Education credits

As discussed in a previous post, paying for higher education can be a stressful task for a parent and/or student.  Unfortunately, expenses for higher education cannot be claimed as deductions on a tax return outright, but there are four available deductions and credits that can help at tax time.

First, it is important to distinguish the difference between a deduction and a credit.  A deduction reduces a taxpayer's taxable income, while a credit reduces a taxpayer's tax.  Therefore a deduction does not reduce a taxpayer's tax dollar-for-dollar like a credit.  Also, some credits are refundable, meaning that if they exceed the amount of tax owed, the taxpayer can receive the difference as a refund.  In all, a credit is better because it reduces tax and could result in a refund.

The American Opportunity Credit (AOC) is a credit available for each eligible student enrolled at least half of the year for the first four years of postsecondary schooling (college).  The credit is the maximum of qualified education expenses or $2,500, and is available to taxpayer's with adjusted gross income (AGI) of $180,000 MFJ / $90,000 S or less.  On top of that, 40% of the credit can be refundable.

The Lifetime Learning Credit (LLC) is a credit available per return, not per student, up to the maximum of qualified expenses or $2,000.  This credit can be claimed for an unlimited number of years which makes it great for students attending law or medical school.  The credit is available to taxpayer's with AGI up to $127,000 MFJ / 63,000 S.  This credit is completely nonrefundable.

Taxpayer's that pay student loan interest can benefit from the Student Loan Interest Deduction (SLID).  The student loan must be taken out solely to pay qualified education expenses and the student must be the taxpayer, spouse, or a dependent.  The student must be enrolled at least half-time.  A deduction is allowed up to the maximum of $2,500 or the amount of interest paid during the year for taxpayers with AGI less than $155,000 MFJ / $75,000 S.  This deduction is an "adjustment to income" on page 1 of the 1040 and reduces AGI before other deductions.

Finally, the Tuition and Fees Deduction (TFD) is available as an "adjustment to income" up to the maximum of $4,000 or qualified tuition and fees.  Note that this deduction is available only for tuition and fees, not other expenses such as room and board, meal plans, or books.  This deduction is available to taxpayers with AGI less than $160,000 MFJ / $80,000 S.  The catch is that the tuition and fees deduction cannot be claimed if the taxpayer is already claiming the American Opportunity or Lifetime Learning credits.

These are four of the most popular education benefits offered to individual taxpayers, and their benefits are maximized in certain situations.  The AOC maximizes its benefits during the first four years of college because it has a high AGI limit and is a credit to reduce tax.  The LLC is beneficial for students that go past the first four years, but is limited in that it has a lower AGI threshold and can only be claimed per return.  The SLID removes some of the sting from paying interest on student loans, but the maximum $2,500 deduction usually pales in comparison to the total amount of interest that is paid in a year.  The TFD is beneficial for someone that goes back to school and only pays tuition, is no longer eligible for the AOC, and has a higher AGI than the threshold for the LLC.

Information from the IRS on benefits for education can be found here. Education benefits can be confusing, but seeking the advice of a professional on the best use of these credits during the college years can help reduce tax liability during years of high expenses.

Ordinary and Qualified Dividends

When a taxpayer receives a form 1099-DIV at the end of the year, a common question they have is "what is the difference between an ordinary and qualified dividend?".

A taxpayer that owns or is the beneficiary of an investment that pays dividends will typically receive a form like this at the end of the year.  The dividends they received during the year are reported in box 1a "Total ordinary dividends" and any of those dividends that are qualified will be reported in box 1b "Qualified dividends".  If dividends are received through a passthrough entity such as a trust or partnership, they will be reported on the Form K-1.

Dividends are the most common way for a corporation to distribute profits to its shareholders.  All of the dividends paid to a shareholder during the year are reported as ordinary dividends and are taxable to the taxpayer.  Qualified dividends will be included in the amount of ordinary dividends, but are subject to capital gains tax rates.

Qualified dividends are subject to the 15% capital gains tax rate if the taxpayer's regular tax rate is 25% or higher.  But, if the taxpayer's regular tax rate is less than 25%, then the qualified dividends are subject to a 0% tax rate.  For 2013, the 25% bracket kicks in when adjusted gross income hits $72,500 MFJ / $36,250 S.

