Making Your Life Less “Taxing”

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Over the years a few brave souls have actually tried to tackle our tax laws for the express purpose of making them simpler and therefore fairer. Back in 1998 I did TV news stories about a couple of proposals then on the drawing board. The first was a proposal for a flat tax, proposed by Congressmen Dick Armey and Richard Shelby. Under this proposal, our entire tax code would have been shredded and replaced with a simple tax of 17% of income. No deductions, no credits, no exceptions. You’d get a big personal exemption, but every dime you made after that would have been taxed. For a family of four, for example, the exemption would have meant that only income above $33,800 would have been taxed, but everything beyond that exemption would have been taxed at 17%. The major selling point of this proposal was that everyone in America would have been able to file his or her taxes on one side of a post card.

Let’s begin our discussion of income taxes with synonyms for the word “complex,” courtesy of the Webster’s Collegiate Thesaurus.

COMPLEX: Byzantine, daedal, elaborate, U.S. income tax laws, Gordian, intricate, involved, knotty, labyrinthine, sophisticated.

OK, so I took a little literary license by adding “U.S. income tax laws” to the synonyms for “complex.” But whether Webster cops to it or not, the U.S. tax code is practically a synonym for complex. The complete Internal Revenue Code contains more than 2.8 million words. Printed 60 lines to the page, it would fill almost 6000 letter-size pages. That’s a ridiculously complicated way to express a brutally simple concept, namely that Uncle Sam wants to share in the spoils of your success.

Over the years a few brave souls have actually tried to tackle our tax laws for the express purpose of making them simpler and therefore fairer. Back in 1998 I did TV news stories about a couple of proposals then on the drawing board. The first was a proposal for a flat tax, proposed by Congressmen Dick Armey and Richard Shelby. Under this proposal, our entire tax code would have been shredded and replaced with a simple tax of 17% of income. No deductions, no credits, no exceptions. You’d get a big personal exemption, but every dime you made after that would have been taxed. For a family of four, for example, the exemption would have meant that only income above $33,800 would have been taxed, but everything beyond that exemption would have been taxed at 17%.The major selling point of this proposal was that everyone in America would have been able to file his or her taxes on one side of a post card. Proponents of the flat tax claimed that it would result in savings of $100 billion a year in IRS expenses alone. Those opposed said that a 17% rate wouldn’t be enough, claiming that it would take a rate of more like 22% to keep the red, white and blue in the black.

Also in 1998, Congressmen Billy Tauzin and Dan Schafer proposed an even simpler plan. They wanted to do away with income taxes altogether and replace them with a national sales tax. This plan had some real pizzazz since it repealed all personal taxes, corporate taxes, inheritance taxes and gift taxes. Better yet, it suggested completely dissolving the IRS by the year 2001. And it was very simple: income tax was to be replaced with a 15% sales tax on all retail purchases of goods and services. Sounded good, at least until you looked under the hood. Because while a national sales tax replaced all income taxes, it didn’t replace Social Security, other employment taxes or state or local income taxes. And when they said the tax applied to all goods and services, the key word was “all.” Houses, cars…everything. The final straw was that even with that onerous additional burden, some experts said that 15% wouldn’t be enough. It would take more like a tax of between 17% to 37% to make the system work. Try adding that on top of a new house.

While neither of these ideas ever made it to second base, at least the thought was good. The tax code doesn’t need to be complicated to accomplish its mission. If you can put a man on the moon, you should be able to separate a citizen from their money with less than 2.8 million words. So why are taxes so complicated?

Let’s turn again to Webster:

PORK: government money, jobs, or favors used by politicians as patronage

Many of the wrinkles in the tax laws are there because some special interest benefits from them. I also believe that another reason our taxes are kept so complicated is the same as why investing is made to appear complicated. Namely, because lots of people make lots of money with the current system. As with investing, there are thriving industries built around interpreting tax laws and offering paid guidance to the less informed multitude. But as with investing, we can pull aside the curtain, blow away the smoke and break the mirrors. Because the truth is that very few of those 2.8 million words apply to your situation, and you don’t need expert help, especially now that personal computers are on the scene.

That being said, you do need to understand the broad strokes when it comes to income taxes, or more specifically, reducing your income taxes. When it comes to taxes, a 60-minute money manager invests a few minutes a year on strategy, then hits the sofa, leaving the details for their computer.

Even if you know next to nothing about income taxes, you probably do know that the taxes that you pay in April are a result of money made and spent the preceding calendar year. This is factor one in determining how much income tax you’ll pay. You probably also know that the more income you report, the more taxes you pay. This is factor two. Finally, you’re most likely aware that you’re allowed to reduce your income by subtracting certain allowable expenses, called deductions. This is factor three in determining your personal tax burden. So if you understand these three factors, you’re already 90% of the way to becoming an effective tax planner. Because the term “tax planning” is really nothing more than a fancy phrase describing the process of reporting as little taxable income as possible and reporting as many tax deductions as possible. No big deal.

