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MONTHLY TAX NEWSLETTER

June 2008

THE RELATIVE VALUE OF A TAX BREAK

by Andrew D. Schwartz, CPA

Not all tax breaks are created equally.  Due to the complexities and nuances of the continually evolving tax code, certain credits and deductions save you significantly more in taxes than others.

Let's look at an example comparing the mortgage interest deduction with the student loan interest deduction.  With the high cost of college these days, you can easily owe more than $100,000 in student loan debt upon completion of your degree.  On $100,000 of debt, which type of interest saves you more in taxes?

When you have a mortgage on your primary residence, you deduct the full amount of interest paid on up to $1 million of mortgage debt.   For your student loans, you are limited to the first $2,500 of interest paid each year.  Without even factoring in that you're also required to phase-out this deduction once your Adjusted Gross Income (AGI) exceeds $115k if married or $55k if single, there is no question that the mortgage interest deduction is a much more valuable tax break than the student loan interest deduction.

Determine Relative Value

Figuring out how to objectively compare tax breaks took quite a bit of thought.  To determine the relative value of a variety of tax saving opportunities, we designed our analysis to factor in the following six criteria:

  • Type of Tax Break:  Credits are more valuable than deductions, and tax-free growth trumps tax-deferred growth.

  • The Alternative Minimum Tax:  Any deduction or credit limited by the AMT is less valuable - until Congress either fixes or eliminates this tax.

  • Expenditure Cap:  Most tax breaks limit how much you can spend each year before maxing out the deduction or credit.  The lower the annual limit, the lower the relative value.

  • Phase-out:  Some tax breaks are phased-out based on your AGI, and the value of those tax breaks is reduced accordingly.

  • Threshold:  Other tax breaks, such as medical expenses and miscellaneous itemized deductions, are only deductible to the extent they exceed a percentage of your AGI.  The higher this threshold, the lower the relative value.

  • Ease of Reporting:  Any tax break that requires you to either complete and attach an additional tax form or to work through a separate worksheet indicates that the rules for this tax break are complicated, impacting its relative value.

Using these six criteria, we calculated a score for each tax break, with a maximum score of 100.  Let's take a look at the winners and losers.

The Winners

What were some of the attributes that the six winning tax breaks all had in common?  None are limited by the AMT.  Plus, the amount of the maximum annual expenditures are pretty substantial. 

Here are the six tax breaks with a score of 75 or higher:

  • Mortgage Interest Deduction - (Score: 75) Full deduction for interest paid on the first $1 million of outstanding debt on your primary residence and second home.  Plus, your allowable mortgage interest is deductible when calculating the AMT as well.

  • Self-employed Retirement Plans - (Score: 77) Maximum contribution of $46k for 2008, which reduces your AGI and is exempt from the AMT.

  • 401(k) and 403(b) Salary Deferrals - (Score - 76) Contributions into these employer sponsored retirement savings accounts reduce your taxable wages by up to $15,500 ($20,500 if 50 or older), grow tax deferred, and are unaffected by the AMT.

  • Charitable Contributions - (Score - 80) Did you know you can deduct charitable donations of up to 50% of your AGI each year?  Plus, like mortgage interest, this itemized deduction is also deductible when calculating the AMT.

  • 529 Plans - (Score - 85) Even though 529 plans don't provide for a current year deduction, you and your spouse can sock away up to $120k all at once into these tax-free college savings accounts.

  • Flexible Spending Accounts - (Score - 75) Through your employer's FSA, you can pay for up to $5,000 of dependent care expenses, and an equal amount of your family's healthcare expenses, with pre-tax dollars.

The Losers

You may be surprised to see the tax breaks that provide the least bang for the buck under the current rules.

  • Personal exemptions - (Score - 36) A meager $3,500 ( in 2008) for you, your spouse, and each of your children and other dependents.  And even though the phase-out threshold is reasonably high, anyone in the AMT loses out on this tax break.

  • Savers Tax Credit - (Score - 46) While the government paying you to save for retirement is a great deal, the combination of an annual expenditure limit of just $2,000 and a low phase-out of $52k for married couples and $26k for single individuals gives this tax break a low value. 

  • Hybrid Tax Credit - (Score - 41) Not even factoring in that the credit for hybrids manufactured by Toyota and Lexus are fully phased out, and those manufactured by Honda will soon be fully phased out, the fact that this credit isn't allowed if you're in the AMT greatly reduces its value.

  • Student loan interest - (Score - 52) Low annual limit of $2,500 coupled with an AGI phase-out starting at $115k if married or $55k if single gives the student loan interest deduction a low value.

  • Interest on An Equity Loan Not Used to Improve Your Home - (Score - 54) While you get to deduct the interest paid on up to $100,000 of your equity loan or line of credit no matter how you spend the money you borrow, not being able to deduct this interest when calculating the ATM if you don't use the proceeds to improve your residence hurts its value.

Interpreting the Results

Own where you live.  Max out your retirement savings opportunities.  Save for your child's education.  Even though the US Tax Code is overly complex, the current set of rules do reward you for make prudent financial planning decisions.

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TALK TO THE IRS ON YOUR TERMS

Did you know that the IRS has personnel available to meet with you face-to-face?

According to the IRS, "if you need to resolve a tax problem, have questions about how the tax law applies to your individual tax return, or you're more comfortable talking with someone face-to-face, visit your local Taxpayer Assistance Center where you can spread out your records and talk with an IRS representative across the counter. No appointment is necessary - just walk in."