In order for dividends to be considered qualified, they must meet three criteria.  First, the dividends must have been paid by a US or qualified foreign corporation.  Second, the dividends must not be considered capital gain distributions, payments in lieu of dividends, or payments from a tax-exempt organization or a farmer's cooperative.  Third, the taxpayer must meet the holding period for the investment.

For a dividend to be considered qualified, the taxpayer must have held the investment for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.  So if an investment's ex-dividend date (first day someone can own the investment without receiving the dividend) is September 1, then the taxpayer would have had to own the investment for at least 60 days during the period of July 1 to Nov 1 (121-day period beginning 60 days before ex-dividend date).

Confusing?  It can be, but in theory the investment should be owned for a longer term in order for the dividends to qualify for capital gains tax rates.

In all, taxation of qualified dividends with capital gains tax rates is an attractive reason to own domestic, qualified, dividend paying investments for the long-term, as long as the taxpayer is familiar with how the qualified dividends are calculated and whether or not their investments meet the characteristics for qualified dividends.

Retirement plans

Saving for retirement should be an important financial goal for everyone, no matter their age or income. Everyone has dreams for retirement, whether it is soaking up the sun on a beach somewhere or traveling the country in an RV, and saving for retirement is the key to making those dreams come true. One struggle that people face, especially younger workers, is that retirement is so far away that it's hard to acknowledge the benefit of saving for retirement now, which is why it helps to view a retirement account as both a savings account and a tax reduction tool. In the world of retirement plans, there are a variety of options available for everyone, whether you are an employer, employee, or self-employed.

401(k) plan

This is probably the most common retirement vehicle out there. The 401(k) plan is typically offered by employers, and allows employees to contribute a portion of their wages to an account. The contributions are "pre-tax" meaning that they go in before payroll and income taxes are calculated. The employee usually can direct the investment of the funds within the account, either by buying individual investments or selecting an allocation between mutual funds / ETFs offered within the plan. Employers also have the option (but not the obligation) to make profit-sharing or matching contributions (i.e. free money). The catch is that employee contributions are limited to $17,500 for 2013, and catch-up contributions of $5,500 for employees 50 years old and over.

Individual retirement account (IRA)

The traditional IRA is a useful product for many reasons, but does not carry the same tax deduction characteristics as other retirement accounts. An IRA can be opened by anyone at a participating institution and contributions can be made at any time during the year up to a maximum of $5,500 or taxable compensation for the year. The catch to an IRA is that distributions are almost always taxable, but contributions are not always tax deductible.  In other words, the contributions have the potential to be taxed twice.  For example, for a married filing joint taxpayer that is covered by a retirement plan at work with AGI in excess of $115,000 gets no deduction.  Limits can be found on the IRS website  here.

Roth IRA

The Roth has grown in popularity in recent years due to its tax deferral attributes. The Roth functions almost entirely the opposite as a traditional IRA in that contributions are made "after-tax" i.e. they are still included in your taxable income, but the distributions in future years are not taxable. This is a great resource for someone with the ability to make contributions and still pay the taxes currently such as a young worker with a higher level of disposable income. There are two catches to a Roth, 1) the contribution limit is the maximum of $5,500 or taxable compensation for one year (2013) and 2) taxpayer's with AGI in excess of $188,000 MFJ / $10,000 MFS / $127,000 S cannot make a contribution to a Roth.

All of the options above are also available to self-employed individuals depending on the income level of the business and whether or not it has employees.

The 401(k) and IRA plans can be useful tools in reducing taxable income.  By making higher contributions to a 401(k) plan, an employee's W-2 taxable income will decrease.  Also, if a taxpayer's income is in a certain range, IRA contributions can also help reduce taxable income.  Contributions to a Roth IRA have a different benefit.  Although current contributions are not deductible, distributions from the plan in the future are not taxable, meaning that a taxpayer can experience years of tax free growth for their retirement.

Bonus

One of the better moves made by Congress at the end of 2012 was to extend the 50% bonus depreciation allowance to 2013. This is a great resource for businesses, but is often confused with its less beneficial counterpart, the Section 179 depreciation allowance. Bonus depreciation allows a business to expense 50% of the original cost (depreciable basis) of a qualified asset in the year of acquisition. The taxpayer can then take normal depreciation on the remaining 50%, beginning in the first year. For example, if a business buys a $5,000 piece of equipment, they can expense $2,500 in the first year plus the normal depreciation on the remaining $2,500. This is why it's called "bonus" depreciation - because you get your normal depreciation, plus a "bonus" of 50%.

