Over the past months various Congresspersons, among them those who chair and sit on the committees that actually write tax law and the candidates for the Presidency, as well as several politicians at the state level, have proven their total “cluelessness” when it comes to even the most basic of tax knowledge. So I have decided to try to explain to them some of the fundamental concepts of the 1040. I am aware of the level of intelligence of the average Congressperson, so I will try to explain the law as simply as possible.
If any of this is “over your head” please feel free to ask questions via posting a comment.
Basically the US Internal Revenue Code says that “everything is taxable ‘except’ . . .” and “nothing is deductible ‘except’ . . .” It is in the “exceptions” that the meat, and complexity, of the tax law lies.
There are three types of tax benefits – exclusions from income, deductions and credits (well actually four if you also add the special capital gains and “unrecaptured Section 1250” tax rates – but that is an item for another post).
Among the more familiar exclusions from income are interest from municipal bonds and dividends from funds that invest in municipal bonds, most life insurance proceeds, gifts, all or part of Social Security and Railroad Retirement benefits (based on the taxpayer’s filing status and level of income), etc.
The availability of a tax deduction or a tax credit (or in the case of taxable Social Security or Railroad Retirement benefits an exclusion from income) often depends on the level of the taxpayer’s income – generally the taxpayer’s Adjusted Gross Income (AGI) or the Adjusted Gross Income with some minor modifications (MAGI). Over the last 20+ years Congress has felt that what they consider to be higher-income taxpayers do not deserve certain tax breaks and have decided to place various different AGI or MAGI “phase-outs” on various different deductions, credits and exclusions. To insure confusion the income ranges are different for just about each deduction, credit or exclusion that is phased-out.
There is a big difference between a deduction and a credit – which seems to confuse most politicians.
A deduction is a dollar for dollar reduction of taxable income. If your taxable income is $100,000 and your allowable deductions total $50,000 you will calculate your tax liability based on $50,000 of net taxable income.
The value of a deduction depends on one’s individual tax bracket. A deduction of $1,000 will be worth $250 (put an additional $250 in your pocket – or reduce what you will owe by $250) to a taxpayer in the 25% bracket, only $150 to someone in the 15% bracket, but $350 to one who falls in the 35% bracket. It is possible that a deduction of $1,000 will push you into the next lower tax bracket, so part of the deduction will be worth, say 25%, and part worth 15%.
There are two types of deductions – those that are allowed “above the line” and those that are claimed “below the line”. The “line” is your Adjusted Gross Income.
Deductions that are allowed “above the line” include business deductions claimed on Schedule C (self-employment income), Schedule F (self-employed farm income) and Schedule E (rental income and income related to “pass-through” entities such as partnerships, Sub-S corporations and estates and trusts), the expenses of selling a capital asset that are included in the cost basis of the asset when calculating gain or loss on Schedule D, and “adjustments to income” such as educator expenses, IRA and self-employed pension contributions, qualified tuition and fees, one-half of the self-employment tax paid on Schedule SE, qualified health insurance premiums for self-employed taxpayers, moving expenses, student loan interest, etc. All of these deductions are taken on Page 1 of the Form 1040.
“Above the line” deductions reduce your Adjusted Gross Income and so could reduce the amount of tax benefits that are “phased-out” based on AGI or MAGI (as discussed above), thereby increasing certain other tax benefits. Because of this an “above-the-line” deduction of $1,000 could actually reduce your net taxable income by much more than $1,000. As a result such deductions are “more better” than those that are allowed “below the line”.
Deductions that are claimed “below the line” include the standard deduction, plus any additional amount for age, blindness and real estate taxes paid, the deduction for personal exemptions, and Itemized Deductions reported on Schedule A - such as real estate taxes, state income taxes or state sales taxes, mortgage, home equity and investment interest, contributions to church and charity, gambling losses (to the extent of winnings reported as income) and excess medical, casualty and theft, job-related and investment expenses.
An itemized deduction is only of tax benefit if the total amount of your allowable itemized deductions exceeds the total standard deduction allowed for your filing status and situation. Making a contribution of $1,000 to charity will provide absolutely no tax benefit if you are single and your total itemized deductions, including the contribution, are only $4,000. Charities may advertise that you will get a tax deduction if you give them your used car – but this is not true if you are not able to itemize.
(Not to complicate matters, but there may be occasions when you are either required to, or will pay less tax if you, claim itemized deductions when the total is less than your appropriate standard deduction – again a subject for another post.)
The tax benefit of a deduction claimed “below the line” is always limited to the amount of the actual deduction. A $1,000 “below the line” deduction will only reduce your net taxable income by $1,000. So a “below the line” deduction is not as good as an “above the line” deduction.
A credit is a dollar for dollar reduction of actual tax liability. A credit of $1,000 will be worth $1,000 to every single taxpayer, regardless of one’s tax bracket. A credit of $1,000 means that you can put $1,000 in your pocket, or reduce what you owe by $1,000. In most cases a credit is better than a deduction, regardless of where the deduction is located in relation to the “line”.
The personal exemption deduction for a child, $3,500 for 2008, is worth $525 “in pocket” for a taxpayer in the 15% tax bracket. Claiming a $1,000 Child Tax Credit is the same as putting $1,000 in your pocket, and this is true whether you are in the 15% bracket or the 25% bracket.
A tax credit is of no benefit if you already have a “0” tax liability – unless the credit is “refundable” (like the Earned Income Credit or in some cases the Child Tax Credit). A $1,000 Hope Education Credit will put $0 dollars in the pocket of a couple who has already reduced their tax liability to “0” using other deductions and credits.
Similarly a deduction will be of no tax benefit if your net taxable income is already “0”.
Tax deductions, whether above or below the line, are allowed in calculating net taxable income. Tax credits are allowed after the initial tax liability has been calculated. So there are occasions when a deduction is better than a credit – if claiming the deduction reduces your net taxable income to “0” so that you will not receive any tax benefit from a non-refundable credit.
I don’t want to overtax (pun intended) the brains of any Congresspersons or other politicians, knowing of their limited attention span, so I better end here. I hope my little “primer” has been of some help. John or Barack, Joe or Sarah, Chuck or Jon – any questions?