Friday, September 5, 2008

Maximizing Adjustments to Minimize Taxes

The other day at our staff meeting a comment or two (or even three) was made that I am a type A personality. Of course I protested but just now I found myself gleefully punching numbers into Dinky Towns 1040 tax calculator. Because this isn't the first time nor the second that I have happily plugged numbers into this calculator or others like it, I have finally come to the conclusion that the comments about me being an A personality are right. Be that as it may, I hope you can benefit from my love of playing "what if" with numbers.

Before going into the example I used to look at the difference that using pre-tax money for retirement savings and flexible spending accounts would have on a family's tax burden. I think it might be helpful to explain the process that is used to calculate a person's income tax. Calculating your taxes can be a fairly complicated process. If you find that your situation is complex enough or you are confused enough I highly recommend hiring a professional to assist you. Although I have some valuable information to share, I am not a tax professional and don't have the latest information on all the rules and regulations involved in calculating your taxes.

Calculationg your Income Taxes:

Total Income
― Income exclusions =
Gross Income
― Income Adjustments =
Adjusted Gross Income
― Deductions & exemptions =
Taxable Income
  1. The first step is to calculate total income. Your total income is all the money, property and services that you received in exchange for any work that you did and any profit that you earned from selling your "stuff".

  2. The next step is to calculate Gross Income. Gross Income is calculated by subtracting out the income from total income that is supposed to be excluded. For many of us, the two figures are the same.

  3. The third step is to calculate Adjusted Gross Income. This is the number that I will be "playing" with in my example below. Adjusted Gross Income is calculated by subtracting your adjustments to income (flexible spending accounts and tax-deductible retirement accounts fall in this category) from Gross Income.

  4. Next your subtract either your standard deduction or your itemized deduction from your Adjusted Gross Income.

  5. Then you subtract out your exemptions for your family members. This gives you your Taxable Income.

  6. Now you use the tax table or a tax-rate schedule to determine what taxes you are responsible for.

  7. But before you finish you subtract out any tax credits you might have.

  8. And finally you figure out how much you owe or are owed based upon what you have already paid.

Phew, that was a big process and painful. Luckily for those of us working for someone else, we only have to go through it once a year. Okay, back to my little analysis. I used a family of three for my example (two parents and one child) earning a total of $100,000 per year between the two adults. To keep things simple I didn't include any excludable income so their Total Income and Gross Income are both $100,000. What I did include was a number of adjustments to income so that we can compare how changes to Adjusted Gross Income will impact this hypothetical family's tax burdern.

Without any income adjustments (pre-tax retirement savings or flex spending accounts) this family's Adjusted Gross Income will be the same as their Gross Income ($100,000) and their Taxable Income (Adjusted Gross Income - Deductions [standard deduction = $10,900] and Exemptions [$10,500]) is $78,600. Without taking into consideration any tax credits their tax bill would be $12,338.

The next thing I did was to assume this family spends $500 a year on medical bills so I deducted that by putting it into a Flexible Spending Account for Health Care and I assumed they spend $500 per month on child care so I deducted $6000 a year by putting it into a Flexible Spending Account for Dependent Care. I also helped this family put together a spending plan so they can contribute $15,500 to one of their 401(k) plans and $4,000 to a Traditional IRA. Making these changes dropped this family's Adjusted Gross Income down to $74,000 and subtracting out their Standard Deduction and Exemptions gave them a Taxable Income of $52,600 reducing their tax bill to $7,088. A difference of $5,250 a year.

Now for most of us, putting almost $20,000 a year into a retirement account probably isn't feasible but this examples shows what a difference using your adjustments can make to your tax bill. In the case of this family their after tax income wouldn't be reduced by the full $20,000 they put into retirement accounts since they saved over $5,000 in taxes. In essense, Uncle Sam would be putting over $5,000 into this couples retirement account for them.

Even though the money they are putting into a college savings account for their child doesn't decrease their taxes today, they won't have to pay taxes on the interest that money earns when they use it for approved educational expenses.

Again, I would highly recommend that you contact an income tax professional about strategies that you can use to legally reduce your tax burden.

Let me know if you have any questions or would like additional information on this subject.


1 comment:

Anonymous said...

Hello. My wife and I bought our house about 6 months ago. It was a foreclosure and we were able to get a great deal on it. We also took advantage of the 8K tax credit so that definitely helped. We did an extensive remodeling job and now I want to refinance to cut the term to a 20 or 15 year loan. Does anyone know any good sites for mortgage information? Thanks!