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Taking the Ax to Taxes

by Marc Eisenson, Nancy Castleman, & Gerri Detweiler

Chomp! When it comes to your paycheck, nothing takes out a bigger bite than government. Between federal, state, and assorted local taxes including property and sales tax -- plus those Social Security and Medicare "contributions" (that box marked "FICA" on your check stub) -- a huge portion of your earnings evaporate on the journey from your employer to your bank account. Poof!

According to the non-profit, non-partisan Tax Foundation, the typical two-income family forks over 37.6% of its income to pay federal, state, and local taxes. Taxes now claim a greater share of the family's budget than: "food (9%), clothing (3.8%), housing (15.4%), and transportation (6.7 %) -- combined," the Tax Foundation reports.

To slide past every April 15th with a fatter wallet, follow our unconventional strategies for saving money on your taxes:

1. Stop spending a fortune to get tax deductions! The bottom line is the less you spend, the more you keep. Nowhere is this more true than in the most popular tax deduction -- the home mortgage. While you may be able to deduct a percentage of what you pay in mortgage interest, a 28% deduction on your federal income taxes would mean you'd still be out 72 cents on every dollar you fork over to the bank in interest.

And because of the standard deduction all couples are entitled to, the first $7,000 or so you shell out in any one year won't buy you or your spouse a nickel's worth of tax benefit. Since the standard deduction gets higher every year ... and the interest you pay keeps getting lower (albeit slowly) ... the tax benefit to paying interest keeps getting slim-mer and slimmer as the years go by.

Of course, if you do pay enough in mortgage interest, state income taxes, and real estate taxes to itemize, certainly enjoy those savings ... but make pocket change pre-payments on your mortgage anyway. Your tax loss will be far, far less than your interest savings.

For example, say you send in pre-payments of $25 a month -- during just the first year of a typical $100,000 loan. Because of compounding, that $300 in advance payments will save you over $2,800 in interest over the loan's life -- even if you never pre-pay another cent.

But in that first year, you'll only pay $11.26 less in interest than had you not pre-paid. If you're in the 28% federal tax bracket, that would increase your tax bill by $3.15. Tell me, where else can a mere $3.15 get you $2,800 back, guaranteed? And if you keep sending in that $25 every month -- that's 83 cents a day -- you'll save over $23,000.

2. Invest smart and tax-free. I'll give you a hint: The key to absolutely safe, tax-free investing today is saving money. Here's how Ben Franklin might have put it if he were still around: "A dollar earned leaves less than 72 cents after taxes, whereas a dollar saved is $1.40 you'll never have to earn, assuming you're in the 28% federal tax bracket." (Not as pithy, we know.)

For example, say your favorite pasta normally costs $1.00 a pound. On sale, at 2 for a buck, you're guaranteed to save 50%, tax-free. Why is it tax-free? Because Uncle Sam doesn't tax us (yet) on money we save ourselves by shopping smart.

Stocking up on your favorites when they're on sale is an unbelievably powerful investment, especially when you think about the "yield." For example, on our pasta, the yield is actually 100% -- because 50 cents will buy what usually costs $1.00. Where else could you get a 100% tax-free return on a measly 50 cent investment? At 2 for $1, buy all you can store!

We in fact just had a very entertaining experience with someone who stocks up on pasta whenever it's on sale. Our son-in-law, Danny, took this advice so much to heart, that the shelf holding his pasta actually broke!! Nancy and our four year old grandson, Zachary, counted up all the boxes, while we fixed the shelf. Thanks to recent sales of both his favorite and a cheap store brand, plus whatever he already had in the house, Danny had invested in 53 pounds of pasta. I like the way he thinks!

3. Think of your life cost. For example, say you want to take the family to Disney World. According to our local travel agent, a basic 6 day, 5 night package for a family of four would run about $3,000 in the off-season. This would include airfare, one hotel room for the four of you, a rental car, 5 day passes for everyone to the assorted theme parks, taxes, and food. The price could of course be lower or higher depending on the age of your children, where you would fly in from, the time of year, how you choose to deal with meals, lodging, etc. For now, we'll just go with the $3,000 package price.

Say you put it on your 17% credit card, and vow to pay it off within the next 12 months. You'd spend in the range of $3,283, including interest.

Now let's figure out how much money you'd have to bring in to cover the credit card bill. We'll use the Tax Foundation's figure, and assume that like the typical couple, 37.6% of your income will go to taxes. To find out how much you'd have to gross to pay for the trip, divide that $3,283 by .624 (1.00 - .376). You'll discover that the vacation will really cost you more like $5,261 ... before taxes. But that's just the cost in dollars.

