If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan.  Stop by HERE for a complete list of classes currently available and HERE for more information about the website.

Class Objectives: To understand the basics of calculating and projecting income taxes using Form 1040.
Prerequisites: TX301: Income Tax Basics
Handout: none
Assignment: Download the income tax spreadsheet for Excel | Google Docs (previews in lecture material below)

CLASS LECTURE

We covered the very basics of income taxes in TX301.  Hopefully, you went through your tax return and understand your income and deduction items so that you have a good basic understanding of your personal tax situation.

The goal of this additional class is to cover some of the additional rules and exceptions that may apply to you.  We are moving past the overview formula presented in the previous class and now we are going to take the jump to looking at the actual 1040 Form and Schedules.

I’m going to present you with this spreadsheet first.  I’ve set up this spreadsheet for this class with the purpose of matching the 1040 return line items so that you can easily calculate your tax projection for current and future years.  The reasons I like to use a spreadsheet to project my taxes include:

• I can easily change numbers to run different scenarios without having to go through the numerous inputs and screens involved in tax software programs.
• I can create sheets for actual and projected salary, wage and investment income and have it directly link to the tax calculation.
• I can project future taxes easily before tax software comes out for that tax year (generally tax brackets, exemptions and phaseouts are released early enough to be beneficial in planning this way).

Starting with the Form 1040 spreadsheet, we cover the basic summary from income and deduction items, credit and overall tax liability.

The Schedule A spreadsheet covers the itemized deductions:

The Schedule B and D spreadsheet covers investment income such as interest, dividends and capital gains:

Last are the calculations for tax on qualified dividends and capital gains and Alternative Minimum Tax:

QUALIFIED DIVIDENDS

We covered the basic tax brackets and tax rates for federal tax purposes, however, there are special rates that apply to qualified dividends and capital gains.

A qualified dividend is an ordinary dividend that is paid from domestic corporations and qualified foreign corporations.  In addition, an investor must meet certain holding requirements as well for the stock (I won’t bore you with all the details).

How will you know if your dividends are qualified?   Your brokerage firm will just tell you on a 1099-DIV tax form how much of your ordinary dividends (line 1a) are qualified (line 1b).  Why do you care if they’re qualified?  Only qualified dividends are eligible for special tax rates.

CAPITAL GAINS & LOSSES

Capital gain is the profit (sales price minus what you paid originally) from the sale of a capital asset, such as a stock share.  Everything you personally own is essentially a capital asset.  If you own a small business, inventory would be an example of an asset that is not capital in nature.

A short-term capital gain occurs when you own the asset for less than a year.  A long-term capital gain occurs when you own the asset for one year or more.  Why is this important?  Long-term capital gains are taxed at preferential tax rates, while short-term capital gains are taxed at ordinary tax rates (the tax tables we covered in Income Tax Basics).

If you receive capital gains from a stock sale, you will receive a 1099-B from your brokerage firm.

A capital loss occurs when you have the unfortunate circumstance of selling your capital asset for less than what you paid for it.  Capital losses are also separated into short-term and long-term holding periods.

Capital gains and losses are netted together to determine the total gain or loss, however, capital losses are limited to only $3,000 per year.  The remaining amount can be carried forward to use on your income tax return in future years.

The process of netting capital gains and losses is as follows:

• Step 1.  Total all short-term capital gains/losses combined.
• Step 2. Total all long-term capital gains/losses combined.
• Step 3.  Determine the tax treatment for the situation as explained below.

Scenario 1: Both a long-term and a short-term capital gain (lucky duck!).  Do not combine these, as they will be taxed at two separate tax rates.

Scenarios 2: Both a long-term and a short-term capital loss (bad year!).  Deduct up to $3,000 of the losses using the short-term capital losses first, then carry forward the remaining loss, keeping the short-term or long-term characterization.

Scenario 3: A long-term capital gain and a short-term capital loss.  Net the short-term loss against the long-term gain.  If the gain is greater than the loss, you have a net long-term gain that will be taxed at preferential rates.  If the loss is greater than the gain, you can deduct that loss up to $3,000 and carry forward the rest as a short-term capital gain.

Scenario 4: A long-term capital loss and a short-term capital gain.  Net the long-term capital loss against the short-term capital gain.  If the gain is larger than the loss, the remaining short-term capital gain will be taxed at ordinary income tax rates.  If the loss is larger than the gain, you can deduct up to $3,000 of the additional loss and carry forward the remaining amount.

PREFERENTIAL TAX RATES FOR QUALIFIED DIVIDENDS & CAPITAL GAINS

As mentioned previously, qualified dividends and some capital gains are taxed at separate, lower tax rates from ordinary income items.  The tax rates for these items are:

• 0% for amounts that would otherwise be taxed at 10% or 15%
• 15% for amounts that would otherwise be taxed at 25%, 28%, 33% or 35%
• 20% for amounts that would otherwise be taxed at 39.6%

As you can easily see, these preferential tax rates are significantly lower than normal tax rates, so it’s very much worthwhile to increase your passive income streams.  What else has a 0% tax rate?!

I’ve updated the tax tables to show the preferential rates in each bracket:

There is a worksheet that the IRS provides to be able to reconcile the amount of tax you owe when some of your income qualifies for preferential tax treatment.  It is titled “Qualified Dividends & Capital Gain Tax Worksheet.”  This is included in the tax spreadsheet for this class.

