What Time is It? Tax Refund Time!
Now that 2016 is finally over, Americans will soon be receiving reminders of the good, bad and the ugly in their finances last year. These digital and paper tax forms are intended to help them prepare their taxes. It is estimated that American’s waste 6.1 billion hours (695,000 years) preparing and filing their taxes each year. This breaks down to over 19 hours for every single person in the US. About half those hours are for personal filings and half for business. Assuming an average cost of $25/hr (either real or opportunity), that’s $152.5 billion sucked from our lives, each year.
Preparing and submitting federal and state taxes can be daunting for many, which would explain why so many procrastinate it until the bitter end. Taxes are overly complicated and can be overwhelming at first, but a little knowledge as well as some on-line tax preparation software assistance can take most of the complexity and drudgery out of calculating taxes.
Hiring a tax professional or do it yourself?
Many people simply don’t want to deal with the headache of preparing and filing their own taxes and are happy to pay someone to take their box of documents and convert it into a tax return. For those with very complex returns that does make sense. For example professional athletes generally have to file returns in each state where they played, and must allocate how that income by how many games they played in each state. For people with significant business income/expenses, it is also likely that a tax professional will complete that return.
For the rest of us who don’t have too many complex filing situations, on-line tax preparation software like Intuit’s TurboTax, Tax Act or even Credit Karma’s new free filing tool are sufficient to complete and check the personal return. This software generally does a good job of getting the return completed based on entering all your information, but doesn’t give many tips on what to do to get more back or how to optimize taxes based on what goals you have. There are a few popular credits and deductions that people can take, along with a few less common ones. Unless someone is familiar with the tax code, he might not know to investigate a certain tax break. It should be emphasized that this list is not comprehensive and there are caveats to some of the items below, but most common tax prep software will ask the appropriate questions. Using on-line software reduces my tax prep time to around 2-3 hours including small business info, and lots of deductions and credits. With average refunds in the $1000’s, it’s time well spent.
Deductions vs. Credits
A common question when people file taxes is what is the difference between a deduction and a credit. In general, credits directly reduce the taxes paid, dollar for dollar. For example the child tax credit will reduce the taxes owed by up to $1000. Deductions, on the other hand reduce your taxable income by a set amount, but your tax rate determines how much of a discount is applied to your taxes. For someone in the 15% marginal tax rate, a $1000 deduction would reduce their taxes by up to $150, but someone in the 25% rate, could see a tax benefit of up to $250 on the same $1000 deduction. The marginal tax rate is the tax rate on the final dollar of income earned, not the average rate.
Primer on Common Tax Breaks
For a brief explanation of some of the basic tax advantaged accounts, including 401ks, IRAs, HSAs, FSAs, please refer to the previous post on the Pieces of Rightirement. Additional tax breaks are briefly explained below. Please note that the main points are summarized and further details on eligibility would need to be determined.
SEP/SIMPLE/Solo 401k Retirement plans-available to many who own a small business. These funds are similar to regular 401ks but allow the business owner to contribute both as an owner and as an employee. These accounts permit much larger total contributions than might be available through an employer. On a pure contribution limit consideration, Solo 401ks offer the largest opportunity to contribute as one contributes to the plan as both an employer (25% of income or $53,000, whichever is lower). SEP and SIMPLE plans have similar features, but some differences as well.
Student loan interest-one of the few deductions that lowers Adjusted Gross Income (AGI). Limited to $2500 per person or per couple-one of the few tax breaks that penalizes Married Filing Jointly (MFJ) filers. Deduction starts phasing out at the $65,000 single/$130,000 MFJ and is unavailable at incomes above $80,000 and $160,000 for singles and MFJ, respectively.
