Steve TeSelle, CFA, CFP ™ and
Stephen Schramm, CPAMarch 2001
Most people view taxes right up there with death or going to a shopping mall in December, something to be avoided as long as possible. But figuring out the tax rules can really be quite fun.
While exploring taxes can be fun, making decisions solely to avoid taxes can be bad news. This activity can leave you feeling like you've been in a boxing ring with Mike Tyson. If you start to do things, whether investing or anything else, based primarily on tax implications, you're in for some silly decisions. All those people who invested in loss-making limited partnerships in the 1980s realized their investments didn't make much sense when the tax code changed.
This piece won't be like one of those year-end articles in the newspaper that tells you to prepay your mortgage. The idea of this piece is to give you some information about the tax code so you can see for yourself how fun taxes can be, and maybe to give you some ideas about things you could do to reduce your tax burden in the future.
Journalists and politicians go on and on about the marriage penalty.
As far as we can tell, there are three places where married folks are worse
off than if they had stayed single. One is the standard deduction. If you're
single, your standard deduction for 2000 is $4,400; if you're married filing
jointly, it's $7,350. So you lose $1,450 in standard deduction. Two is itemized
deductions for high-income taxpayers. Whether you're married or single, your
itemized deductions start to phase out at $128,950 - so two incomes get hit
harder than one. Exemptions phase out, too, but at varying income levels for
single and married, so there's less of a penalty there. The last place you could
get hurt if you tie the knot is by moving into a higher marginal rate. Two people
who each earn $25,700 in 1999 would face total taxes of approximately $7,700
if they filed as single people. As a married couple, with the same income (and
not adjusting for the difference in standard deductions described above, which
would only make the marriage penalty worse), they would face taxes of approximately
$8,800 - an increase in their effective tax rate from 15% to 17%. Just thought
you'd want to know what all the fuss is about.
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If you have a business, you can own a vehicle and depreciate the
car over time, or you can lease. Both options are subject to limitations, so
there is usually not a tax reason to choose buy or lease. Rather, just as you
would for your own car, you should make the choice on other factors. For example,
if you would rather drive a new car every three years, leasing is probably for
you. But if you drive a lot of miles, you may be better off owning or leasing
the car personally and getting reimbursed by the company.
If you don't have the hair loss and indigestion of being a business owner, or
if you're a business owner who would rather go a different route than putting
your car in your business, you can still take deductions for the use of your
car. As long as you're not reimbursed for expenses, you can deduct 34.5 cents
per mile for business use of your car in 2001. You can also take deductions
for medical-related or for charity use of your car, but at lower rates per mile.
The Internal Revenue Service requires that you have written evidence of this
mileage. Some people use their daily planners; others make up numbers out of
thin air. The safest approach is to keep a log in your car and document each
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The AMT was created to deal with all those nefarious, wealthy
people who took so many deductions that they didn't have to pay their "fair
share" of tax. So the AMT makes you add certain deductions back in. The
AMT rates are 26% and 28%, which doesn't sound too bad compared to the regular
tax rates, but the rates are applied to a bigger base. So if you've taken deductions
on your Schedule A (itemized deductions) that are not allowed for AMT purposes,
you could end up owing more under AMT. The big one to watch for is home mortgage
interest that is not for buying, building, or improving the home, such as a
home equity loan that you used to buy a car. That interest has to be added back.
Also, though it's not a deduction, the exercise of incentive stock options can
cause income to be added back. Specifically, the excess of the market value
at the time of exercise over the exercise price is the add-back amount. There
are other add-back items, and there's no income threshold at which AMT applies,
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Have you ever wondered why lenders say home equity loan interest
only may be deductible? The AMT description above is one case; but home equity
loans carry restrictions regardless of the AMT. The deal is that home equity
debt is deductible if it's below $100,000, and if it's not larger than the difference
between the market value of the home and whatever debt is still on the home
that went for buying, building or improving the home, whichever is lower. An
example might help. If you take out a home equity loan for more than $100,000,
and the loan is for debt consolidation or a vacation or a car, only the interest
on $100,000 is deductible. If you take out a home equity loan for $50,000, you
have a market value on your home of $200,000, your first mortgage is $180,000,
and the loan is for debt consolidation or a vacation or a car, only the interest
on $20,000 of that home equity loan is deductible. So make sure you know your
tax situation before you sign up for the delectable deduction of a home equity
loan.
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Let's focus on stocks, bonds, and mutual funds. Generally, you want to hold on to these assets for at least twelve months because you get preferential tax treatment. If you own stocks and bonds directly, you can determine when you get your gains or losses by deciding when to sell. If you hold mutual funds, you don't have a choice; the law requires mutual funds to distribute capital gains to shareholders. This is no fun if you have mutual funds in a taxable account, but irrelevant if you have them in a tax-deferred account like a 401(k).
We don't recommend that you sell an investment solely for tax reasons. However, you can reduce your tax burden if you have a few losses, no matter how long you've held them. Congress requires you to first calculate your long-term gains and losses separately from your short-term gains and losses. But then you can offset one against the other. For example, if you have short-term gains of $10,000 and long-term losses of $10,000, you won't owe any capital gains tax. This is why a little tax planning can go a long way to reduce your tax bill. Also, you can use up to $3,000 in losses to reduce your taxable income from wages and such.
If you own individual stocks, you have a few additional options you might want to consider. Suppose you decide that you still like that Internet stock that you bought in March, even though it's down 80%. You could sell the stock now and book the loss this year, then wait at least 30 days to buy it back (the wash sale rule). The risk you run is that the stock rises dramatically in those 30 days. Another possibility is to put the proceeds into a different, but similar, stock. For example, if you lost a bundle on Internet Capital Group, you might sell it and buy CMGI.
There are many more fun and interesting rules for taxes. We've covered only a few fun facts here. The great thing about taxes is that the rules are always changing, kind of like a Florida election. This means you want to keep current with what Congress is up to, and be wary of great deals that that are great primarily because they allow you to take deductions on your taxes. Those deductions can desert you faster than common sense at a frat party.
Whatever you do, remember -- taxes are fun.
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