The first broad stroke you’ll want to master is exactly what the heck tax brackets are all about.

While you may think that tax brackets are hardware used to hold up tax shelves, guess again. Tax brackets describe what percentage of the money we make Uncle Sam expects to receive. Our tax brackets are called progressive or incremental. That’s because the more you make, the higher your rate. Note that I’m not saying the more you make the more you pay, although that’s also true. I’m saying that as you make more money, the incremental money you make is taxed at a higher rate. This concept becomes clear when you look at projected tax tables for 2003.

Married Filing Jointly

2003 Taxable Income

Tax Rate













Single Tax Payers

2003 Taxable Income

Tax Rate













There are additional tax tables reflecting other categories of tax filers, like married people filing separate returns and heads of household (translation: unmarried with children). But since we’re only trying to grasp a concept or two, let’s stick with the two most common: joint filers and single filers. A glimpse at the tables reveals what a progressive tax structure is all about. Looking at the table for single taxpayers, we see that in 2003, if you made $6,000 or less, you were in the 10% tax bracket. If you made more than $6,000 but less than $28,401, you were in the 15% tax bracket. And if you made more than $311,950, you’re paying 38.6%.

Before we go on, let’s make sure we understand what we’re looking at. The term “taxable income” in the tables doesn’t refer to every dime you made. That would be your total income, your gross income, or simply your income. Taxable income, on the other hand, is what’s left after all your deductions and exemptions. (Pull out your most recent 1040 and you’ll see this amount somewhere around line number 40. You’ll be able to identify taxable income because it will be labeled “taxable income.”) So theoretically you could have an income of a million dollars, but if you have $994,000 worth of exemptions and deductions, you’d still be in the 10% tax bracket.

Now let’s revisit the term “progressive.” Remember, I said that the more you make, the higher rate you pay? Here we see it in action. Look again at the table for single taxpayers. The first $6,000 of taxable income is going to be taxed at 10%. So if that’s all you made, you’d owe $600, you’d be in the 10% tax bracket and that would be that. But say your taxable income was $25,000. Our table tells us that the first six grand is taxed at 10%, then the rest, $19,000, will be taxed at the next highest bracket, which is 15%. Our tax bill would be $6,000 x 10% + $19,000 x 15%. Total tax due? $3,450, which is a little less than 14% of our $25,000 taxable income. So, while we’re in the 25% tax bracket, we’re not paying 25% of everything we make in taxes. If our taxable income is $50,000, our total tax bill will be $9,792. We’re in the 27% tax bracket, and we’re paying a little less than 20% of our total taxable income in taxes.

I’m sorry to drag you through Tax Accounting 101, but I want you to understand what tax brackets are and what they’re not. What they are is a picture of how your incremental income (i.e., income after it crosses a certain threshold) is going to be taxed. What they’re not is a picture of how your total taxable income is going to be taxed.

There are many ways that you can use information about what tax bracket you’re in to potentially lower the amount of tax you pay. For example, suppose you’re single and it’s December 27th. You’ve got a $1,000 profit in a mutual fund and you’re thinking of selling. Should you sell it now or wait till January first? Based on how much money you’ve made this year and the amount of deductions you expect to have (information instantly available from your personal finance software program) you determine that your taxable income this year is going to be $28,400. This is exactly where the 27% tax bracket begins, which means that if you add to your income by making an additional $1,000, you’re going to owe $270 in taxes on that $1,000. If, however, you expect that next year you’ll only make $25,000, you could sell the mutual fund after January 1st and only pay an additional $150, since $1,000 on top of $25,000 still leaves you well within the 15% bracket. So waiting a few days will save you $120, not to mention postponing the tax bill for an entire year.

That’s one way that tax brackets can help you save tax dollars. Another is in an area we’ve already discussed: buying investments that offer tax-free income. Tax-free interest is obviously worth a lot more to someone in the 38.6% federal tax bracket than to someone in the 10% bracket. You can’t compare tax-free investments with their taxable cousins until you know what tax bracket you’re in.

I don’t know about you, but I’m now officially sick of talking tax brackets. It’s high time we talked timing.

Keep in mind that the vast majority of us are not only calendar year taxpayers, we’re also cash basis taxpayers. That means that income becomes taxable when you receive it and allowable expenses become deductions when you pay them. As you’ll soon see, this is a key ingredient when it comes to reducing income, increasing deductions and shrinking tax bills.

Let’s focus on reducing taxable income first, since that’s the factor that presents the fewest options and therefore takes the least effort to understand.

