Uncle Sam cuts you a deal on mortgage insurance, college bills and retirement savingsProcrastinators, rejoice! You don't have to feel quite so guilty if you get a late start on your income taxes this year. Thanks to Congress's tardiness in passing tax legislation, the IRS couldn't begin to process some returns until mid February -- about a month later than usual. Unfortunately, that delay will also postpone refunds for millions of taxpayers who usually file simple returns early in the season.
But if your tax situation is complicated, you probably won't even notice the slowdown. You may be waiting for the stragglers among your 1099s to arrive from brokers, mutual funds and IRA sponsors. By the time you've gathered all of your paperwork, the IRS backlog should be cleared out. At least, that's the plan.
The stealth taxWhy the holdup? Blame it on the alternative minimum tax. Congress created the AMT back in 1969 to ensure that 155 wealthy Americans paid their fair share of taxes. But the tax was never indexed to inflation. Lately, it's been entrapping millions of unsuspecting taxpayers -- mainly upper-middle-income Americans with big families and fat state write-offs.
That's because this parallel tax system requires you to figure your taxes twice. First you calculate your taxes under the regular rules, claiming all your allowable credits and deductions. Then you do it again under the AMT rules, which don't allow many of those adjustments. You owe whichever tax is higher (the table on page 61 shows which taxpayers are most likely to pay the AMT). Although the AMT taxes more of your income, it does so at a rate of 26% or 28%. So wealthy taxpayers in the 33% and 35% tax brackets are often unaffected by the AMT.
Last year, the AMT snared four million people, whose tax bills increased by an average of about $2,000. Without congressional intervention, another 20 million taxpayers would have been hit by the AMT when they filed their 2007 tax returns this spring. After prolonged squabbling, Congress finally approved a one-year patch that boosted AMT-exemption amounts slightly above 2006 levels to prevent the expansion of this stealth tax.
That means that if you didn't pay the AMT in 2006, you're probably safe for 2007. But if you paid the AMT in 2006, and your financial situation is essentially unchanged, you can expect to pay it again in 2007.
Ironically, many people affected by this season's delay won't be paying the AMT. They file certain tax forms that can't be processed until the IRS reprograms its computers to reflect the AMT change. For example, if you claim the Hope or Lifetime Learning credit for college tuition -- which is available only to individuals whose income is less than $57,000 and to married couples with incomes less than $114,000 -- mid February is the earliest you can file your tax return.
The delay also applies to taxpayers with incomes less than $100,000 who claim child-care or elder-care credits on the 1040A form. (They can skip around the delay and claim the credit, though, by filing a standard 1040.) Also affected: anyone, regardless of income, who claims a tax credit for installing energy-efficient windows and doors. In either case, if you try to file your return electronically too early, it will be rejected. Paper returns mailed too soon will languish in the to-be-processed pile.
Filing made easyIf you are still filing a paper tax return, this may be a good year to switch to electronic preparation and filing to reduce errors and speed your refund. With direct deposit, you can expect your refund in as little as ten days, the IRS says, compared with four to six weeks in the case of a paper return. If you buy tax-preparation software in a box (such as TurboTax, which includes tax advice from Kiplinger's), download all the latest updates to ensure that you are using the correct forms. If you use the online versions, the programs are updated automatically.
If your adjusted gross income is $54,000 or less (as it is for 97 million taxpayers), you can prepare and electronically file your federal tax return free (go to www.irs.gov and click on "Free File" for details).
When it comes to filing tax returns, the majority of Americans take the easy route. Only 35% of us itemize our deductions; the rest claim the standard deduction. For 2007, that's $5,350 for individuals, $7,850 for heads of households, and $10,700 for married couples filing jointly, all up slightly from 2006.
But don't let habit (or just plain laziness) cost you money. If you bought your first home in 2007, that could be the trigger that makes itemizing make sense. You can deduct your mortgage interest and property taxes, which, along with state income or sales taxes and charitable contributions, may push your total write-offs over the standard deduction.