Now let's talk about your life cost, that is, how much of your time you're going to have to spend to make that money. First, you need to figure out roughly what you make an hour. (If you're paid a yearly salary, divide it by 2,000 hours, which is 50 weeks times 40 hours.) If you earn $30,000 a year, that's $15 an hour ($30,000 divided by 2,000 hours).

To earn that $5,261, you'll have to spend almost 351 hours on the job ($5,261 divided by $15 an hour). That's almost 9 weeks of full-time labor! Now the memories of an almost full week at Disney World may be well worth 9 weeks of your life, but maybe not. Only you can decide.

4. Pay off your credit card bills. Depending on your tax bracket, paying down a 17% credit card balance is like earning 20-25% before taxes. Your returns are guaranteed, risk-free, and tax-free. While the IRS will tax earnings from stocks and mutual funds, to say nothing of salaries, it still hasn't figured out how to tax the money you save by pre-paying your debts.

To save the most, start with the debt that charges the highest interest. Send in as much as you can on that bill until it's paid off, and send in the minimums due on your other bills. Once your highest priced piece of plastic is retired -- pay off the debt with the next highest interest rate, and so on.

Before you know it, you'll be stuck looking for other great tax-free investments, because you'll be out of debt. Chances are, though, that no matter how wonderfully the stock market does, you'll never find another investment that will offer you a guaranteed 17% return, tax-free.

5. Create an Ace in the Hole. A small side business can mean extra tax deductions, as well as protection from the whims of the job market and economy. We recommend a home business, one that doesn't require a lot of cash, until you've proven there's a market for what you have to deliver.

The IRS has liberalized a few key deductions for self-employed people in 1998 and '99, making an Ace even more of a tax advantage. If you're self-employed (and not eligible for health insurance at a "day job"), you can deduct up to 45% of your health insurance premiums on your 1998 return. That deduction goes up to 60% when you file your 1999 return.

Deducting your home office will also be easier on that '99 return. The IRS had toughened the rules a few years back, disallowing deductions for a home office when it wasn't "your principal place of business." That meant if you were a self-employed salesperson who met with customers primarily on the road or a self-employed massage therapist who saw clients at a health club, you were out of luck -- even if you used your home office space only for work associated with your business.

Now the IRS has loosened up, allowing the home office deduction if you do some of your work elsewhere. Caution: This has always been one of the trickiest deductions, so be sure to consult a good tax pro before you claim it for the first time.

6. Sock it away. Take maximum advantage of tax de-ferred retirement plans, such as your company's 401(k) plan, an IRA, or a Keogh plan. As of 1998, you can generally contribute up to about 15% of your compensation to a 401(k), with a maximum of $10,000 a year (a figure that is adjusted annually for inflation).

Your contribution isn't included in your taxable income for the year. So for example, if your salary is $50,000 a year, and you contribute $3,000 to your 401(k), you're taxed on only $47,000. If your "contribution" to Uncle Sam is 28%, you've held back $840 from the IRS -- at least until you retire. Remember, 401(k) and other retirement plan money is tax-deferred, not tax-free. They'll get you later, hopefully when your tax bite will be at a lower percentage.

7. Grieve Your Property Taxes. Don't just grumble and accept your property tax assessment. Most homeowners who challenge their tax bills get them lowered. Math errors, incorrect classifications, and out-of-date information are just a few of the reasons that your assessment might be just plain wrong. You can do the research on your own with the help of Save a Fortune on Your Homeowner's Property Tax, a new book by Harry Koenig and Bob Lafay, which tells you exactly what to do to make sure you're paying no more than you ought to be paying for your piece of the rock.

And if you'll be building a new home, or making renovations to one you already have, get Your Low-Tax Dream House, by Steve Carlson. It'll help you minimize the tax consequences of your construction project.

Even if you have no plans to pick up a hammer and nails, check on whether you're eligible for any special property tax rebates in your state -- perhaps because you're a senior citizen, or maybe because you simply live there. For example, New York now has a program to save homeowners money on their school taxes. By completing a short form, folks in the Empire State will see a reduction on their next bill. Call your town clerk or tax assessor to ask about any possible programs.

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The Pocket Change Investor
The Secrets to Getting Ahead -- Even If You Have a Pile of Credit Card Bills, Hefty Mortgage Payments,
Loans Out on a Clunker or Two, & a Bad Case of the "I'm Tired of Living Payday to Payday" Blues.

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Reprinted from The Pocket Change Investor© 1999, Marc Eisenson & Nancy Castleman

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