
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. Youd 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.
Lets begin our discussion of income taxes with synonyms for the word complex, courtesy of the Websters 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. Thats 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. Youd 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 wouldnt 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 didnt 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% wouldnt 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 doesnt 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?
Lets 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 dont 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 youll pay. You probably also know that the more income you report, the more taxes you pay. This is factor two. Finally, youre most likely aware that youre 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, youre 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 youll 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. Thats because the more you make, the higher your rate. Note that Im not saying the more you make the more you pay, although thats also true. Im 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 |
|
$0-$12,000 |
10% |
|
$12,000-$47,450 |
15% |
|
$47,450-$114,650 |
27% |
|
$114,650-$174,700 |
30% |
|
$174,700-$311,950 |
35% |
|
$311,950 |
38.6% |
Single Tax Payers |
|
2003 Taxable Income |
Tax Rate |
$0-$6,000 |
10% |
$6,000-$28,400 |
15% |
$28,400-$68,800 |
27% |
$68,800-$143,500 |
30% |
$143,500-311,950 |
35% |
$311,950 |
38.6% |
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 were only trying to grasp a concept or two, lets 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, lets make sure we understand what were looking at. The term taxable income in the tables doesnt 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 whats left after all your deductions and exemptions. (Pull out your most recent 1040 and youll see this amount somewhere around line number 40. Youll 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, youd still be in the 10% tax bracket.
Now lets 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 thats all you made, youd owe $600, youd 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 were in the 25% tax bracket, were not paying 25% of everything we make in taxes. If our taxable income is $50,000, our total tax bill will be $9,792. Were in the 27% tax bracket, and were paying a little less than 20% of our total taxable income in taxes.
Im sorry to drag you through Tax Accounting 101, but I want you to understand what tax brackets are and what theyre 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 theyre 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 youre in to potentially lower the amount of tax you pay. For example, suppose youre single and its December 27th. Youve got a $1,000 profit in a mutual fund and youre thinking of selling. Should you sell it now or wait till January first? Based on how much money youve 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, youre going to owe $270 in taxes on that $1,000. If, however, you expect that next year youll 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.
Thats one way that tax brackets can help you save tax dollars. Another is in an area weve 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 cant compare tax-free investments with their taxable cousins until you know what tax bracket youre in.
I dont know about you, but Im now officially sick of talking tax brackets. Its high time we talked timing.
Keep in mind that the vast majority of us are not only calendar year taxpayers, were also cash basis taxpayers. That means that income becomes taxable when you receive it and allowable expenses become deductions when you pay them. As youll soon see, this is a key ingredient when it comes to reducing income, increasing deductions and shrinking tax bills.
Lets focus on reducing taxable income first, since thats the factor that presents the fewest options and therefore takes the least effort to understand.
If youre an employee, you dont 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, its 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 wont 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 wont be easy, since your taxable income is your companys 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 wont 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 youre 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?) youve still moved that income to the next tax year. Congratulations: youre an income-shifting tax planner!
While your pay is most likely your largest source of income, its 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, youve got nothing to report to the IRS. Gifts arent 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 youre reporting in any given year, good luck. In this respect, interest is basically like your salary; you have no control over when its paid. The only possible exception is the interest from a debt thats 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 isnt much more flexible timing-wise than your salary. Unless that interest comes from a tax-advantaged source.
The main source of tax-advantaged interest weve already discussed: tax-free interest from various types of government bonds. Youll 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 youll 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 thats 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, youre ready for a quick computation. Remember the formula? Taxable rate times reciprocal of tax bracket = equivalent tax-free rate. Heres an example:
Taxable Rate (for example, the rate available on a medium term bond fund) = 5%
Reciprocal of Tax Bracket (if Im in a 30% tax bracket, the reciprocal is 1 minus .3) = .7%
Equivalent Tax-Free Rate (5% x .7%) = 3.5%.
Result? Well 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 its still worth scoping out every now and then, especially since its so easy to do. In fact, Ill 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 Vanguards website at vanguard.com.
Step Two: I went to a listing of all Vanguards 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 Im in. Since Im a joint filer and my taxable income is slightly more than $114,650, but woefully less than $174,700, Im in the 30% tax bracket. I multiplied 4.57% by .7. The answer: 3.199%.
