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Trimming Your Taxes 101
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July 4, 2001: 8:51 a.m. ET
From 401(k)s to ETFs and muni bonds, tax-friendly ways to save abound
By Staff Writer Shelly K. Schwartz
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NEW YORK (CNNfn) - In the hierarchy of necessary evils, taxes reign supreme.
The dollars collected by the Treasury Department each year are used to pay for road repairs, new schools and disaster relief. They cover the tab for everything from government salaries to programs for those who can't help themselves.
And they can put a dent in your paycheck faster than you can say FICA.
There's nothing you can do about your debt to society, of course, but there are steps you can take to cut your tax bill down to size.
From tax-deferred retirement plans to continuing education credits, Uncle Sam offers dozens of ways to help hardworking Americans boost their take-home pay. Add to that the new menu of investment options designed to minimize taxable gains, and the potential for savings grows larger still.
But it's up to you to make it happen.
"People forget about tax credits and they don't take all the deductions to which they're entitled," said Cindy Hockenberry, an enrolled agent with the National Association of Tax Practitioners. "That happens all the time."
Claim those deductions
First and foremost, experts say, you'll get the most mileage out of your paychecks by maxing out your retirement plans, including individual retirement accounts (IRAs) and 401(k)s.
Both allow for tax-deferred contributions and both levy hefty penalties in the event that money is tapped before retirement day dawns.
Keep in mind, however, that only traditional IRAs allow taxpayers to deduct their contributions up front. Those who opt for a Roth IRA use after-tax dollars, instead, which yields no immediate write-off. The benefit of a Roth, of course, is that your earnings are withdrawn tax-free in retirement.
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 WHAT'S THE BIG DEAL?
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Taxpayers in the 15% bracket would have saved $1,500 in taxes last year had they maxed out their 401(k). Those in the 28% bracket would have saved $2,900.
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"If you want to save tax dollars, deferring your funds into a retirement account is probably the best solution," Hockenberry said. "That money grows tax free and (if you take out a traditional IRA) you reduce your taxable income in the year you make the contribution."
Thanks to the 10-year tax cut signed by President Bush last month, the tax-deferred limit for contributing to a 401(k) will climb to $15,000 from $10,500 by 2006. IRA contributions will climb to $5,000 from $2,000 – allowing for still larger deductions against your income.
Tax credits for kids, college
Other big breaks that can lighten your liability to the IRS include the Child Tax Credit and education-related credits.
Tax credits are full dollar-for-dollar rebates that put extra money directly in your hands – which is more lucrative than an exemption or deduction.
Parents and legal guardians are entitled to claim a $600 deduction for every dependent child under age 17. For an eligible family with two young kids, that's $1,200 they can subtract from their 2001 tax returns.
The Child Tax Credit is reduced by $50 for each $1,000 that your adjusted gross income exceeds $110,000 for joint filers and $75,000 for singles.
College students are entitled to a few tax credits of their own.
The HOPE Credit, for example, allows for a 100 percent deduction of the first $1,000 of qualified tuition expenses and related fees paid during the tax year, plus 50 percent of the next $1,000 – for a maximum credit of $1,500 per year.
You must be enrolled at least half-time to qualify and the credit applies only to the first two years of post-secondary education.
Lastly, students pursuing graduate and professional degrees may qualify for the Lifetime Learning Credit, which equals 20 percent of tuition and fees up to $1,000 per year. That limit climbs to $2,000 per year in 2003.
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THE RULES
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Keep in mind the HOPE and Lifetime Learning Credits cannot be claimed for the same student in the same year. They can be claimed by either the parent or the student, but not both.
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Both the HOPE and Lifetime Learning credits begin phasing out for those with an adjusted gross income (AGI) above $40,000 for singles and $80,000 for married taxpayers filing jointly. They are eliminated completely for single taxpayers with AGI over $50,000 and for married filers who earn $100,000 or more.
Index funds, ETFs and tax-managed mutual funds, Oh my!
Tax-saving strategies, of course, are important for investors, too.
Over the last few years, brokerage firms have caught on to the growing demand for mutual funds that seek to minimize capital gains.
Tax-managed mutual funds, as they are known, include everything from equity funds that employ a buy-and-hold strategy, to funds that invest in municipal bonds, which are free of federal income tax.
Fund managers in this investment category typically sell off losing stocks within their portfolio to offset gains. They also limit their turnover rate – or the number of times they buy and sell holdings within their portfolio.