Check out http://www.irs.gov/localcontacts/index.html to find the IRS Taxpayer Assistance Center closest to your home or workplace.

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WHAT'S YOUR STUFF WORTH?

by Andrew D. Schwartz, CPA

With each passing Tax Act, there seem to be fewer and fewer "Opportunities for Exaggeration" remaining on your federal income tax return.  One such tax break targeted by Congress in recent years is the value people claim for their non-cash contributions.

Back in 2004, Congress first went after the increasingly popular (and often exaggerated) tax savings opportunity available to people who donate a vehicle to charity.  As of January 1, 2005, the deduction you can claim for a donated vehicle is limited to what the charity sell your car for.  Unless you meet one of three very specific exceptions, you can no longer claim this tax break based on the vehicle's Blue Book value.

After passing that rule, Congress wasn't done yet, and a few years later passed the Pension Protection Act of 2006 which containied a provision greatly affecting non-cash contributions of clothing and household items.  Effective August 17, 2006, the date the bill was signed into law, you can only claim a deduction for donated goods that are in good condition or better.

IRS Guidelines

Let's take a look at the guidelines provided by the IRS to help taxpayers comply with this new standard.  First stop, the instructions to the Form 8283 - Non-cash Charitable Contributions, where we are told:

The FMV of used household items and clothing is usually much lower than when new. A good measure of value might be the price that buyers of these used items actually pay in consignment or thrift shops. You can also review classified ads in the newspaper or on the Internet to see what similar products sell for.

You cannot claim a deduction for clothing or household items you donate after August 17, 2006, unless the clothing or household items are in good used condition or better. However, you can claim a deduction for a contribution of an item of clothing or household item that is not in good used condition or better if you deduct more than $500 for it and include a qualified appraisal of it with your return.

Our second stop is Publication 526 - Charitable Contributions, where the IRS sheds more light onto this issue:

The fair market value of used household items, such as furniture, appliances, and linens, is usually much lower than the price paid when new. These items may have little or no market value because they are in a worn condition, out of style, or no longer useful. For these reasons, formulas (such as using a percentage of the cost to buy a new replacement item) are not acceptable in determining value.

You should support your valuation with photographs, canceled checks, receipts from your purchase of the items, or other evidence. Magazine or newspaper articles and photographs that describe the items and statements by the recipients of the items are also useful. Do not include any of this evidence with your tax return.

We Can Help

Properly valuing your donated clothing and household rules has become more important in the post August 17, 2006 "Good or Better" world.  If you ever get audited, there is a good chance that the IRS will use these new rules as a way to greatly reduce the deduction they will allow you to claim unless you can:

  • Substantiate that the donated goods were in good condition or better, and

  • Demonstrate how you came up with the Fair Market Value you claimed

To help you put a value on the donated goods, we have created a few different tools based on the published values of used merchandise sold at the thrift shops of the Salvation Army and Goodwill Industries.  Download our Non-cash Charitable Donation worksheet in either pdf format or as an Interactive Microsoft Excel Spreadsheet(To download the Excel Spreadsheet, right click your mouse and hit "Save Target As", and then choose the directory on your computer where you want this file to sit.)

Simply complete either version of this worksheet, take a few photos of what you are donating, and file along with your tax records.  Hopefully this information will do the trick if you ever get audited.  While we don't recommend that you exaggerate the value you claim for the items you're donating, we do believe you should take the full deduction based on the fair market value of the stuff you gave away.

Understanding the new rules and documenting what you give away will help ensure that the deduction you claim on your tax return will withstand reasonable scrutiny from our friends at the IRS.

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TAX AND FINANCIAL PLANNING CALENDAR FOR JUNE, 2008

Month

Income Taxes

Saving and Investing

 

June

  • 2nd quarter estimates due 6/15/08
  • Income tax returns for Ex-Patriots due 6/15/08

 

  • Determine if you are on track to meet the savings and debt reduction goals you set back in January
  • See if you have adequate Disability Insurance in place.

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2007 & 2008 TAX FACTS

  • For 2007, the standard deduction for a single individual is $5,350 and for a married couple is $10,700. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
  • For 2007, the personal exemption is $3,400. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  • The maximum earnings subject to social security taxes is $102,000 for 2008, up from $97,500 in 2007.
  • The standard mileage rate is $.485 per business mile for 2007, increasing to $.505 per mile in 2008.
  • The maximum annual contribution into a 401(k) plan or a 403(b) plan is $15,500 in 2007 and 2008.  And if you'll be 50 or older by December 31st, you can contribute an extra $5,000 into your 401(k) or 403(b) account that year.
  • The maximum annual contribution to your IRA is $4,000 for 2007, increasing to $5,000 in 2008.  And if you turn 50 by December 31st, you can contribute an extra $1,000 that year.  You have until April 15, 2008 to make your 2007 IRA contributions. 

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This Month's Topics

The Relative Value of a Tax Break

Talk To The IRS On Your Terms

What's Your Stuff Worth?

The FICA Refund for Medical Residents 

2007 & 2008 Tax Facts

Tax and Financial Planning Calendar for June 2008

 

NEWSLETTER ARCHIVES
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WHAT'S NEW WITH THE FICA REFUND?

Most recent information issued by the IRS

Check out the memorandum issued by the U.S. District Court in Minneapolis and you'll see that the court found that medical residents and fellows might not be subject to FICA taxes in many instances.

For more information, go to our February 2001 Newsletter or read through the IRS' Chief Counsel Advice Memorandum on this issue.

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