If you’re an employee, you don’t have to spend a lot of time on your employment income, because you have virtually no control over when you receive it. If your employer writes you a check on December 30th, it’s still reportable income for that year, even if you wait till January 1st to cash the check. While you may not have actually received your cash until the next year, it was theoretically receivable in the current year, so not cashing checks won’t reduce your taxable income. But suppose you have a year-end bonus coming to you? If you can persuade your boss to cut that check after January 1st, you will have effectively postponed the taxes due on that income for an entire year. The only problem with this approach is that convincing your boss to delay a check won’t be easy, since your taxable income is your company’s deductible expense. So if your company is also on a calendar tax year, postponing your income means postponing their write-off. An idea they probably won’t squeal with delight over.

Those of us who are self-employed often have more flexibility when it comes to the timing of our income (which, by the way, is one of many good reasons to be self-employed). If you’re a consultant, you can choose to send the invoice for work you did on December 30th out on January 1st. Even if your customer pays you instantly, (as if, right?) you’ve still moved that income to the next tax year. Congratulations: you’re an income-shifting tax planner!

While your pay is most likely your largest source of income, it’s probably not your only source. You could be getting gifts, borrowing money, collecting interest, selling stuff, winning money from gambling or contests, getting alimony, receiving child support, collecting Social Security (or other retirement income) or getting rent checks from real estate. How does each of these sources of cash affect your tax picture?

Getting Gifts

When you get money as a gift, you’ve got nothing to report to the IRS. Gifts aren’t taxable income. So, if you can arrange it, my advice would be to receive all your money this way. In addition, this method of paying the bills will also significantly reduce the time you now spend working for a living. In my experience, however, the only people who consistently manage to receive significant portions of their income this way resemble Mae West (wink, wink). But if you do find a way to accomplish this without the Mae West approach, please forward this information to me ASAP.

Borrowing Money

Borrowing money also results in no requirement to report taxable income, because borrowed money is only yours temporarily, and is therefore not considered income for tax purposes. Despite this tax advantage, however, I would stringently advise against this method of making ends meet.

Collecting Interest

Interest income is just like your salary: totally taxable in the year it is either received or receivable. So when it comes to being able to shift your taxable interest around to try to influence the amount you’re reporting in any given year, good luck. In this respect, interest is basically like your salary; you have no control over when it’s paid. The only possible exception is the interest from a debt that’s owed to you in the form of a personal or real estate loan. Then you might be able to exert some influence on the person who owes you the interest by pleading with or coercing them to pay it in a fashion that would move the interest from one tax year to another. But by and large, your interest income isn’t much more flexible timing-wise than your salary. Unless that interest comes from a tax-advantaged source.

The main source of tax-advantaged interest we’ve already discussed: tax-free interest from various types of government bonds. You’ll recall that interest arising from state or local government bonds (i.e., municipal bonds) is normally federally tax exempt. Interest from federal obligations (i.e., treasury bonds) is exempt from state and local taxes. And the interest from bonds issued within the state where you live (i.e., local municipal bonds) is the best deal of all, because that can be completely tax-free: federal, state and local. But as you’ll also recall, the problem with these sources of tax-free interest is that the tax advantages are usually off-set by lower interest rates, so what you gain by not paying taxes on these sources of interest you lose by not getting as much interest to begin with. Since that’s not always true, however, you should periodically check the rates available on tax-free bonds and mutual funds, especially if you live in high-tax states like New York or California. And, as we just discovered in our discussion about tax brackets, you should also see what your tax bracket is. Once armed with this information, you’re ready for a quick computation. Remember the formula? Taxable rate times reciprocal of tax bracket = equivalent tax-free rate. Here’s an example:

Taxable Rate (for example, the rate available on a medium term bond fund) = 5%

Reciprocal of Tax Bracket (if I’m in a 30% tax bracket, the reciprocal is 1 minus .3) = .7%

Equivalent Tax-Free Rate (5% x .7%) = 3.5%.

Result? We’ll have to find a tax-free rate of more than 3.5% to be better off than earning 5% in a taxable investment. This will probably prove difficult to do in investments of similar risk, but it’s still worth scoping out every now and then, especially since it’s so easy to do. In fact, I’ll do it right now, time myself, and see how long it takes.

The following exercise took one minute and 19 seconds.

Step One: I went to Vanguard’s website at

Step Two: I went to a listing of all Vanguard’s funds, organized by fund type.

Step Three: I scrolled down to the list of intermediate-term bond funds.

Step Four: I noted that the Vanguard Intermediate Term Bond Index Fund had a current yield of 4.57%, while the Vanguard Intermediate-Term Tax-Exempt Fund had a current yield of 3.2%.

Step Five: I look at the tax tables to see what tax bracket I’m in. Since I’m a joint filer and my taxable income is slightly more than $114,650, but woefully less than $174,700, I’m in the 30% tax bracket. I multiplied 4.57% by .7. The answer: 3.199%.