NET INVESTMENT INCOME TAX

Taxpayers that make over a certain threshold ($200,000 for single/head of household filers and $250,000 for married filers) are also required to pay the NIIT (net investment income tax).  This is an additional 3.8% of unearned income items including:

• Interest
• Dividends
• Rental and royalty income
• Nonqualified annuities

This tax is calculated on Form 8960.

ALTERNATIVE MINIMUM TAX

Because the tax law isn’t complicated enough, we also have a tax called the Alternative Minimum Tax (AMT) that adds to the federal income tax for some individuals.  The idea behind this tax is that the government wanted to prevent higher income individuals from being able to take a considerable amount of deductions and avoiding higher income tax rates.  Currently, it most impacts those making $200,000-1,000,000 a year.

There is a separate exemption for AMT, so individuals making less than these specified amounts are not required to pay AMT.  For 2016, these exemptions are $83,800 for married filing joint filers and $53,900 for single filers.  Being above these thresholds does not mean these taxpayers will automatically be paying AMT, it just makes it more likely that if they have a large number of certain deductions, it may push them into the AMT liability.

To further explain, to calculate the AMT, you start with your taxable income before exemptions (line 41 of the tax return), and add back any deductions you took for medical expenses, taxes, possibly some home mortgage interest, and miscellaneous deductions.  If you don’t itemize and take the standard deduction instead, these would not be applicable.  You also have to add tax-exempt interest income from private activity bonds and make an adjustment for incentive stock options.

Then you subtract your AMT exemption and calculate tax on the remainder at a 26% or 28% tax rate (the higher rate starting at $186,300 for all filers in 2016).  If this tax is higher than your regular tax liability, you have to pay the AMT liability.

There are many additional rules, which we won’t cover.  However, I’ve included the AMT tax as part of the tax spreadsheet provided with this class.

COMMON PHASE-OUTS FOR HIGH INCOME INDIVIDUALS

While we’re on the subject of AMT, there are a few phase-outs that high-income individuals need to consider related to their tax return.  Some of the common tax items that are subject to phase-out for high-income individuals include:

• Itemized deductions
• Personal exemptions
• Tuition deduction
• Child tax credit
• Dependent care credit
• Higher education credits
• Roth IRA contribution
• Deductible Traditional IRA contributions

We won’t cover the specifics, but if you are a higher income individual you will want to be aware of these limitations.

COMMON TAX CREDITS

A tax credit is more valuable than a tax deduction because it reduces tax dollar for dollar.  A deduction provides an amount that won’t be subject to tax, but is only as valuable as your tax rate.

For example, if you are in the 15% marginal tax bracket and you are able to deduct your tuition fees of $4,000 that will potentially save you $600 in taxes.  If alternately you are able to take the full Lifetime Learning Credit, you would be eligible for 20% of the $4,000 expenses, resulting in $800 tax savings.

Some common tax credits include:

• Child Tax Credit
• Dependent Care Credit
• American Opportunity Credit and Lifetime Learning Credit for higher education
• Savers Tax Credit
• Earned Income Tax Credit
• Energy and Appliance Tax Credit

MINIMIZING YOUR FEDERAL TAX

There are numerous ways to minimize your federal tax, but it requires a good base knowledge of how taxes work and what deductions and credits are available to you.

Some simple ideas to get you started include:

• Group deductions together in certain years if you’re close to being able to itemize your deductions, instead of taking the standard deduction.  For example, you might delay paying your winter property taxes until the beginning of the year or group charitable contributions in certain years.
• Group deductions in years that you expect to have a higher taxable income to shelter in order to take advantage of getting a higher tax benefit based on a higher tax rate.
• Take advantage of special tax rates for qualified dividends and capital gains.  All income is not created equal.
• Increase your qualified retirement account and IRA contributions to shelter more income from taxes.
• Contribute to an HSA or FSA account.
• Invest in municipal bonds, since municipal bond interest is not taxable for federal income tax purposes.
• Increase your charitable contributions.  Consider contributing to a donor-advised fund in a year where you are in a higher tax bracket

Just remember, you don’t need to know everything about the tax law to do your own taxes, you just need to know the things that are relevant to your own specific situation!  You can do this!

EXAMPLE: THE SMITH FAMILY

The Smith Family is just starting to focus on their financial future, so their tax returns are quite basic.  They don’t have investment income (yet) and are not subject to Alternative Minimum Tax.  Their tax spreadsheet is shown below.

HOMEWORK ASSIGNMENT

Your homework assignment is to populate the tax spreadsheets with your personal tax numbers.

• IMPROVING – Go through your 2015 tax return and update the numbers in the 2015 spreadsheet to make sure you understand your personal income and deductions, as well as how the tax is calculated on your personal income items.
• INVESTED – Go through your 2015 tax return as above, then look through your 2016 income and deduction items to see if you have any new tax situations.
• UNSTOPPABLE – Go through the 2015 taxes as above, but after ensuring that the tax spreadsheet covers your personal tax situation sufficiently also project your 2016 income taxes.

What is the most difficult part of income taxes for you?  What additional questions do you have?