federal and state income tax bills. You know it. I know it. But do you really do it? (You may keep the answer to yourself.) Undoubtedly, your best defense against the Internal Revenue Service and the state tax collector today is to arrange your spending, investing, saving, borrowing and bookkeeping so you don't have to pay a penny more in taxes than you owe. -- That's exactly what the taxpayers profiled in this article have done. For example, Nina Diamond, a 27-year-old public-television producer in St. Louis (at top left on the opposite page), managed to uncover $2,000 of 1993 deductions, thanks to careful record keeping throughout last year. The canny couple Ken and Susan Pruett, 58 and 47 (bottom left), realized they could lower their state income taxes in retirement by 10% a year just by moving from Hawaii -- where they paid a 10% state income tax -- to Washington State, where residents aren't hit with state income taxes. They did just that in April 1993. -- The lesson to be learned from these stories is simple: The tax laws offer a generous range of savings for everyone, from day-old infants to seniors born before the income tax was imposed in 1913. Since tax-cutting opportunities change as you age, MONEY presents the most valuable tips in each of the four stages of adult life -- when you're first on your own, raising a family, looking toward retirement and actually retired. In addition, the box on page 147 offers three ways to minimize taxes on your kids' income. These last weeks of 1994 are the ideal time to take stock of your taxes, since you can make last-minute adjustments to snip your '94 taxes while taking steps to lower your bill for years to come.

ON YOUR OWN: Be a pack rat and a deduction buncher

The earlier you start finding ways to keep your taxes down, the easier it'll be to keep them to a bare minimum for the rest of your life. Here are eight ways to get on the right path: Keep tax-smart records. It pays to be a pack rat, since meticulous record keeping for taxes can save you thousands of dollars over a lifetime. Train yourself to keep the documents you'll need -- such as canceled checks, bank statements and copies of your W-2 forms -- to reconstruct your year's income and deductible expenses at tax time. This somewhat annoying task will also come in handy if the IRS ever questions your return. Need proof that tax records can lower your IRS tab? Let's say you drive for business. You could write off a flat mileage rate of 29 cents a mile. But if you can document your actual auto expenses, you can write off your true -- almost certainly higher -- costs for gasoline, oil, insurance, repairs, car washes, parking and tolls. Plus you'll be allowed to claim depreciation for the car, up to $2,860 a year. A little-known tax fact: If you lease a car used for business, you must use the actual expenses method to write it off. Without adequate records, you won't be able to claim any deduction for leasing. Start totting up those deductions. When you file your federal tax return, you may either itemize your write-offs or take the standard deduction -- now $3,800 for singles and $6,350 for married couples filing jointly. Many young people have deductible expenses that fall just short of the standard deduction. If you're in this camp, try an old C.P.A. trick: bunching. This means you cram as many deductible expenses as you can into one year so you can cross the standard deduction threshold and itemize. For example, you could give to your favorite charity twice in one year -- in January and December, rather than every December. Go for weighty gains by investing in stocks or mutual funds that buy stocks. Not only have stocks outperformed all other investments over the long run by around seven percentage points a year, they're also taxed more lightly than bonds and bank certificates of deposit for many investors. If you're in the 31% tax bracket or higher (income of more than $55,100 for singles and $91,850 for married couples filing jointly), your profits (known as capital gains) are taxed at a top rate of 28%. But your income from bonds and CDs is taxed at your tax rate, up to the top rate of 39.6%. In addition, you can defer paying tax on your stock gains until you sell the shares. Income on taxable bonds and CDs is generally taxable as you receive it. * Plunge into your first retirement plan. Sure, you're young and have lots of expenses -- clothes for work, furniture and student loan debt. Why worry about retirement now? Precisely because you have 40 years or so until you call it quits. Start socking $2,000 a year into a tax-deferred plan earning 7% when you're 25. If you're in the 28% tax bracket ($38,000 to $91,850 for a married couple filing jointly; $22,750 to $55,100 for a single), you could have $255,632 more at age 65 than the poor soul who waited until he was 45, according to John Scarborough, an investment manager with Bingham Osborn & Scarborough in San Francisco. You have lots of choices. Your employer's 401(k)-type plan or an IRA if you're an employee; an IRA, a Keogh or a SEP-IRA if you're self-employed. With all of these plans, your contribution generally isn't taxed until you withdraw the money later on, usually after age 59 1/2. And the amount you invest may be tax deductible. You can invest and deduct each year up to $2,000 in an IRA ($2,250 combined if your spouse does not work), even if you or your spouse is covered by a pension at work. But joint filers must earn $40,000 or less ($25,000 if you are single). Self-employed people typically can deduct Keogh contributions of up to 20% of their income, or $30,000, whichever is less, or SEP contributions up to 13.04%, or $22,500, whichever is less. Payments to 401(k)-type plans aren't deductible, but since you invest in them before your pay is taxed, you get the equivalent of a deduction. Maximum 401(k) contribution for 1994: $9,240. Moonlight, and pull down luminous tax breaks. In addition to the income it provides, freelancing offers a host of write-offs to offset any extra tax on your additional earnings. Even if your primary job is as an employee, you can shelter your self-employment income in a Keogh or SEP-IRA retirement plan. What's more, you may write off a portion of household expenses, including rent, utilities and property insurance, if you work out of your home. You can also deduct the full cost of business equipment, up to $17,500 a year. And if you start out in the red, any loss from the business will reduce taxes on the wages from your primary job. Slash the cost of moving. Uncle Sam remains willing to help shoulder your moving bill to take a new job, though he has just become a little less generous. Starting this year, if you move and the distance between your new job and your old home is at least 50 miles more than the distance between your old job and former home, you can deduct the unreimbursed costs of moving your household goods and personal effects plus your travel expenses en route (except meals). If you didn't have a job before the move, the new job must be at least 50 miles from your old home. Last year, however, you needed only a 35-mile stretch to get this tax break. But there's some welcome news for younger tax-payers: You no longer have to itemize to take moving deductions. Now, job-related moves can be deducted directly from your gross income. Learn while you earn tax goodies. Improve the skills required in your current job or take courses required by your employer and you may be able to claim your unreimbursed educational expenses. There's no guarantee of deductibility, however. Education expenses fall into the category of miscellaneous itemized deductions, whose total must exceed 2% of your adjusted gross income before you can claim any of them. Take a gulp and prepare your own tax return. At this stage in life, you probably don't have enough deductions to itemize or a lot of investments to complicate your return. So hiring a tax pro to fill out your forms (the cost ranges from $50 all the way to $500 for a complicated return) is unlikely to pay you back in tax savings. By working through your own return, you'll not only save cash but you'll also learn the basics of the tax law. That's knowledge that will serve you well later when you really need to hire a pro. For help, pick up a tax preparation paperback (like mine!) at a bookstore for about $14. If you're computer literate, you might want to prepare your return with help from a tax software program such as Turbotax (Intuit, $35) or TaxCut (Meca, $79.95). The 1994 versions will be in bookstores and computer outlets starting in December.

