Category Archives: Deductions

Things I Hate About Tax Day

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Why writing the big check to Uncle Sam is the least of it.

By Brett Arends | SmartMoney – Thu, Apr 12, 2012 12:53 PM EDT

 
 

Have you got your schedule C in order? Have you hunted down all your receipts? Have you made sure to count the depreciation on your laptop and the percentage of your cable bill attributable to your home office expense? And what about those education credits?

After all, it’s not like you have anything else to do, right? It’s lucky it’s all so easy and painless. Ha!

Everybody hates Tax Day, which comes this year on April 17. And so do I. But not for the usual reasons.

This is the time of year when everyone seems to scream about just how much the federal government is costing us all. Weirdly enough, that’s not one of the things that really gets me. It’s the things that apparently no one else — at least no one else in the media — seems to notice.

Am I crazy? Am I alone? Maybe. You tell me.

Here are my top Tax Day hates.

1. Paperwork

Why isn’t there a riot about this? According to the National Taxpayers Union, we each waste about 12 hours a year, every year, filling out this crazy stuff. Schedule B. Schedule C. Above the line. Below the line. Deductions, exemptions, non-refundable credits. Medical bills over 7.5% of adjusted gross income.

It’s like we’re being mugged and held hostage. Every year.

The instruction booklet for the 1040 now runs to 189 pages. No kidding. Seventy-five years ago, says the NTU, it was two pages.

The U.S. tax code is insane and out of control. It’s tripled in a decade. It now runs to 3.8 million words. To put that in context, William Shakespeare only needed 900,000 words to say everything he had to say. Hamlet. Othello. The history plays. The sonnets. The whole shebang. But the IRS needs four times as many words? Really?

2. Dishonesty

Your tax bill this year is a lie. You’re only seeing about two-thirds of the full cost of government services. Really. Taxes are $2.3 trillion. Government spending is $3.6 trillion. The rest is being put on the national credit card.

The tax bill is a lie every year. We’ve only paid our bills in full on April 15 five times in the last fifty years. The last president to balance the books every year he was in office? Calvin Coolidge — back in the 1920s. How pathetic is that?

Deficits are just future taxes. According to the non-partisan Tax Foundation, “Tax Freedom Day” falls on April 17 this year — but “Deficit Day,” which includes the full bill, won’t come for another month.

Taxes — to steal from Albert Einstein — should be as low as possible, but no lower. Stop lying to me.

3. How they treat investment income

Aunt Sally in Dubuque lives off her savings. Her taxes should be relatively simple. But good luck with that.

She has money invested in blue-chip companies like AT&T and Wal-Mart. Her stock dividends are taxed at 15% or less. Meanwhile her bond coupons are taxed at ordinary income rates up to 35%. It’s crazy.

Yes, I know the corporations get a break on their bond payments. But what’s up with that?

Now try this: Aunt Sally can pay lower taxes on the money she makes from bonds — but only if she sells them after a year for a long-term capital gain. If she hangs on and keeps clipping the coupons, she gets whacked with higher taxes.

The tax treatment of investment income is arbitrary and stupid. We treat debt and equity differently for companies and investors. It’s irrational. The rules encourage debt. And we treat long-term capital gains better than short-term ones. That’s absurd. We only buy securities because we think they are undervalued. Why is it better if they rise in price slowly instead of quickly?

It doesn’t end there. Why should you pay income tax on zero-coupon bonds last year just because they rose in value — even if you didn’t sell them or pocket any income? If that’s the rule, why shouldn’t you pay income tax on your Apple stock? Instead you don’t even have to pay capital gains tax, until you sell.

Make the rules simple, rational and clear.

4. The mortgage interest deduction

Uncle Sam should stop bribing me to borrow money I don’t have to buy a home that I cannot currently afford.

The mortgage interest tax deduction is wildly popular, but it’s a terrible idea. The logic is upside down. It rewards debt and real estate speculation. It rewards high earners who buy really pricey homes at the expense of everyone else.