Don't forget, shareholders are assessed capital gains tax each time a security is sold. Studies show the average investors in an activity managed stock fund surrenders between 2.5 percent and 3.3 percent of their returns in taxes from capital gains, distributions and dividend income.
(Click here for more on tax-managed mutual funds.)
Index equity funds are another good way to limit your tax liability. Such investments track entire stock indexes, including the Dow Jones industrial average, S&P 500 and Nasdaq Composite, allowing shareholders to own all of the stocks within that index.
Because they are not actively managed, their turnover is virtually nil. Keep in mind that shareholders will owe capital gains tax once they sell the fund, but distributions during the years they own it will be held to a minimum.
Lastly, you don't want to overlook exchange-traded funds which are fast becoming a favored mechanism for keeping investment dollars out of the IRS' mitts.
Simply put, ETFs are baskets of stocks that put investors back in the driver's seat. Some track an index or part of an index. Some invest in a particular sector. And unlike mutual funds, which are priced once a day, ETFs trade like stocks on an exchange (usually the American Stock Exchange), complete with ticker symbols.
Financial planners say exchange-traded funds can be a solid bet for buy-and-hold investors, since their expense ratios are among the lowest in the market and there is little to no turnover of your holdings.
Fixed-income security
If you're closing in on retirement and looking to limit your level of risk, there is one other investment option that's sure to please: municipal bonds.
Muni bonds are issued by the federal, state and local governments as a way to foot the bill for community services. Like all bonds, they promise a fixed rate of return at a pre-determined maturity, of anywhere from 12 months to 20 years.
The interest investors earn on muni bonds is exempt from federal tax and in some cases state and local tax.
"A lot of people believe you have to be in the highest tax brackets to benefit from munis, but based on their yields over the last few years, anyone in the 28 percent and 31 percent brackets can benefit, too," said Eric Jacobson, a senior analyst with Morningstar. "To even match the yields of tax-free muni bonds, you'd either have to buy some sort of unusual, riskier taxable bond or drop down in credit quality."
Over the last 12 months, the average muni bond fund returned 9.4 percent, according to Morningstar. The group's three-year annualized return was 3.7 percent.
(Click here to check your bond funds.)
Turning lemons into lemonade
When it comes to playing the markets, we all like to think of ourselves as savvy investors with a knack for double-digit returns. But let's face it, we all end up with a few dogs now and then, too.
Experts say the truly savvy investor knows how to turn those losses into tax-free gains.
"This is another thing people forget about," said Hockenberry, of the NATP. "If you had a huge capital loss that you're carrying over from 2000, this year is the perfect time to sell off investments that you know will have a high gain."
Each year, she said, the IRS allows individuals to offset 100 percent of your losses against capital gains, plus an additional $3,000 in losses against your ordinary income, including salary and dividends.
Any leftover capital losses can be carried forward to future years, at a maximum annual loss of $3,000.
"If you had a $20,000 loss carryover from last year, and $30,000 in gains this year, you can offset that whole $20,000 – plus an additional $3,000," Hockenberry said. "You can really minimize your tax burden if you do that."
Gimme shelter
Lastly, there are tax shelters.
Such investments usually require substantial investment with a degree of risk and often involve current losses to produce future gains. According to the IRS, the amount of your deductions or losses from most tax shelters is limited to the amount you have at risk.
One example of a legitimate tax shelter is an investment in low-income property that provides depreciation benefits to the investor. Others include trust funds.
Irrevocable trusts, for example, are legal entities set up to provide for beneficiaries. In essence, they allow individuals the flexibility to pass on a portion of their assets through a designated trustee, without subjecting those assets to punishing estate taxes.
Credit-shelter trusts are a little different, allowing individuals to bequeath an amount equal to the estate tax exemption ($675,000 this year) to the trust, and pass the rest of your estate to your spouse.
But be forewarned. The IRS is cracking down on taxpayers who take part in abusive tax shelters, which exist solely to reduce tax liabilities.
(Click here for more information from the IRS on abusive tax shelters and how to spot them.)
The bottom line
It may be complex, but tax savings strategies are a pivotal part of financial planning. As such, experts say it's critical that taxpayers claim every deduction to which they're entitled and educate themselves on ways to minimize their tax bite this year and into the future.
After all, this is your money we're talking about. 
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