RAISING A FAMILY: Take summer camp as a tax write-off

Let's be blunt: Having kids means shouldering a whole lot of new expenses. But some of the costs, such as child care or a college fund, can be tax deductible or at least tax sheltered. You may also need more room -- and many housing costs can be tremendous tax savers too. Trim your tax withholding. When you celebrate the birth or adoption of a child or buy your first home, you get showered with new tax write-offs. So direct your employer to reduce your tax withholding on your wages accordingly. Use the Deductions and Adjustments Worksheet on Form W-4 to revise the number of your withholding allowances. For example, if a couple earning $75,000 have no house and do not itemize, they might take two withholding allowances. If the same couple have a child, buy a house costing $12,000 in annual mortgage interest and $2,000 in property taxes and plan to itemize deductions, they would raise the number of allowances from two to eight. That would boost their biweekly paycheck by about $110. Claim a tax credit for all child-care costs that count. If both you and your spouse work, remember you can include far more than just babysitting when calculating your child-care credit (up to $480 a year for one child, $960 for two or more if your income is over $28,000). Don't forget to figure in the cost of a day-care center, nursery school, summer day camp, household services such as cooking and cleaning (if done partly for the well-being of your child), meals a sitter eats in your home, extra expenses for a live-in's lodging, and in-home nursing care for a disabled child. Capitalize on company benefits. One popular type of bennie is a flexible spending account (FSA), now offered by nearly three-quarters of medium-size and large employers. FSAs let you pay medical and dependent-care expenses with before-tax dollars. A $5,000 FSA is worth $1,550 in federal tax savings alone if you're in the 31% bracket ($91,850 to $140,000 for couples filing jointly; $55,100 to $115,000 for singles). If your employer offers you choices from a so-called cafeteria plan (about two-thirds do), you can reap terrific tax savings by picking the benefits that suit you. Just remember that if you elect to receive cash under such a plan instead of another benefit, that money will be taxable income. But if you opt to have your employer pay for your medical or child-care expenses, that amount is not included in your W-2 wages; in effect, it's tax-free. (For more guidance in making smart selections in your benefits plan, see the story on page 182.) Consider buying Series EE savings bonds for your child's college education. Interest on the bonds (current rate: 4.7%) is always free from state and local income taxes, and it also could be exempt from federal tax. That depends on your adjusted gross income when you redeem the bonds. This year, you get a full tax-free exclusion if your adjusted gross income is $61,850 or less and you're married or $41,200 and you're single. The exclusion shrinks as your income rises and disappears for couples with incomes above $91,850 and singles above $56,200 (those income figures are scheduled to rise with inflation each year). Run for shelter. Nothing wards off taxes like buying a house, thanks to roomy deductions for mortgage interest and property taxes. With a $100,000, 30-year mortgage at 8h%, for example, you would pay $8,404 in mortgage interest in the second year of ownership -- for a tax savings of $2,353 if you are in the 28% bracket. And if your property tax bill was, say, $1,000, that would deliver another $280 tax savings. Points you pay to secure your loan -- each point is equal to one percent of the mortgage amount -- are also fully deductible in the year you buy. Tip: Check your settlement statement for property taxes or mortgage interest you paid at the closing that don't show up on the year-end statement from the lender.