Forget the idea of a “middle-class tax break.” If you’re a typical family, you’re lucky to save a few thousand dollars. But if you’re a bond trader buying a Park Avenue penthouse it could save you $20,000.

Until the recent housing collapse — caused, of course, by too much debt — this tax break helped drive up real estate prices. That priced many ordinary people out of the housing market. They had to borrow even more to get in. Cue the debt crisis. (Or they were forced to rent for longer — and their rents, perversely, weren’t deductible.)

According to various analyses, home owners “save” about $130 billion a year from this break. But that’s nonsense. Tax breaks like this drive up overall tax rates for everybody. To bring them back down, you have to borrow money and buy an expensive home so you can take the deduction.

Get rid of this stupid break and just raise the standard deduction for everyone.

5. Stupid retirement rules

Uncle Sam wants me to save for my retirement. But only under certain conditions. Sure, he says, I can put aside $17,000 in pretax income. But only if I save through my employer’s 401(k) plan. If I’m a regular salaried worker, I can’t go down to Fidelity or Schwab and open my own such plan.

Why not?

For that matter, why am I allowed to invest $5,000 in a Roth IRA, but only if my income is below a certain threshold? Why are married couples filing taxes separately basically not allowed to invest in a Roth IRA at all? And why do the “catch-up” provisions, which allow people to save even more in their IRAs, only kick in once they turn 50? Isn’t that too late? Shouldn’t we be encouraging people to save more when they are younger?

Uncle Sam has some good instincts, but he is like your worst boss or your most annoying aunt. He just can’t stop meddling. He just can’t leave people alone.

Most 401(k) plans are mediocre, because employers run them. They have to protect themselves from costs and liabilities. So they limit the choices, and shunt you into one-size-fits-all investment plans. Yet amazingly they often include one of the riskiest investments you can make — their own stock.

It makes no sense. If Uncle Sam wants me to save $17,000 off the top of my income, he should just let me do so, and get out of my way. And the “catch-up” provisions should affect everyone.

Click here to see the full list of Things I Hate about Tax Day.

IRS Enlists Tax Day to Push Consumers to Save

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By David Wessel | The Wall Street Journal – Thu, Apr 12, 2012 12:01 AM EDT

 
 
For many Americans, Tax Day—April 17, this year—means writing a check. For most it means a refund. Last year, the Internal Revenue Service refunded $300 billion, or 25 cents for every $1 it collected. More than 80% of the 143 million returns filed resulted in a refund.Paying more in taxes during the year than one actually owes amounts to an interest-free loan to the government. Economists used to consider it irrational: The smart thing to do is reduce withholding to come close to matching one’s tax obligation.But new evidence—and insights from behavioral economists—challenge that view and suggest that many people, particularly lower-income Americans, use the tax system to force themselves to save. Now, the government is looking for ways to take advantage of what Mark Iwry, the Treasury point man on saving and retirement issues, calls “savable moments.”

“People want to have a ready way to save,” says Michael Barr, a University of Michigan law professor and a former Obama and Clinton Treasury official. “For some families, tax time is a good time to do so.”

In the mid-2000s, Mr. Barr and colleagues surveyed about 650 low- and moderate-income families in the Detroit area who had filed tax returns in 2003 or 2004. About 82% received refunds—either because they had overpaid or because they qualified for the federal Earned Income Credit, a federal cash bonus to low-wage workers that is paid through the IRS. The average refund exceeded $2,000, a significant sum for people who say they have trouble making ends meet.

Retailers often target refund recipients, and half the Detroiters said they spent all the refund, most often to pay bills or debts or to buy appliances or cars.

Half the recipients saved at least some of the refund. “There is a desire to save,” Mr. Barr says. “The saving is not for retirement. It’s for short-term goals, for financial stability, so if tough times hit, they don’t have to go see the payday lender or go to family and friends or stop eating.”

In fact, Mr. Barr and co-author Jane Dokko of the Federal Reserve Board, found these folks don’t want smaller tax refunds. In the survey, researchers offered them choices: Withhold $100 a month more and get a bigger refund (an option favored by 35%), withhold the same amount and get the same refund (46%) or withhold less and get a smaller refund (only 19%). This and other survey findings appear in a coming Brookings Institution book, “No Slack: The Financial Lives of Low-Income Americans.”

