Everyone gripes about all the tax loopholes and shelters that decrease the tax burden of the world’s Warren Buffetts and Mitt Romneys. Why aren’t there any tax shelters for the rest of us?
There are. Tragically, a lot of people don’t know about them, so they leave money sitting on the government’s table.
Now then: This isn’t a book about taxes, so it’s important to realize that the summaries below are shortened and simplified. Many of these tips come with footnotes—they’re available only if your income is under a certain figure, or they have an upper limit, or they’re available only if you itemize your deductions, or they’re subject to change with each year’s new tax laws.
In short, think of this list as a conversation starter—for you and a tax expert. The idea is that you don’t want to miss out on a deduction, credit, or shelter because you didn’t think to ask about it.
The 42 deductions available to everyone
There are dozens of deductions and credits that you could be taking advantage of but may not know about. Skim this list and make sure you’re getting all you should be!
• Standard deduction. This is a deduction the government gives you for just being you. The amount depends on your income, but it’s in the thousands. If you’re at least 65 by year’s end, and your income is under $20,000 or so, the deduction is even higher.
• Dependents. Each child you have is worth a deduction of about $4,000. Nice going, kids!
• State, local, and foreign taxes. It wouldn’t make sense for the government to tax you twice on the same income, would it? Nope. So you can deduct sales tax, property tax, and income taxes you’ve paid to your state, city, or another country.
• Donations to charity. You need a receipt or letter as proof. Your donation can be cash, physical things (like clothes or household stuff), expenses for volunteer work (like the gas to drive yourself there), or property (appraisal fees).
• Profit from selling your home. Here’s one of the last big tax shelters. If you made a profit from selling your home after living there at least two years, the first $250,000 of profit is yours, tax-free. (If you’re married and filing jointly, make that $500,000.) Ka-ching!
• Hobby expenses. If you made money from a hobby (stamp collecting, antiquing, etc.), you can deduct what you spend on it. See? Your government really does care about you.
• Mortgage insurance premiums. Yep, if you pay mortgage insurance, you can deduct it.
• Tax preparation. You can deduct what you pay someone to do your taxes, and the cost to file them electronically.
• Social Security taxes. If you’re self-employed, and you’ve had to pay the 15.3 percent Social Security tax on your earnings, here’s a little blessing: You can deduct half of it.
• Tuition. Deduct up to $4,000 you’ve paid for school (yours or your kid’s).
• The interest you’ve paid on mortgages and student loans. There are various limits and footnotes.
• Mortgage points. If you paid “points” to get your mortgage or building loan, you can deduct them.
• Medical, dental, and nursing-home costs, if they’re very high (over 10 percent of your income). You can even deduct the cost of renovations to your home if it was for medical reasons.
• Expenses finding a job. Ads, agency fees, résumé prep and printing, transportation to interviews, that kind of thing.
• Moving expenses for a new job. Both moving companies and your own travel.
• Travel expenses for military reservists. If you have to travel more than 100 miles for your service, you can deduct the travel, meals, and hotel.
• Business use of your home. Home office? Inventory storage for your shop? Day care? Great! Deduct all the expenses you pay for that piece of your home. If the office is 15 percent of your home’s square footage, then deduct 15 percent of the taxes, insurance, heating, cooling, electricity, maintenance, phone bills, depreciation, and so on.
• Business use of your car. If driving is part of your job, great! Deduct your gas, parking, and insurance costs. If you don’t feel like calculating all that, use 54 cents a mile (or whatever the IRS’s current cents-per-mile allowance is).
• Business travel expenses that your job doesn’t reimburse you for. Planes, meals, hotels, laundry, the whole thing.
• Employee expenses. If wining and dining clients is part of your job (entertainment, gifts, meals, driving), you can deduct some of it.
• Education expenses. Yep—you can deduct up to $2,500 per higher-education student to pay for expenses like school supplies. Even if the student or a relative is paying those expenses in the first place!