Wow! Whod a thunk it? The after-tax return of these two funds is virtually identical. So if Im investing in the Vanguard Intermediate Term Bond Index Fund, theres no reason to switch because I wont come out ahead after taxes. But it doesnt 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 dont 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 dont pay the taxes now, nor do you deal with any time-consuming paperwork reporting interest you receive or profits you make. Thats why we like these types of accounts. Yes, well have to pay taxes in the long run. But in the long term were 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, youre only allowed to deduct losses from stuff that you bought for investment. In other words, you dont get to deduct the bath you took on the sale of the family car, but youre 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. Doesnt seem fair, does it? Well, if youre 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 doesnt tell, perhaps nobody will know and your profit will be tax-free. But if the transaction is being reported, youd 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 dont 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 youve 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 dont have a choice. Theyre 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 whos sent you a check that theyre about to tell the IRS about it. That way, when you file your taxes, youll 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 dont gibe, they write a not-so-polite letter to the taxpayer asking why.)
If you get a form in the mail marked simply 1099, its 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 were 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 youve 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 weve already discussed, interest you earn and profits you make in tax-deferred accounts like your 401(k) dont have to be reported. So one way of avoiding 1099-Bs is to confine your investing to tax-deferred accounts. But weve already decided that were going to be investing in the stock market outside of our retirement accounts. And since we certainly will be aiming to make money, lets see how these things are taxed.
As you know, when you make a profit by selling something youre expected to share the wealth. If the gain was from something you owned for one year or less, its considered short-term. If you held on for more than a year, its a long-term gain. Why does it matter? Because long-term gains are taxed at lower rates. Its also important to note that gains and losses realized during the year are netted against each other before youre taxed on them. Then the result is taxed as either profit or loss, long-term or short-term.
If this sounds confusing, thats because it is. Nonetheless, youre going to be making profits and losses, which means you should understand how theyre taxed. So lets go over this in a bit more detail.
First, heres 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%.
Ill 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. Heres 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 its long-term, it will be taxed at a maximum rate of 20%. But what if wed 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 arent gone forever, however. You get to store them indefinitely until theyre 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 theyre netted against one another, how theyre taxed and how losses are carried over to subsequent years, youre 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, Id normally want to. If Ive 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 isnt the simplest of stuff, especially when you start considering all the exceptions. (You can download Publication 544 from irs.gov to see what I mean.) But its not really rocket science, so it doesnt 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 youve won. So if youre a net loser for the year, youre out of luck both figuratively and literally. If youre a net winner for the year, hopefully youve kept track of your gambling losses to partially offset that income. If you havent, drive out to the track and grab a bunch of losing tickets off the floor.
Alimony
Alimony is generally income for tax purposes and therefore taxable. A bummer if youre receiving it, but righteous if youre paying it, because alimony payments are deductible. Providing, you meet the list of requirements found in Form 504, viewable at irs.gov.
Child Support
Child support, also covered by Form 504, isnt 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 theres a divorce in your future. If youre going to be faced with a big property settlement and/or child support payments, youre better off as the payer of this stuff if its repackaged as alimony, since alimony is pretty much the only divorce-related money youll pay thats deductible. (Attorneys fees generally arent.) And making it deductible could ultimately save you 30% or more in income taxes. Of course, the amount youll pay in child support is often statutory, so it may be impossible to have it designated as alimony. In addition, the money youre 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 wasnt taxable income. Then Congress decided that if your income was high, you should be taxed on at least part of your Social Security benefits. Whats 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 youre single) you could pay taxes on half of your Social Security retirement, survivor and disability benefits…perhaps on even more than half. But since theres not much you can do about it, and your tax-preparation software will figure it all out for you, theres no reason to dwell on it. Thats just the way it is. If you feel like dwelling on it anyway, however, download Form 915 from irs.gov 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 weve covered the most likely sources of income youll 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
Youll recall from the beginning of this chapter that tax planning is all about timing. In other words, exactly when youre forced to report money thats taxable and exactly when youre able to report money thats deductible. Youve just learned that most of the money you make is taxable, and that youre pretty much forced to report it when its receivable. Now its time to learn that most of the money you spend isnt deductible. But at least you have the flexibility to deduct allowable expenses in the year you pay them, which as youll soon see can be useful.
