The weeks building up to the April 15 filing deadline for personal income tax returns can often be a stressful and confusing time for taxpayers. Concerns for one’s personal wealth can mount amid a last-minute flood of tax advice that takes many forms, comes from many sources and, at times, offers conflicting points of view on a given topic.
The University of Alabama’s Dr. Shane Stinson offers a few items to keep in mind when evaluating your personal income tax return.
• A large refund isn’t necessarily a win for the taxpayer.While it is generally more desirable to receive a check at tax time than to write one, a large annual refund may be a better indicator of an overpayment issue than of real tax savings. Before celebrating a sizeable refund, consider the following:
◦ It’s your money. Generally speaking, an income tax refund represents the amount by which income tax withholdings and other payments exceed a taxpayer’s final tax liability.Thus, a large refund may simply be the result of a large overpayment and/or poor estimate of taxable income during the year. In this instance, refund dollars represent real income that the taxpayer could have used throughout the year (for consumption, savings, investment, etc.), but, instead, loaned to the government free of interest.
◦ Withholding allowances can be adjusted.Taxpayers generally complete Form W-4 to determine proper withholding allowances each time they start a new job. However, subsequent events such as the birth of a child or a change in marital status can drastically change the amount of payroll withholdings necessary to satisfy a taxpayer’s annual income tax liability. As these major life events occur, it may prove useful to submit a new Form W-4 to your employer in hopes of preventing excessive overpayments rather than waiting for a sizeable refund after your federal income tax return has been processed. This same tactic can work in reverse for taxpayers who tend to withhold too little during the year and have to make large payments (subject to penalties and interest) to the government with each tax return.
◦ Safe harbors allow some margin of error in withholdings and estimated payments.Taxpayers can avoid underpayment penalties if their withholdings and estimated tax payments meet one of two safe harbor requirements. Current safe harbor provisions require that a taxpayer’s total payments made during the year equal or exceed the smaller of (1) 90 percent of the current tax liability or (2) 100 percent of the previous year’s tax liability (110 percent for individuals with adjusted gross income over $150,000).
• Two important questions about deductions – Where and when?
◦ Where? Personal deductions are broadly categorized by their location on Form 1040. First, “For AGI” deductions are deducted from gross income to calculate adjusted gross income, or AGI. Next, “From AGI” deductions are deducted from AGI to determine a taxpayer’s final balance of taxable income. Subtleties in the Internal Revenue Code make this distinction immensely important when preparing a personal income tax return.
• The determination of AGI is critical.“For AGI” deductions (student loan interest and qualified moving expenses, for example) are sometimes preferable to “From AGI” deductions because AGI is a common threshold used to limit the benefit of various tax incentives. For instance, many tax credits and “From AGI” deductions are reduced when AGI exceeds a particular threshold. Thus, by taking advantage of “For AGI” deductions to reduce AGI, a taxpayer may stand a better chance of qualifying for other incentives that are phased out for high income individuals.
◦ When? In addition to the “For AGI” or “From AGI” distinction, the timing of activities that produce income tax deductions is critical. For example, “bunching” is a common strategy in which a taxpayer makes multiple tax-deductible expenditures in the same year in order to maximize the benefit of itemized deductions. Itemized deductions are a subset of “From AGI” deductions that are taken when their allowable total exceeds the standard deduction set by the IRS for a given filing status, but unused itemized deductions typically expire at the end of the taxable year they are generated. Thus, while there are often non-tax reasons to engage in many of the activities that qualify for itemized deductions (charitable giving, investment, and home ownership, for example), the amount of tax savings generated by these activities depends, in part, on the taxpayer’s ability to group them in the same year.
• Tax deductions and credits are vastly different incentives.While tax deductions and credits can both be used to put more money in the hands of taxpayers, they work in very different ways. In general, tax credits reduce a taxpayer’s tax liability dollar-for-dollar, whereas tax deductions reduce a taxpayer’s taxable income dollar-for-dollar. As a result, the amount of tax savings generated by a deduction depends on the taxpayer’s marginal rate of tax (i.e., his or her tax bracket), making it impractical to compare deductions and credits based solely on the face value of the incentive. For activities that require a taxpayer to choose between receiving a credit or a deduction (higher education expenses, for example), this distinction generally requires a taxpayer to estimate his or her tax liability using each method of incentive before choosing the one with the most favorable result.
Stinson is an assistant professor of accounting in UA’s Culverhouse School of Accountancy.