If you had a baby or adopted a child, you can claim a $1,000-per-child tax credit for each child under 17 whether you itemize or not.
If you turned 65 in 2007, you may benefit by switching from itemizing to taking the standard deduction -- particularly if your mortgage is paid off -- because you are now entitled to a larger standard deduction than younger taxpayers.
And if you have paid the AMT in the past but recently became an empty nester, losing the $3,400 personal exemption for your former dependent might be enough to slip you back into regular-tax territory, says Donna Cocovinis, a tax lawyer and contributing editor to J.K. Lasser's Your Income Tax Guide series.
If you itemize, you need to know about a tough new rule for charitable contributions: You now need documentation -- in the form of a bank record, credit-card statement or acknowledgment from the charity noting the date, amount and recipient -- for every contribution you deduct.
Breaks for homeownersIf you bought a house last year and made a down payment of less than 20%, you are probably paying for mortgage insurance. If your income is $100,000 or less, you can now deduct all of your private mortgage insurance, or mortgage insurance that you purchase through the Veterans Administration, Federal Housing Administration or Rural Housing Administration. (The IRS added a line to the Form 1098 from your lender to show how much mortgage insurance you paid in 2007.) The deduction phases out completely once your AGI tops $110,000.
Some homeowners affected by the subprime-mortgage mess will also benefit from new tax relief. Ordinarily, if you lose your home to foreclosure or your lender forgives some of your mortgage debt, that debt relief is considered taxable income. For example, if a bank forecloses when you owe $400,000 on your home and then sells the property for $310,000 in full satisfaction of the debt, you would normally owe tax on the $90,000 difference. Ouch!
But a new law excludes up to $2 million of forgiven indebtedness from taxes, if the debt is secured by a principal residence and if the money was used to buy, build or substantially improve your home. The exclusion does not apply to second homes or vacation property, or to home-equity debt resulting from cash-out refinancing. The relief is temporary and applies only to debts that are eliminated in 2007, 2008 and 2009.
Also new in 2007: relief for taxpayers who paid the AMT in 2003 or earlier because they exercised options on company stock that later lost value. As a result, they were taxed on gains they never realized, and received AMT credits they could never fully recover under old tax rules. Starting in 2007, these taxpayers can claim a refund of $5,000 or 20% of their unused AMT credit, whichever is greater. The refundable AMT credit is phased out for taxpayers with incomes of more than $278,900 for individuals and $357,100 for married couples.
Trim tuition costsThanks to inflation adjustments, some education tax breaks now have slightly more generous income-eligibility levels. Individuals with incomes up to $57,000, and married couples with incomes up to $114,000, can claim some or all of the Hope credit for first- and second-year college students, which is worth up to $1,650 per student. The same income limits apply to the Lifetime Learning credit for any postÐhigh school education. That credit is worth up to $2,000 per tax return.
A tax credit is more valuable than a deduction; it reduces your tax bill dollar for dollar compared with a deduction, which merely reduces the amount of income subject to tax. Still, if you earn too much to qualify for education tax credits, you can benefit by deducting $4,000 of college tuition if your income is $130,000 or less on a joint return ($65,000 for others), or $2,000 if your joint income is between $130,001 and $160,000 ($65,001 to $80,000 for others).
But wait, there's more. If you are single and your income is $70,000 or less, or married with a joint income of $140,000 or less, you can also deduct up to $2,500 of student-loan interest for yourself, your spouse or your dependent. And you can take the deduction regardless of whether you itemize.
Even if your income is too high to qualify, you can pay back the student loan on behalf of your child. The IRS will treat it as though you gave the money to your child, who then paid the debt and can claim the tax break, says Bob Scharin, senior tax analyst with Thomson Tax & Accounting.
Bear in mind that if your child takes the deduction, you can't claim him or her as a dependent. But this strategy makes even more sense if you're subject to the AMT, because you lose the dependent deduction anyway.
If you used savings bonds to pay for college expenses, the interest is tax-free if your income doesn't exceed certain thresholds. For married couples, the exclusion begins to phase out above $98,400 and disappears when your income reaches $128,400. For other taxpayers, the interest exclusion is available to those with incomes of $65,500 or less and disappears once your income hits $80,600.