Before we continue, lets be clear about what deductions are. A deduction represents money youve 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? Heres a good rule of thumb: if the money youre spending is putting a smile on your face, its probably not deductible.
Think Im kidding? Take a look at the form youll use to report your itemized deductions, the infamous 1040 Schedule A. Heres what youll 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, theres 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 wont let you take them if you make too much money. Whats 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, theyre still better than a sharp stick in the eye. Lets 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. Thats because only those expenses that exceed 7½% of your adjusted gross income are deductible. So if youve got an adjusted gross income of $50,000, youll 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, heres where timing comes in. Imagine that its mid-December. Were watching football, and during commercials were going over whats happened this year money-wise and whats 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. Thats got us scrounging for some extra deductions. Can we find some help in the medical expense category? Lets see. We know that were 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, lets see what weve spent. We open our personal finance program and have a look. Our health insurance costs around $250 month, and thats deductible, so theres $3,000 right off the bat. In addition, because we dont have a lot of bells and whistles on our health policy, were 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 were willing to claim that we drove a thousand miles to see the doctor and fifteen hundred to see the dentist, were 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 Billys orthodontic treatments now? What if we give Betty a gift certificate for eye surgery for Christmas? (You romantic devil! By the way, in case youre wondering, boob jobs arent deductible.) When we pile these expenses on top of everything else, were going to generate a deduction after all. Never mind that these deductible medical treatments havent occurred yet. If we pay for them this year, theyre deductible this year. Weve 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 irs.gov and downloading Publication 502, Medical and Dental Expenses.
Taxes
You dont 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 youve paid. Here again, we have an opportunity to time our payment and therefore reduce our tax liability if we so choose. Because theres 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.
Interest
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 its kind of like gambling losses: only deductible to the extent youve got investment interest income.) But here again, were 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
Dont forget money you give to your church. And dont forget to deduct mileage you incurred while engaging in charitable activity. You can write off 14 cents per mile. (That doesnt mean, however, you should hit the Goodwill box outside Disney World. The cost of out-of-town travel isnt normally deductible.)
You dont 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, theres 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 didnt 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 its 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, youre toast.
Want to try to beat the two-percent threshold? The work-related expenses youre looking for include things like tools, uniforms, protective equipment, subscriptions to professional journals, dues to professional organizations…anything work-related that your employer doesnt pay or reimburse you for.
Far and away the most common income tax question Ive 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 youre 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, its not deductible. For example, say youre 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 youre 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 youre interested, or are having trouble sleeping, the handbook is called Publication 508, and its waiting for you at irs.gov.
Once youve educated yourself on educational expenses, in the same box of Schedule A youll find miscellaneous expenses. This category of potential write-offs appears encouraging, but its 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 youve reported. Its 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 isnt 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 doesnt mean you have to be General Motors. Youre witnessing a business in action right now: Im 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 Im going to be making with this book is deductible. If I had an office, I could write off the rent, but since Im 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 theyre constantly on the lookout for abuse in this area. So while its 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 doesnt make money isnt a business: its a hobby. And hobby expenses arent 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 doesnt double as a den.) If you have only one computer and want to fully deduct its cost, dont think youll convince the IRS that you use it strictly for business. They wont 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 Sams 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 dont do as much good to one where they do. Since its one of the only tools you have, might as well use it.
Alternative Minimum Tax
Before we conclude, Ill mention one more thing, simply because you may hear about it every now and then and wonder what it means. Its called the alternative minimum tax. You wont 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 its still kind of interesting.
By now youre familiar with how certain actions can change the outcome of your tax story. For example, you already know that the interest from municipal bonds isnt taxable, and pretty soon youll also learn that real estate can radically reduce your tax liability. Now imagine that youre really, really rich…say youve got a billion dollars. You put the entire billion into five percent municipal bonds from your home state. Result? Youre 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 dont get to exploit tax loopholes to the extent that they dont 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. Theres 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, dont worry too much about AMT. First because theres 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
Arent you glad this subject is almost over? I cant 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 dont think for a second that youre supposed to remember all, or even part of it. Only a savant could, and only an insane savant would want to. Ive 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 whats 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 its 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 its human counterpart, your software asks you questions to make sure youve taken all the deductions to which youre 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 youd 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, whats left for you to do? Hmmm…did I hear someone say Jerry Springer?
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