Dorothy in Taxland: Overview

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Dorothy and Toto 1040Many people who use tax computation software don’t understand the changing structure of the U.S. tax code. They fill in the blanks, click Compute and pay the tax. Then they forget about the torture until next year.

Into this dark forest of the tax code, we throw college students and recent graduates. It is almost a rite of passage, better likened to a fraternity hazing than a step into adulthood.

The byzantine rules and regulations of the tax code are carefully crafted to cover up just how much we pay each year. In other words, tax laws are obscure by design. While you are busy trying to translate word problems written in Taxglish, you don’t realize the IRS is asking all the wrong questions. Like Dorothy in the field of poppies, you can’t seem to stay awake long enough to realize the danger.

A professional tax expert can help you get the correct deductions. But he or she likely won’t motivate you to keep the right records unless you understand the benefits for yourself.

The three basic ways to reduce your tax burden are above-the-line deductions, below-the-line deductions and credits. The line in this case is your adjusted gross income (AGI).

Each method is used in one of the four general formulas on the 1040 tax form.

The first formula is “Gross income minus above-the-line deductions equals your adjusted gross income (AGI).”

Above-the-line deductions are subtracted from your gross income to compute your AGI. Therefore, they reduce your AGI, which also lowers your taxable income.

Above-the-line deductions are more common if you are self-employed. But if you are not a small business owner, there are still above-the-line deductions you can take such as stock losses up to $3,000, IRA contributions, student loan interest, moving expenses, alimony and several other items.

Payments to your Health Savings Account (HSA) can also be deducted above the line. In 2010, the family limit is $6,150 in tax-free contributions. One of every 10 patients consumes 69% of health-care costs. The other nine would benefit from an HSA.

The second formula is “AGI minus deductions equals your taxable income.”

Below-the-line deductions are more uncertain. Like many items in the tax code, whether they will reduce your taxes depends on many factors.

You can either itemize your deductions or you can take the standard deduction, whichever is greater. For 2010 the standard deduction is $5,700 if you are single and $11,400 if you are married. And whether you itemize or not, you can take additional personal exemptions of $3,650 each.

Home ownership is the most common way to boost your deductions above the standard deduction. The IRS allows home owners to deduct their interest payments each year. If your home mortgage is at 6% and your payments are mostly interest, most of your mortgage is tax deductible. If your marginal tax rate is near a third, the government is paying 2% of your interest, and you are only paying 4% of your interest. For most middle-class families that results in a large tax savings.

If home ownership alone doesn’t make itemizing worthwhile, your state and local taxes (including personal property taxes) along with any charitable deductions may push you over the top. Alternatively, if you have high medical expenses that exceed 7.5% of your AGI, you can deduct them as well.

In the third formula, after looking up your taxable income, you compute your total tax. Two different methods are used, and the higher of the two must be paid.

The first method uses the traditional tax tables. The second uses the Alternative Minimum Tax (AMT).

The AMT method of computing tax owed undoes many of the deductions you took in previous steps and turns much of traditional tax planning upside down. Increasingly middle-class families are hit by the AMT, whereas upper-class families pay such a high tax rate already, they are unaffected.

The fourth and final formula is “Total tax minus payments equals the amount you owe or have overpaid.”

The critical part of this formula is that payments include not only the money you have given the government but also any tax credits you are eligible to receive.

Deductions only reduce the amount you are taxed on. One dollar of deduction might only be worth 35 cents in tax savings. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And some tax credits are refundable. That could mean the government ends up owing you money you never paid in the first place!

Thus tax credits are much more valuable than tax deductions. But most people fail to claim all their legal tax credits and miss opportunities to gain some real wealth redistribution.

Investment management is central to building wealth. But comprehensive wealth management includes tax management as well. A proactive CPA is another essential component of the team. CPAs do more than just fill out your taxes. They may charge a little more, but they can earn their fee multiple times over.

Photo by Megan Marotta

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.