Working the Numbers

Richard Connor

THIS YEAR’S TAX DAY was the strangest I can remember. Amid the pandemic, the filing deadline had been pushed back to July 15, three months later than usual. And for me, it was our most complicated tax year ever. I had both retirement income and income from various in-state and out-of-state consulting gigs.

But the biggest complication stemmed from last year’s sale of our second home. This was a vacation home that we rented part-time and also used ourselves. The year you sell such a house brings special tax considerations. You can recapture losses that weren’t allowed in previous years. But you also have to recapture depreciation previously used. You have to break down the realized capital gain into personal and business portions. The business portion is further broken down into land and building, because you can depreciate buildings but not land. And that’s just federal taxes. Pennsylvania, where I live, treats it as a straight capital gain. I was happy I had three extra months to research all of this.

We fought our way through these complications, got our taxes filed and tax bills paid—and I furthered my financial education. In fact, I’d encourage everyone to take a little time to review their tax return and see what they can learn. Here are five of my favorite questions to ask:

1. What’s your income? For tax purposes, there are multiple definitions of income, including adjusted gross income (AGI) and taxable income. AGI is your gross income minus so-called above-the-line deductions. It includes both earned and unearned income. This is the starting point for calculating your tax bill. AGI is also the key to determining your eligibility for various deductions and credits. Meanwhile, your taxable income is the income used to calculate how much tax you owe. It starts with your AGI, but then you subtract either the standard deduction or your itemized deductions.

2. What are your deductions? These reduce the amount of income that’s taxed. The most common above-the-line deductions include retirement account contributions, health insurance premiums and self-employment taxes. These deductions are available before deciding whether to claim the standard deduction or to itemize. One way to reduce your tax bill is to increase these deductions. For many folks, the most effective strategy is to boost their 401(k) contributions—and this is typically also the best strategy for their long-term financial health.

3. Do you itemize or take the standard deduction? The Tax Cut and Jobs Act of 2017 greatly increased the standard deduction and put limits on what you can itemize. The items on Schedule A—the itemized deduction form—are some of the biggest and most important line items in a family’s budget. The upshot: Even if you end up claiming the standard deduction, it’s worth taking a close look at your itemized deductions.

I recently helped my son and daughter-in-law review their tax return. They bought their first home in mid-2019, but their standard deduction still turned out to be $118 greater than their itemized deductions. I noted that in 2020, when they’ll pay a full year of mortgage interest, they’d likely have more than enough to itemize. I recommended keeping track of medical expenses and charitable contributions, as these could become more valuable.

One strategy for those on the cusp of itemizing: Bundle several years of charitable contributions into one tax year, so you’re able to itemize your deductions. A donor-advised fund is a good way to accomplish this.

4. What’s your marginal tax bracket? This is the tax rate you pay on your last dollar of income. It depends on your filing status and your taxable income. There are currently seven federal income tax rates, ranging from 10% to 37%. Sound (relatively) straightforward? There are, alas, complications caused by the phase-in and phase-out of various credits, as well as the impact of other taxes.

The Tax Foundation has a good analysis of how these interact to create tax brackets beyond the seven standard ones. Take married filers who claim the standard deduction and are in the 24% bracket, which means their total income is between $195,851 and $351,400. Once their income hits $250,000, an additional 0.9% Medicare tax is imposed. Similarly, the phase-in and phase-out of the earned income tax credit and child tax credit can skew your marginal rate.

5. What’s your effective tax rate? TurboTax provides a good summary of your federal tax situation. It gives you an effective tax rate, which is your total income tax bill divided by your gross income. That rate is probably lower than you thought. On the other hand, if you add in your payroll, state, local, real estate and sales taxes, you may discover your total annual tax bill is far higher than you ever imagined.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Summer JobDon’t Leave a Mess and Treasure Hunting. Follow Rick on Twitter @RConnor609.

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