Wow! Who’d a thunk it? The after-tax return of these two funds is virtually identical. So if I’m investing in the Vanguard Intermediate Term Bond Index Fund, there’s no reason to switch because I won’t come out ahead after taxes. But it doesn’t hurt to check every now and then, especially since it took me less than 90 seconds to do it. Now I can move on with confidence.

Another tax-advantaged source of interest is the money you collect in tax-deferred accounts. Prime example of this type of account? Your 401(k,) IRA or other retirement account. You don’t report money you make in these accounts. While you will pay taxes on any money you withdraw, investing in these types of accounts is cool because you don’t pay the taxes now, nor do you deal with any time-consuming paperwork reporting interest you receive or profits you make. That’s why we like these types of accounts. Yes, we’ll have to pay taxes in the long run. But in the long term we’re all dead.

Selling Stuff

What about when you get money as a result of selling stuff? Whenever you sell anything, the government wants a share of the profit you make. They may offer you a tax deduction, however, for money you lose. This is where we learn about what are called “capital gains” and “capital losses.”

When it comes to profits, Uncle Sam wants a share of anything you make, period. When it comes to getting a deduction on losses, however, you’re only allowed to deduct losses from stuff that you bought for investment. In other words, you don’t get to deduct the bath you took on the sale of the family car, but you’re supposed to pay taxes on the profit you made by buying a painting at a yard sale for five bucks and selling it to an art museum for a thousand. Doesn’t seem fair, does it? Well, if you’re willing to risk the wrath of Uncle Sam, be a tax cheat and forget to report the profit on your painting. As long as the museum doesn’t tell, perhaps nobody will know and your profit will be tax-free. But if the transaction is being reported, you’d better fess up.

Interesting side note: not reporting gains is how some people find themselves behind bars. Drug dealers often go to prison simply because they live high on the hog but don’t file tax returns revealing where the money is coming from. These guys are buying low, selling high (pun intended) and not reporting it. Moral of the story? If you’ve got a lot of undeclared profits, might want to avoid luxury living.

Most of us, however, will never face the dilemma of whether to report our gains or other sources of income because we don’t have a choice. They’re reported for us.

Every January, mailboxes across America fill up with tax forms called 1099s. 1099s are all about potential sources of income being reported to the IRS by whoever paid it. Consider them a warning from anyone who’s sent you a check that they’re about to tell the IRS about it. That way, when you file your taxes, you’ll be sure to tell the IRS about it too. (This is another way the IRS catches tax cheats. They simply compare the 1099 forms they get from money-payers with the tax returns they get from money-receivers. If the amounts don’t gibe, they write a not-so-polite letter to the taxpayer asking why.)

If you get a form in the mail marked simply “1099,” it’s normally a record of money you were paid the previous year for work you performed. A 1099-INT is a statement of interest you received. A 1099-DIV is a statement of dividends you got. A 1099-R is a report of a distribution from a retirement plan. And the one we’re most concerned with here, a 1099-B, is a report of securities you sold. So if you get a 1099-B, you sold something and you’ve got to tell the IRS what it was, when you bought it, what you paid for it, and how much profit or loss you realized from the transaction.

As we’ve already discussed, interest you earn and profits you make in tax-deferred accounts like your 401(k) don’t have to be reported. So one way of avoiding 1099-Bs is to confine your investing to tax-deferred accounts. But we’ve already decided that we’re going to be investing in the stock market outside of our retirement accounts. And since we certainly will be aiming to make money, let’s see how these things are taxed.

As you know, when you make a profit by selling something you’re expected to share the wealth. If the gain was from something you owned for one year or less, it’s considered short-term. If you held on for more than a year, it’s a long-term gain. Why does it matter? Because long-term gains are taxed at lower rates. It’s also important to note that gains and losses realized during the year are netted against each other before you’re taxed on them. Then the result is taxed as either profit or loss, long-term or short-term.

If this sounds confusing, that’s because it is. Nonetheless, you’re going to be making profits and losses, which means you should understand how they’re taxed. So let’s go over this in a bit more detail.

First, here’s how gains are taxed based on how long you own the asset.

Short-term gains: taxed like any other income you receive during the year.

Long-term gains: If your normal tax rate is lower than 20%, you pay 10%. If your normal tax rate is higher than 20%, you pay 20%.

I’ll briefly explain the process of netting out your short- and long-term gains, then tell you why it matters.

Say you get a 1099B in the mail that reveals a bunch of gains and losses, both short- and long-term. Step one is to net your short-term gains and short-term losses. Step two is to net your long-term gains and long-term losses. Step three is to net the results of both to arrive at a bottom line, which will be either short-term or long-term. Here’s an example.

