Tax planning to minimize tax liability and maximize after-tax returns starts with an understanding of Form 1040, the tax return filed annually by individual taxpayers. My goal in this article is to give the reader a “primer” on Form 1040 and the key considerations that will impact your tax liability.
Status: The first thing you as a taxpayer have to decide is the status under which you’re going to file, because different schedules apply to different statuses.
- To file as a Single, you must be unmarried, divorced, or legally separated on the last day of the tax year.
- To file as Head of Household (which has higher standard deductions and more favorable tax brackets than Single taxpayers) you must be single or separated from a spouse for the last six months of the tax year and pay half the cost of providing a household that is the principal place of abode for a child or dependent for at least half a year.
- To file as Married Filing Jointly, you must be legally married on the last day of the tax year. A widow or widower may file Jointly in the year of the spouse’s death, and for 2 years afterward if he/she continues to provide a household for a dependent child and remains unmarried (the filing would be as a “qualified widow(er)”). When a couple files jointly, the spouses are treated as one person and each is jointly and severally liable for the taxes owed.
- If you are married on the last day of the tax year but you want to avoid being jointly and severally liable for the tax liability, you can choose Married Filing Separately. If you are married, you do not have the option to file as a Single. Your only choices are Married Filing Jointly and Married Filing Separately. Same-sex couples who now are legally married may find themselves disadvantaged being prohibited from filing as Single (which in general is more advantageous than Married Filing Separately).
Gross Income: Unless specifically excluded, all income is subject to tax and must be reported. This includes all forms of compensation, investment income, alimony, income from business, taxable Social Security, annuities, pensions, unemployment income, rents, royalties, and trust income, to name a few. Moreover, income does not have to be in cash. You can also receive income in the discharge of an indebtedness, from services provided, or the transfer of property.
The following exclusions are some of the most common classes or items that are excluded from income: property received as an inheritance or gift; employer contributions for health or accident benefits (in a properly designed plan); workers’ compensation; child support; damages for personal injury; municipal bond interest; employerprovided child care services; payments from insurance (accident, health, long-term care); proceeds of life insurance; certain non-cash fringe benefits; educational assistance provided by the employer up to $5,250; employer-paid group life insurance up to $50,000; distributions from 529 accounts for qualified educational expenses; return of original investment (cost basis); and meals and lodging provided to an employee for the convenience of the employer.
There are several examples of imputed income to note: if you lend more than $10,000 to someone and do not charge at least the applicable federal rate of interest (AFR), the difference between the actual rate and the AFR will be imputed to you, the lender (so you pay taxes on interest you did not receive); if you purchase a bond for less than the amount the issuer will pay at maturity—for example a zero-coupon bond—a portion of the difference between the amount paid and the maturity value will be included in your income each year even though you will not receive the income until maturity; and if you sell property for installment payments and do not charge the AFR, the AFR will be used to discount the planned payments to present value and the difference between the present and future values will be imputed as interest income, taxed at ordinary rates (instead of the more favorable capital gains rates).
Adjusting Gross Income: After you’ve totaled all non-excluded income, you may subtract certain items to arrive at the Adjusted Gross Income (AGI). These subtractions are called “Above the Line Deductions.” Some of the more common ones are: contributions to an IRA up to $5,500 ($6,500 for those over 50), though this is phased out for active participants in a company 401(k) plan who earn more than the threshold compensation (phase out starts at $61,000 for Single filers and $98,000 for Married Filing Jointly); alimony that is paid by the taxpayer (the receiver includes the alimony in his/her income); certain payments by self-employed persons (retirement savings, one-half of the self-employment tax, and medical insurance); penalties on early withdrawals of savings such as CDs; moving related expenses to start work in a new location; interest on qualified educational loans (this is phased out for higher income taxpayers, starting at $65,000 for singles and $130,000 for married couples); up to $4000 of qualified educational expenses (again, phased out at higher income levels); and contributions to a Health Savings Account up to the allowable amount.
