Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

SHOULD YOU PREPAY STATE AND LOCAL TAXES?

December 16, 2005

Paying state and local non-business taxes early is a time-honored tax planning tool. Sometimes, though, it's best to leave a tool in the box. While prepaying taxes is sometimes wise, sometimes it's nothing but an interest-fee loan to your friends at the Hoover Building.

Before pre-paying 2006 state and local income and property taxes, you need to answer some questions:

1. Can I even itemize this year? If not, and your taxes don't get you over the standard deduction, don't bother.

2. What is my AMT situation for 2005 and 2006? If your tax projection shows you will be paying alternative minimum tax this year, pre-paying your taxes will do you no good. By allocating your payments between two years, you may find that you can avoid AMT in both years and minimize your taxes. If you have AMT next year but not this year, pay up this year, or the deduction is wasted.

3. Is the deduction this year worth giving up use of the cash now? Assuming the amount will be deductible at the same marginal rate either year, this is a time value of money question: is the present value of getting a deduction a year earlier worth more than the lost earnings from the amount you prepay? The further ahead you have to prepay to get the deduction this year, the less you benefit.

In the chart below we compare the time value of accelerating a $1,000 deduction by one year -- reducing tax on April 15, 2006 instead of April 15, 2007 -- to the earnings you will lose on the money by prepaying an amount on December 31, 2005 instead of the actual due date. We compare some due dates for amounts that can be prepaid:

January 31: due date of Iowa fourth quarter estimated taxes.
March 1: due date of first Iowa property tax installment.
April 15: due date of most state individual tax returns.
April 30: due date of Iowa individual tax returns.
September 1: due date of second Iowa property tax installment.

Using a 4% discount rate, you can see that taxpayers in any bracket are better off making their first quarter state payments early. At the lowest brackets, however, it doesn't make sense to pay your March 2006 property taxes early; the value of accelerating the deduction by one year is less than the interest you would earn by waiting until March 1 to make your payment. Only taxpayers in the highest brackets should prepay their state balances due on April 15.

SHORTCOMINGS OF THE CHART

This chart only works if all of its simplifying assumptions are met, and real life seldom works that way. For example, if you are in AMT this year, prepaying never makes sense. If you will be in regular tax this year but AMT next year, you might want to prepay everything you can - maybe even your September property tax installment; then you aren't looking at when you get your deduction, but whether you will get it at all. If you will be in a much lower bracket next year, or you won't be able to itemize, you are probably better off prepaying.

One thing is certain: if you don't run the numbers, you won't be able to make an informed decision.

This is another installment in our series on 2005 year-end tax planning.

 • 2005 Year-end planning       Bookmark: del.icio.us • Digg • reddit