Short-term gains for the year: $4,000

Short-term losses for the year: $5,000

Long-term gains for the year: $8,000

Long-term losses for the year: $5,000

Step One: Netting your short-term stuff leaves you with a $1,000 short-term loss.

Step Two: Netting your long-term stuff leaves you with a $3,000 long-term gain.

Step Three: Netting long-term and short-term leaves you with a $2,000 long-term gain.

So there you have it. A $2,000 net long-term gain. Since it’s long-term, it will be taxed at a maximum rate of 20%. But what if we’d ended up with a net loss? We could use it as a deduction against our income. But not more than $3,000 in any one year. In other words, while gains are fully taxable in the year you receive them, you can only deduct $3,000 of losses in the year you suffer them. Losses above $3,000 aren’t gone forever, however. You get to store them indefinitely until they’re used up. So losses in excess of $3,000 this year can be used next year or the year after or however long it takes to use them to either offset gains you make or income you receive. This is called a loss carryover.

Once you understand how gains and losses are characterized as short-term and long-term, how they’re netted against one another, how they’re taxed and how losses are carried over to subsequent years, you’re in a much better position to plan. For example, if I can wait a few days to convert a gain from short to long-term, I’d normally want to. If I’ve got a $5,000 loss carryover from last year, that means I can take $5,000 worth of gains this year without having to worry about paying taxes on them. Granted, this isn’t the simplest of stuff, especially when you start considering all the exceptions. (You can download Publication 544 from to see what I mean.) But it’s not really rocket science, so it doesn’t hurt to brush up on the basics now and again.

Gambling Winnings

Winning money by gambling is just like making it any other way. In other words, difficult to do and totally taxable. The money you lose gambling, however, is only deductible against what you’ve won. So if you’re a net loser for the year, you’re out of luck both figuratively and literally. If you’re a net winner for the year, hopefully you’ve kept track of your gambling losses to partially offset that income. If you haven’t, drive out to the track and grab a bunch of losing tickets off the floor.


Alimony is generally income for tax purposes and therefore taxable. A bummer if you’re receiving it, but righteous if you’re paying it, because alimony payments are deductible. Providing, you meet the list of requirements found in Form 504, viewable at

Child Support

Child support, also covered by Form 504, isn’t taxable income to the one getting it or deductible to the one paying it.

The deductibility of alimony and non-deductibility of child support could be of monster importance if there’s a divorce in your future. If you’re going to be faced with a big property settlement and/or child support payments, you’re better off as the payer of this stuff if it’s repackaged as alimony, since alimony is pretty much the only divorce-related money you’ll pay that’s deductible. (Attorney’s fees generally aren’t.) And making it deductible could ultimately save you 30% or more in income taxes. Of course, the amount you’ll pay in child support is often statutory, so it may be impossible to have it designated as alimony. In addition, the money you’re saving on taxes by paying alimony is money your ex-spouse is losing since they have to declare it as income and pay taxes on it. But think of the possibilities: you pay the ex-husband alimony, knowing that the schmuck will never report it as income. Let a couple of years go by…call the IRS with an anonymous tip…what fun!

Collecting Social Security

Used to be that Social Security retirement wasn’t taxable income. Then Congress decided that if your income was high, you should be taxed on at least part of your Social Security benefits. What’s considered high income? As of the 2002 tax year, it was $32,000 for joint taxpayers. And that income includes half of the Social Security benefits you received, and all of the interest income you received, whether or not it came from otherwise tax-free sources like municipal bonds. If your taxable income exceeds $32,000 ($25,000 if you’re single) you could pay taxes on half of your Social Security retirement, survivor and disability benefits…perhaps on even more than half. But since there’s not much you can do about it, and your tax-preparation software will figure it all out for you, there’s no reason to dwell on it. That’s just the way it is. If you feel like dwelling on it anyway, however, download Form 915 from and dwell away.

Getting Rent Checks

Rental income is fully taxable. However, rental income can be offset by deductible rental expenses: see the chapter on real estate.

Income Summary

Now that we’ve covered the most likely sources of income you’ll be receiving, a pattern should be starting to develop. Basically, when it comes to taxes, pretty much every dime you ever see is taxable. To create tax deductions by losing or otherwise parting with money, on the other hand, often requires you to jump through hoops. Surprised?

Income Tax Deductions

You’ll recall from the beginning of this chapter that tax planning is all about timing. In other words, exactly when you’re forced to report money that’s taxable and exactly when you’re able to report money that’s deductible. You’ve just learned that most of the money you make is taxable, and that you’re pretty much forced to report it when it’s receivable. Now it’s time to learn that most of the money you spend isn’t deductible. But at least you have the flexibility to deduct allowable expenses in the year you pay them, which as you’ll soon see can be useful.

