Your Income Taxes: Avoiding the Unknown Unknowns
Your Income Taxes: Avoiding the Unknown Unknowns
This morning, I woke up with a sore throat, swollen lymph nodes, and fatigue – Surely I must have come down with a severe case of tonsillitis, mononucleosis, or laryngitis. Panic set in for a few minutes until I had my morning cup of tea. I felt much better, and I felt a little ridiculous for my hypochondriac reaction. Although, for all I know, it could have been a serious medical issue. As someone with no medical training whatsoever, but someone who cares very much about her health, I tend to overreact to even the most minor of symptoms. Why do I overdramatize these potential signs of illness? Because of the unknown unknowns. I don’t know what is wrong with my health, there’s a two month waiting list to see my physician, and I don’t have the medical training to know how to determine if the symptoms are serious.
Former U.S. Secretary of Defense Donald Rumsfeld once said:
“There are known knowns. These are things we know that we know. We also know there are known unknowns. That is to say, we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.”
It is the unknown unknowns that strike fear into our hearts. As long as you know what you DON’T know, you can seek the information you are lacking; you know what questions to ask. Do you know everything there is to know about filing your federal income tax return? If you are like most tax payers, probably not. But if you can achieve a basic level of understanding with regards to your income tax return, you’ll develop the ability to reduce the amount of unknown unknowns, and you will be better equipped to communicate with your accountant and financial advisor.
Whether you’ve already filed your tax return or you’ve filed an extension, these basic concepts will help you wrap your head around your tax situation and reduce the chances of a horrifyingly expensive surprise come April 15th.
Let’s start with Adjusted Gross Income, or “AGI.” In essence, AGI is your income from all sources less any applicable adjustments to income. These adjustments include items such as IRA contributions and student loan interest, among others. Adjustments to income are referred to as “above the line” deductions. AGI is a key component in determining your total tax liability. In addition, AGI is the number used by banks, mortgage brokers, and many financial aid programs to determine your eligibility for the products and services offered by those institutions.
Taxable Income is the amount of income that is subject to income tax. To determine your taxable income, you subtract from AGI any deductions and exemptions that apply. These deductions that are taken after you’ve determined your AGI are called “below the line” deductions.
All Income Is Not Taxed Equally:
To add a level of complexity to what we’ve just discussed, some types of income (such as insurance proceeds, child support, and workers’ compensation to name a few) are generally not subject to income tax.
Social Security benefits are a different animals completely. Is it taxable? The answer is: It depends. If your income is low enough, none of your Social Security income will be taxable. However, if your income is high enough, you may be paying tax on 85% of your benefit.
Winnings, whether from gambling or winning an all-expense-paid vacation from a radio contest, are taxable. You may think that the IRS will never know that you won that vacation, but most companies that award those prizes will send you a 1099 for the value of the prize. The company will also report the prize to the IRS. If you have gambling losses, you can offset your taxable winnings for that year with those losses, as long as you have proof of the loss.
If you receive a state income tax refund and you itemize your deductions, that refund may be taxable. Talk to your accountant or financial advisor about the types of income you receive if you have questions regarding how your income is taxed.
Minimizing Income Tax:
How can you reduce your income tax liability? You can reduce your income, increase your deductions, and/or take advantage of tax credits.
Reducing income: I do not mean to imply that you should take a lower paying job or work less hours (although, that would certainly reduce the amount of tax you are paying). Reducing income is a very common strategy among the self-employed. If you are self-employed, you can reduce income in a given year by timing your business expenses. Only the self-employment income in excess of expenses is subject to tax. Tread carefully, though, as reporting less income means that you may not qualify for the mortgage on your dream home. Remember that lenders use the figures you report on your tax returns to determine your loan eligibility.
Increasing Deductions: A deduction allows you to reduce the amount of taxable income by the amount of the deduction. Deductions become more valuable to you as your income rises. If you are in the 10% tax bracket, a $1,000 deduction will knock $100 off your tax bill. If you are in the 25% tax bracket, a $1,000 tax deduction reducing your tax bill by $250.
Taking advantage of Tax Credits: Unlike tax deductions, tax credits are a dollar for dollar reduction of the tax you owe. If you have a tax credit of $1,000, then your tax bill is reduced by $1,000. Accordingly, a tax credit has the same dollar value regardless of which tax bracket applies to you. Most credits are non-refundable, which means that if your tax credits total more than your total tax liability, the IRS won’t refund you the difference. There are a few refundable credits, such as the Earned Income Tax Credit and the Child Tax Credit. Ask your accountant about any tax credits for which you may qualify.
Although we can never fully eliminate our “unknown unknowns,” we can certainly chip away at the learning curve and convert those unknowns to knowns. With a basic understanding of how your income is taxed, and with a little consideration and guidance throughout the year, tax season can become far less intimidating.
Registered Representative Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Conte Wealth Advisors are not affiliated.