IN THIS CHAPTER

Figuring out taxable income and marginal tax rates

Decreasing your taxable employment income

Boosting your deductions

Making tax-wise investment decisions

Writing off your educational costs

Surveying your options for tax help

Taxes are likely one of your largest expenses along with your housing costs. So you should be highly motivated to reduce your taxes within the boundaries of the law. And you need to understand enough of the tax laws and rules so you don’t get whacked with penalties and interest charges. This chapter can help you stay on the right side of the law and understand what strategies you can use to legally and permanently reduce your income taxes.

Understanding Taxable Income

Your taxable income is income on which you actually pay income taxes. For example, your employment income and the interest you earn on bank savings accounts and certificates of deposit (CDs) are all federally taxable. By contrast, interest paid on municipal bonds is generally not federally taxable. As I discuss later in this chapter, some income, such as from stock dividends and long-term capital gains, is taxed at lower rates than ordinary income.

Knowing your taxable income is important because it can help you focus on strategies for legally lowering it. When doing your federal income tax return, you calculate your taxable income by subtracting deductions from your income. Certain expenses, such as mortgage interest and property taxes, are deductible in the event that these itemized deductions exceed the standard deduction. (See the later section “Increasing Your Deductions” for more details.) When you contribute to qualified retirement plans, you also get a deduction, just as you do if you put money into a health savings account.

Comparing Marginal Taxes

My purpose in writing this chapter is to help you legally and permanently reduce your taxes. Understanding the tax system is the key to reducing your tax burden.

As an important starting point, you need to understand the concept of marginal tax rates. Get out your most recent year’s federal and state income tax returns and look up the total taxes you paid that year. Many people don’t know this amount (perhaps in part because it’s too often a depressingly large number) but instead can tell me whether they got a refund. Remember — all a refund reflects is the repayment to you of some tax dollars because you overpaid your taxes during the year.

Regarding taxes, not all income is treated equally. This fact is far from self-evident. If you work for an employer and earn a constant salary during the course of a year, a steady and equal amount of federal and state taxes is deducted from each paycheck. Thus, it appears as though all that earned income is being taxed equally.

In reality, however, you pay less tax on your first dollars of earnings and more tax on your last dollars of earnings. Your marginal tax rate is the rate of tax you pay on your last, or highest, dollars of income. For example, if you’re single and your taxable income totals $40,000 during 2017, you pay federal tax at the rate of 10 percent on the first $9,325 of taxable income, 15 percent on income between $9,325 and $37,950, and 25 percent on income between $37,950 and $40,000. Your marginal tax rate is 25 percent. Your total marginal rate includes your federal and state tax rates, as well as local income tax rates in the municipalities that have them. You can look up your state income tax rate in your current state income tax preparation booklet or on your state’s government website. Table 6-1 shows the federal income tax brackets for single folks and married couples filing jointly for 2017.

The marginal tax rate is a powerful concept that allows you to determine the additional taxes you have to pay on more income. Conversely, you can calculate the amount of taxes you save by reducing your taxable income, either by decreasing your income or by increasing your deductions.

Reducing Taxes on Work Income

When you earn money from work, you’re supposed to pay income tax on that income. Some people avoid taxes by illegal means, such as by not reporting such income (doing that isn’t really possible if you’re getting a regular paycheck from an employer), but you can very well end up paying a heap of penalties and extra interest charges on top of the taxes you owe. And you may even get tossed in jail. This section focuses on the legal ways to reduce your income taxes on work-related income.

Increasing Your Deductions

Deductions are amounts you subtract from your adjusted gross income before calculating the tax you owe. The IRS gives you two methods for determining your total deductions and allows you to select the method that leads to greater deductions and lower taxes.

The two methods are as follows:

• Standard deduction: If you have a relatively simple financial life, taking the standard deduction is generally the better option. Those who are blind or who are age 65 or older get a slightly higher standard deduction.
• Itemized deduction: Itemizing your deductions on Schedule A of IRS Form 1040 is the other method for determining your allowable deductions. Itemizing tends to make more sense for those who earn a high income, own their own home (mortgage interest and property taxes are itemized deductions), and/or have unusually large expenses from medical bills, charitable contributions, or loss due to theft or catastrophe.

If you don’t currently itemize, you may be surprised to discover that your state income taxes can be itemized. Also, when you pay a fee to the state to register and license your car, you can itemize a portion of the expenditure as a deduction (on Schedule A, “Personal Property Taxes”). The IRS allows you to deduct the part of the fee that relates to the value of your car. The state organization that collects the fee should be able to tell you what portion of the fee is deductible. (Some states detail on the invoice what portion of the fee is tax-deductible.)

Several states have state disability insurance funds. If you pay into these funds (check your W-2), you can deduct your payments as state and local income taxes on Line 5 of Schedule A. You may also claim a deduction on this line for payments you make into your state’s unemployment compensation fund.

