Kiddie tax is a tax paying at the parental rate when the child’s income exceed $1700 (in 2007). For the first $1700, the tax that you would pay is 0% on the first $850 and 10% on the second $850, which amounts to $85. Assuming your marginal tax bracket is at 28%, that’s a tax saving of $391. But $1700 is not much at all after years of inflation. If you have a $34000 bank CD in your child’s name, you will have $1700 interest. And let’s say if your gift your appreciated stock to your child, which has returned you 25% total accumulated gain, you are due paying kiddie tax when this stock investment is valuing at $8500 (while your original cost was $6800, giving a 25% gain of $1700).

If you can afford to give away money to your child, I would guess that $8500 is not that much. It is almost guaranteed that you will be hit by the kiddie tax. The only way was to sell the stock with gain beyond the age of the kiddie tax, which was 14 and then changed to 18. But now it has been effectively changed to 24.

Here is from thestreet.com:

Last year, the age limit was raised, requiring children under age 18 to be taxed at the parents’ rate. Now, starting in tax year 2008, the age limit will apply to children under age 19 — or to “kiddies” who are full-time students under the age of 24.

My own child paid more than one thousand dollar in kiddie tax last year from the stock gain. Tax sucks. There are just very little ways for savers to get ahead. Especially when the income tax rate is high like mine is at 40% marginal bracket, sometimes it is very hard to motivate myself earning more money. I only get 60 cents out of every $1 anyway. Even my long term stock capital gains/losses are marginally taxed at almost 30%. No wonder America likes to consume instead of working for the government 5 months (~40%) in a year every year. Maybe I really need to change my state of residence.

If your tax deduction is too much out of the range for your income, it may raise a red flag to IRS. Here is a link to the latest tax statistics excel spreadsheetdirectly from IRS. I modified the spreadsheet a bit so that it is showing the actual dollar amount PER filing, much easier to read. You can look at my spreadsheet here which contains the original IRS numbers (46 million returns in Fall 2006), and my modified sheet, converting “number of returns” to “percentage of returns”, and “(total) amount” to “dollar amount per tax filing”.

The most interesting column to me personally is the non-cash charity donation. It is amazing to me that these non-cash amounts are so large across all income range. For example, non-cash donation averages $1178 for 64.82% of the returns with AGI from $100K to $200K. I’m way under that amount. I really wonder how much “valuable junk” you can donate to charities. And even 23.45% of the filing with AGI less than $5000 can “think of” $562 non-cash donation. My cash donation to charity is right at the ball park of my income. I guess I’m not comparatively stringy nor generous among my peers.

If you are interested, you can also calculate out how many percentage of people who have adjusted gross income above $500K? I calculated at the bottom of column B. Just 1.33% of people who pulled in more than $500K. But there were 4.78% who earned $200K to $500K, and 18.94% who earned $100K to $200K. Note that these numbers are per Filing. So it can be incomes from two wage earners in married joint filing.

I am not at the top 6%, but I made it to the top 25%. Are you just starting or have made some progress on this income ladder already?

Posted by “Frugal” at My 1st Million At 33.com

It was no secret that I’ve got $11781.91 dividends for year 2005. For year 2006, my dividends are $11646.15, not counting $2200 in royalties, more than $500 dollar from MLP cash distribution, and also not counting about $860 dividends in my children’s custodial accounts. These amount look great on paper, but actually this year I got slaughtered in some of these dividend stocks, and incurred a net realized or unrealized capital losses of about $12000 in 2006 in these, which pretty much erased all the gains from dividends + royalties. I incurred this huge loss in my dividend portfolio because I didn’t stay diversified enough, and had sold out all of my MLP positions due to their lower yields. The ones that I sold last (MMP, EPD) have gone up by 20+% instead of falling 20+% for some Canadian royalties. I did trade MLPs for PM stocks at the lowest point which have gone up 32% so far.

There is nothing to brag about (especially this year due to the surprising Canadian tax law announcement), but I really just want to share with all of you some “potential” money making tips. Everytime a company management pays out some dividends, they have absolutely no intentions of bringing down the stocks by distributing cash out, but rather believing that such dividends are sustainable in the long term.

By the way, producing such dividend stream does not require investing millions of dollars especially if they are paying 10+%. Currently, I have less than 10% of my portfolio invested in such dividend stocks.

Check out some of the investing series on My 1st Million At 33.com if you have not done so. Just my “two-cents” investing tips.

A reader asks me about some tax advice to save on tax without setting up some complicate business structure. I wish I have more things to tell him and you. But the fact is that even if you have some rental business going on, your passive loss deduction is limited by the rental income, and even with active participation, the loss is limited to $25K, and will be phased out when your modified adjusted gross income reaches more than $150K. Now, $25K is a lot but not much in these days. A conforming loan of $417K at 6% mortgage interest rate will put you over $25K mortgage interest deduction.

