No matter your circumstances or the time of year, planning in advance usually pays off in a lower tax bill. We’ve provided the following information so that you can develop a basic understanding of taxes before you discuss filing options and strategies.
Adjusted Gross Income (AGI)
AGI is generally the sum of a taxpayer’s income less adjustments. Some tax allowances, benefits, and deductions (including certain adjustments and credits) are limited by a taxpayer’s AGI.
Alternative Minimum Tax (AMT)
– Personal and dependent exemptions are not allowed under the AMT. Therefore, separated or divorced parents should may not claim the exemption and allow the other parent to do so.
– The standard deduction is not allowed for the AMT and a person subject to the AMT cannot itemize for AMT purposes unless they also itemize for regular tax purposes. Therefore, taxpayers make every effort to itemize if subject to the AMT.
– The depletion allowance that is in excess of a taxpayer’s basis in the property is not allowed for AMT purposes.
Anticipating when the AMT will affect you can be tough, as it typically results from a combination of circumstances. In addition to those items listed above, watch out for transactions involving limited partnerships, depreciation, and business tax credits only allowed against the regular tax.
Taxpayers can choose between using the standard deduction and itemizing their deductions.
The standard deduction is increased by $1,450 for unmarried taxpayers who are over age 64 as well as for taxpayers who are blind. There is also an additional standard deduction for married taxpayers of $1,150. Large deductible expenses can itemized in lieu of claiming the standard deduction.
Itemized deductions include:
(1) Medical expenses
(2) Taxes consisting primarily of real property taxes, state income (or sales) tax and personal property taxes
(3) Interest on qualified home debt and investments
(4) Charitable contributions
(5) Miscellaneous employee business expenses and investment expenses
To qualify as a dependent, an individual must be the taxpayer’s qualified child or pass all five dependency qualifications:
(1) Member of the Household or Relationship Test,
(2) Gross Income Test,
(3) Joint Return Test,
(4) Citizenship or Residency Test, and
(5) Support Test.
Unless you are a surviving spouse or married individuals who have lived apart for the entire year, your filing status depends on your marital status at the end of the tax year. Typically, if you are married at the end of the tax year, you have three possible filing status options: Married Filing Jointly, Married Filing Separate, or (if you qualify) Head of Household.
Head of Household is the most complex filing status to qualify for and is often incorrectly claimed or overlooked. To qualify, you must be unmarried AND:
• Pay more than half of the cost of maintaining a household serving as your principal place of residence for more than half the year for each qualifying child (or individual for whom the taxpayer may claim a dependency exemption);or
• Pay more than half of the cost for maintaining a separate household that served as the main home for a dependent parent for the full year
It is possible for a married taxpayer to be considered unmarried (for the purpose of qualifying for the Head of Household status) if the spouses legally separated (with a divorce or separate maintenance decree); or, were separated for at least the last six months of the year. Additionally, the taxpayer must have maintained a home for a dependent child for over half the year.
A surviving spouse can file jointly with the deceased spouse (if not remarried by the end of the year) for the year in which the spouse passed away.
Surviving Spouse is used for taxpayers whose spouse died in one of the prior two years and who has a dependent child at home. Joint rates can be used; however, an exemption is not claimed for the deceased spouse.
Marginal Tax Rate
Various types of income, even for the same person, are not taxed at the same rate. The sum of your deductions and exemptions are not taxed whatsoever. The next increment is taxed at 10%, then 15%, etc., until you reach the maximum tax rate. When you hear people discussing tax bracket, they are referring to the marginal tax rate. Your exact marginal rate is important to know because an increase or decrease in your taxable income will affect your tax at the marginal rate.
For example, suppose your marginal rate is 25% and you are able to reduce your income $1,000 by contributing to a deductible retirement plan. You would save $250 in Federal tax ($1,000 × 25%). Your marginal tax bracket depends upon your filing status and taxable income.
A qualified child must meet the following tests:
(1) Has the same principal place of abode as the taxpayer for more than half of the tax year.
(2) Is the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual.
(3) Is younger than the taxpayer.
(4) Did not provide over half of his or her own support for the tax year.
(5) Is under age 19 (or under age 24 in the case of a full-time student), or is permanently and totally disabled (any age).
(6) Was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund).
Once your tax is calculated, tax credits can reduce the amount further. Credits are divided into two categories: those that are nonrefundable and can only offset the tax, and those that are refundable. In addition, some credits are not deductible against the AMT, and some credits (when not fully used in a specific tax year) can carry over to the following years.
Taxable income is your AGI after your deductions (itemized or standard) and exemptions are calculated. Whether using the IRS tax tables or the rate schedule, your regular tax is based on your taxable income.
Taxpayer & Dependent Exemptions
Taxpayers are permitted to claim a personal exemption for themselves, their spouse (if filing jointly) and each individual who qualifies as their dependent. The amount are allowed to deduct is adjusted for inflation annually.
Withholding and Estimated Taxes
Our “pay-as-you-go” tax system requires taxpayers to make payments evenly throughout the year. If regular payments aren’t made, it’s possible to could owe an underpayment penalty. When a taxpayer’s income is primarily from wages, they typically meet the requirements by relying on their employer to withhold the right amount of tax based on the withholding allowances on their W-4. Some taxpayers meet the requirements by making estimated payments on a quarterly basis.
If you had a significant change in income during the year, we can assist you in projecting your tax liability to maximize the tax benefit and help you keep as much of your hard-earned money as possible.