Deductions: After calculating the AGI, you apply your deductions. These are “Below the Line” deductions. You can choose to use the standard deduction ($6,300 Single, $9,300 Head of Household, $12,600 for Married Filing Jointly, with an additional amount for those who are over 65 and/or blind), or you can itemize, whichever results in the highest deduction. If you choose to itemize, here are the major categories and their limitations:
- Medical expenses: Although this is a significant cost for most households, you can only deduct medical expenses (insurance premiums, out-of-pocket, dental work, travel for medical care) to the extent they exceed 10% of your AGI. Thus for a married couple earning $175,000 per year combined, only medical expenses in excess of $17,500 are deductible.
- Taxes paid: You can deduct the taxes you paid for personal property (auto), real estate, and state and local taxes.
- Mortgage interest: Mortgage interest is deductible on both a principal and second residence up to a maximum acquisition cost of $1,000,000. Interest on home equity loans is deductible up to $100,000. Points paid on the acquisition of a principal residence are deductible in the year paid.
- Qualified charitable contributions: Contributions of cash or property are deductible from AGI. You can deduct cash contributions up to 50% of your AGI, and appreciated capital gain property up to 20 or 30% of your AGI (depends on the type of entity receiving the contribution).
- Casualty and Theft Losses: Damage or destruction of property losses due to sudden unexpected causes (hurricane, fire, etc.) are deductible for amounts in excess of 10% AGI, less $100 per loss.
- Investment interest: Interest on loans attributable to property held for investment such as interest on a margin account is deductible to the extent of net investment income. Net investment income is the excess of investment income over investment expenses. However, investment expenses are deducted only to the extent they exceed 2% of AGI. Thus a taxpayer with an AGI of $75,000 who pays $2,000 for investment fees can only deduct $500 from his investment income (2% of $75,000 is $1,500, so he can only deduct the $500 excess).
Phase out of itemized deductions: For high income households, itemized deductions are phased out up to 80% of the allowable deductions. Single taxpayers with AGI over $259,400 and Married Filing Jointly with household income over $311,300 will lose deductions equal to 3% of the value to which their AGI exceeds these thresholds.
Personal exemptions: The final deductions are personal exemptions. A personal exemption of $4,050 can be claimed on the taxpayer, the spouse, and dependents. Once again, personal exemptions for high-income taxpayers are phased out beginning at $259,400 for Single filers and $311,300 for Married Filing Jointly. The total amount of exemptions is reduced by 2% for every $2,500 by which AGI exceeds the applicable threshold. A married couple with 3 children would thus lose all personal exemptions when their AGI reaches $436,300.
Calculate Tax Liability: The tax tables provide the progressively higher rates at which income brackets are taxed. The lowest tax bracket is 10% (for Married Filing Jointly income up to $13,250), and the highest marginal tax rate is 39.6% (for Married Filing Jointly income over $441,000). However, there is an additional 0.9% “Medicare” tax charged on all taxable income of Singles over $200,000 and on the income of Married Filing Jointly taxpayers over $250,000. In addition, the Net Investment Income of those high-income households is taxed an additional 3.8% tax on the lesser of net investment income or the excess of modified AGI over those threshold amounts ($200,000 Single, $250 Married Filing Jointly). Long-term capital gains and qualified dividends are taxed at either 0% (taxpayers in the 10% or 15% brackets), 15% (taxpayers in the 25%, 28%, 33%, or 35% brackets), or at 20% for those in the 39.6% bracket.
Credits: Once the liability is determined, certain payments can be claimed as credits to offset dollar-for-dollar the tax liability. Many of these credits are phased out for (and thus unavailable to) higher-income households. Some of the more popular credits include: American Opportunity Tax Credit (up to $2500 per student) for college tuition (subject to phase-out at $80,000 for Single filers, $160,000 for Joint); Child Tax Credit ($1,000 per child, subject to phase-out at $75,000 for Single, $110,000 for Joint); Child and Dependent Care Credit (phase-outs apply); Adoption Credit (phase out for all taxpayers at $201,920); and Premium Tax Credit for those who purchase health insurance through the Marketplace.
Taxes must be paid by the filing date for their returns, whether or not an extension is filed. Payments are typically made throughout the tax year, either through employer withholding or estimated payments. Estimated payments may be based on either 100% of the prior year (110% for Joint filers with AGI over $150,000) or 90% of the estimated current year.