Before we continue, let’s be clear about what deductions are. A deduction represents money you’ve spent that ultimately serves to reduce your taxable income, which in turn reduces the amount of tax you owe. As such, deductions are highly desirable. But how can you tell which checks you write will qualify as deductions? Here’s a good rule of thumb: if the money you’re spending is putting a smile on your face, it’s probably not deductible.

Think I’m kidding? Take a look at the form you’ll use to report your itemized deductions, the infamous 1040 Schedule A. Here’s what you’ll find. First category of qualified deductions: medical and dental expenses. Next category: taxes paid. Then interest. Then gifts to charity. Then casualty and theft losses. Finally, job-related expenses.

Real barrel of monkeys, right?

Fact is, with the exception of gifts to qualified charities, the only checks you write that end up helping you deduction-wise are checks you have to write, not checks you want to write. But wait…it gets worse. Because even when you write these checks, you may still not end up with any deductions. Why? First, because the government figures most everyone will have some deductible expenses, so they allow us all a standard deduction. For married couples filing a joint return, that amount is around eight grand. For single people, around five. So unless you spent more than that on allowable deductions, there’s no point in keeping track of them. (At least not for federal tax purposes. If you pay state income taxes, these deductions may still be useful.) Second, even if you have a lot of deductions, Uncle Sam won’t let you take them if you make too much money. What’s too much money? If your adjusted gross income (total income minus a few things like IRA contributions, moving expenses, interest paid on student loans and alimony: you can see the complete list adjustments at the bottom of first page of a 1040 form) is in the neighborhood of $150,000 for joint filers, you start losing your deductions. Another way that Uncle Sam sticks a fork in rich folks.

All that being said, you should still keep an eye out for deductions, because despite their scarcity, they’re still better than a sharp stick in the eye. Let’s go back to our list from 1040 Schedule A and have a closer look.

Medical and Dental Expenses

If you get to deduct much in the way of medical and dental expenses, odds are that you have one foot in the grave and the other on a banana peel. That’s because only those expenses that exceed 7½% of your adjusted gross income are deductible. So if you’ve got an adjusted gross income of $50,000, you’ll need to spend more than $3,750 on unreimbursed medical expenses before you see your first dollar of deduction.

Now that we know this, what can we do with this information to improve our situation? Well, here’s where timing comes in. Imagine that it’s mid-December. We’re watching football, and during commercials we’re going over what’s happened this year money-wise and what’s coming up next year. Hmmm…. due to an unusual year-end bonus this year, looks like the adjusted gross is going to be around 55 grand instead of the usual 50. That’s got us scrounging for some extra deductions. Can we find some help in the medical expense category? Let’s see. We know that we’re going to need more than 7½% of adjusted gross to get any help. Seven and a half percent of $55,000 is $4,125. Ok, let’s see what we’ve spent. We open our personal finance program and have a look. Our health insurance costs around $250 month, and that’s deductible, so there’s $3,000 right off the bat. In addition, because we don’t have a lot of bells and whistles on our health policy, we’re also out of pocket for co-payments, a couple of prescriptions, contact lenses, teeth cleaning…it adds up to about $700. In addition, mileage to and from doctor and dentist is deductible: we get to write off 13 cents for every medical-related mile driven. Still, unless we’re willing to claim that we drove a thousand miles to see the doctor and fifteen hundred to see the dentist, we’re not going to make it over the $4,125 threshold. Oh well…but wait! Son Billy is going to need braces next year. Wife Betty is thinking of laser surgery for her eyes. What if we prepaid part of Billy’s orthodontic treatments now? What if we give Betty a gift certificate for eye surgery for Christmas? (You romantic devil! By the way, in case you’re wondering, boob jobs aren’t deductible.) When we pile these expenses on top of everything else, we’re going to generate a deduction after all. Never mind that these deductible medical treatments haven’t occurred yet. If we pay for them this year, they’re deductible this year. We’ve harnessed the power of timing to offset part of our unexpected, albeit most welcome, year-end bonus.

Feel strangely compelled to find out more about the deductibility of medical expenses? Then you may have a mental problem. But at least the treatment for it is probably deductible, and while waiting for an appointment with a qualified professional you can indulge your bizarre compulsion free by logging onto and downloading Publication 502, “Medical and Dental Expenses.”


You don’t get to deduct the federal taxes that have been withheld all year from your paychecks, but you do the money withheld for state income taxes. You also get to deduct real estate taxes you’ve paid. Here again, we have an opportunity to time our payment and therefore reduce our tax liability if we so choose. Because there’s nothing that prevents us from whipping out the checkbook and pre-paying part of our property taxes for next year. Except, perhaps, the balance in our checking account.