Behavioral economists have found that people respond better to a nudge than a simple up-or-down choice, an observation that has led many employers to automatically enroll workers in retirement-savings plan (and allow them to opt out) instead of asking if they want to enroll or not. A 2005 academic experiment in which some H & R Block customers were offered a 20% or 50% match when they learned the size of their refund if they put money into an Individual Retirement Account proved more successful than the little-understood Saver’s Credit in the tax code that offers much the same incentive.

Pushed by the Treasury and outside academics, the IRS has been experimenting with ways to nudge people to save at refund time. In the mid-2000s, it began allowing taxpayers to split tax refunds between, say, a checking account and a savings account or an Individual Retirement Account. Last year more than 750,000 people took the option, an increase of 36% from 2010.

But that requires the person to have a pre-existing savings account or an IRA; a lot of low-income people don’t. Last year, the Treasury mailed letters to 808,000 taxpayers likely to have low or moderate incomes and offered to load their refunds on a debit card; only 239 took the offer, according to the inspector general for tax administration.

Another experiment appears a bit more promising. Two years ago, the IRS began asking taxpayers if they wanted to use some or all of their refund to buy a U.S. savings bond. Last year, about 30,000 people bought $11.5 million in savings bonds. The program is very small, but growing. So far this year, sales are running 60% above year-ago levels.

While the Treasury is doing away with paper savings bonds for everyone else, it has made an exception for these savers, figuring making the savings tangible is important.

The goal is “to create as many avenues as possible to make it easier to save,” Mr. Iwry says. “Someone who begins saving at least part of their tax refund might acquire the habit and start saving in other ways as well.”

None of this is going to solve the national savings dearth. Most personal saving in the U.S. will continue to be done by people with lots of money to spare. These experiments, instead, are aimed at making individuals a bit more financially secure, a creative attempt to promote a culture of saving in a country with too little of it.

Red flags that tempt the tax auditor

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By Kay Bell • Bankrate.com
 

It is the most dreaded letter a taxpayer can receive.

Dear Taxpayer,
Some of the information that you provided to us does not agree with the information we received from other sources.
– The Internal Revenue Service

You’ve just joined an elite club, one whose initiation ritual is an IRS audit. Unfortunately, you can’t refuse membership — and the dues could be astronomical.

 When the IRS Restructuring and Reform Act was enacted in 1998, lawmakers ordered the agency to focus more on taxpayer rights instead of collection activities. Not surprisingly, the number of audits — or examinations, as the agency prefers to call them — dropped dramatically.

The first year of the kinder, gentler IRS, about 1 in 79 tax returns was audited. By 2003, it was even easier for tax scofflaws; that year, according to IRS data, only 1 in 150 individual taxpayers was audited.

But the tax times, they are a-changing.

More audit attention

IRS Commissioner Doug Shulman says he wants to balance his agency’s enforcement and service responsibilities. To that end, he has announced programs designed to take into consideration the financial struggles that many taxpayers are encountering in today’s economy.

But balance doesn’t mean taxpayers are off the hook. Facing pressure from a Congress dealing with a growing federal deficit, the IRS has made it clear it takes the enforcement portion of its job seriously.

Audits have been increasing, although the pace was slow in fiscal year 2010. According to the IRS’ 2010 annual data book (the latest edition available), individual taxpayer audits last year were up slightly, just more than 1 percent. Of that number, says the IRS, individual income tax returns reporting higher adjusted gross incomes were more likely to be examined.

But the rich aren’t the only targets. Recent tax law changes, particularly when it comes to confusing tax breaks such as the first-time homebuyer credit, always prompt closer looks at returns. And if you’re a small-business person, either as a partnership or a Schedule C filer reporting self-employment income on your personal tax return, make sure you take extra care with your returns.

And those with lower incomes that make them eligible for the complicated earned income tax credit also face added scrutiny. Nearly 30 percent of audited returns claimed this tax credit.