My advice is to stuff some money into spousal IRA account, and then Roth IRA account, both of which you should probably do, AFTER you finish your taxes if your total income including all bank interest, capital gain, etc. is near $140K. The reason is that it is possible for you to hit the phase out limits around $150K. I hit that once, and I ended up filing form 8606 so that I can up the basis in my spousal IRA account. When I make a distribution 30 years down the road, I don’t need to claim those after-tax dollars that I put in as before-tax income.

There is really no “magic” way to avoid paying tax (unless you earn all of your income through having a business). Every year when I look at the amount of taxes that I’m paying, I feel a little down. But on the other hand, I actually feel that I am happy to contribute my part to the US treasury chest. Even though government is kind of wasteful, and they don’t spend every dollar according to your wish. But at least you know that some part of your tax money do go to the necessary social welfare programs that pay some elders’ bills and their medical bills. Furthermore, the total tax as a percentage of your total income is actually no where close to your marginal tax bracket. There were a couple of times that I hit a marginal tax bracket of 42% including state and payroll tax. That’s quite a lot, but hey, I was glad that I had those income to be taxed. In fact, I didn’t have any child credits, my exemption amounts are being phased out, and I got hit by alternative minimum tax.

The only tax that quite gets me is the tax on capital gain and dividends. Government inflates which causes everything to go up including your stocks, and you still need to pay tax on their sins. It’s really not that easy to achieve a positive return after-inflation and after-tax. There have been many discussions about tax reforms, and I fully agree that we should change to a consumption tax system. I am fully behind such system, even if the sales tax is more than 30%. Such system will level the playing field between business owners and salary earners.

In any case, I’m sorry that I cannot be more helpful. I’ve heard people setting up business to channel their daily expenses. I would not advise that both on a legal and ethical basis. There are always some gray area for certain expenses, but to spend a majority of personal expenses as business expenses, hmm…. No further comments.

Before the end of year, I’m contemplating what stocks to sell for capital losses to offset my capital gain this year. Here are some of the evaluation & steps that I suggest to take:

1. The maximum loss that one can deduct per year is $3000 (married filing jointly) or $1500 (filing separately). By the way, The US government should really index this number by inflation. It has been this low for so many years.
2. You should try to sell the minimum number of positions, without impacting your overall investing portfolio/direction/philosophy.
3. Don’t fall into wash sale trap, selling the same stock, and buying back within a month.
4. In order to avoid wash sale trap, you can use this opportunity to swap with other technically stronger stocks in the similar sectors. Or you can use sector ETF instead of individual stocks.

Another tax tip that most people don’t pay attention to is the tax rate differences between long term/short term capital gain. Because long term capital gain is taxed at a lower rate, it also means that long term capital loss will offset less tax than short term capital loss (whenever you have some long term capital gain to be offset). Your long term capital loss will be equivalent to short term loss when you don’t have any long term gain, but only losses. In that case, all losses will be deducting against your highest tax bracket income.

Therefore, for tax purpose, you should try to take short term capital loss, while retaining long term capital gain. In principle, the two best scenarios for taxes are to show either a short and/or long term loss without any long term gain, or a long term gain (+ any short term gain but not loss). For example, if you have two stocks A & B. In stock A, you have made $3000, while in stock B, you have lost $3000. If you let them offset each other in the same year, you get $0. If you somehow make the gain to become a long term gain, and take the gain in a different tax year (1/1 and 12/31), you will actually gain some $300 from tax. How so? Take $3000 loss in one year, assuming that you don’t have any long term gain to be offset, then $3000 short or long term loss will be deducting against your highest tax bracket income. Then taking the $3000 long term gain in another year will be taxed at 20%. Assuming your tax bracket is at 28% to 33%, you can gain $240 to $390 in tax difference (after-tax money). A general tax strategy can be that you alternate between showing losses and long term (+short term) capital gain. But obviously, $3000 tax loss is too small of a room to play out such strategy for most people.

In summary, don’t “waste” your long term capital gain by shrinking it with losses. Move the losses to another year. The only exception to this is when you are hitting AMT or alternative minimum tax. But with Congress expanding the AMT deduction, most likely you won’t hit AMT unless your capital gain is above roughly $30000. In that case, you can use my tax calculator to exactly figure out whether you will hit AMT or not.

My biggest financial blunder is not using my parental gifts wisely. Most people don’t use their parental gifts wisely and spend through it. I’m at the opposite end of the spectrum. I didn’t use it wisely, because I did NOT use it.

If you have read the composition of my 1st million dollar, the money given by my parents was definitely not a small amount. But I did not considered it as mine for a long time. In fact, after my parents gave me the money, I simply left it under the control of my parents for probably 5 years before I had it transfered to under my control for the purpose of investing, but not spending. I have not spent a dime from that amount of money my parents have given me. I have always treasured the gift and vowed to pass it on to their grand children. I guess maybe the reason that my parents were willing to give me a significant sum of money to me is precisely because that they know me that I will NOT use the money on unworthy purposes.