PLANNING RETIREMENT: Boost savings with tax-free bond funds

Now that you're in your prime, you should be working hard to make your money last your lifetime. That means easing out the tax man as much as possible through tax-sheltered investments and pension plans:

Investigate tax-free municipal bond funds and tax-deferred annuities. If you're in the 28% bracket or higher, you can now earn more on an after-tax basis from a high-quality, intermediate-term muni bond fund (average current yield: 4.4%) such as no-loads Vanguard Intermediate Term Municipal (800-851-4999) or Fidelity Spartan Intermediate Municipal (800-544-8888) than from a taxable corporate or U.S. Government fund. In the 28% bracket, that 4% is the equivalent of a 5.5% taxable return. In the 36% bracket ($140,000 to $250,000 for married couples; $115,000 to $250,000 for singles), it's around 6.25%. Annuities are sold by insurance agents, stockbrokers, financial planners and bankers and resemble nondeductible IRAs. Your earnings grow tax deferred until withdrawn, presumably at retirement. Unlike IRAs, however, there is no federal ceiling on the amount you can stuff into an annuity. There are two types: fixed annuities, whose rate is locked in for one to 10 years (current yield: 4.5% to 7.5%), and variable annuities, whose returns fluctuate, depending on the portfolios you choose. Annuities aren't for everyone. They can work, however, if you're in the 28% federal tax bracket or higher, have at least $10,000 to invest, don't plan to retire for 10 or more years, and have maxed out on other tax-favored retirement savings plans. Caution: Avoid variable annuities with annual expenses exceeding 2.1%. And snub fixed annuities that offer interest rates that are much higher than the average of around 6%. Such annuities are likely to lower the rate in the second year or make risky investments. They could devour a good portion of your tax break. Roll over pension distributions tax-free when you change jobs. Those career moves you make on the way up could cost you dearly at tax time unless you take preventive measures. When you leave a company before age 59h, it's critical to roll over any lump sum you receive from its pension or savings plan into your new employer's plan or an IRA within 60 days. If you don't, you'll pay ordinary income taxes on the amount, plus a 10% tax penalty. (The penalty is waived if you are older than 55 and take early retirement.) Worst of all, if you're more than a few years away from retirement, you'll also lose the dynamic benefit of tax-deferred buildup of your assets.

Turn your IRA into a lifetime annuity without penalty. Normally, you get hit with a 10% tax penalty on IRA withdrawals before age 59h. But there's a loophole: If you instruct your plan's custodian to pay out your funds in equal annual installments based on your life expectancy, voil , there's no 10% tax! You'll still pay income taxes on these withdrawals, though. And you can't reverse the arrangement. Buy a second home. Now that you are earning a comfortable income, it may be time to invest in the tax shelter of a vacation or retirement home. You can deduct all the interest you pay on as much as $1 million of debt borrowed to buy, build or improve a first and second home combined -- plus property taxes, of course. Get into rental real estate. If you own at least 10% of the property and make management decisions (such as approving new tenants or authorizing repairwork), the IRS dubs you an "active" participant. That means you may be able to deduct as much as $25,000 yearly in rental losses from your salary and investment income, while raking in rental income that could help you attain a cushy retirement. This tax break begins to phase out for investors with adjusted gross incomes of $100,000 or more and disappears at $150,000.

