Taxes

A quick tax season reader question for today:

“I’m a little confused about exemptions. When you start a new job, you’re required to complete a W-4. Don’t you have the option to claim how many exemptions you want? For example, when I started my job a few years ago, I claimed “0″ so that I’d get more taxes taken out and then get a refund at tax season (rather than possibly owe more at tax time).

However, I’m married and have a son. Should I be claiming “3,” or is that automatically done by my tax preparer when doing my taxes? In other words, am I missing out on my 3 exemptions because I didn’t claim them on my W-4?”

You’re confusing two separate concepts: exemptions and allowances.

Exemptions are claimed on your Form 1040. They reduce your taxable income and, therefore, your income tax. You are allowed one exemption for yourself, one for your spouse, and one for each qualifying dependent.

Allowances are claimed on Form W-4 — when you start a new job, for instance. Each allowance you claim reduces the amount of your income that is withheld for taxes. The point of Form W-4 is to help your employer estimate how much tax you’ll owe on the wages they pay to you, so that they can withhold the appropriate amount from your paychecks.

The link between the two concepts is that the maximum number of allowances you can claim depends on (among other things) the number of exemptions you’re allowed to claim — though, if you want, you can choose to claim fewer allowances than the amount to which you’re entitled.

In other words, choosing not to claim the maximum number of allowances on your W-4 will only increase the amount of income tax withheld from your paychecks. It will not have any effect on your ability to claim the appropriate number of exemptions on your Form 1040.

For More Information, See My Related Book:

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less See it on Amazon.

• The difference between deductions, exemptions, and credits,
• Itemized deductions vs. the standard deduction,
• Several money-saving deductions and credits and how to make sure you qualify for them,
• Click here to see the full list.

A testimonial from a reader on Amazon:

• Read other reviews on Amazon

January 25, 2012 3 comments

Most years, I update the three tax-related books in the “in 100 Pages or Less” series shortly after tax season ends. (So, for example, updates for 2012 will be started in the second half of April 2012, once the 2011 tax season has ended.) This past year, however, the CPA exam put me several months behind schedule, and I didn’t start book updates until September.

As of last week though, all three tax books have been updated with 2011 info, just barely in time for the 2011 tax season. To kick tax season off, I thought I’d put each of the three books on sale for a couple days so that regular readers can get them at a reduced price.

The details: Each of the three following books will be on sale for $5 (print) or $0.99 (Kindle) — rather than the normal list prices of $15 for print and $4.99 for Kindle — until Friday at noon (CST):

• Taxes Made Simple: Income Taxes Explained in 100 Pages or Less
• LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
• Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

A Favor to Request

For some reason, Amazon has refused to link the old edition of the LLC vs. S-Corp vs. C-Corp book to the new edition, so there are no reviews on the book’s Amazon page at the moment. If you purchase the book and end up finding it helpful, I’d be super appreciative if you took a few minutes to write a brief 2-3 sentence review explaining why you liked it.

And, as always, if you buy any of the books and find that you don’t like it, please send me an email so that I can send you a refund. (The refund is limited to one refund per household per title though, so, for example, please don’t purchase 50 copies of a given book unless you’ve already read it and know that you like it.)

For More Information, See My Related Book:

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less See it on Amazon.

• The difference between deductions, exemptions, and credits,
• Itemized deductions vs. the standard deduction,
• Several money-saving deductions and credits and how to make sure you qualify for them,
• Click here to see the full list.

A testimonial from a reader on Amazon:

• Read other reviews on Amazon

January 11, 2012 0 comments

Rebecca writes in to ask,

“Because of my work (I’m a physician), I’m in a high tax bracket (33% federal). I was recently contacted by a financial advisor who suggested a variable annuity as a way to minimize my taxes because the growth in a variable annuity is tax-deferred. I’ve also heard plenty of bad things about variable annuities though. What do you think? Would an annuity be useful in my situation?”

First let’s cover some background information to make sure we’re on the same page.

How Deferred Variable Annuities Are Taxed

You are not taxed on growth that occurs within a variable annuity. You are taxed, however, when you take money out of the annuity.

How you are taxed depends on whether or not you have “annuitized” the annuity. (To annuitize an annuity is to convert it to a series of substantially equal periodic payments over a specified period — the rest of your life, for instance.)

If you have not annuitized the annuity, distributions of earnings will be subject to ordinary income tax, while distributions of the original cost of the contract are tax-free. Note, however, that distributions are assumed to come from earnings until all earnings have been withdrawn.