What’s the DIF?

When it comes to avoiding prying IRS eyes, it’s best to be just one of the crowd. “Don’t draw any more attention to your return than you need to,” says Robert G. Nath, author of “The Unofficial Guide to Dealing with the IRS.” “Simple, plain-vanilla returns are fairly safe.”

The IRS says there are several ways a return can be selected for audit and the first is via the agency’s computer-scoring system known as Discriminant Information Function, or DIF. The IRS evaluates tax returns based on IRS formulas, and DIF is based on deductions, credits and exemptions with norms for taxpayers in each of the income brackets.

The actual scoring formula to determine which tax returns are most likely to be in error is a closely guarded secret. But Nath, a tax attorney in the Washington, D.C., area, says it’s no mystery the system is designed to screen for returns that could put more money in the government Treasury.

How do your deductions compare?

Tax experts believe one discriminant information function component looks at average deduction amounts. This allows IRS examiners to spot inconsistencies, such as a high mortgage interest deduction and low income.

Tax specialists at CCH Inc. examined 2009 return statistics, the latest complete data, and came up with the following itemized deduction averages. These are for illustrative purposes only. CCH experts note that the IRS takes a dim view of taxpayers who base their claimed deductions on these figures. The numbers can be useful, however, in giving you a general idea as to whether certain deductions on your return might seem out of line.

Check average deduction amounts
Income range Medical expenses Taxes paid Interest paid Charitable contributions
$15,000-$30,000 $7,783 $3,184 $8,434 $2,048
$30,000-$50,000 $7,028 $3,943 $8,699 $2,274
$50,000-$100,000 $7,269 $6,247 $10,133 $2,775
$100,000-$200,000 $9,269 $11,069 $13,456 $3,888
$200,000-$250,000 $21,599 $18,524 $17,572 $5,947
More than $250,000 $38,149 $48,317 $25,527 $18,488

Allison Einbinder, owner of Dollars & Sense, a tax and accounting firm in Oakland, Calif., recommends that all filers review the differential comparisons. How you stack up against a national standard, she says, will give you an idea of whether the IRS might take a closer look at your return.

So what is likely to trigger a discriminant information function red flag?

  • Higher incomes.
  • Income other than basic wages; for example, contract payments.
  • Unreported income, such as investment returns.
  • Home-based businesses, especially when in addition to salary income, and home-office deductions.
  • Noncash charitable deductions.
  • Large business meal and entertainment deductions.
  • Excessive business auto usage.
  • Losses from an activity that could be viewed as a hobby rather than a business.
  • Large casualty losses.

Returns claiming the earned income tax credit, designed as a tax break for lower-income wage earners, also catch IRS eyes. The credit’s complexity often results in legitimate mistakes on returns. Some filers, however, have been caught making false claims to increase the payment the credit provides.

Schedule C filers who report a business loss also are likely to face more questions from the IRS. The agency wants to be sure that it was indeed the economy, and not an effort to trim taxes, that produced the bad business results.

Don’t cheat yourself

But don’t let fear of a potential audit discourage you from filing for tax credits or taking legitimate tax deductions.

Although some tax return actions are likely to flag your return, Nath says that doesn’t necessarily mean you’ll be audited.

Even if your return is questioned, it’s not a foregone conclusion that you’ll end up owing the IRS. As long as your deductions and expenses are legitimate and you have documentation, Nath says, they will be allowed.

The groundwork you put into preparing your return will pay off in an audit situation. “Be confident in what you entered,” says Einbinder. “That’s easy when you have good records to support your tax return entries.”

And even if an audit doesn’t go your way, don’t despair. “You have rights to contest audits,” Nath says, “at every level of the process.”  

Education loans can provide a tax break

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By Kay Bell | Bankrate.com – Thu, Mar 22, 2012 6:00 AM EDT
 
A good education is a valuable commodity. It can even pay off for you at tax time if you took out a loan to further your schooling.

You might be able to deduct up to $2,500 of the interest you paid on a student loan last year. Your interest will be reported on the Form 1098-E or a similar document you receive from the lender. If the amount of interest shown on that form is less than $2,500, you can deduct only the actual amount of interest you paid.