• Investment fees. If you pay an adviser, or you’ve paid a bank or broker to collect interest and dividends, you can deduct those payments.
• Losses in your IRA. In the unlikely and terrible event that you cashed out your IRA or Roth IRA and got less than what you put in, you can deduct the difference.
• Income you gave back. If you were overpaid in a previous year and had to return some of the money, you can deduct what you gave back. Otherwise, it just wouldn’t be fair.
• Certain legal fees. You can deduct lawyers’ fees that involve either taxes or collecting money that you’ll pay taxes on—like what you paid a lawyer to get the alimony you’re owed, or attorney fees related to doing or keeping your job.
• Safety-deposit box rentals. If you rented one of these boxes to store investment documents, you can deduct the rental fee.
• Gambling losses. If you won some and lost some, you can deduct what you lost up to the amount you reported having won.
• Disaster losses. If something bad happened to your house or car, you can deduct the losses that weren’t covered by insurance.
• Estate tax on an IRA. Someone rich who loves you passed away, which is very sad. But in his will, he left you his IRA, which is less sad. The estate was so big, the government charged estate tax, which is sad. But if you paid the estate tax on that IRA, you can deduct it, which is less sad.
• Teacher’s expenses. You, dear teacher, can deduct up to $250 for books, computers, and other teaching supplies (that you weren’t reimbursed for).
• Health savings accounts (HSAs). An HSA is a special, tax-exempt savings account that you can use to pay for medical expenses. And you can deduct what you pay into it.
• Dependent care flexible spending account (FSA). Here’s another special kind of savings account, this one containing funds you spend to take care of a child or a disabled spouse or parent. The first $5,000 you put into this account is deductible.
• Union dues, including initiation fees.
• Uniforms for your job. You can deduct the cost of your uniforms (nurse, usher, surgeon, police officer) and even safety gear. Sorry, suits and dresses don’t count as uniforms.
• Alimony. If you have to pay alimony to your ex, at least you don’t have the pain of being taxed on that amount. (Your ex gets to pay the taxes!)
• Health insurance (if you’re self-employed). Medical and dental, baby. Off the top, no limits.
• Early-withdrawal penalties. If you withdrew money from a CD or some other time-fixed account and had to pay a penalty, you can deduct it.
• Contributions to your IRA. Pay into that retirement account, dear reader. That’s $5,000 or $6,500 you can deduct right off the top. (Roth IRAs not included.)
• 401(k) or SEP contributions. Anything you pay into this retirement account is deductible, too. (SEP means a Simplified Employee Pension—the retirement account of choice if you’re self-employed.)
• Car registration. Yep—in some situations, you can deduct what you paid for your car’s license.
• Jury-duty pay. OK, so you served on a jury. After the first few days, the court paid you the tiny amount that they pay jurors. But your boss is enlightened and cool (or lives in a state with laws about this sort of thing) and paid your salary anyway. In that case, you don’t get to keep both your salary and what the court paid you; you have to give your boss the jury-duty pay. You can deduct that money from your income (duh).
• Bad debts. If you lent out money and there’s no chance of getting it back, then you can deduct it—and you can learn a lesson.
A good tax-preparation person knows about all of these already, of course, and (in theory) should already be applying them for your benefit. But if you do your own taxes, or if you want to make sure your tax person isn’t missing anything, this could be a handy list indeed.
The magic of the tax credit: Are you getting ’em all?
There’s a big difference between a tax deduction and a tax credit.
A deduction lowers the amount of income you use to calculate your taxes. Suppose, for example, that you pay 30 percent of your income in taxes. If you made $1,000 this year (well done!), and you get a $100 deduction, then you’ll be taxed as if you earned only $900. You’ll pay $270 instead of $300. The tax deduction saved you $30.
But a tax credit subtracts money from your taxes, not your income. If you made $1,000 this year, and you get a $100 tax credit, then your taxes will be $200 instead of $300. The tax credit saved you $100.
