What is tax planning for Form 1040?
If you are an individual taxpayer who completes federal income tax Form 1040, you should be aware of a number of tax-planning opportunities that could lower your tax bill. Topics you should review include your selection of a filing status, the tax calculation rules, available deductions and exemptions, available tax credits, year-end tax planning techniques, and year-end investment decisions. In addition, you should become familiar with the rules surrounding tax refunds, taxes owed, options when you can’t pay your tax bill immediately, and IRS audits.
What should you know about selecting a filing status?
Marital status is determined on the last day of the tax year (December 31 for most taxpayers). There are five possible filing statuses–unmarried, head of household, married filing jointly, married filing separately, and qualifying widow(er). The following rules apply:
You can select unmarried as your filing status if you were unmarried as of the last day of the tax year and were not eligible to claim head of household status.
Head of household
The head of household rules vary, depending on whether you are considered single (including divorced) or married.
Married filing jointly
You and your spouse (or former spouse) can choose to file a joint return if you were married to each other through the last day of the tax year, even if you were living apart.
Married filing separately
You can select married filing separately as your filing status if you are married or if you are no longer married but were married to your former spouse up to and including the last day of the tax year (December 31 for most taxpayers).
Concept of the “marriage penalty”
The marriage penalty refers to the inequitable result that can occur when a couple who files married filing jointly (MFJ) winds up with a tax liability that is greater than it would have been if they were unmarried and filing as unmarried individuals. This occurs when the tax code provides a standard deduction for MFJ filers in an amount that is less than twice the amount for unmarried filers, tax brackets that are wider but not twice as wide as those for unmarried filers, and other inequities. Whether spouses experience the marriage penalty depends on many factors including the distribution of earnings between them (some spouses may actually experience a “marriage bonus”). Spouses who earn relatively equal amounts are more apt to experience the penalty than spouses who earn disproportionate amounts.
The Economic Growth and Tax Relief Reconciliation Act of 2001, the Jobs and Growth Tax Relief Reconciliation Act of 2003, the Working Families Tax Relief Act of 2004, and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 reduce, but do not completely eliminate, the marriage penalty by (1) increasing the MFJ standard deduction to twice the single standard deduction, and (2) widening the MFJ 15 percent tax bracket to twice as wide as the single 15 percent tax bracket. These changes are effective through 2012.
What should you know about tax calculation?
If you file Form 1040, you must compute your adjusted gross income (AGI) and your taxable income before you can calculate your tax. Essentially, your AGI is your total income minus certain adjustments. Your taxable income is your AGI minus your itemized deductions (or standard deduction) and your exemptions. After finding your taxable income, you need to determine your income tax liability from the tax tables or tax rate schedules. This tax amount is then reduced by certain credits to which you may be entitled and increased by any other taxes you may owe. In terms of tax calculation and tax planning, the following taxes deserve particular note.
Alternative minimum tax (AMT)
The purpose of the alternative minimum tax (AMT) is to ensure that taxpayers with substantial income will not escape federal income taxation entirely by employing certain exclusions, deductions, and credits. The federal income tax law gives special treatment to some kinds of income and allows special deductions and credits for some expenses. Taxpayers who benefit from the law in these ways may have to pay at least a minimum amount of tax through an additional tax–the AMT. By understanding the AMT, you may discover planning opportunities that will allow you to keep your AMT exposure to an absolute minimum.
Capital gains tax
Currently, the highest marginal tax rate applicable to ordinary income is 35 percent, whereas the top long-term capital gains rate is generally 15 percent (which is substantially lower). Therefore, if you can generate net capital gains instead of ordinary income, you may save considerably on your taxes. You generate capital gains by selling capital assets (such as stocks). Certain dividends are also taxed at capital gains tax rates.
Self-employed taxpayers are subject to a special tax- the self-employment tax. You must file Schedule SE if either of the following applies to you (or to your spouse if you file a joint return):
- You were self-employed and your net earnings from self-employment were $400 or more
- You had church employee income of $108.28 or more
What should you know about deductions and exemptions?
The amount of federal taxable income is figured by taking your gross income and subtracting certain allowable adjustments, deductions and exemptions. A deduction may be defined as an expense that can be used to offset income. Taxpayers may subtract the greater of either their statutory standard deduction or the total of their itemized deductions. An exemption, by comparison, is a special type of deduction granted to individuals to relieve them from taxation on a certain portion of their income. In general, taxpayers are entitled to an exemption for themselves and for each of their dependents.
Knowledge of your available deductions and exemptions is an important part of your tax planning for Form 1040. If your adjusted gross income level lies above a certain specified amount, the tax benefits of some personal and dependent exemptions are phased out (but not in 2010 to 2012). In addition, certain deductions are only available to you if your expenses exceed a particular percentage of your adjusted gross income (but the overall limitation on deductions does not apply in 2010 to 2012).
By becoming familiar with the various tax credits available (and the qualification rules), it may be possible for you to lower your tax liability.
What should you know about year-round tax planning and year-end investment decisions?
Year-round tax planning and investment decisions may often result in substantial tax savings. Tax planning primarily concerns the timing and the method by which your income is reported and your deductions and credits are claimed. The basic strategy for year-round planning is to time your income so that it will be taxed at a lower rate and to time your deductible expenses so that they may be claimed in years when you are in a higher tax bracket. Specific techniques may be utilized, including reviewing a year-end checklist of tax-saving strategies, performing a marginal tax rate analysis, shifting income, and postponing income and accelerating deductions (or vice versa). In a nutshell, you should try to:
- Recognize income when your tax bracket is low
- Pay deductible expenses when your tax bracket is high
- Postpone incurrence of income tax liability whenever possible
By using these methods, it may be possible for you to lower your overall taxes.
In terms of investment planning, investing in capital assets may help you to better control the timing of the recognition of some of your income. You usually have the flexibility to control when you recognize the gain or loss with respect to capital assets, because in most cases, you determine when to sell each asset. In some cases, however, shifting capital gain income to other taxpayers through gifting appreciated property may be appropriate for you. You should become familiar with the rules for year-round investment decision making.