Any amount you can deduct, however, will help reduce your taxable income, possibly giving you a smaller tax bill.

Filing requirements

You don’t have to itemize to get the student loan interest deduction, but it’s not available to Form 1040EZ filers. Instead, you must file one of the longer returns. The tax break is one of the adjustments to income, also called above-the-line deductions, found right on Form 1040A (line 18) and Form 1040 (line 33).

The Internal Revenue Service also has a filing status restriction when it comes to the student loan deduction. If you’re married, you cannot file separately and get this tax break. Married couples must file jointly to claim the student loan interest deduction.

Regardless of your filing status, if you can be claimed as an exemption on anyone else’s tax return, you’re ineligible for this deduction even if you made the student loan interest payments.

Student and school qualifications

The student for whom the loan was taken out must be you, your spouse or a dependent. A dependent isn’t necessarily a relative, but it must be someone who receives most of his or her support from you.

The IRS also demands that the qualifying student be enrolled at least half-time in a program that leads to a degree, certificate or other educational credential.

The school also must be an eligible educational institution. This is a college, university, vocational school or other post-secondary establishment that meets student aid program guidelines administered by the U.S. Department of Education.

Loan guidelines

Interest payments are deductible over the life of the loan, making those long-term college debts a bit more tax valuable. But there are some other guidelines you must meet.

You must have taken out the loan solely to pay for educational expenses. This means you can’t tack on schooling costs to a personal loan and expect the IRS to approve the interest deductibility.

And don’t double-dip. If you use home equity loan proceeds to pay for schooling, that interest might be deductible as allowable mortgage interest, but you cannot also use it to claim the student loan interest deduction.

The loan, and any interest paid on it, cannot be from a related person. Neither can you deduct interest you paid on a loan you got from a qualified plan offered by your employer.

You must use the loan to pay qualified higher education expenses. These include tuition and fees, room and board, books, supplies, equipment, and other necessary expenses, such as transportation.

These expenses must have been incurred or paid within what the IRS calls a “reasonable period of time” before or after you got the loan. This generally means the costs can be traced to a particular academic period, such as a semester, trimester or quarter. The IRS also accepts schooling payments made within 90 days before the start or after the end of that academic session as reasonable.

One nice option for a financially struggling student is the IRS position on help you get making your loan payments. Even if someone else makes payments on your behalf, if you are the one legally obligated to pay the principal and interest, you can deduct these third-party interest payments on your tax return. The IRS considers such situations as if you received the loan payment money from the third party and then used it to pay your student loan and interest.

Income limits

Also keep in mind that, as with many other tax breaks, the IRS limits the student loan interest deduction if you make more than a certain amount.

The phaseout range amounts are based on your modified adjusted gross income, or MAGI, and are adjusted annually for inflation. For most taxpayers, MAGI is adjusted gross income with certain other tax deductions or income exclusions added back.

On 2011 tax returns, the amount of your student loan interest deduction is gradually reduced if you are a single, head of household, or qualifying widow or widower filer with modified adjusted gross income between $60,000 and $75,000. The income phaseout range for married couples filing jointly is $120,000 to $150,000.

Once you make more than the income range for your status, you cannot take any deduction for your student loan interest.

For more details on the deduction for student-loan interest, check out Chapter 4 of IRS Publication 970, Tax Benefits for Education.

Maximizing your medical deductions

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By Kay Bell | Bankrate.com – Fri, Mar 23, 2012 3:01 AM EDT
 
 

Medical costs seem to increase every year. There is a way to get Uncle Sam to foot some of the doctor bills, but you need to make sure you know and follow the rules.

The Internal Revenue Service lets you deduct medical costs as long as they are more than 7.5 percent of your adjusted gross income. This percentage may seem unattainable at first glance, but with a little tax triage you might just meet it.

Don’t overlook the medical expenses of everyone listed on your tax return. Medical and dental bills for you, your spouse and your dependents count toward reaching the allowable deduction limit. You might be able to count some medical expenses you paid for a parent, even if Mom or Dad isn’t considered your dependent for exemption purposes.