American Opportunity Tuition Credit-one of the great tax benefits of sending a child to college. The credit gives up to $2500 back per child who is enrolled in eligible post-secondary schools in the form of a tax refund. The first $2000 of that is dollar for dollar of contributions, so covering $2000 per year is a no-brainer as it all gets credited back (provided the payer has tax enough to offset the contribution). The next $2000 contributed is credited at 25% back. This is good for the first four years of post-secondary education and is per calendar year. Additionally, 40% of the credit is refundable, meaning that if there is insufficient tax remaining to be paid to the IRS, the filer could get $800 back in tax refunds on $2000 spent even if no tax is owed. The other 60% can only be used to reduce the taxes due to the government.
Itemized Deductions-filers have the option to claim the standard deduction or itemize their deductions for a given year. Most often, people either don’t bother to itemize as they don’t understand what it means or find it complicated and avoid it. Most itemized deductions fall in several categories: medical expenses over 7.5% of AGI, property taxes, state and local taxes, mortgage interest, charitable contributions, casualty or theft losses and job expenses. Since medical expenses beyond 7.5% are not common, especially when discounting FSA and HSA expenses, they won’t be covered here, but might be a slight comfort to those experiencing serious ailments. State and local taxes, mortgage interest and property taxes are more common, especially when the filer is a home-owner. Charitable contributions refer to any money or goods donated to approved charities. Taken together, these items can significantly reduce taxes in some situations and usually take less than an hour to complete the forms with tax software.
Child and Dependent Care– actually two types of tax break can be claimed-an FSA type reduction of payroll taxes and/or a tax credit based on AGI:
- Credit will drop up to 35% of eligible daycare expenses from taxes. The maximum amount of expenses for 1 child is $3000 and for 2 or more it’s $6000. If the 35% tax credit rate is assumed, the max tax credit would be $1050 for 1 child and $2100 for 2+ children. Children must be 12 or under or otherwise unable to care for themselves. Can include a spouse or other dependent that is unable to provide care for themselves. Must exclude expenses paid for with the Dependent Day Care FSA money.
- Dependent Care FSA-type account that allows filers to pay for eligible care with pre-tax dollars-before federal, state and possibly Social Security taxes. Contributing to the Dependent Care FSA reduces eligibility for the Dependent Care Credit-generally dollar for dollar.
Retirement Savings Contribution Credit-A well-intentioned credit is the equivalent of the tax break unicorn–it benefits only a very small minority of tax filers. The idea of this credit was to incentivize less prosperous individuals and families to contribute to retirement plans by offering a tax credit for contributions. The credit is available for up to 50% of the retirement contributions made to 401ks and IRAs. The downside is that most people who could benefit are in one of the following groups:
- Too cash poor to contribute
- Get no benefit as other tax breaks zero out their tax liability before calculating the Retirement Savings Credit, or
- Have income that is too high to claim the credit.
The credit starts at 50% of contributions for AGIs up to $18,500 for singles, $27,750 for Heads of Households (HoH) and $37,000 for MFJ, up to $2,000 per person/$4,000 per couple. The credit drops to 20% of contributions for incomes up to $20,000 (single), $30,000 (HoH) or $40,000 (MFJ). It drops to 10% of retirement contributions for incomes above those in the 20% range until hitting the maximums of $30,750 (single), $46,125 (HoH) and $61,500 (MFJ). Even at the 10% contribution rate, it’s possible to get the maximum $2000 credit by contributing at least $14,500 to a 401k and $5500 to an IRA. These even work for Roth IRAs, so in theory, you could double dip in the before-tax and after-tax columns. If one contributes $5500 ($6500 for those over 50) to a Roth IRA, she can claim a 10-50% immediate credit on herr taxes AND not pay taxes on any growth in the Roth as long as she withdraws the funds after 59.5 years old. This is one of the few hybrid tax options that can beat out an HSA for low income workers, as there’s an immediate 50% tax credit back (i.e. $2000 back for a $4000 contribution) plus never paying taxes on those gains in the future.
