Thursday, March 11, 2010

Life for Less: Taxes, Part Deux (In English, please?)

Matt gives me a hard time for speaking almost entirely in acronyms. It's true, I'm cursed. In fact, I'd say all CPAs (that's Certified Public Accountants, for those of you who've been looking at my profile & thinking to yourself, huh?!) have a tendency to abuse acronyms.

Can you blame me? After graduating from UofI with a BA in Accy and MST, I passed the CPA exam &  started my career at PwC, in the PCS group. I saved all of my work in DMS, complied with our QRM policies, squeezed in L&E & met my PC&D goals. Eventually I moved to the PFS group where I learned a whole new slew of acronyms..... and I've been consistently speaking in letters ever since.

When I start talking taxes, I effortlessly shift into accountant-speak and sometimes forget that not everyone is wired like me. In fact, most people aren't.

So I'm going to break down some basic terms (& acronyms!) you should be familiar with when filing your tax return. For those of you about to tune out since you pay someone to prepare your returns or use a software, I would urge you to read this quick overview since you dang well should understand what you're signing. Lastly, I want to assure you that it's okay to be a little clueless the first time you expose yourself to personal financial / tax matters. In all fairness, I frequently call my dad with questions about my own taxes / personal finances. He's a smart dude, loves me & is more than willing to help me make sense of the things I don't understand:
 Thanks, Dad!
Let's start at the top of a 1040 and work our way down with some key terms: 

Filing Status: Are you single? MFJ (married filing jointly)? MFS (married filing separately)? Head of household? Qualifying widow(er)? Quick tip: your filing status is determined by your status on the last day of the tax year. That means if you're a calendar year taxpayer and you got married in 2009, you would file either MFJ or MFS. See definitions of the different statuses in these instructions.

Exemptions:  Exemptions are reductions of your income for you & your dependents. For 2009, you may claim exemptions of $3,650 for yourself, your spouse (if you file a joint return) and any of your dependents. I get quite annoyed when I see babies with t-shirts like this. Children don't give you an extra deduction they generate a dependency exemption. Here's an example: Matt & I are married and file a joint return. We get 2 exemptions of $3,650 each for a total of $7,300. $7,300 of our income is exempt from tax. 

Gross Income: I hope this is pretty straightforward. Your gross income is the sum of any income you've earned that's subject to tax. Duh, right? I should note that some income isn't subject to federal income tax (like interest from municipal bonds) but those exceptions are few & far between. 

Above the Line Deductions: Deductions are typically expenses that you've incurred that the IRS allows you to deduct from your income. "Above the line" deductions can be taken regardless of whether you choose to itemize or take the standard deduction (more on that later). Examples include student loan interest, contributions to a health savings account or a traditional IRA, moving expenses, educator expenses, etc. 

Adjusted Gross Income (AGI): This is your gross income minus any above the line deductions. This is "the line" that the deductions are above. 

Below the Line Deductions: Here's where you have a decision to make as a taxpayer.... You may either take the standard deduction or itemize your deductions, whichever is bigger! 

Standard Deduction: This is where your filing status comes into play. Your standard deduction is determined by your filing status. For 2009, standard deductions are $5700 for single of MFS, $11,400 for MFJ. 

Itemized Deductions: You may choose to itemize your deductions instead of taking the standard deduction. You'd only want to itemize if the sum of your Schedule A deductions exceeds your standard deduction for your filing status. Generally speaking, itemized deductions include: medical and dental expenses in excess of 7.5% of your AGI, state & local income taxes, real estate taxes, home mortgage interest, investment interest, charitable contributions, certain job expenses & miscellaneous deductions in excess of 2% of your AGI, etc. Here's my rule of thumb, if you own a home, there's a good chance your itemized deductions will exceed your standard deduction, but for most 20somethings who are not homeowners, the standard deduction is typically the way to go. 

Taxable Income (TI): Adjusted gross income minus your exemptions and either your standard or itemized deduction. 

Alternative Minimum Tax (AMT): Just in case you haven't paid enough tax already, you may also be subject to the alternative minimum tax. This tax was intended to capture high-income taxpayers from benefiting from loopholes in the tax code and paying less tax than the government thought they should. Problem is, due to inflation, many middle income taxpayers are now subject to AMT. AMT has it's own set of rules and, quite frankly, is pretty darn confusing. For that reason, I'm not going to use this blog to try to explain it. Read this if your interest is piqued. You may be exempt from AMT all together. 

Credits:Whereas credits & exemptions reduce your INCOME, credits reduce your TAX dollar-for-dollar. Examples of some federal tax credits are the child tax credit, education credits, retirement savers credit, making work pay credit, etc...

Pop Quiz! If my taxable income is $100,000 (wishful thinking) and I'm taxed at a 10% rate (again, unrealistic), what is more valuable -- a credit or a deduction of $1,000?
  • If I have a $1,000 deduction, my income would be reduced to $99,000. At a 10% rate, I'd pay $9,900 in taxes.
  • If instead I have a $1,000 credit,  my income would remain $100,000. At a 10% rate, my tax would be $10,000. I could then take my $1,000 credit, reducing my tax liability to $9,000.
  • Which would you rather have? A $1k deduction or credit? The credit, of course! In this scenario I'd pay $900 less in taxes!
Here's a recap of the simplified individual tax formula. Forget what something means? Refer to your handy-dandy definitions above:
    Gross Income
    Less     Above the Line Deductions
    Equals Adjusted Gross Income
    Less    Standard Deduction or Itemized Deduction
    Less     Personal & Dependency Exemptions
    Equals Taxable Income
    Times   Tax Rate
    Equals  Tax
    Plus      Alternative Minimum Tax
    Less     Credits
    Equals Tax Payable or Refund

    Clear as mud? Great.

    Sorry.... My anal retentive side is telling me this is necessary: Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, I inform you that any U.S. federal tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.

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