RETIRED: Keep your taxes down on pension payouts

You probably won't be working much, so more than ever you need to keep whatever income you have out of the mitts of the IRS and your state. That means uncovering every little-known tax break you can and getting clever about $ how to accept money you have coming to you: Muzzle the tax bite on your Social Security benefits. Until 1994, as much as 50% of your benefits were taxed if your so-called provisional income exceeded base amounts -- $32,000 on a joint return and $25,000 on a single return. (Provisional income is your adjusted gross income plus tax-exempt interest and half of your Social Security benefits.) Those thresholds still apply, but there's now a group of retirees who will see as much as 85% of their Social Security benefits taxed -- couples with provisional income over $44,000; for singles, $34,000. If you're in the 50% or 85% crowd and can adjust your retirement plan withdrawals, consider lowering the payouts so your income won't cross the thresholds. Another suggestion to lower your provisional income: Reposition your investment portfolio. Sell some municipal bonds or bond funds, which pay tax-exempt interest, and buy tax-deferred investments like Series EE savings bonds or ones with deferred gains, such as stocks or rental real estate. Turn your hobby into a paying avocation. Use your newfound free time to turn pleasure to tax advantage. The IRS' rule: If you make your hobby a business and it shows a profit for three out of five consecutive years, you may deduct related expenses including the losses during the years you're in the red. You just need to be able to prove that you always intended to turn a profit on the activity -- you really did! Catch your $125,000 windfall. If you're age 55 or over, you may -- once in your lifetime -- exclude up to $125,000 in capital gains on the sale of your principal residence. One requirement: You must have lived in the home for at least three of the past five years. Average out your lump. If you landed a lump-sum pension payout and have decided to take the money directly instead of rolling it over into an IRA, you may be able to save thousands of dollars by using a tax computation called five-year averaging. Even though you got the withdrawal all at once, you pay taxes as if the money were received over five years. If you were born before 1936, you may use even more beneficial 10-year averaging and pay taxes as ifIwell, you can figure it out. Have your accountant run the numbers before you decide to average, because the IRS says you can use averaging only once in your life. Reduce your taxable income by making your IRA withdrawals as teeny as possible. Once you reach age 70 1/2, you must take a minimum amount out of your IRAs each year or face a 50% penalty tax on the shortfall. For instance, if you were supposed to take out $8,000 a year and you withdrew only $4,000, you'd get taxed 50% on the $4,000 difference. Because minimum withdrawals are based on your life expectancy as estimated in IRS tables, one way to limit the required payout is by recomputing your life expectancy each year. That's because the longer you live, the longer your life expectancy. Another tactic: If your spouse is younger than you, name him or her as beneficiary and use the longer joint-life expectancy. If you had $150,000 in an IRA at age 71 1/2 and you did not name a beneficiary, you would have to spread the distributions over 11.6 years and take $12,931 per year. If you named your 61-year-old spouse as beneficiary, you could spread the distributions over 25.6 years and draw down just $5,859 per year. Defer taxes with a spousal IRA. If you or your spouse is still pulling down employment income, don't retire those IRAs just because one of you is over age 70 1/2 and ineligible to make IRA contributions. A working spouse over 70 1/2 may still contribute up to $2,000 a year to the IRA of a nonworking spouse under age 70 1/2. And the contribution is tax deductible if you meet the normal standards for IRA deductibility. Finally, escape! To a no- or low-tax state, that is. With no job to tie you down, you may be able to simply pick up and kiss high state taxes good-bye. The best tax havens for retirees: Alaska, Nevada, South Dakota, Texas, Washington and Wyoming, with no state tax on earned or unearned income at all. Four low-tax states: New Hampshire, Florida, Pennsylvania and Tennessee. You may not be able to get make a clean getaway, though. Some states, such as California and New York, may pursue and tax emigre retirees on pension or IRA income earned while they were residents. So check the hunting habits of your old state before turning out the lights and heading out.