Tax moves to make now so April's bill is smaller
By Kay Bell • Bankrate.com

If you're one of the millions expecting an advance child tax credit check in a couple of weeks, you might think midyear tax planning means deciding what to do with that extra cash.

If only it were that easy.

Go ahead and dream of ways to spend your added Internal Revenue Service refund. But now is also the time to make tax moves that can ensure you don't end up giving the money back to Uncle Sam on April 15.

Working with new withholding rules
Parents aren't the only beneficiaries of the recent tax legislation. Almost every worker will soon pocket a bit more cash thanks to reduced income tax rates and wider brackets. Working married couples especially get a break here, with changes that help ease the marriage penalty.

The law lowered the rates retroactively, meaning the feds get less of all 2003 income. But the benefits didn't actually appear until July 1. That's when employers began using revised IRS tables to compute payroll withholding.

Since your boss is taking care of withholding, there's nothing you need to do, right? Not necessarily. Payroll taxes taken out before July were under the old, higher rates, causing many workers to overpay the IRS a bit.

"The rate change is prospective," says Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, a monthly journal written for tax professionals. "There's less tax withheld for the rest of year but no make up for over-withholding in the earlier part of year. So what taxpayers could do if they feel they're going to be quite over-withheld is file a new W-4 and have even less withheld for the last half of the year."

Even if you don't expect the new rates to dramatically affect your withholding, midyear is a good time to reassess your W-4 information. Ideally, the amount you have withheld should equal your eventual tax bill.

With six months of pay stubs in hand, look at how much has been taken out so far. Then project that amount over the rest of the year, keeping in mind that rates are now a few percentage points lower. If it's close to what your last tax bill was and you've had no substantial change in your lifestyle, that's great. But if it looks like the amount will be substantially different, or you've gotten married, had a child or bought a house, you should change the number of exemptions you claim on your W-4.

Taxpayers who earlier upped their withholding to cover investment income taxes also need to do some W-4 refiguring.

"The people more likely to be over withheld are those who were having extra tax taken out because they were expecting significant capital gains or dividend payments," says Scharin.

Earlier this year, investors were looking at tax rates as high as 38.6 percent on dividends. It was a bit better for long-term capital gains, which would have produced a 20 percent tax bill for most investors. The new law, however, sets dividend and long-term capital gain taxes at 15 percent (or just 5 percent for taxpayers in the two lower tax brackets).

"Now that tax on those sources is reduced," Scharin says, "investors need to adjust withholding in light of the new lower rates."

Adjusting your assets
Don't stop with your W-4. The capital gains and dividend changes mean you also need to evaluate your stock portfolio with an eye to the tax ramifications.

"People should look at the mix of their investment portfolios," says Michael Joyce, president of Michael Joyce & Associates, with offices in Richmond, Va., and Bethlehem, Pa.

"A lot of people have money in taxable and tax-deferred accounts," notes Joyce, who also is incoming chairman of the National Association of Personal Financial Advisors. "Now we are very actively looking at restructuring the composition of client portfolios."

This is particularly true for owners of traditional IRAs or 401(k)s. The IRS doesn't get its cut of these accounts until the money is withdrawn at retirement, when the taxes are assessed at the taxpayer's ordinary income rate.

Where such a retirement account contains dividend-paying stocks, it might make sense to switch to interest-bearing assets, since interest income already is taxed at the higher ordinary income rates. The dividend-producing assets can then go into a regular investment account where the tax rate is only 15 percent (or less).

Of course, Joyce adds, all tax and investment moves depend upon each individual's situation. Be sure that the dividend-paying security you opt for does indeed qualify for the new rate. Some funds call their payments dividends, but the distributions are technically interest in the IRS' eyes. Others do pay dividends, but the shareholder still isn't eligible for the lower rate because of the way the company handles its taxes.

So double-check before making any changes and remember that the lower investment income rates are only temporary. Without further Congressional action, they're set to expire in 2009.

"It's fairly easy to restructure portfolios right now," says Joyce. "We hope it will be fairly easy to restructure in the future if need be."

While you're in the midst of refining your retirement funds, don't forget to contribute to them. Some of the extra paycheck cash you'll get from the lower income tax rates can go toward the $3,000 you're allowed to put into an IRA this year, $3,500 if you're 50 or older. The sooner you put the money in, the sooner its earnings start accumulating tax-deferred (if it's a traditional IRA) or tax-free (in the case of a Roth). And don't overlook your workplace plan. Enroll in the company 401(k) program as soon as you're eligible.

Finally, as you reallocate assets, consider selling. If you have some holdings that have appreciated significantly, now may be the time to cash in and pay the lower tax rate. You also might want to dump some losers. Poorly performing assets can offset any capital gains you have. Even without gains, up to $3,000 of investment losses can be used to reduce regular taxable income.

Other summer tax tweaks
Now that you've got your payroll tax and investment situations squared away, here are a few more midyear moves that could help whittle down your next tax bill:

• Start giving early. Most people make charitable donations at the end of the year, but there's no law that says you have to wait. Avoid the yearend rush and get a head start on the deductions available here.
  
  
• Convert nondeductible interest into a tax break. With interest rates at historic lows, consider obtaining a home equity loan. You can use it to pay off all your high-interest consumer debt that does you no good at tax time. A home equity loan is fully deductible under most circumstances. Don't forget, however, that such loans do put your home at risk if you can't make the payments.
  
  
• Buy a house now. If you're a renter in the market for a home, consider buying sooner rather than later. Again, you'll get the current good rates, as well as more months of mortgage interest (and other home-related tax breaks) to deduct on your upcoming return.

Some of these tax moves may not apply to you, but others could help cut your eventual tax bill. By taking a few minutes now to examine your tax circumstances, you'll be able to make the moves that guarantee you, not the IRS, gets your money.

-- Updated: July 8, 2003