A number of miscellaneous expenses are also deductible on Schedule A to the extent that they exceed 2 percent of your AGI (adjusted gross income). Most of these expenses relate to your job or career and the management of your finances:

• Work-related educational expenses: You may be able to deduct the cost of tuition, books, and travel to and from classes if your education is related to your career. Specifically, you can deduct these expenses if your course work improves your work skills. Courses required by law or your employer to maintain your position are deductible. Continuing education classes for professionals may also be deductible. Note: Educational expenses that lead to your moving into a new field or career are not deductible.
• Expenses for job searches and career counseling: After you obtain your first job, you may deduct legitimate costs related to finding another job within your field. You can even deduct the cost of courses and trips for job interviews — even if you don’t change jobs. And if you hire a career counselor to help you, you can deduct that cost as well.
• Expenses related to your job that aren’t reimbursed: When you pay for your own subscriptions to trade journals to keep up with your field, or you buy a new desk and chair to ease back pain, you can deduct these costs. If your job requires you to wear special clothes or a uniform (for example, you’re an EMT), you can deduct the cost of purchasing and cleaning these clothes, as long as they aren’t suitable for wearing outside of work. When you buy a computer for use outside the office at your own expense, you may be able to deduct the cost if the computer is for the convenience of your employer, is a condition of your employment, and is used more than half the time for business. Union dues and membership fees for professional organizations are also deductible.
• Investment and tax-related expenses: Investment and tax-advisor fees are deductible, as are subscription costs for investment-related publications. Accounting fees for preparing your tax return or conducting tax planning during the year are deductible; legal fees related to your taxes are also deductible. If you purchase a home computer to track your investments or prepare your taxes, you can deduct that expense, too.

Lowering Investment Income Taxes

The distributions and profits on investments that you hold outside of tax-sheltered retirement accounts are exposed to taxation. Interest, dividends, and capital gains (profits from the sale of an investment at a price that’s higher than the purchase price) are all taxed. The good news: You can take action to reduce the taxes in those accounts. This section explains some of the best methods for doing so.

Enlisting Education Tax Breaks

The U.S. tax laws include numerous tax breaks for education-related expenditures. Here are the important tax-reduction opportunities you should know about for yourself and your kids if you have them:

• Tax deductions for college expenses: You may take up to a $2,500 tax deduction on IRS Form 1040 for college costs as long as your modified adjusted gross income (AGI) is less than $65,000 for single taxpayers and less than $135,000 for married couples filing jointly. (Note: You may take a partial tax deduction if your AGI is between $65,000 and $80,000 for single taxpayers and between $135,000 and $165,000 for married couples filing jointly.)
• Tax-free investment earnings in special accounts: Money invested in Coverdell Education Savings Accounts (ESAs) and in Section 529 plans is sheltered from taxation and is not taxed upon withdrawal as long as the money is used to pay for eligible education expenses. Subject to eligibility requirements, you may contribute up to $2,000 annually to Coverdell ESAs. 529 plans allow you to sock away more than $200,000. However, funding such accounts may harm your kid’s qualifications for financial aid.
• Tax credits: The American Opportunity and Lifetime Learning credits provide tax relief to low- and moderate-income earners facing education costs. The full credit (up to $2,500 per student) is available to individuals whose modified adjusted gross income is $65,000 or less, or $130,000 or less for married couples filing jointly. The credit is phased out for taxpayers above that. The credit can be claimed for expenses for the first four years of postsecondary education. You may be able to claim an American Opportunity tax credit in the same year in which you receive a distribution from either an ESA or 529, but you can’t use expenses paid with a distribution from either an ESA or 529 as the basis for the American Opportunity credit.

Preparing Your Tax Return and Minimizing Your Taxes

Every year that you earn money, you’ll probably complete a federal and state income tax return. Regardless of which approach you use to prepare and file your returns, you should take financial moves during the year to reduce your taxes.

Here are some resources to help:

• IRS materials and guidance: If you have a relatively simple, straightforward situation, filing your tax return on your own by using IRS instructions and pamphlets is okay. However, recognize that their publications don’t go out of their way to highlight tax-reduction opportunities. And if you call the IRS with questions, know that the IRS has been known to give wrong information from time to time. For you web surfers, the Internal Revenue Service website (www.irs.gov) is among the better Internet tax sites, believe it or not.
• Preparation and advice guides: Books about tax preparation and tax planning that highlight common problem areas and are written in clear, simple English are invaluable. They supplement the official instructions, not only by helping you complete your return correctly but also by showing you how to save as much money as possible. Please visit my website (www.erictyson.com) for up-to-date recommendations.
• Software: Good tax-preparation software can be helpful. TurboTax is a good program that I’ve reviewed. If you go the software route, I highly recommend having a good tax advice book by your side.

• Professional hired help: Competent tax preparers and advisors can save you money by identifying tax-reduction strategies you may overlook. They can also help reduce the likelihood of an audit, which can be triggered by blunders. Tax practitioners come with varying backgrounds, training, and credentials. The more training and specialization a tax practitioner has (and the more affluent his clients), the higher his hourly fee usually is. Fees and competence vary greatly.

  Enrolled agents (EAs) must pass IRS scrutiny in order to be called an enrolled agent. This license allows the agent to represent you before the IRS in the event of an audit. Continuing education is also required; the training is generally longer and more sophisticated than it is for a typical preparer. Returns that require some of the more common schedules (such as Schedule A for deductions) cost about $250+ to prepare. To obtain names and telephone numbers of EAs in your area, contact the National Association of Enrolled Agents (NAEA) at 202-822-6232 or www.naea.org.

  If you’re self-employed and/or you file lots of other schedules, you may want to consider hiring a certified public accountant (CPA). But you don’t need to do so year after year. If your situation grows complex one year and then stabilizes, consider getting help for the perplexing year and then using preparation guides, software, or a lower-cost preparer or enrolled agent in the future. CPAs go through significant training and examination before receiving the CPA credential. In order to maintain this designation, a CPA must also complete a fair number of continuing education classes every year. CPA fees vary tremendously. Most charge $100+ per hour, but CPAs at large companies and in high-cost-of-living areas tend to charge somewhat more.