So Long, 1040 Blues - ways to lower income tax

Kiplinger's Personal Finance Magazine, Feb, 2001 by Mary Beth Franklin

TAXES | Get yourself psyched to ATTACK YOUR TAX FORMS by seeing how others have driven down their bills.

ADD THIS corollary to Benjamin Franklin's sage pronouncement that the only certainties in life are death and taxes: One sure thing about taxes is that each year more and more Americans will receive ever-larger refund checks from the federal government. Last year, more than 73 million returns demanded money back from the IRS. The checks averaged a record-high $1,624 ($82 more than in 1999) and totaled nearly $120 billion. Heck, the IRS is still looking for 90,000 taxpayers whose $67 million in refund checks were returned because the Postal Service couldn't find the owners.

There is no reason to think the trend will be reversed this year. In fact, refunds for 2000 are likely to get an extra boost because of an unwelcome stranger: investment losses. But for most of us, a refund is simply evidence of sloppy tax planning (see the box on page 79 for how to do better in 2001). For now, attack your tax forms with zeal and with the unabashed goal of maximizing your refund. If you're among the 23% or so of taxpayers who will have to send the IRS a check on April 16 (the 15th is a Sunday), do your best to keep it small. That, after all, is no less than your patriotic duty. As President-elect George W. Bush repeated over and over during the campaign: It's your money, not the government's.

Timing is everything

ONE OF THE great misconceptions about taxes is that moneysaving maneuvers must be made before New Year's Day. In fact, there is still time to cut your 2000 tax bill by avoiding mistakes and claiming breaks you deserve.

Brian Park of Gresham, Ore., learned that lesson last year when his tax adviser, Tony Bardi, showed him how the right moves in March could slash his tax bill and transform a balance due into a healthy refund. While reviewing Park's financial records, Bardi discovered that the 36-year-old former navy lieutenant had converted his traditional IRA to a Roth IRA in 1999, shortly after he resigned from active duty. The Roth conversion was a good idea to ensure future tax-free growth. But the timing was terrible.

Money converted from a regular IRA to a Roth is taxed in the year of the switch. Because the extra taxable income pushed Park into the 28% federal tax bracket, the $16,000 conversion came with a $4,500 price tag.

But not necessarily. Since Park planned to enroll in Portland State University, Bardi suggested Park undo the Roth conversion before filing his return. He could then reconvert to a Roth later in 2000 when his income --and his tax bracket--would be substantially lower.

"I went from owing nearly $300 in federal taxes to getting a refund of almost $4,200," Park says. By the time Park reconverted his IRA to a Roth last October, losses inside the account had driven its value down to about $12,000. That amount will be reported on the return he files this spring, and because he's now in the 15% bracket, the federal tax bill will be just $1,800.

If you made a Roth conversion in 2000 and the account has lost money since then, you may want to consider the unconvert-reconvert strategy, too. That way you won't have to pay taxes now on retirement assets that have disappeared. To accomplish the switch--called a recharacterization--tell your IRA sponsor to retitle the account as a traditional IRA.

But note this: The rules have changed since Park's pirouette. Now if you unconvert a Roth, you must wait until the following year to convert the account again. If the IRA gains value in the meantime, you could wind up owing tax on a larger amount than if you had left things alone.

Give yourself credit

COURTNEY LANE and Brandon Eason from Smyrna, Ga., are savoring a veritable feast of tax breaks on their 2000 return.

Start with the relatively new tax breaks to help families pay for higher education. Courtney, 24, works as a roadway designer for an Atlanta engineering firm. Her husband, Brandon, 25, is a graduate student and research assistant at Georgia Tech.

Courtney will write off every dime of the more than $700 in interest she paid on her student loan last year. For 2000 returns, the limit for this deduction--which you can claim even if you don't itemize deductions--is $2,000. This deduction covers interest on almost any kind of loan used to pay for higher education, including community colleges and technical schools. Not covered: interest on loans from relatives or on loans from a retirement plan such as a 401 (k) a parent might tap to pay a child's tuition.

Although Brandon's tuition is covered because he is a research assistant, he is responsible for about $1,000 in educational fees. That means he qualifies for a Lifetime Learning credit that will shave the couple's tax bill by about $200. The Lifetime Learning credit is worth 20% of the first $5,000 of qualifying tuition and fees (but not room and board) you pay for yourself, your spouse or your dependents. The maximum credit is $1,000 per year, not $1,000 per student.