Bonus depreciation has benefits that make it more useful than Section 179 in some cases. There is no income limitation, which means a business is eligible to take advantage of bonus depreciation no matter their level of income (or even loss). As a matter of fact, bonus is considered to be automatic, and the taxpayer actually has to elect not to take it. Bonus is also elected by "class life" instead of by specific asset.

Bonus can be helpful because, unlike Section 179, it can be used to reduce taxable income below zero. Using bonus to create a loss can be an especially helpful planning tool for 2013. With the 50% special bonus depreciation allowance slated to go away in 2014, a taxpayer can take advantage of the special allowance in 2013 by making as many planned PP&E acquisitions as possible. By utilizing bonus depreciation, the taxpayer can push their company into a loss for 2013, and the net operating loss (NOL) can be carried forward to 2014 (and future years) and used to offset ordinary income.

In some cases, electing out of bonus is a better decision for a business. For businesses that do not turn over PPE very often and count on depreciation each year to keep their taxable income down, bonus might not be ideal. It will provide a 50% write-off in year one, but the depreciation expense in each subsequent year will be significantly lower. Also, some states (such as my state of Arkansas) do not conform to the same rules as the IRS, which can create a Federal to State difference in depreciation. Although this is not a reason in itself to elect out of bonus, it does require the taxpayer to keep a record of the Fed to State difference in future years.

Thanks to my colleague for suggesting this topic. Have something you want to hear about? Email me.

Haircuts

How often do you get a haircut?  On average, I get a haircut every two weeks.  If I don't get a haircut regularly, I start to look funny.  Although the frequency with which you visit the barber or hair salon is at your discretion, if you are a high-income taxpayer, you might be getting an extra haircut in 2013 that you didn't know about. As a part of the new tax laws implemented at the end of 2012, the IRS will be giving high-income taxpayers their own haircut through the provisions known as PEP and Pease.  This refers to the phaseout of personal exemptions (PEP) and certain itemized deductions (Pease) when adjusted gross income (AGI) reaches a certain amount.  The AGI limit is different based on your filing status, which can be Single (S), Head of Household (HOH), or Married Filing Jointly (MFJ).

Personal exemptions

Personal exemptions are allowed to reduce adjusted gross income (AGI) in arriving at taxable income.  Taxpayers typically receive one exemption for themselves, their spouse, and dependents.  For instance, if you are a married taxpayer with two dependent children, you are allowed four personal exemptions.

The personal exemption amount for 2013 has been set at $3,900.  However, the exemption amount will begin to phase out when AGI reaches $250,000 (S) / $275,000 (HOH) / $300,000 (MFJ) and phases out completely at $372,500 (S) / $397,500 (HOH) / $422,500 (MFJ).  The exemption is reduced by 2% for every $2,500 over the AGI limit.

Example: Bonnie and Clyde are married taxpayers with three children.  Their AGI is $330,000 and their personal exemption amount is $19,500.  Their AGI exceeds the limit by $30,000 and therefore their personal exemptions are reduced by $4,680 ($30,000 / $2,500 x 2% x $19,500).

Itemized deductions

Itemized deductions consist of specific expense items that are permitted to be deducted on an individual tax return, the most common of which are medical expenses, state taxes paid, charitable contributions, and mortgage interest.

Itemized deductions will be limited when AGI reaches $250,000 (S) / $275,000 (HOH) / $300,000 (MFJ).  When these limits are reached, itemized deductions will be reduced by an amount equal to the lesser of 1) 3% of AGI or 2) 80% of certain itemized deductions.  All itemized deductions are subject to the 80% calculation except for qualified medical expenses, interest expense, and casualty/theft losses.

Example: Bob is a single, unmarried doctor.  His AGI is $285,000 and he has total itemized deductions of $50,000.  Of these deductions, $10,000 is interest expense.  His itemized deductions are therefore reduced by $8,550, which is the lesser of 3% of his AGI ($285,000 x 3% = $8,550) and 80% of certain itemized deductions (($50,000 total itemized deductions - $10,000 interest expense) x 80% = $32,000).

Conclusion

If you are a high-income taxpayer, you will most likely be affected by one or both of these provisions.  There are still 3 months left in the year, which is plenty of time to consult a tax professional on ways to reduce the impact of the PEP and Pease on your individual situation.  This will ensure that the only haircut you have to worry about is the one you get every two weeks.