I wanted to take a shot at an orthogonal topic where I recently did some reading on.. We always wonder about the jargons used in filing taxes. Every year, though I replenish some information that I need to know about taxes, I forget it faithfully the next year. This blog is an attempt to capture some of the information that I learnt. Hopefully, it will be helpful, atleast to me…:)
Most of what I talk about in this blog is extracted from the IRS document http://www.irs.gov/pub/irs-pdf/p17.pdf for those who are excited about reading more on taxes. Also, for the most part, I am assuming a simple case (either single or married and filing jointly). So, dont expect advanced technical information. This is just a very simple tutorial to understand the basic terminologies.
I will start with the basic equation. You pay tax on the income that you earned…a no brainer..:).. You can choose to Deduct portions of the income if you spent it on certain qualified expenses. This is called the Itemized Deduction. By default, the government gives you a standard amount that you can deduct for which you dont have to pay tax. That, my friend, is the standard deduction. Clear so far…
Tax = (Income – Deductions)*Tax Rate [Tax Rate % determined by tax bracket]
Income ==> Salary, Stock Options, Employee Stock Purchase Plan etc.,
Deductions ==> Standard Deductions OR Itemized Deductions
Standard Deductions => $4850 for single and $9700 for married filing jointly
Itemized Deductions => Medical & Dental Expenses, Home Mortgage Interest Expense, Home Mortgage Points, Charitable Contributions, Casuality, Theft & Disaster Losses, Business Entertainment/Travel/Car/Use of Home expenses, Educational Expenses, 401k/IRA contributions, Property Tax.
I hope the equation is very clear now. You can only claim standard OR itemized deduction and not both. You will claim one vs other based on which one is higher…obviously… As you can see from the data above, if your itemized deductions is lesser than $9700 (mfj)/$4850 (single), you will choose to file standard deductions. With turbo tax software, you dont have to make a decision in the above cases.
The next immediate question is how much of itemized deductions can I claim. Right now, the IRS has limits on each items categorized under itemized deductions. But, they dont have a single number for the entire category. However, since wealthy people made use of the loopholes in itemizing more to claim more money from being taxed, there comes the rule of AMT (Alternate Minimum Tax).
AMT is very simple to understand. If you earn more than $58000 (joint filers)/ $40250 (single), then for every extra dollar of income, the tax rate is 26% for first $175,000 and 28% on the excess (mfj). IRS picks the tax that you owe by taking the bigger of the 2 numbers (number computed with AMT and with standard/itemized deductions). This is to prevent people from claiming too much of itemized deductions. AMT does not have any deductions. However, AMT is not adjusted for inflation. As housing prices and property taxes go up by a bigger fraction than income and the average income also being high, more people get affected by AMT. Also, AMT considers buying stock-options from your employer to be a capital gain. If your employer gave you a bunch of stocks for $1 and while quitting the company, you chose to buy those options at the set price and if the current price then was $100, even if you dont really realise the gain by selling the stocks, the $99 of un-realized income is counted as a capital gain. There is a proposal to take out AMT from the equation in the future and constrain the itemized deductions (especially mortgage interest rates exemption).
That is all there is to know about taxes in general. The easiest ways of using up the itemized deductions are 401K/IRA contributions (since the return on those investments is also tax deferred) and companies usually pitch in an amount, mortgage interest rates and charitable contributions. Especially, since there are different tax brackets for different income, if you are close to getting into a higher bracket*, you might be better off by contributing more to 401K ($14000 annual limit) or to charity than keeping quiet.
Hopefully, you learnt something …
Thats all folks !!
*TAX Bracket information:
Joint return Single taxpayer Tax Rate (%)
$0-$14,600 $0-$7,300 10.0
14,601-59,400 7,301-29,700 15.0
59,401-119,950 29,701-71,950 25.0
119,951-182,800 71,951-150,150 28.0
182,801-326,450 150,151-326,450 33.0
326,451 and up 326,451 and up 35.0