As you probably know, pretty much the only interest you get to deduct is on your mortgage. (About the only other deductible interest is investment interest, meaning interest on margin loans. And it’s kind of like gambling losses: only deductible to the extent you’ve got investment interest income.) But here again, we’re presented with an opportunity to time our deduction. Because we can pay our January payment in December, capturing that extra interest deduction this year instead of next.

Gifts to Charity

Don’t forget money you give to your church. And don’t forget to deduct mileage you incurred while engaging in charitable activity. You can write off 14 cents per mile. (That doesn’t mean, however, you should hit the Goodwill box outside Disney World. The cost of out-of-town travel isn’t normally deductible.)

You don’t get to deduct political contributions, or the value of the time you donate. If you donate stuff instead of money, you get to deduct its fair market value at the time you donated it. And you get to specify its value. (In the middle ages, people believed that it was possible to turn lead into gold. Turns out they were right: happens every December at the Salvation Army!)

Casualty and Theft Losses

This deduction arises when you get burgled, lend money to a friend or otherwise get ripped off. It also applies to your insurance deductible if you have a wreck or otherwise suffer a loss. Too bad your total losses have to exceed 10% of your adjusted gross before you get to deduct them. So you have to be a real loser to get any deduction here. In any case, there’s not much you can do to plan around, or time, this particular deduction.

(Note: Casualty losses are a perfect example of how the government can appear to lower your taxes while actually raising them. It used to be that casualty losses didn’t have a 10%-of-adjusted-gross-income limitation. Likewise, the threshold for medical expenses used to be five percent instead of 7½%. But these are the types of changes that can be made without citizens really noticing. So when it’s time to make headlines, the politicians lower tax rates, then simply go in and fiddle around with deductions like these to keep those lower rates from costing too much.)

Job Expenses and Most Other Miscellaneous Expenses

Here you get to write off money you spent related to your job, along with some other stuff. However, if the total of these things is less than two percent of your adjusted gross income, you’re toast.

Want to try to beat the two-percent threshold? The work-related expenses you’re looking for include things like tools, uniforms, protective equipment, subscriptions to professional journals, dues to professional organizations…anything work-related that your employer doesn’t pay or reimburse you for.

Far and away the most common income tax question I’ve been asked over the years is the following: “I only wear suits to work. That makes them deductible, right?”

Nice try, but no dice. Uniforms, yes. Suits, no. While you may only wear your suits to work, you could theoretically wear them elsewhere. Rule of thumb? If you want to deduct your work clothes, make sure your name is sewn on the outside.

You might also get to deduct some work-related educational expenses, but this is a potential minefield, so be careful. To be deductible, the education you’re getting has to either be required by your employer (or the law) or serve to increase your job skills. But if it qualifies you for another job, or is required to meet the educational requirements of your current job, it’s not deductible. For example, say you’re a teacher with a degree in education, but your employer requires you to take a college course every other year. Fine…your tuition is deductible. But if you end up graduating from medical school as a result, those costs may not be deductible after all. Your employer required you to take courses, but you chose courses that qualified you for an entirely different job. No deduction.

If that sounds complicated, it just shows you’re paying attention, because of course it is.

Despite being a bit on the confusing side, employee-related expenses are an area where you might increase your deductions with timing your cash outlays. Just make sure the purchases meet the requirements. If you’re interested, or are having trouble sleeping, the handbook is called Publication 508, and it’s waiting for you at

Once you’ve educated yourself on educational expenses, in the same box of Schedule A you’ll find miscellaneous expenses. This category of potential write-offs appears encouraging, but it’s not as flexible as it sounds. You can write off the cost of tax-preparation, including the cost of the software you bought and the cost of filing electronically. You can also write off the cost of your safe-deposit box (whoopee!) as well as a few other expenses too rare to bother mentioning. Besides, your tax-preparation software will find out if you have them anyway.

Other Miscellaneous Expenses

This is where you get to deduct your gambling losses, but only to the extent of winnings you’ve reported. It’s also the place to deduct other common expenses we all wonder about, such as amortizable bond premium on bonds acquired before October 23, 1986.

In other words, this isn’t the mother lode for additional deductions.

Self Employment

As you can see from our cursory glimpse at the itemized deductions found on Schedule A, expenses that easily convert into tax write-offs are as common as nuns in Vegas. So where are all the tax loopholes we read so much about? Well, many are found along the path to self-employment. Actually, “loopholes” is a pretty strong word… “advantages” is probably better terminology.

Businesses get to deduct everything they spend to create a profit: the parts they use to make their products, the machines they buy to assemble them, the wages they pay to their employees and the building that houses it all. So if you want to create loads of tax deductions, be a business. And that doesn’t mean you have to be General Motors. You’re witnessing a business in action right now: I’m in the business of writing this book. That makes my computer a tax deduction, along with the electricity that powers it. So are my desk, my chair, my phone, my paperclips, my files, my Internet access, yada, yada, yada. Everything remotely related to producing the tidal waves of income I’m going to be making with this book is deductible. If I had an office, I could write off the rent, but since I’m working at home, what I could do instead is depreciate a portion of my house.

