From the Merrill Edge Minute e-newsletter.
By now you have a pretty good idea of how well you fared with Uncle Sam. But don't shut the door on taxes yet. Whether your 2011 tax bill was minimal or monumental, now is the time to consider moves that could help you shrink next year's tax bill and devote more of your earnings to funding a comfortable retirement, saving for education expenses or pursuing other pressing financial goals.
Just filed a rough tax return? Here are six potentially tax saving moves for 2012.
1. Review your tax withholdings. Those still reeling from a hefty tax bill can consider boosting withholdings to avoid a surprise next year. But anyone receiving a significant refund should also consider a change, notes Bill Hunter, Director, IRA Product Management, Merrill Lynch, who says giving the government an interest-free loan is far from the best use of funds. "Adjusting your withholdings and channeling the money into a retirement plan or even a savings account is a smart move," he says. You could adjust your income tax withholdings, allowing more money to be automatically transferred to your preferred investment or savings vehicle — a 401(k), an IRA, a Section 529 plan or an emergency fund.
2. Shift income into retirement savings to reduce your taxable income. In 2012 you can contribute as much as $17,000 in pre-tax dollars to a 401(k) account you've set up through your current employer ($22,500 if you're age 50 or older).
Moreover, you can put up to $5,000 into an IRA ($6,000 if you're age 50 or older), which, if you participate in your employer's retirement plan, generally will be fully tax-deductible as long as you meet annual "modified adjusted gross income" restrictions (less than $58,000 for single taxpayers and less than $92,000 for married couples). If you are not eligible to participate in your employer's plan, then your IRA contribution may be fully deductible regardless of the amount of your modified adjusted gross income.
You might also consider making a nondeductible IRA contribution if you do not qualify to make a deductible contribution. If you struggled to find the funds for an IRA contribution last year, consider automating payments into your IRA, suggests Hunter, who notes that money unseen is less likely to be spent. "That way you can just set it and forget it — and you won't be caught with a contribution that's less than desired."
3. Invest your increase. If you earned a raise or bonus this year, or you've received a tax refund, rather than spend this extra money, consider investing it in a tax-advantaged account. There are a number of good options: contribute an equivalent amount to your retirement plan at work, or invest it in a tax-deductible IRA or a non-tax-deductible IRA as an alternative. If you've maxed out tax advantaged saving opportunities, consider establishing or funding a Section 529 plan for your child — the contribution won't be deductible, but the money has the potential to grow tax-free.1 Another option is to invest in a Roth IRA, which wouldn't lower your current taxes but would give your investments the potential for tax-free growth and allow for federal (and possibly state) tax-free withdrawals if taken as part of a qualified distribution.2 "If you have multiple goals, you may need to balance competing priorities," notes Hunter, who suggests thinking strategically.
4. Consider a Roth IRA conversion. Given the country's significant debt, many believe that tax rates will go up. If you are concerned about this, you might want to consider converting all or part of any traditional IRA to a Roth IRA. You'll need to pay ordinary income taxes on the amount you convert that does not represent your initial contributions, but after that, your investments will have the potential to grow tax-free.3 "If you have enough money outside your retirement accounts to pay the conversion tax, converting may make a lot of sense," says Hunter. Using a distribution from retirement assets to pay the tax would trigger a tax on the withdrawal plus possibly an additional 10% early withdrawal federal income tax if you are under age 59½.
5. Consider refinancing your mortgage. With mortgage interest rates near all time lows, consider refinancing your mortgage. Then, take the money available as a result of lower monthly mortgage payments and boost your tax advantaged retirement plan contributions. But be sure to weigh your closing costs against how long you plan to stay in your home to determine whether it's a smart move for you.
6. Consider making your debt tax-deductible. Of course, you don't want to take on debt unnecessarily. But if you wish to make home repairs or consolidate existing debt, a home equity line of credit (HELOC) may be right for you. Interest payments on HELOC loans generally are tax-deductible. And you could be converting unsecured debt into secured debt, possibly giving you the option of lower interest rates (of course converting unsecured debt to secured debt may have negative implications). Be sure to consider yourclosing costs to determine whether this is a smart move for you.
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