Q: My wife and I just owed a ton of money for taxes because we had to take the standard deduction. How in the world to people accumulate enough deductible expenses to be able to itemize? I refuse to believe that the average individual makes thousands of dollars of deductible purchases or donates thousands to charity.
A: Well, you’re right on that score. About two-thirds of the nation’s taxpayers take the standard deduction, typically because they don’t have enough deductible expenses to itemize.
What usually allows people to itemize is mortgage interest, often combined with property taxes and state and local taxes. (For years, only state and local income taxes qualified as deductible expenses, but now you can choose to deduct sales taxes instead.)
So it follows that people who live in areas where real estate is expensive and taxes are high are more likely to itemize than those who don’t. Someone who buys a house in Amarillo, Texas–where the median house price is $97,100, according to the National Association of Realtors, and there is no state income tax–may not have enough deductions to itemize, whereas someone who buys a home in Orange County, California–median home price $627,300–almost certainly does.
AmarilloÂ homeowners who put 10% down on median-priced homes would pay just $4,777 a year in interest during the first year of ownership, assuming a 30-year loan at 5.5%. That’s well short of the $9,700 standard deduction in 2004 for a married couple filing jointly.
San FranciscoÂ homeowners, by contrast, would pay $30,862 in mortgage interest during the first year.
Some commentators have used these differences to asset that folks in many parts of the Midwest and South are subsidizing those on the coasts and in the Northeast, thanks to the mortgage interest deduction. While that might be a bit of a stretch, it is true that the ability to itemize isn’t evenly distributed.
You may never have enough deductions to itemize, but you have a few other ways to avoid a big bill on April 15. Making contributions to a 401(k), if available, is one such way. If you’re not covered by a workplace retirement plan, or you are but your income is below certain limits, you can make deduction contributions to an individual retirement account.
You also should take time now to estimate your taxes for 2005 and adjust your withholding accordingly so you don’t face such a big bill next year. The IRS has a withholding calculator on its site,Â www.irs.gov, thatÂ can help.
Q: I just finished my taxes, and I know my refund would have been bigger if I had been able to find more of my tax-related receipts. You’ve talked about how to organize your records and when to get rid of old paperwork. Do you have any suggestions for tracking receipts?
A: Essentially, you need to figure out a way to separate your important receipts from all the other paperwork you carry around, and to be consistent with whatever system you set up.
Professional organizer Debbie Stanley has some great tips about handling receipts in her book, “Organize Your Personal Finances in No Time” (2004,Â Que). She notes that most receipts for purchases, ATM withdrawals and credit card transactions need to be retained for short periods of time only; typically three months or less, which is long enough to compare them against your statements or return an unwanted item.
So your first step is implementing a system in your wallet or purse that allows you to separate these short-term receipts from those you’ll need to retain longer, such as tax-related paperwork or sales slips for major purchases.
Some folks will have a third category: receipts that they need for reimbursement or rebates. If you’re an employee who regularly travels or entertains clients, you’ll want to include this category so you can get paid back for your expenditures.
Fortunately, many wallets have a number of different compartments where you can stow receipts of different types, or you might want to carry envelopes for this purpose in your backpack or purse.
Then, every night–or at least a few times a week–you can empty your receipts into an appropriate file folder or box: one labeled for short-term receipts, one for taxes and one for reimbursements or rebates.
The key to being able to find your important receipts when you need them is to put them in the same place every time–both when you receive them and when you get home. Don’t stuff them in your pants pocket or let clerks put them in the bags, and don’t let them linger in your wallet or purse.
StanleyÂ also has a pretty nifty idea for dealing with short-term receipts. Rather than waste much time sorting through them, she set up three file folders, labeled “This Month,” “Last Month” and “Two Months Ago.” She empties her short-term receipts from her wallet into the “This Month” folder; at the end of the month, she transfers the contents of that folder to the “Last Month” folder. The previous contents of the “Last Month” go into the “Two Months Ago” folder, and whatever’s in the “Two Months Ago” folder goes into the trash. After three months, her receipts have spent time in each folder and she’s had plenty of time to retrieve them if necessary.
Q: Last year, I briefly worked for a local school district that had a pension fund. Participation was mandatory. I contributed only $650 in the four months I worked there.
