Second of an eight-part series.

        The complexity of the tax code is one reason why the tax-filing season is so agonizing for many individuals. But complexity can work to your advantage when filling out the 2000 income tax return.

        In the tax code's labyrinthine maze of rules, you'll find different formulas for computing certain deductions and calculating the tax on various types of income.

        There are alternative methods for computing write-offs for job-related use of a car, foreign taxes paid on overseas investments, business-equipment purchases and business-trip meals.

        There is more than one way to compute the tax on the sale of mutual fund shares, lump-sum distributions from pension plans, farm income, interest on U.S. Savings Bonds and the investment income of younger children.

        As you work through your return, take the time to evaluate the various options. Which method you choose can sometimes make a significant difference in your tax bill.

        For instance, some retirees who received lump-sum distributions from their company pension plan last year can knock thousands of dollars off their tax bill by taking advantage of a couple alternative methods for computing the tax on the payout.

        To be sure, the options are more limited this year. Retirees can no longer take advantage of a five-year averaging formula to reduce the tax on lump-sum distributions. Congress abolished the favorable method for distributions after 1999, but a 10-year averaging formula is still available for many retirees born before 1936.

        Not as many people qualify for 10-year averaging. “But for those who are eligible, 10-year averaging is generally better than five-year averaging was,” said Jim Seidel, a tax attorney and editor at RIA in New York, which publishes references for tax professionals.

        Retirees born before 1936 may also be able to take advantage of preferential capital-gains tax treatment for the taxable portion of their distribution that represents the time they were in the pension plan before 1974.

        Good accountants will evaluate the alternatives for clients. But taxpayers who are preparing their own returns often have the most opportunity to take advantage of the optional methods for making tax calculations.

        That's because certain tax-saving options aren't always economical to implement when you're dealing with a preparer who is charging by the hour or by the return.

        For example, most parents have the option of including on their return the investment income of a child under age 14. But filling out a separate return for the child will sometimes result in a smaller tax bill for the family. If you're using a paid preparer, however, the extra fee to prepare a separate return for the child may more than offset the tax savings.

        If you're using computer-tax software to prepare your return, comparing the options can often be done easily and quickly.
       

Investment, business options

        Some comparisons can be made without much calculation at all, such as which form of tax treatment is better for U.S. Savings Bonds. Most people with savings bonds choose to take advantage of the bonds' special tax-deferred feature

        Tax on the interest of Series EE and Series I bonds can be postponed until the bonds are cashed in. But if the savings bond is held by a young child, you may find that deferral is not the best option. Your child might be better off having the interest subject to tax each year. If your child is expected to earn only moderate amounts of investment income, little if any tax is likely to be owed on the bond's interest annually.

        If you made a partial redemption of shares in a mutual fund last year, you may be able to take advantage of an alternative formula, known as “average cost,” to minimize the capital gains tax bite. Averaging can be helpful if you bought your shares over time at different prices and didn't instruct your fund which specific shares you wanted to redeem.

        When writing off business use of a car, basing the deduction on your actual expenses will often yield the biggest deduction. But in some cases, claiming the IRS fixed mileage rate will be the more lucrative option.
       

Joint vs. separate returns

        Married couples have a choice when it comes to filing status.

        Couples will find they'll usually pay less tax by filing joint returns. The tax-rate schedule is lower on joint returns, and certain valuable tax breaks can only be claimed if you file a joint return. such as the earned-income credit.

        Filing separately can pay off in some circumstances. “But it takes an unusual composite of income and deductions,” said David Rhine, national director of family wealth planning at the accounting firm of BDO Seidman in New York. Probably the most common situation is when one spouse had unusually large medical or “miscellaneous” itemized expenses.
       

Avoiding penalties

        There are even ways to duck some IRS penalties. If you suspect you'll be subject to a penalty for failing to pay enough tax last year through withholding or quarterly estimated tax payments, you may be able to minimize the bite by filling out Form 2210, Underpayment of Estimated Tax.

        “The form is confusing, and it can be difficult to fill out,” said Bruce Wertheim, a senior manager in the personal financial planning practice at the accounting firm of KPMG in New York. “But there are ways to either minimize or avoid the penalty on the form.”

        If you don't fill out the form, the IRS will figure the penalty and send you a bill. By filling out the form, you can compute the penalty using a more favorable formula than the IRS will.

        One alternative formula that can provide salvation for many people is the “annualized income installment method.” This formula can help people who received more of their income in the latter part of 2000, such as investors who had a large capital gain late in the year. The annualized formula can also be a godsend for self-employed workers with seasonal businesses and other workers who didn't receive their income evenly throughout the year.
       

Dig through tax records

        How much you'll be able to deduct on your tax return will partly depend on how well you search through your records for deductible expenses. Even if you're having a professional prepare your return, it will likely be your responsibility to dig through your records, sort them and tote up the figures.

        Tax practitioners say many clients miss out on valuable deductions because they don't search hard enough through their records for common expenditures, such as for volunteer charity work and incidental business expenses.

        Besides going through your 2000 records, also check your 1999 tax records.

        What you may find in your 1999 records are expenses that you weren't allowed to fully deduct on your 1999 return but that are eligible for a deduction on your 2000 return.

        An example is “points” paid in a refinancing. Deductions for these one-time lender fees usually must be spread over the life of the refinanced loan. As a result, many homeowners who refinanced a mortgage in recent years should have some points eligible for a deduction on their 2000 return.

        Other items to check for possible “carryover” deductions are capital losses, home-office expenses, depreciation, multiyear subscriptions to professional and investment publications, investment interest, rental property losses, large charitable contributions, “passive-activity” losses, net operating losses and alternative minimum tax credits.

        Also, look through your bank and credit card statements from early this year. Expenses incurred at the tail end of the year may not show up on credit card bills or in your canceled checks from the bank until January or February of the following year.

        Gary Klott is the editor of TaxPlanet.com, a year-round tax information Web site, and a nationally syndicated tax columnist.

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