Your accountant hands you your completed tax return. You pull out your checkbook to pay the accountant’s fee that you pay every year. But wait…WHAT? Your bill is $1,100??? The experience of owing more than you expected is a common one, and it can be avoided by gaining a fundamental understanding of how your income is taxed and the factors that influence your overall tax bill. If you can achieve a basic level of understanding with regards to your income tax return, you will be better equipped to communicate with your accountant and financial advisor.
Whether you’ve already filed your tax return or you’ve filed an extension, grasping these concepts will help you get a grip on your tax situation and reduce the chances of a surprisingly expensive tax bill.
A good starting point is Adjusted Gross Income, or “AGI.” In essence, AGI is your income from all sources less any applicable adjustments to income. These adjustments include items such as IRA contributions and student loan interest, among others. Adjustments to income are referred to as “above the line” deductions. AGI is an important number to know because its application goes beyond your tax return. AGI is also the number used by banks, mortgage brokers, and many financial aid programs to determine your eligibility for the products and services offered by those institutions.
Taxable Income is the amount of income that is subject to income tax. To determine your taxable income, you subtract from AGI any deductions and exemptions that apply. These deductions that are taken after you’ve determined your AGI are called “below the line” deductions.
To add a level of complication to what we’ve just discussed, some types of income (such as insurance proceeds, child support, and workers’ compensation) are generally not subject to income tax.
Social Security benefits are a different animal completely. Is it taxable? It depends. If your income is low enough, none of your Social Security income will be taxable. However, if your income is high enough, you may be paying tax on 85% of your Social Security benefit.
Winnings, whether from gambling or winning an all-expense-paid vacation from a radio contest, are taxable. Think the IRS will never know that you won that vacation? They probably will. Most companies that award those prizes will send you a form 1099 for the value of the prize, and they will also report the prize to the IRS. If you have gambling losses, you can offset your taxable winnings for that year with those losses, as long as you have proof of the loss.
If you receive a state income tax refund and you itemize your deductions, that refund may be taxable. Talk to your accountant or financial advisor about the types of income you receive if you have questions regarding how your income is taxed.
Fundamentally, there are three methods of reducing your tax bill: You can reduce your income, increase your deductions, and/or take advantage of tax credits.
Reducing income: I do not mean to imply that you should take a lower paying job or work less hours (although, that would certainly reduce the amount of tax you are paying). Reducing income is a very common strategy among the self-employed. For example, if you are self-employed, you can reduce income in a given year by timing your business expenses. Only the self-employment income in excess of expenses is subject to tax. Tread carefully, though, as reporting less income means that you may not qualify for the mortgage on your dream home. Remember that lenders use the figures you report on your tax returns to determine your loan eligibility.
Increasing Deductions: A deduction allows you to reduce the amount of taxable income by the amount of the deduction. Deductions become more valuable to you as your income rises. If you are in the 10% tax bracket, a $1,000 deduction will knock $100 off your tax bill. If you are in the 25% tax bracket, a $1,000 tax deduction reducing your tax bill by $250.
Taking advantage of Tax Credits: Unlike tax deductions, tax credits are a dollar for dollar reduction of the tax you owe. If you have a tax credit of $1,000, then your tax bill is reduced by $1,000. Accordingly, a tax credit has the same dollar value regardless of which tax bracket applies to you. Most credits are non-refundable, which means that if your tax credits total more than your total tax liability, the IRS won’t refund you the difference. There are a few refundable credits, such as the Earned Income Tax Credit and the Child Tax Credit. Ask your accountant about any tax credits for which you may qualify.
With a basic understanding of how your income is taxed and with a little consideration and guidance throughout the year, tax season can become far less intimidating.
Ali Bach, CFP®
Financial Advisor
Conte Wealth Advisors, LLC
www.contewealth.com
Registered Representative Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Conte Wealth Advisors are not affiliated.