But when I tried to make my usual tax-deductible IRA contribution for the year, my bank said that brief participation was enough to prevent me from contributing. My income was more than $100,000 so I’m looking for ways to reduce my tax bill.
Is what the bank said true â€” am I out of luck?
A: Yes, if what you want is a tax deduction, said Nicholas Kaster, a senior analyst with tax research firm CCH Inc.
Anyone who is an “active participant” in a workplace retirement plan for any part of a tax year faces significant limits on how much of an IRA contribution, if any, may be deductible.
For single filers, the ability to deduct a contribution begins to phase out at $45,000 and disappears entirely at $55,000; for married filers, the phase-out range is $65,000 to $75,000. (These figures are for 2004 contributions, which can be made until April 15 of this year.)
That does not mean, however, that you can’t contribute to an individual retirement account â€” just that you can’t deduct your contribution. Anyone who has earned income can make a nondeductible contribution to an IRA.
If your income is below certain limits, you might consider contributing to a Roth IRA, which offers tax-free withdrawals in retirement. You can contribute as much as $3,000 for tax year 2004 if you are single and your income is less than $95,000 or if you are married and your income is less than $150,000. (Your ability to contribute to a Roth phases out as your income rises; singles with incomes of more than $110,000 and marrieds with incomes of more than $160,000 can’t contribute.)
With all IRAs, you can make an additional $500 “catch-up” contribution if you are 50 or older.
Q: You had a column last year about what documents to save, and for how long. I put it aside, but now I can’t find it. Would you mail me a copy?
A: Well, no. But with the idea that it’s better to teach a reader to fish than to mail her the fish wrap, here are a few ideas for better managing your paper flow.
The guidelines for keeping and discarding paperwork aren’tÂ all thatÂ complex. If it has to do with taxes, you’ll generally want to hang on to it for seven years. The exception is for assets that may incur tax when you sell, such as a home or an investment. In that case, you’ll want to keep the paperwork for as long as you own the asset, plus seven years.
If you make a nondeductible contribution to an individual retirement account or other retirement plan, keep the paperwork indefinitely. You can subtract a portion of those contributions from future withdrawals, which will save on taxes.
If you get a periodic summary of your transactions, you can generally discard the interim paperwork. In other words, you can toss your pay stubs once you’ve checked them against yourÂ W-2s,Â and your automated teller receipts once you’ve compared them against your monthly bank statement.
If you make a big purchase, keep the receipt for as long as you own the item. A receipt can help in the short run, when you need to return an item, and in the long run, by establishing its value for insurance purposes.
Old insurance policies and paperwork can be discarded once they’re replaced with new versions and there’s no longer a possibility of filing a claim.
Most people hang on to way too much paper, fearful that they’ll need it somehow, someday â€” when actually all it does is add to their clutter.
Professional organizer Debbie Stanley, author of “Organize Your Personal Finances in No Time” (Que, 2004), recommends an annual purge of your paper, and tax season is as good a time as any to tackle that.
Once you’re done, though, consider creating one new file â€” for helpful newspaper articles. Then you’ll be able to put your hands on the information right when you need it.
Q: I recently received compensation for serving as executor for a deceased neighbor’s estate. The amount was just under $10,000. I am 72, single, with few assets. What is the best way to invest this money so I don’t wind up paying a chunk in taxes?
In the retirement community where I live, this is a common question, because many residents serve as executors for their neighbors, and all have very modest income.
A: The income you receive as an executor or personal representative is taxable as income in the year you receive it, and there’s not much you can do about that. What you’re probably asking is how to minimize future taxes on any gains this money might generate.
One of the easiest choices, if you really don’t want to pay any taxes, is to simply invest in a tax-free money market account. These accounts typically invest in insured municipal bonds with little risk of loss, and your money is accessible whenever you need it.
What you probably don’t want to do is invest in an annuity. These are often pushed on seniors who want tax deferral, but annuities usually come with relatively high expenses and surrender charges that could seriously eat into your stash if you needed to withdraw money.
Before you do anything, though, you might want to have a chat with a tax professional about the implications of your investment. You may be overestimating how much this money will cost you. If you’re in the 15% tax bracket, for example, you may be better off in a taxable money market account that earns a higher return. Currently, taxable money market accounts are averaging better than 2%, while tax-free money markets average less than 1%.
Many seniors get in trouble with inappropriate investments in trying to avoid a tax bite that’s really little more than a nibble.