But it did not occur to me much later that not using the money is NOT equal to using the money wisely. When I bought my current residence, I could have bought a bigger home, more commensurate to my networth. However, my consideration for home was more of an usage or spending, rather than an asset or as an investment. Because I treated buying a home more as a spending, I did not consider using the gift money from my parents at all. Certainly, with $90K less in my pocket, my choice for home was quite different than what it could have been, especially when my networth was much smaller at that time. With housing market gone up crazily, cash was certainly not a good investment. Eventually, I transferred those cash over for putting them into better investment. But I cannot go back to fix my financial blunder.

You may think that I may be the very few persons who don’t take the parental gifts into the pocket right away. Actually, I married another such person. My parents-in-law also gave my wife and I some $30K cash as a wedding gift (at the same time as the $90K from my parents for our wedding gift too). She never took it. She asked me whether I am okay with it, and I told her that I had no problem at all. My wife is very filial, and she thinks that her parents can use those money better than we do. In fact, I also told my wife that her parents can always count on my financial help anytime as long as they may need it and within what I can afford to help. Of course, my wife did not deny her parents’ gift, but rather left the money under her parents’ control. Till this day, I’ve never counted that $30K as part of my networth even though my parents-in-law still have it available for us.

The primary reason for putting money into 401K or traditional IRA account is for the current tax benefit.  However, if the current tax benefit is small, it may not make a lot of sense to stuff money into your IRA account.  Obviously, we don’t know what the future tax rates will be, but my best guess is that it will be higher, if not much higher than today’s tax rates & brackets.  The reason is that the coming dues of social security & medicare services will simply drain the tax revenue base, and will require raising tax (and lowering benefits and probably print more money) to cover any shortfalls.

If you’re not paying much income tax, or your marginal tax bracket is not that high (below 20%), I would actually consider not saving in your pre-tax accounts, but instead saving those money in Roth IRA.  A Roth IRA is an IRA that you pay tax now, but don’t pay tax later on the earnings.  Comparing Roth IRA to individual IRA, it has a couple of benefits like no forced withdrawal, nor an age limit on the contribution.

While it may be extremely time-consuming to go over the 100+ pages of IRS Pub 590 document on traditional IRA & Roth IRA, you can use my tax calculator to figure out the contribution limit on your Roth IRA & traditional IRA accounts.  The calculator may not contain all the necessary inputs, but for the most part, it suffices.

The decision over whether Roth IRA vs 401k/IRA is actually pretty simple.  Excluding the factor of company match on 401k account, for investing in Roth IRA in respect to pre-tax dollars, you will be getting taxed now.  And for 401k/traditional IRA accounts, you will be getting taxed (much) later.  Assuming that the rate of return on investment is the same for both scenario, if the tax factors are exactly the same, then both decisions will come out equally.  If you think tax rate may go up, or your retirement income may be quite high due to all the accumulated assets, then it might be better to just take some tax bite now instead of 30 or 40 years down the road.

Some people don’t have the financial discipline to carry out a plan of under-withholding taxes. Some people don’t have the financial cushion to carry it out to make a difference. However, if you have both, you can use under-withholding to your advantage.

Is under-withholding illegal? No. Unlike estimated tax payments, which go towards a specific quarter and due on the 15 of April, July, October, and January for the following year, the tax withheld from your paycheck is calculated as if the entire withheld amount is contributed throughout the entire year. What does that mean exactly? It means that whether you pay your tax out of your paycheck in January or December, they’re treated exactly the same by IRS, as if every 1/12 of the amount was paid evenly every month throughout the entire year. Knowing this, why would you want to pay IRS in January when you can pay IRS in December? You can almost put the amount in a 11 month CD, and get some 4% to 5.x% interest out of it.

I personally have carried out this practice for several years now. I under-withhold my taxes throughout the entire year, and I start to check on the exact amount of taxes that I should be paying in around October. The bigger amount you under-withhold, the earlier before year end that you should check on your taxes. The reason is that if you don’t start planning early enough, you may not pay enough taxes for the whole year, even if you send your entire paycheck to IRS for the last month in December. Essentially, you want to pay just enough taxes in a year, as not to trigger a tax penalty, and you want to pay more of your taxes near the end of year, instead of the beginning of the year. Calculating how much taxes you should pay can be very complicated. It’s also different for people whose adjusted gross income in the last year exceeded $150K. But you can easily figure out the underpayment taxes using my 2006 tax calculator. The calculation of underpayment taxes have taken into accounts for all of the conditions listed by IRS. It is the amount of additional taxes that you need to pay in order to avoid any tax penalty assessment. You don’t need to work through any IRS rules. Just enter all the numbers, and it will tell you how much more in taxes you need to withhold or pay.

