Tax Guide 2002
We quizzed some top experts to find out how to reduce your income taxes.
February 15, 2002: 10:32 a.m. ET
By Leslie Haggin Geary
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NEW YORK (Money Magazine) - It's no small thing to face down a 1040 and a blizzard of documents, from canceled checks and restaurant receipts to 1099 dividend slips. And just when you think you've nailed down a strategy, the folks in Washington change the rules.
Sure, this latest overhaul -- the so-called Economic Growth and Tax Relief Reconciliation Act -- brought rebate checks for many of us. But what other considerations come with the new law? How different is it going to be to file intelligently?
Money went to some of the country's top tax experts to find out. We asked them the questions that are most likely to affect readers like you, and we sought out strategies to help you minimize next year's taxes while avoiding the pitfalls. Because no matter what Washington may do, taxes will always be there -- and they're not getting any simpler.
We've heard a lot about the new tax laws. But how different will filing really be this year?
Tom Pudner, manager, McLean, Va. personal financial planning practice, KPMG: Much of the new tax law complicates tax planning, but the returns themselves aren't going to be a lot more complicated. The biggest changes are the new tax brackets and the reduction in income tax rates. From a preparation standpoint, you can still look at a table and find what your tax is. But from a planning standpoint, there's a lot you can do. These new brackets and lower rates are fully phased in by 2006, then go up again in 2011. So, for example, you can try to time the exercise of nonqualified stock options for later years, if possible, because that's when you may be in a lower tax bracket.
Evan Snapper, senior manager, personal financial counseling, Ernst & Young: Early filers have been making mistakes filling in line 47. If you got a rebate check for the maximum amount -- either $600 or $300 -- leave the line blank. If you didn't get a check, or believe that you were entitled to more than you received, complete the Rate Reduction Credit Worksheet in the 1040 instruction booklet to determine what you're entitled to. Then put that amount on line 47.
Many people refinanced their mortgages this year. What's deductible? What about home-equity loans?
Mark Luscombe, principal analyst, federal and state tax group, CCH: Basically, when refinancing a mortgage, what you have is an ability to deduct interest. So the question that usually arises is, 'What counts as interest? If I pay points on the refinancing, is that interest and can I deduct it?' When you're refinancing, points have to be deducted over the term of the loan. That's different from an initial mortgage, where typically the points are characterized as prepaid interest that you can deduct up front.
John Battaglia, tax director, private client advisors, Deloitte & Touche: When you refinance, there may be some interest you had to pay from the date of the last mortgage payment to the closing date of the refinance. When you get your mortgage interest statement from your bank -- it's called a 1098 -- make sure that this interest is on it. Sometimes this interest is omitted by mistake.
One confusing change is the number of people who will be subject to the alternative minimum tax. How do I know if I'm likely to be subject to the AMT, and what does that mean?
Kathy Burlison, manager, tax operations field training, H&R Block: The way the AMT works is that you calculate your income without certain deductions or credits you'd otherwise be allowed to take. That's called your alternative minimum taxable income (AMTI). For instance, you don't deduct your dependents, any state and local taxes you paid, medical expenses or other miscellaneous itemized deductions.
Luscombe There are two things in the new legislation that could make more people subject to the AMT. One is that while regular tax rates were reduced, the AMT rates stayed the same, and you have to pay the higher amount. Another is that the amount of AMTI that is exempt from this tax -- $37,750 for single filers and $49,000 for joint filers -- falls by a few thousand after 2004. So it's more important than ever to work through the AMT calculation. A preparer can do it for you, and so can tax software.
Burlison If you're stuck with the AMT for 2001, there's not much you can do at this point. But it will serve as a heads-up for this year. Look at the kinds of items that kicked you into AMT for 2001 -- whether it's because you live in a high-tax state or because you have lots of personal exemptions. Then plan your strategy if you can.
The long-term capital-gains rate is supposed to drop from 20 percent to 18 percent for assets held for five years, starting this year. But to get the lower rate, people will need to do a 'deemed sale and repurchase election' on 2001 returns. Who should do this -- and how?
Burlison This is a one-time-only move that applies only to assets or property purchased before Jan. 1, 2001, and for which you want the five-year holding period to potentially apply. It's worth considering if you have an asset that you think you'll hold for at least five more years, and you can use its gain in value to offset losses in other investments. Say you had investments whose net capital losses in 2001 were $13,000. You could write off $3,000 against ordinary income and carry the other $10,000 into future years. Or you could elect to take an asset you currently hold that on Jan. 2, 2001 had gone up in value and do a deemed sale. You'd be able to get an increase in the cost basis of that asset of up to $10,000 (matching your loss) at no current tax cost.
The value of my Roth IRA has dropped significantly, but I owe taxes from when I converted it in 2001. How do I recharacterize it back to a traditional IRA?
Battaglia Let's say you rolled your regular IRA over to a Roth last year and it was worth $50,000. Now it's worth only $25,000. That's when you want to do a recharacterization. Basically, that means telling the IRA administrator that you're going to make the Roth back into a regular IRA in a trustee-to-trustee transfer. This must be done by Oct. 15 of this year.
Pudner When you take the money out of the Roth, it's not taxable anymore. You can recharacterize it as a traditional IRA, then wait 30 days and put it back in a Roth. You'll end up owing less tax, plus you'll wait an extra year to pay.
Many people got laid off this year, and they've spent a lot on job searches. What can they deduct?
Snapper Job searches are deductible, but they're subject to the 2 percent miscellaneous itemized deduction rule. You can't deduct anything until your total miscellaneous itemized deductions are more than 2 percent of your adjusted gross income (AGI). Once you're over that hump, any money you spend to make money is deductible. For a job search, that includes things like buying magazines with want ads, hiring someone to help prepare a resume and purchasing the stationery that you printed the resume and cover letters on. Mailing. Traveling to and from job interviews. If you hired a job coach who charged you a fee. But buying a new suit for an interview is not deductible because you can use the suit personally. If you have to buy a uniform for a job, that's deductible.
Luscombe Quite often people assume that unemployment benefits are not taxable, and that is not the case. From the IRS' point of view, unemployment benefits are income, just like the check you used to get when you were employed.
There are lots of new education savings in the new tax law. What will save the most on taxes?
Burlison The student-loan interest deduction rose to $2,500 for 2001, from $2,000. That's one really big change.
Snapper You can deduct interest only on student loans incurred in the last 60 months, but starting in 2002, that 60-month window goes away. So if you still have student loans, you've been out of school awhile and you fall within the income limits, you may be able to deduct interest in 2002.
Pudner The biggest development is with the vehicles that you can use to save for education. The main two are the 529 state plans and the former Education IRAs, which are now known as Coverdell Education Savings Accounts.
Luscombe The ESA contribution limit goes up from $500 to $2,000 per student in 2002. And you can use them not only for higher education but for elementary and secondary education too. And starting in 2002, you can contribute to them until April 15 of the following year. But there's an income limit for contributors: up to $220,000 for joint filers and $110,000 for single filers. But since you don't have to be a parent to open an account, you can give the money to a relative whose income qualifies and let him or her make the contribution.
Battaglia Distributions from the 529 are completely tax-free beginning in 2002, provided they're used for qualified higher education expenses. Distributions from Coverdell accounts have always been tax-free. 
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