If you have annuitized the annuity, distributions will be partially taxable as ordinary income and partially tax-free. The portion that is non-taxable is calculated so as to return the original cost of the annuity to you, without taxation, over your life expectancy. If  you live long enough to receive the original cost of the annuity tax-free, any remaining payments will be entirely taxable.

Finally, distributions from a variable annuity prior to age 59½ will also be subject to a 10% penalty — with a few exceptions.

Note: All of the above assumes that the variable annuity is not held within a qualified retirement plan such as a 403(b). If the annuity is held within such a plan, the annuity will be taxed just like anything else in the plan. (In other words, you get no additional tax benefit from using an annuity within a qualified retirement plan.)

When Are Variable Annuities Useful for Tax Planning?

While variable annuities do have the benefit of tax-deferral, they have two major disadvantages.

First, they’re expensive. According to Morningstar, the average variable annuity (without any optional riders) costs 2.42% per year. Even at Vanguard, the average variable annuity costs 0.59%. This is in contrast to index funds or ETFs, which can be found for less than 0.20% per year in most asset classes.

Second, they turn income that would ordinarily be taxed at advantageous rates (e.g., qualified dividends and long-term capital gains) into ordinary income.

Because of these two drawbacks, variable annuities generally aren’t beneficial as a tax planning tool for most investors. In general, the only time they should be considered for such purposes are when three conditions are met:

1. You have already maxed out your contributions to IRAs and qualified retirement plans,
2. You’ve filled up your tax-advantaged accounts with your least tax-efficient asset classes (e.g., REITs and high-yield bonds), and
3. You still want to own more of those asset classes (such that they’d have to go into a taxable account or a variable annuity).

For More Information, See My Related Book:

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less See it on Amazon.

• The difference between deductions, exemptions, and credits,
• Itemized deductions vs. the standard deduction,
• Several money-saving deductions and credits and how to make sure you qualify for them,
• Click here to see the full list.

A testimonial from a reader on Amazon:

• Read other reviews on Amazon

December 12, 2011 4 comments

Note: This article covers tax brackets for 2012. See here for the 2011 tax brackets, which will apply to the returns due 4/17/2012.

The Bureau of Labor Statistics recently released the CPI-U figure for August of this year, thereby providing the last piece of information needed for the calculation of the 2012 tax brackets.

The reason the August inflation figure is the last piece needed to calculate next year’s tax brackets is that, according to the internal revenue code, for purposes of calculating tax brackets:

“The cost-of-living adjustment for any calendar year is the percentage (if any) by which the CPI for the preceding calendar year, exceeds the CPI for the calendar year 1992. [...] The CPI for any calendar year is the average of the Consumer Price Index as of the close of the 12-month period ending on August 31 of such calendar year.”

So, in short, to calculate a given year’s tax brackets, you take the 1992 tax brackets, adjust the tax rates based on the Jobs and Growth Tax Relief Reconciliation Act of 2003, then adjust the applicable income levels upward in keeping with inflation.

If the upper income limit for any tax bracket determined in the above manner is not a multiple of $50, it’s rounded down to the nearest multiple of $50 — with the exception of married filing separately tax brackets, for which you round down to the nearest multiple of $25.

As it turns out, the September 2010 – August 2011 average CPI-U was 2.43% higher than the September 2009 – August 2010 average CPI-U. And that leaves us with the following tax brackets. (Thanks to the Tax Foundation for doing the math, and to their analyst Nick Kasprak for explaining it to me!)

A quick reminder before we get to the tax bracket tables: Being in a given tax bracket does not mean that all of your income will be taxed at that rate. Rather, only the portion of your income that is in that bracket will taxed at that rate. (See this article for a more complete explanation.)

Single 2012 Projected Tax Brackets

Married Filing Jointly 2012 Projected Tax Brackets

Head of Household 2012 Projected Tax Brackets

Married Filing Separately 2012 Projected Tax Brackets

Projected 2012 Standard Deduction and Exemption

The standard deduction and personal exemptions are calculated similarly (that is, using annual inflation figures from September-August) but with different base years (1987 for the standard deduction and 1988 for exemptions).

For 2012 the projected personal exemption is $3,800, and the projected standard deductions are:

• $5,950 for single taxpayers and married taxpayers filing separately,
• $11,900 for married taxpayers filing jointly, and
• $8,700 for taxpayers filing as head of household.

