What's Your Tax IQ?

March 16, 2011

Dear Readers,

It's tax time again and I'm getting lots of questions about how to reduce your tax bill. What to report? What not? What to deduct? While the tax code is complex, there are some basics everyone can—and should—understand. So whether you do your own taxes or work with a professional, brush up on these concepts. It will help you ask smart questions and make sure you're taking advantage of legitimate breaks. Because, bottom line, it's not how much you earn but what you keep that counts.

—Carrie

What's included in total or gross income?
To calculate your total or gross income you need to add together your earned income (wages, salary, tips, commissions and bonuses) and your unearned income (dividends, interest, capital gains).

That may seem to cover just about everything. But, fortunately, there are some types of income the government doesn't touch. These are called exclusions and include a gift or inheritance, child support, life insurance proceeds following the death of the insured, municipal bond interest, disability income if you paid the premium with after-tax dollars, and certain employee fringe benefits.

Another bit of good news is that once you've added up your total income, you can start subtracting.

How do you determine adjusted gross income (AGI)?
Right off the bat, you can subtract certain things from your total income, such as a deductible contribution to an IRA or 401(k), alimony payments, qualified moving expenses and certain education expenses. If you're self-employed, you can subtract contributions to a small business retirement plan as well as health insurance premiums and half of the self-employment tax. The result is your AGI.

Your AGI is important because it determines your eligibility for certain other deductions and credits, as well as for a Roth IRA.

Should you choose standard or itemized deductions?
Once you know your AGI, the next step is to subtract either the standard deduction or your itemized deductions from your AGI—whichever is greater. If your financial situation is straightforward, the standard deduction might be the best and simplest choice. The 2010 standard deduction is $5,700 for single filers, $11,400 for married filing jointly.

If you own property, run a business from home, have paid extensive medical bills or manage a lot of investments, you might be better off itemizing deductions. Itemized deductions include property taxes, state and local income taxes, specified medical and dental expenses that exceed 7.5% of your AGI, mortgage interest, margin interest paid, charitable contributions, casualty and theft losses and more. You can get a full list of legitimate itemized deductions at irs.gov.

What's a personal exemption?
You can also subtract personal exemptions from your AGI. Personal exemptions are determined by the government and indexed annually for inflation. The 2010 personal exemption is $3,650. You can claim one exemption for yourself, one for your spouse if you’re married and filing a joint return, and one for each qualified dependent, which can be a child or other relative.

What's the difference between marginal and average tax rates?
Once you've done all the subtracting, you're left with your taxable income—the amount you actually pay taxes on. This also determines your tax bracket. Here's where more confusion comes in because, in reality, you don't pay a flat rate on your taxable income. Rather, taxes are graduated. Here's an example.

Let's say you're single and your taxable income is $40,000, putting you in the 25% tax bracket. That 25% is your marginal tax rate, which is the percentage you pay on the last dollar of your taxable income. In actuality, according to the 2010 tax tables, you'd pay 10% on the first $8,375 of taxable income, 15% between $8,375 and $34,000—and 25% on anything above that. That would give you an average tax rate of just over 15%. That sounds a lot better!

Who qualifies for a tax credit?
When it comes to reducing taxes, there's one more thing to be aware of: tax credits. A tax credit reduces the taxes you owe dollar for dollar. A $100 credit means you pay $100 less in taxes. There are a number of tax credits available depending on your income and personal situation, including credits for qualified adoption expenses, child and dependent care credit, residential energy credit and the Earned Income Tax Credit (more on that next week).

Why it matters
You don't have to be a CPA or get bogged down in details, but these basics can go a long way in helping you use tax software or talk to a tax professional more knowledgably. Plus, while none of us enjoys paying taxes, feeling confident that you're not paying more than you owe may make it a little easier.

Important Disclosures

The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.

(0311-1857)



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