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Personal Finance
The IRS and your savings
February 3, 1999: 4:53 p.m. ET

Reducing taxes on savings depends on your timing and investment strategy
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NEW YORK - In an ideal world, saving money for retirement, a new home or college would not only be heavily encouraged but also tax-free.
     But come April 15, reality sets in and the Internal Revenue Service starts looking for its cut of any interest earned on your savings.
     Some folks don't realize that bank interest on passbook and statement accounts, certificates of deposit, money market accounts and money market mutual funds is taxable.
     Whatever the type of interest-earning account, the IRS requires institutions to submit a Form 1099 INT to the account holder. This form is used to record any interest earned on the account.
     "Reporting interest earned on CDs and other interest-earning accounts, no matter how minimal that interest was for the year, is essential and will not go unnoticed by the IRS," warned E. Leonard Goldberg, principal of Goldberg and Associates, an Ithaca, N.Y.-based accounting firm.
    
Keep the paperwork

     Some financial planners advise savers to keep receipts and other related paperwork going back at least three years.
     "That's not to say the day you throw those statements out is when the IRS will be calling you for an audit," said Raymond Cliff, an enrolled agent based in Nashville, Tenn., but "it's easy to get burned if these earnings go unreported year after year."
     When it comes to the average savings account, there isn't much that savers can do to avoid the taxman. One strategy is simply to make more, so that there's more left after taxes are paid.
     One way to do that may be with a money market account. At most banks, the account works approximately like a savings account, but it gets a better rate of return, although it may carry a few restrictions. Typically, there is a minimum balance requirement and only a certain number of withdrawals per year. Some financial experts say it's an ideal choice if you plan to hold money for a short period of time, such as three months to a year.
     "Keep in mind the returns are low, but its always going to offer greater return over the long run and it's a step up from other bank products that, really, can be wasted investments," Goldberg explained.
    
Tax relief plans

     There is a movement to give savers some relief.
     Rep. Kenny Hulshof, R-Mo., is sponsoring the Savings Advancement and Enhancement Act, which aims to spare low- and middle-income workers from paying taxes on their savings income. The bill died in the Senate last year but Hulshof plans to reintroduce the bill this year.
     If passed, the bill will allow individuals to exclude from taxes up to $200 worth of income per year, so long as that income is generated by interest-bearing accounts or dividends. Married couples filing jointly would receive an annual exemption of up to $400 on such income.
     Hulshof's office estimates that his bill would wipe out the interest and dividend liability for more than 30 million taxpayers.
     "He's eager to get this through Congress this year," said Laura Kennedy, a spokesperson for Hulshof's office.
     Savers who branch out from bank accounts to government investments can get more protection from taxes, though.
    
An IRS agent's strategies

     In his book, "Julian Block's Tax Avoidance Secrets," the former IRS agent and tax attorney also recommends ways to lessen the taxes paid on U.S. Savings Bonds and Treasury bills. He suggests either declaring the interest from savings bonds as it builds up each year, without cashing in the bond, or to delay reporting the accumulated interest until the bonds are cashed.
     "The deferral break provides you with some valuable leeway in reporting your interest," Block writes. "With careful planning, the deferral can become the equivalent of an exemption from taxes."
     With Treasury bills, Block says that by switching from a money market mutual fund or bank account to a T-bill with maturity dates beyond Dec. 31, interest won't count until the fund matures. "Like interest on other U.S. government securities," Block writes, "T-bill interest, though subject to federal taxes, is completely exempt from state or local taxes."
     Tax-free money market mutual funds are another way for savers to sidestep Uncle Sam.
     Money market mutual funds can invest in all sorts of things, including U.S. securities such as Treasuries, tax-free instruments, letters of credit and commercial paper - which are short-term loans to corporations. Money can be withdrawn at any time without penalty, unlike certificates of deposit.
     Tax-free money funds are invested in short-term obligations of state and municipal concerns that have a tax-exempt status. The money is invested for less than six months at a time, and dividends paid daily are exempt from federal income taxes. Some funds also provide returns that are free of state and local taxes as well, says Peter Crane, managing editor of the IBC Financial Data Money Fund Report, in Ashland, Mass.
     "You really need to know what federal income tax bracket you're in to determine whether tax-free funds offer more of a benefit," Crane says. "As a rule of thumb, anyone who falls in the 36 or 39 percent tax bracket should consider tax-free funds."
     The downside to tax-exempt funds is that typically they pay lower yields than those that are taxed. Savers who pay taxes in Arizona, California, Connecticut, Florida, Massachusetts, Maryland, Michigan, Minnesota, New Jersey, New York, North Carolina, Ohio, Pennsylvania, Virginia and Texas have the option of investing in money funds that are free of federal, state and local income taxes.
     Savers have many more options when it comes to sheltering money socked away in retirement nest eggs.
     Sen. William Roth, R-Del., made it easier to reap the rewards of the individual retirement account through tax-free withdrawals. Holders of traditional IRAs must begin making minimum withdrawals at age 70½. The amount is based on the value of the IRA and the life expectancy of the holder and his or her beneficiary, if any. If the account includes nondeductible contributions, the holder needs to have a record of those so he or she doesn't pay tax on them again.
     None of that applies to the Roth. However, it's worth keeping a record of your contributions at least until age 59½, since holders may make an early withdrawal of their contributions without tax or penalty.
    
Roth IRA or not?

     Debate over conversion from a traditional IRA to a Roth IRA warrants weighing the tax pros and cons, advise some financial planners.
     "Generally, if you have decades before retirement, the mathematical argument in favor of conversion is even stronger," Nolworth says.
     The Roth IRA also permits pre-retirement withdrawals without paying a tax or penalty, but only under certain conditions and for certain purposes, such as a down payment for a house.
     "Stick with a traditional IRA and pay the taxes if the rollover, particularly a big one, would make you ineligible for certain tax breaks and push you into a higher tax bracket for the next four years," Nolworth recommends.
     Though it's tempting to jump on the Roth bandwagon, Nolworth says "some people need the discipline of the taxes and penalties of a traditional IRA to avoid the temptation to use the money too quickly in retirement."
     Also, converting isn't for everyone. Only individuals or married couples filing jointly and earning less than $100,000 a year can take advantage of the Roth IRA.
     Some financial planners advise long-term investments to avoid paying taxes each year. Nolworth recommends contributing to a 401(k) account, an IRA, purchasing individual growth stocks that do not pay or reinvest dividends and using certain types of annuities or life insurance. Back to top
     --by Bank Rate Monitor for CNNfn.com

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.