So owning your own business is a huge generator of tax deductions, with the consequence to the IRS of creating irritatingly low tax bills. Which is why they’re constantly on the lookout for abuse in this area. So while it’s great to generate tax deductions with a home-based business, be sure you ultimately have some income to offset them. In other words, a business that doesn’t make money isn’t a business: it’s a hobby. And hobby expenses aren’t deductible.

Bottom line? If you work at home, whether full-timer or part time, make your business business-like. Keep your accounting as separate as possible. Likewise with your workspace. (My office is used only as my office…it doesn’t double as a den.) If you have only one computer and want to fully deduct its cost, don’t think you’ll convince the IRS that you use it strictly for business. They won’t bite. But when properly governed and fairly reported, self-employment is wonderful in terms of both personal freedom and tax deductions.

Deduction Summary

As I mentioned earlier, when you examine federal income taxes you find that Uncle Sam’s definition of taxable income is exceedingly liberal, while his definition of allowable deductions is exceedingly strict. This is, of course, no surprise. But as a cash-basis taxpayer, you can still influence the outcome by using timing to help you batch deductions, thereby postponing liability, or shifting them from a year where they don’t do as much good to one where they do. Since it’s one of the only tools you have, might as well use it.

Alternative Minimum Tax

Before we conclude, I’ll mention one more thing, simply because you may hear about it every now and then and wonder what it means. It’s called the alternative minimum tax. You won’t have to actually become conversant with this parallel system of collecting income tax, because if it applies to you your tax preparation software will know what to do. But it’s still kind of interesting.

By now you’re familiar with how certain actions can change the outcome of your tax story. For example, you already know that the interest from municipal bonds isn’t taxable, and pretty soon you’ll also learn that real estate can radically reduce your tax liability. Now imagine that you’re really, really rich…say you’ve got a billion dollars. You put the entire billion into five percent municipal bonds from your home state. Result? You’re now earning $50,000,000 every year totally tax free. This would make you very happy, but it would make people who earn $75,000 a year and surrender $10,000 of it as income tax a bit miffed. This is why Uncle Sam came along in 1969 with something called the Alternative Minimum Tax, or AMT. The AMT is a totally separate way of computing your tax liability, designed specifically to ensure that rich folks don’t get to exploit tax loopholes to the extent that they don’t pay anything. The way it essentially works is to have you compute your tax liability under the regular set of rules and again under AMT rules. Then you pay whichever bill is higher. There’s no distinct set of warning whistles that would alert you to the possibility of an AMT liability, but in general people with high tax-breaks in certain key areas should be aware of the possibility. Those key areas are: personal exemptions, state and local taxes, interest on second mortgages, medical expenses, miscellaneous itemized deductions, long-term capital gains and incentive stock options.

Again, don’t worry too much about AMT. First because there’s not much you can do about it anyway. Second because your tax preparation software has already studied the subject and is waiting to help.

Conclusion: An Important Note Regarding Minutia

Aren’t you glad this subject is almost over? I can’t stand talking about income taxes, much less writing about them.

Even though I was trying to paint in broad strokes, taxes are so comically detailed that I was forced to introduce a bunch of boring details in this chapter. I hope you don’t think for a second that you’re supposed to remember all, or even part of it. Only a savant could, and only an insane savant would want to. I’ve been a CPA for more than 20 years and I just relearned practically everything you just read for the millionth time as I was writing it. And every single thing I wrote I found in a few seconds simply by plugging a few search terms into the IRS website. Why the heck would I want to attempt to memorize it?

The purpose of this chapter was simply to demystify what’s happening in Federal Income Tax Land. In other words, think of what you just read as an overview of how the internal combustion engine works, not a manual on how to rebuild one. In the age before computers, income taxes were the forte of bespectacled magicians known as tax accountants. Like the Wizards of Wall Street in Investment Land, they promised much and charged much. And we had no choice but to pay what they were asking. But that was then. The formerly insurmountable hurdle of six thousand pages of tax law is gone now. Now it’s a 10-minute walk in the park with your computer and a $20 tax-preparation program that automatically imports the necessary information from your personal finance software and transfers it to your tax return. Like it’s human counterpart, your software asks you questions to make sure you’ve taken all the deductions to which you’re entitled and claimed all the income you should. It prints a copy of your return for your records, then files it electronically for you. It even asks if you’d like to do a little tax planning for next year. If you understand the basics so you set yourself up properly, know where to go to learn more and have yourself organized so all the information is in place, what’s left for you to do? Hmmm…did I hear someone say “Jerry Springer?”

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