Therefore, missing out on a tax credit is a really big boo-boo. Make sure you know them all! As usual, these are only pointers; there are footnotes and limits on most of them.
• Earned income tax credit. The EITC is meant to help out people earning less than $50,000 or so, especially working parents with children. The amount you get varies according to your income and number of kids, but it’s worth between $500 and $6,200.
• Child-care credit. If you pay someone to take care of your kid while you’re at work—like a nanny, preschool, daycare, before- or after-school care, even summer day camp—you can get 20 to 35 percent of that back as a tax credit. Maximum credit is $1,050 for one kid, or $2,100 for two or more. (It’s for kids under 13, but it’s also available if you paid someone to care for an adult who’s incapable of self-care.)
• Child credit. Kids: They’re the gifts that keep on giving. If you earn less than $75,000 (or $110,000 if you’re married and filing jointly), you can subtract $1,000 per kid from your taxes. You still get this credit if you earn more than that, but the credit drops by $50 for every $1,000 you make over the $75,000 threshold.
In some cases, this credit comes out to more than your entire tax bill—the IRS will pay you.
• Saver’s tax credit. Your government really, really wants you to save for retirement.
The saver’s tax credit is intended for low- to middle-income workers—those earning less than $60,000 (married couple filing jointly), $45,000 (head of household), or $30,000 (everyone else).
If you can manage to sock away some money for retirement, you can subtract that amount from what you owe in taxes. If all goes well, in fact, this credit can reduce your tax all the way down to zero!
You can deduct either 50 percent, 20 percent, or 10 percent of your retirement-account contribution, depending on your income.
For example, suppose you’re married (it could happen). Together, you and your spouse make $36,000 a year. Each of you socks away $1,000 in a retirement account, like an IRA or 401(k). Boom: You can subtract 50 percent of that from what you owe in taxes—a handy $1,000 IRS discount.
• American Opportunity Credit. If you earn less than $80,000 (or $160,000 filing jointly), then you can get up to $2,500 in tax credits for money you’re paying for someone’s college bills—every year. (If your income is higher, you get a smaller amount back.)
If you like, you may prefer the Lifetime Learning Credit, which is similar. It gives you back 20 percent of what you spend to go back to school yourself, for any reason, at any school. The credit is $2,000, tops. (You can’t claim both of these credits in the same year.) This one’s available if you earn less than $65,000 a year (or $130,000 married).
• Alternative energy credit. Have you blessed your home with the installation of clean-energy systems like solar water heaters, geothermal heat pumps, or wind turbines? The IRS thanks you—by kicking back 30 percent of the total cost, including labor. That is one huge, warm credit.
• Traditional energy upgrades. Even if you upgrade your home’s non-newfangled energy systems, the government will refund 10 percent of the cost (up to $500 in credit). That covers heat pumps, central air conditioning, water heaters, furnaces, insulation, roofs, windows, doors, and skylights.—jean Loughran
Secrets of the 529 plan
Your government wants only the best for you. It really does.
As proof, consider the 529 plan. The goal is to persuade you to set aside money to pay for your kid’s college education now, while the kid is still too young to pronounce “deductible nonfarm income.”
The incentive is protecting that money from being taxed. In any normal investment, you have to pay tax on the amount your money grows over the years, but not in a 529 plan. Essentially, you get to hide it from the IRS—legally.
There are lots of even more attractive aspects to this tax shelter that most people don’t realize. For example:
• Both parents can contribute to each kid’s account. Grandparents can contribute, too. The maximum amount varies by state, but you can kick in $14,000 per parent/ grandparent without triggering gift taxes. And if you’ve got the cash, you can (and should) front-load the account by filling it with up to five years’ worth of $14,000 contributions. That is, a married couple could pour $140,000 into a 529 plan today, and marvel as it grows along with the child—tax-free.
• You don’t have to use your own state’s plan. Every state runs its own 529 plan, but some are much better than others. For example, 34 states let you deduct your 529 contributions on your state income tax return. Six states (Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania) let you deduct your contributions even if you’ve chosen a different state’s plan.