Teachers and aides can deduct up to $250 of out-of-pocket expenses for classroom supplies, regardless of their income or whether they itemize deductions.
Deduct sales taxes?In 2007, taxpayers who itemize get another chance to choose between deducting state income taxes or state and local sales taxes on their federal returns. In most cases, going the income-tax route will result in a bigger deduction. But for residents of states such as Florida, Nevada, Texas and Washington, which have no income tax, the sales-tax deduction is an easy choice.
If you elect the sales-tax deduction, you have two options: Add up the tax on all of your receipts throughout the year, or use the IRS's sales-tax tables or online calculator for your state, family size and income level. Either way, you can tack on the sales tax for major expenses, such as a car, boat or mobile home.
But the sales-tax deduction is easy to overlook. Last year, more than two million taxpayers who were eligible to deduct their state and local sales taxes didn't, missing out on more than $3.5 billion in potential tax breaks.
Blake Young is a self-confessed fanatic about keeping records, and it's paying off. Young, who lives in Bellaire, Tex., racked up roughly $10,000 in sales-tax payments for 2007, thanks in part to the purchase of a new Mercedes and jewelry for his wife, Mindy. That compares with just $3,100 the IRS sales-tax tables say he could deduct based on his situation: a family of four with more than $200,000 in income. "The trick is to be diligent about collecting receipts throughout the year," says Young. His diligence allowed him to claim $5,000 in general sales taxes, plus an additional $5,000 for the car.
In Young's 35% tax bracket, the $10,000 sales-tax deduction could trim $3,500 from his tax bill. But there's a catch: High earners such as Young lose part of their itemized deductions when their income exceeds certain thresholds. (If you're subject to the AMT, which Young is not, you lose the state and local sales-tax deduction altogether.)
If your 2007 adjusted gross income exceeds $156,400, regardless of whether you are married or single, your deductions will be reduced by 2% of the amount by which your AGI exceeds the trigger point. Let's say, for example, that your AGI is $200,000. Your itemized deductions would be reduced by $872 (2% of the $43,600 in income that tops $156,400). If you are single with an AGI of more than $156,400, or married with a combined income of $234,600 or more, you also lose a portion of the personal exemptions that you claim for yourself, your spouse and your dependents. Normally those are worth $3,400 each.
More ways to saveThere's still time to trim your 2007 taxes by contributing to a tax-deductible IRA. You can contribute up to $4,000 (or $5,000 if you're 50 or older) until the time you file your tax return, but no later than April 15. And for 2007 you can earn more than in 2006 and still deduct your IRA contributions.
Even if you participate in a retirement plan at work, you can deduct some or all of your IRA contributions if you are married and your joint income is $103,000 or less, or if you are single and your income is $62,000 or less. If you don't participate in a workplace-based retirement plan but your spouse does, you can deduct some or all of your IRA contributions as long as your joint income doesn't exceed $166,000.
In addition, lower-income taxpayers, such as young workers and retirees who work part-time, can reduce their tax bill or increase their refund by claiming the retirement savers tax credit. This tax credit, which has been made permanent, is worth up to $1,000 when you contribute $2,000 to a traditional or Roth IRA, 401(k) or other workplace-based retirement plan. To claim the credit, you must be at least 18 years old and not a student, and you cannot be claimed as a dependent by anyone else. You are eligible if you are single with an income of $26,000 or less; head of a household with an income of $39,000 or less; or married filing jointly with an income of $52,000 or less.
Retirees who donated some or all of their 2007 IRA distribution to charity can exclude the donated amount from their adjusted gross income. Although you can't claim the contribution as a charitable deduction, your lower income may mean that the taxes you pay on your Social Security benefits will be reduced. Or it may be easier for you to qualify for other tax breaks, such as deducting medical expenses that exceed 7.5% of your AGI. When calculating your medical expenses, don't forget to include your Medicare Part D premiums for prescription-drug coverage.
