Time investment tax deductions to give biggest benefits

This article was produced by the Financial Planning Association and provided by William O. Woody of Stovall Woody Associates.

The end of the year is fast approaching and so are several important Dec. 31 financial deadlines. Here are options investors may want to carry out before the year ends.

Convert to a Roth IRA

With many individual retirement accounts decimated by the bear market, taxpayers may find this the perfect time to convert their traditional individual retirement accounts to Roth IRAs, whose eligible earnings are not taxable upon withdrawal. Because you pay regular income taxes on the money you shift to a Roth, the idea is to convert the smaller pool of assets into a Roth before the assets rebound in value.

Furthermore, taxpayers who couldn't previously qualify for a Roth conversion because their income was too high (more than $100,000 for couples and singles) may qualify now if their income is down for the year. They must take the money out of the traditional IRA by Dec. 31.

The hitch to all this? It's better to pay for the conversion taxes with money outside of the IRA, which may be hard in a bear market.

Open a 401(k) plan

The self-employed and business owners with no full-time paid employees should consider opening solo 401(k)s. The 2001 Tax Relief Act made changes to 401(k) plans that make individual 401(k)s cost effective for the first time. Participants can sock away up to $41,000 in these accounts in 2002, far more than alternatives such as the simple IRA or SEP IRA. For 2002, the 401(k) must be opened by this Dec. 31 if you follow the calendar year.

Retirement distributions

People who turned 70 1/2 before July 1 are required to start taking minimum distributions by Dec. 31 from traditional IRA and employer-sponsored retirement plans (except for the plan of a current employer if still working). Technically, a person can delay the initial distribution to April 1, 2003, but that means he'd have two required withdrawals next year because all subsequent withdrawals must be completed by Dec. 31. Two minimum distributions in the same year could push a person into a higher tax bracket and potentially expose more Social Security benefits to tax.

Mutual fund distributions

A person could face the irony of paying taxes on capital gains distributions made by taxable mutual funds even though the funds lost money for the year. Consider selling it before the "exdividend" date, which commonly is in November or December, if it's a fund you want to sell anyway.

Equally, if not more important, avoid buying into funds before they make their distributions otherwise a person would pay taxes on gains he never earned.

Review gains/losses

Now is the time to consider selling losing investments to offset those scarce investment profits from 2002, or selling profitable investments so they are sheltered by losses that have already been realized (and perhaps rebuying those profitable assets if it makes investment sense). If there are no profits to offset, a person can use losses to offset regular income up to $3,000 (the excess losses carry into future tax years).

Bunch deductions

A time-honored tax strategy is to bunch deductions into a single year. For example, a person might accelerate payment of a second installment of property taxes due next spring into this year. The same can be done for next January's payment for estimated taxes. Bunching elective medical expenses such as orthodontia bills also might push total medical deductions over that often difficult-to-hurdle 7.5 percent threshold.

Charitable deductions

Consider increasing charitable contributions in higher income years or delaying the donation of investments until they regain some of the appreciation they have lost. A person will receive a larger deduction when he does. (Be sure to donate appreciated assets rather than selling them first.)

College-bound strategies

Families may want to postpone into 2003 the receipt of income such as bonuses if they will be applying for financial aid in 2003 (the aid would be calculated on the family's 2002 income). Or they may want to accelerate income from 2003 into 2002 if they anticipate applying for aid in 2004 (which would be based on 2003 income).

Because some of these strategies are complicated and may even conflict with each other, be sure to review them with a financial planner or tax adviser.