Now's the Time to Plan to Reduce Next Year's Income Taxes

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Besides the obvious tax reduction strategies, such as itemizing deductions, there are other steps you can take to lower your tax bill next year. The trick is to plan ahead. If you wait until it's time to file your income tax return, it's too late for some of the best tax-reducing strategies.

Here are some of the things you should be thinking of early in the year to save yourself money.

1. Contribute to a Retirement Plan--If you're not contributing to a 401(k) or other retirement plan, you're passing up some of the best tax savings available. Contributions to 401(k) plans are not subject to federal or most state income taxes. Your contributions and employer match will grow tax-deferred until you withdraw them during retirement. You could save between 20 and 40% of your contribution in taxes. If you're already contributing to a 401(k) or other employer-sponsored plan, increasing your contributions early in the year will increase your tax savins and your earnings over time.

If your employer doesn't offer a retirement plan, contributing to an IRA each year can get you some of the same tax savings. For increased earnings, don't wait until April 15th to open your IRA. The earlier in the year you make your contribution, the faster it will grow.

2. Contribute to a Flexible Savings Account (FSA) or Health Savings Accounts (HSAs)--If your employer offers Flexible Spending Accounts, you can reduce taxes by contributing. A fixed amount is deducted from your paycheck before taxes are calculated, placed in a special account, and repaid to you when you submit documentation for medical or dental expenses that weren't covered by your insurance. This can include some premiums, co-pays, and expenses not paid by your insurance policy, as long as they are IRS-approved medical expenses. Since you're going to be paying these expenses anyway, why not do it with tax-free money?

New in 2004 is the Health Savings Account, which works much like the Flexible Spending Account. To qualify for an HSA, you must be covered by a high-deductible ($1,000 or more) health insurance policy. The money you save on the lower premiums for this policy is placed in a special account which you use to pay your medical expenses as they are incurred, until you meet the deductible on your policy and the insurance company starts paying your bills. The maximum you can contribute is equal to the deductible on your insurance policy, with limits. See Guidelines for High Deductible Coverage & New Health Savings Accounts for details. The plan is like a medical IRA. Unlike traditional Medical Spending Accounts, you get to keep any money you contribute but don't use, and it grows tax-deferred until retirement.

3. Plan Your Charitable Contributions--If you itemize deductions on your income taxes, don't overlook the opportunity to save a few extra hundred dollars by giving clothes or household items you no longer want or need to a charitable organization such as Goodwill, Salvation Army, or similar charities. Start early in the year to put these items aside as you come across them and make sure you donate them before the end of the year. Make a list of the items and assign a price to each item, equal to what somebody would be willing to pay at a yard sale. The IRS has guidelines on reasonable amounts to claim for commonly donated items. Don't forget to get a receipt from the charitable organization.

4. Take Advantage of Lower Long-term Capital Gains Tax Rates--If you plan to sell a capital asset, such as stock or other investment, make sure you hold on to it long enough to take advantage of the new, lower long-term capital gains rates for assets held for at least one year. If you miss the one-year mark by even a day, you'll pay ordinary income tax rates on any gain on the sale. Just a few years ago the maximum long-term capital gains rate was 20%. Now it's only 10% if you're in the 15% income tax bracket and 15% if you're in the 25% or higher tax brackets. Not all assets qualify for the lower capital gain rate, so check with your tax preparer or the IRS.