Changing Gears

By Daniel Kadlec

You've just licked the stamp and dropped your 1997 tax return in the mailbox--with return receipt requested. But this is no time to nap. The taxman has given you plenty to think about in '98. Now is the time to tune up your strategy or get ground up next April in the wheels of change.

Most of the provisions in last year's blockbuster tax "relief" act kick in this year, and if you plan well, they can bring bountiful tax savings. The changes are aimed directly at middle-class taxpayers with dependent children, offering a host of new ways to pay for education and salt away money for retirement. But there's plenty in the new code for others as well. Unfortunately, the laws are more complex than the math for a lunar landing.

The key for this year is to make sure, where possible, that you don't exceed income limits placed on things like the new Roth IRA and child tax credit. You will also want to pay close attention to the investments you have in taxable and tax-deferred accounts. The lower capital-gains tax rate, which came into play in '97, remains a major planning point going forward.

Generally, the targeted tax goodies for education and retirement get phased out for joint filers with an annual household income between $75,000 and $160,000. "The thresholds are tantalizingly high," notes Tom Ochsenschlager, a tax partner with Grant Thornton in Washington. "All of a sudden, you may find it makes sense to keep your '98 income down."

Of course, no one is suggesting that you give up income just to qualify for a tax break. But more than ever it may make sense to defer income into 1999. Among other things, that might mean not selling any stocks for a gain that you can't offset with a loss. Under the new rules, a house sale could send your income soaring. If you are a doctor or lawyer, you can begin slowing your billing process later in the year.

Here, briefly, are the key tax benefits you may qualify for:

THE CHILD TAX CREDIT It's worth $400 in '98, and $500 after that for each child under 17, and is phased out at an annual household income of $120,000.

HOPE SCHOLARSHIP AND LIFETIME LEARNING CREDIT The first is a maximum $1,500 credit per child for college expenses. The second is a yearly $1,000 credit per family for education. The breaks phase out for joint filers at $100,000 of annual income. Note that the effective date of the lifetime learning credit is June 30. Don't pay before then.

EDUCATION LOANS You can deduct up to $1,000 on interest paid in '98. The amount increases in later years. The income limit for joint filers is $75,000 a year.

EDUCATION IRA Up to $500 per child per year may be put away tax-deferred for college expenses. The income limit is $150,000 for married taxpayers.

ROTH IRA Named for its chief proponent, Senator William Roth of Delaware, this lets you put away as much as $2,000 a year of after-tax money in an IRA. When you retire, you can take the money out tax-free. Contributions are phased out for taxpayers with an annual income of $160,000. Existing IRAs can be converted to Roth IRAs for taxpayers making less than $100,000 a year.

Just because you qualify for these options doesn't mean you will use them. The education IRA, for example, doesn't amount to much next to the high cost of college tuition--and it can't be used in conjunction with the Hope or lifetime learning credit, which may be more valuable, depending on how much time you have to let the money grow. Worse, money in these accounts may hurt your chances of qualifying for financial aid.

Generally, you should estimate what you expect to earn this year, and if you are around any of the thresholds, defer income. While you are at it, if you find that you will qualify and take advantage of one or more of these tax savings, refigure your W-4 so that less money is withheld from your paycheck.

One of the first things you need to decide is whether to convert your old IRA to a Roth IRA. It's not an easy call. For starters, you pay tax at your current rate for ordinary income on any money transferred to a Roth. But "99% of the time it makes sense if you have at least 10 years before you start withdrawing" and you expect your tax bracket to remain the same or go higher when you retire, says Mark Watson, a partner at KPMG Peat Marwick.

He estimates that a traditional IRA invested in stocks and worth $50,000 today would be worth $158,530 if withdrawn as a lump sum in 20 years. That allows for taxes of $71,223 by anyone in the 31% bracket. The same $50,000, if converted to a Roth today, would trigger immediate taxes of $15,500 by a taxpayer in the 31% bracket. But the remaining $34,500 would grow to $191,495 in 20 years and could be withdrawn tax-free.

The less time you have until retirement, the more the advantage erodes. And because the money transferred is counted as income the year of the transfer, a Roth conversion may throw you into a higher tax bracket and wipe out any long-term benefits. But if you choose to convert, pay the immediate taxes out of another account if you can. That lets you preserve the IRA balance you've managed to build and is the best way to make the most of the Roth. And make sure you convert this year, when the IRS one-time-only provision will allow you to spread the income resulting from a Roth conversion over four years.

The new lower capital-gains tax should keep you plenty busy planning. In general, the lower long-term rate of 20% diminishes the value of tax-favored accounts such as 401(k) plans and IRAs. But don't panic. Those are still wonderful ways to save for retirement, especially if your company matches a portion of what you contribute. But more than ever it will pay to make sure that in your overall investment picture, it's bonds and dividend-paying stocks that are socked away in a 401(k) plan. Growth stocks should be in a taxable account.

Why? Growth stocks typically do not pay much in the way of dividends. Your return is mostly a function of how fast the stock rises, which creates a capital gain. That gain gets taxed at only 20% in a taxable account. But not in an IRA or 401(k). Any money coming out gets taxed as ordinary income, at rates up to 39.6%. So you could end up swapping a 20% tax rate for one nearly twice its size.

On the other hand, interest payments from bonds and dividend payments to shareholders are taxed as ordinary income, making tax-favored accounts a good place to keep such investments. One strategy for '98 and beyond is to put any new growth stocks in a taxable account, and as you do that, shift the growth stocks that are now in your IRA or 401(k) into bonds or dividend-paying stocks. That way you can slowly get your investments where they belong without triggering any unnecessary taxes and while leaving your overall mix unchanged.

If you own mutual funds, there isn't a lot you can do to take advantage of the new gains rate. Fund managers get paid to deliver superior before-tax returns. Many of them trade stocks furiously, with no regard for the short-term gains they may be piling up. Joel Isaacson, a New York City financial planner, says one smart move is to seek out "tax-efficient" stock funds, which pay attention to short- and long-term gains. Such funds are a growing breed, and most major fund companies have them. Another trick is to seek out funds that tend to buy and hold. That's easily checked through Chicago-based fund researcher Morningstar or simply by asking fund representatives for the turnover rate of a fund. You want one that is well under 100%, the level at which a fund, on average, sells all its shares once a year.

Investors have long been able to give away stock at its current market value and take the full deduction, even though their own cost on the stock may have been much lower. That provision remains. But consider giving away a collectible instead of a stock. Long-term gains from the sales of antiques and such remain taxable at 28%--not the new 20% for stocks and other assets. That means you can deduct the full market value of the item at a higher rate.

These are just some of the things you'll need to consider in '98, which may be the toughest return you'll ever file. Some 69 federal tax-law changes went into effect Jan. 1. The good news is that they are cuts, not hikes. The bad news is that you may need to pay for advice to take advantage of the cornucopia of options.