On the other hand, you should also consider the fees and other aspects of any plan. You really need to do some web research (or consult an adviser) to figure out where to open your plan.
• There’s a pretty generous definition of “expenses.” Once your kid’s in college, you can use the money from the 529 account to pay for almost anything: tuition and fees, room and board, books, supplies, computers, printers, software used for school, and even Internet access.
• You control the money. Unlike some other kinds of contributions to your children, you control this money, even after the kid is 18.
Some parents really like this part.
• You can spend it on anyone. What happens if your offspring founds an Internet startup at age 17 and doesn’t go to college? Or gets a scholarship and doesn’t need the 529 money?
Amazingly enough, you’re allowed to switch the beneficiary. You can use that 529 money to pay for a different kid’s college education—even a niece, nephew, stepchild, or friend. You can even skip a generation and use the money for your children’s children. In fact, you can even use the money yourself if you decide to go back to school.
You’re also welcome to sweep leftover money from one child’s 529 plan into another’s.
• It’s good for more than just college. You can use the 529 money for a trade school, graduate school, or professional program.
And in case you were wondering: If you take out 529 money to spend on anything other than education, you do have to pay taxes on its growth, plus a 10 percent penalty for abusing the system.
Overall, there aren’t many decent tax shelters left for everyday Americans. But this one is yours for the taking.
What to do if you win the lottery
First of all, don’t play the lottery.
Oh, sure, buy a ticket as entertainment, or as a gift of fun for someone’s birthday or graduation. But your chances of making big money from a lottery ticket are roughly the same as if you set fire to the money you used to buy it.
When the jackpot is big, your odds of winning are one in hundreds of millions. You’re more likely to be born with 11 fingers or toes (1 in 500), date a supermodel (1 in 88,000), get struck by lightning (1 in 700,000), or be killed by a mountain lion (1 in 32 million).
But let’s say you enter for fun and you win. Here’s what you have to do:
• Keep your life stable. Harder than it seems. Depending on the study you read, either 44 percent or 70 percent of all big lottery winners are broke within five years. Lottery winners experience higher rates of depression, drug and alcohol problems, divorce, and suicide than the general public.
The reason is simple: Other people will find out that you’ve got money. You’ll be buried by requests for money. Guilt trips. Manipulation. Arguments. Investment schemes. Everyone who’s ever been nice to you will come at you with open hands.
Therefore, your first step should be to hire a financial adviser. Funnel all requests to that person, and spare yourself the nightmare.
• Consider the taxes. By the time the government takes its 40 percent in taxes and your state takes its cut, a $300 million prize is down to $162 million. And remember: Even if you give some of your money to a friend, you have to pay the taxes on it—a little thing called the gift tax.
• Make the right payment choice. When you win, you’ll be offered a difficult choice. You can take the $300 million in yearly installments spread out over 30 years (the annuity option). If you want it all right now, you have to accept a smaller amount (say, $172 million).
Most people take the smaller amount right now, but that could be a bad decision. You definitely need a financial pro to help you decide, because taxes, the stock market, and lots of other factors affect this decision. But here are some elements you may not have considered:
First, the annuity option (annual payments) continues even after you die; they’re part of your estate. So it’s not like you and your descendants will get shortchanged if you pass away before the 30 years is up.
Second, the annuity usually results in a smaller tax bite.
And, finally, the annuity means you won’t be able to blow your whole fortune in the first five years. You’ll be protected from yourself.
Are you living in the right place?
At tax time, your federal income tax is only the beginning of your headache. In most states, you also have to pay state income tax, which takes another chunk out of your income.
But not if you live in Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, or Wyoming. In those states, there’s no state income tax. (Sometimes they compensate with steep property or sales taxes, though.)
Not that you’d move just to save a few percent of income tax. But if you’re considering two job offers, and one’s in New Hampshire … well, you know.