Child Tax Credit-Up to $1000 per child in money back in your pocket, so you can actually afford the cost of raising them. Credit is good for incomes up to the $75,000 (single) and $110,000 (MFJ) thresholds when the amount begins to be reduced by 5% for every $1000 earned over the threshold. This credit is also fully refundable in some situations, so if you’ve used up all your tax credits and owe nothing in taxes, the government could actually pay you up to $1000 per child.
Earned Income Credit-a refundable credit for low and moderate workers, often for those with children. Intended to provide additional income for those at or near the poverty line and who might be considered the working poor. The credit is based on AGI as well as the filing situation and number of children. Investment income above $3400 disqualifies the filer from the credit. Maximum credits are $506 (no children), $3373 (one child), $5572 (two children) and $6269 (three or more children). Difficult to quickly compute-use online tax software to compute.
The table below summarizes many popular tax breaks and shows where in the standard 1040 form they are listed. Those before the AGI in lines 37 and 38 affect AGI, those afterwards do not.
|Form 1040 Line #||Tax Benefit Description||Credit or Deduction||Max credit/ deduction (Ind. / Fam.)||Deadline||Income Phaseout (Ind. / MFJ) or other limitations?||Notes|
|7||Flexible Spending Account||Deduction||$2,550||12/31||None||Use it or lose it calendar year limitations|
|7||401k||Deduction||$18,000||12/31||Catch-up contributions of $6000/person allowed if 50 or over.|
|7||Dependent Day Care FSA||Deduction||$5,000||12/31||Contribution can’t exceed taxable compensation||Can be used together with Dependent Day Care Credit, but can’t cover the same dollars of expenses.|
|Health Savings Account||Deduction||$3450 /
|28||Solo 401k||Deduction||$18,000 employee, 25% up to $53,000|
|32||Individual Retirement Account||Deduction||$5500 /
|4/15||Covered by work retirement plan?
Spouse not covered by work retirement plan?
Not coverd by work plan?
|Catch-up contributions of $1000/person allowed if 50 or over|
|33||Student Loan Interest||Deduction||$2,500||12/31||$80,000 / $160,000|
|34||Tuition Credit||Deduction||$2000 / $4000||12/31||$80,000 / $160,000 (AGI as of line 33)||Can’t be combined with credit on line 50 for same student.|
|37 & 38||Adjusted Gross Income||N/A|
|40||Mortgage Interest||Deduction||Interest on:
≤$1,000,000 mortgage loan
≤$100,000 Home Equity loan
|12/31||$261,500 / $313,800|
|40||Property Tax||Deduction||None||12/31||$261,500 / $313,801|
|40||Charitable Contributions||Deduction||30% of AGI||12/31||No Limit|
|48||Foreign Tax Credit||Credit/Deduction||% of foreign income vs. total income||12/31||This credit/deduction can be very complex depending upon the situation.|
|49||Dependent Day Care Credit||Credit||20-35% of eligible expenses||12/31||None||Max expenses: $3000 for 1 child, $6000 for 2+ children. Can be used together with Dependent Day Care FSA, but can’t cover the same dollars of expenses.|
|50||Education credit||Credit||$2500/child||12/31||$80,000 / $160,000||100% credit of first $2000, 25% of next $2000. 40% is refundable.|
|51 & 68||Retirement Saving Contribution Credit||Credit||$2000/$4000||12/31||$31,000 / $62,000||Tiered rates from 50% down to 10% credit based on income|
|52||Child Tax Credit||Credit||$1000/child||12/31||$75,000 / $110,000||Refundable Credit. Reduced by 5% for every $1000 over the threshold values|
|53||Residential Energy Credit||Credit||10-30% of expenses depending upon type of expense||12/31|
|66a||Earned Income Credit||Credit||0 kids: $510
1 child: $3400
2 children: $5616
3 or more children: $6318
$15,010 – $48,340
$20,600 – $53,930
|Income Phaseout limit dependent upon # of eligible children (0-3+) and filing status|
That’s a whole lot of information to process. In the next blog post, we’ll break down how to use this information to plan and claim the most tax breaks.