The additional standard deduction for taxpayers who are blind or over age 65 is projected to remain unchanged at $1,450 for single taxpayers and $1,150 for married taxpayers.

Important caveat: Everything above is subject to change. Should any new tax legislation be passed before the end of this year (or passed in 2012 and made effective for that year), this information could turn out to be entirely incorrect.

For More Information, See My Related Book:

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less See it on Amazon.

• The difference between deductions, exemptions, and credits,
• Itemized deductions vs. the standard deduction,
• Several money-saving deductions and credits and how to make sure you qualify for them,
• Click here to see the full list.

A testimonial from a reader on Amazon:

• Read other reviews on Amazon

September 21, 2011 5 comments

Jane writes in to ask,

“I’m considering giving a large-ish gift to my son to help him purchase his first home. I think I understand that he won’t have to pay any tax on this gift, but I might have to. Is that correct? And how do I know if I have to pay any tax?”

Will the Recipient Have to Pay Any Tax?

The recipient of a gift does not pay any tax on that gift. Gifts are not included in taxable income, and the gift tax only applies to the person giving the gift, not to the person receiving it.

Will the Giver Have to Pay Any Tax?

The person giving the gift is subject to the gift tax, but, for a few reasons, there won’t actually be any tax owed in most cases.

First, none of the following types of transfers will result in taxable gifts:

• Gifts to your spouse,
• Gifts to a qualifying charity,
• Gifts to a political organization for its use, and
• Payments made directly to an educational institution or health care provider for somebody else’s tuition or medical expenses.

And for gifts that don’t fall under any of those exclusions, you can still give up to $13,000 per year to each recipient without the gift being taxable. (If you’re married filing jointly, you and your spouse can give a total of $26,000 per year to each recipient.)

In addition, even if you pass that $13,000 annual exclusion amount, you still have a long way to go before you actually have to pay any taxes. That’s because you also have a “unified credit” that exempts the first $5,000,000 of otherwise-taxable transfers that you make.

I say “transfers” rather than “gifts” because this credit is also the one that exempts your estate from estate tax when you die. So the more of it you use by giving gifts during your lifetime, the less of it you’ll have available to offset estate taxes for the benefit of your heirs. Still, for most people, $5,000,000 is plenty–more than enough to offset all the gifts they make during their lifetime as well as their entire estate.

Important note #1: Like tax brackets and many other aspects of our tax code, this $5,000,000 figure is something of a political football. It gets kicked around from year to year, so there’s no guarantee that it’ll still be set at $5,000,000–rather than at some lower number–at any particular point in the future.

Important note #2: If you exceed the annual $13,000 exclusion in any year, you do have to file a gift tax return (Form 709), even if you don’t have to pay any tax.

If you do end up exhausting your entire unified credit, the tax rates on the taxable amount of your transfer can be found in the instructions to Form 709.

How about an Example?

Raymond is an unmarried taxpayer. He’s never made any taxable gifts before. In 2011, he makes the following gifts:

• $80,000 to the American Red Cross,
• $10,000 to his nephew, and
• $20,000 to his niece.

How much gift tax will Raymond have to pay? Zero.

• Raymond’s gift to the Red Cross isn’t taxable because it’s a gift to a qualifying charitable organization.
• Raymond’s gift to his nephew isn’t taxable because it’s less than the $13,000 annual per-recipient exclusion amount.
• $7,000 (that is, $20,000 — $13,000 annual exclusion) of Raymond’s gift to his niece will be taxable. But Raymond will not have to pay any gift tax because of his $5,000,000 lifetime exclusion amount. After this year, his remaining exclusion amount will be $4,993,000 (or $5,000,000 — $7,000).

Note, however, that Raymond will have to file a gift tax return for the year because the gift to his niece exceeded the annual $13,000 exclusion.

Generation-Skipping Transfer Tax

If you make a gift to somebody two or more generations below you (e.g., your grandchild), the transfer could be subject to the generation-skipping transfer tax, which is a separate tax in addition to the gift tax. But, like the gift tax, it comes with a large lifetime exemption (currently $5,000,000) that you’d have to exhaust before owing any actual tax.

For More Information, See My Related Book:

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less See it on Amazon.

• The difference between deductions, exemptions, and credits,
• Itemized deductions vs. the standard deduction,
• Several money-saving deductions and credits and how to make sure you qualify for them,
• Click here to see the full list.

A testimonial from a reader on Amazon:

• Read other reviews on Amazon

August 17, 2011 8 comments