To under-withhold or pay additional amount of taxes from your paycheck, you can simply fill out a W-4 form and give it to your payroll department. Besides under-witholding your taxes, another trick that you can play is over-contributing to your 401K, so that you can put in most of the contribution dollars upto the maximum earlier in the year, instead of later. For more details, you can find them at my other post “How I earn extra 1.45% return without risk in my 401k account”.

To summarize and put your cash flow into timeline, here is the picture of “paying yourself first” if you have utilized both early 401k contribution and under-withholding taxes:

1. If you make early 401k contribution, the first 3 to 4 months are the months when you will be paying into your own 401k account. Your net cash from paycheck will be tiny. You will be paying mostly the payroll taxes (social security and medicare taxes), but not much income taxes.
2. Then from March/April to probably October, these are your golden months for cash flow. Since you’re done with your 401k contribution, plus that you are under-withholding income taxes, your net cash from paycheck will look really good. But obviously, it’s not the time for you to spend those cash. Rather, you should be saving or investing those cash and prepare for the upcoming November/December and also till next year of April if you’re doing early 401k contribution every year.
3. November and especially December will literally be the dry months. If you have executed your under-withholding plan perfectly, you should be paying your entire paycheck towards IRS at the end of year. That means that there is $0 or close to $0 cash flow from your paycheck. You will need to be surviving from cash accumulated in the previous boom months of either January through October, or March/April through October if you contribute early to 401k.

Too complicated for you? Hey, if you know any ways to save or earn more money without any work, please let me know. To get something in return, you always need to pay at least a little bit of effort, whether it’s planning your cash flow, reading books or articles, etc.

Here is an article “Get next year’s tax refund now” from MSN money that talks about under-withholding taxes. It should supplement and reinforce this “tax saving” tip.

When I started blogging, I talked to my accounting friend who is a CPA about taking home office tax deduction.  Besides the trouble of maintaining and documenting the exclusitivity of the business usage, and sending a warning flag for audits, he advised me not to take any such deductions for the following financial reasons:

1. If you own your home, the expense items that you can claim for such deductions are mostly mortgage interest, property taxes, insurance, and utilities.  The biggest items are usually mortgage interest, and then property taxes, both of which can already be fully deducted through itemized deduction on the schedule A for your personal tax.  Unless you rent, and have very big utilities bills, the total deductible amount that is otherwise not available in personal taxes, will not be very significant, especially after pro-rating of business usage area to the total.
2. Any amount of depreciation of the home office will need to be re-captured as business gain at the time of the sale of your home.  If no business conversion of the home is taken, your gain is tax-free if it’s $250K for singles, and $500K for couples.  Those business gain can be defered through more complicated loopholes of 1031 exchange.  But this 1031 exchange that involves both home & business will not be as straightforward as a regular 1031 exchange.
3. Home office deduction is limited to your net business positive earning.  You simply cannot use home office deduction and increase your business loss to offset against your other income like salary wages.  Although you can carry forward the deductions that you cannot take in the current year, it is of no use if your business cannot produce significant income to take advantage of those deduction.  You can check out form 8829 for home office deduction and Schedule C for business income.

Here are some other useful links for more information:

1. Directly from IRS: home office deduction.
2. From Quicken: Factors to Consider Before Taking Home Office Deduction.  This article is very informative.
3. A very good online calculator for home office deduction.

I updated my federal tax calculator for 2006, with the latest AMT exemption amount passed by Congress.  Without an increase in the AMT exemption in 2006, a lot of working family will need to pay about extra $2000 in federal taxes due to kick-in of AMT.  You can experiment yourself using my 2006 tax calculators, entering $45000 for married couple (now at $62550), and $35750 for singles (now at $42500):

1. Joint with 2 kids, $80,000 income with $5000 401k contribution will need to pay $830 AMT tax.
2. Joint with 2 kids, $100,000 income with $15000 401k contribution will need to pay $1910 AMT tax.
3. Joint with 2 kids, $140,000 income with $15000 401k contribution will need to pay $2310 AMT tax.

I am glad that this is passed.  In fact, millions of families in the higher income states would face with paying extra taxes.  While I am concerned about growing government deficit from this tax cut, I think less taxes and smaller governments should be better for the citizens.  According to Lao Tze in his Tao Te Ching, ”Governing a great state is like cooking small fish“.  When my teacher in religion asked for the meaning of Lao Tze’s writing, one of my classmates answered that politics is like a culinary art, requiring many delicate and complex handlings.  I was a little shocked by the westerners’ default perspective because I knew what the answer was from my Asian background.  The correct answer was that government should leave people (fish) alone, and the less handled, the more remained.

So back to my point.  I’m for less taxes and smaller government.  Hope you have enjoyed the little digression.