And while it’s not something we want to think about, don’t forget about medical bills you paid for a deceased dependent in the year they were paid, whether before or after the person passed away.

Once you’re confident you know just whose costs are covered, make sure you don’t miss one.

Often-overlooked medical deductions:

  • Travel expenses to and from medical treatments. The IRS evaluates the standard cents-per-mile allowance each year. Because of a midyear inflation adjustment in 2011, you can deduct eligible medical travel between Jan. 1, 2011, and June 30, 2011, at 19 cents per mile. For the last half of the year, the rate was 23.5 cents per mile. For 2012, the medical travel rate is 23 cents per mile.
  • Insurance payments from already-taxed income. This includes the cost of long-term care insurance, up to certain limits based on your age.
  • Uninsured medical treatments, such as an extra pair of eyeglasses or set of contact lenses, false teeth, hearing aids and artificial limbs.
  • Costs of alcohol- or drug-abuse treatments can be counted on your Schedule A.
  • Laser vision corrective surgery is a tax-allowable procedure.
  • Medically necessary costs prescribed by a physician. That means if your doctor told you to add a humidifier to your home’s heating and air-condition system to relieve your chronic breathing problems, the device — and additional electricity costs to operate it — could be at least partially deductible.
  • Some medical conference costs. You can count admission and transportation expenses to the conference if it concerns a chronic illness suffered by you, your spouse or a dependent. Meals and lodging costs while at the seminar, however, are not deductible.

Health-conscious taxpayers also have a friend in the IRS. Weight-loss programs, in some instances, now might count as a deductible medical expense, joining the stop-smoking programs the agency approved earlier.

But don’t try to cheat on your calorie intake or the IRS. The diet program must be medically necessary. Acceptable situations include, for example, when a doctor recommends the regimen to reduce the health risks of obesity or hypertension.

Special medical needs

If you have special needs, however, there are some costs you can write off. Take into account the cost of a wheelchair, crutches, equipment that enables a deaf person to use the telephone or devices that provide television closed-captioning. Don’t forget a Seeing Eye dog or canine for the hearing-impaired, or the costs to retrofit your car with special hand controls or space to hold a wheelchair.

Changes include:
  • Installing ramps.
  • Widening doors and hallways and lowering counters and cabinets.
  • Adjusting electrical outlets and fixtures.
  • Grading exterior landscape to ease access to the house.

Some home remodeling also might be just the prescription for a tax break, as long as you follow your doctor’s orders and IRS rules. If you need, for example, to add a chair lift to get up and down the stairs because of a medical condition, this is considered a legitimate expense.

Changes to your home to make it more accessible for a handicapped resident also are allowable.

Elevators, however, generally aren’t deductible. The IRS considers this a structural change that could increase the value of your house and, therefore, doesn’t allow it as a medical deduction.

In calculating residential remodeling as a medical deduction, keep in mind that you likely won’t be able to write off the full costs on your tax return. If the improvement increases the value of your property, that amount is subtracted from the project’s cost and the difference counts as a medical expense. The value added to your home isn’t lost tax-wise. It will increase its basis so that when you do sell, it will help you in reducing any possible taxes owed on that profit.

Household help to care for you or an ailing dependent isn’t deductible either, even if it’s recommended by your doctor. Such assistance, however, might help you qualify for the dependent care credit.

Medical, but not tax-deductible

Uncle Sam does set some additional medical deduction limits. As a general rule, he doesn’t care how we look.

Cosmetic surgery, health-club dues or costs of a weight-loss program that is not medically necessary aren’t deductible.

Neither are hair transplant operations or, at the other extreme, electrolysis treatments.

And don’t try to write off that expensive bottled water you have delivered each week. Sure, H2O is critical to good health, but the tax collector thinks your tap water will suffice.

For a complete list of what the IRS will and won’t allow you to count toward your medical deductions, check out Publication 502. You might find a few things there that apply to you — maybe just enough to get you over that 7.5 percent deduction hurdle.