5 Surprise Costs That May Affect Your Tax Bracket

By Stephanie Powers | February 23, 2010 AAA
5 Surprise Costs That May Affect Your Tax Bracket

There's a lot more to calculating taxable income than browsing your W2. Federal income tax brackets for 2009 and 2010 haven't changed much, but there are some transactions that may push you into a higher tax bracket.

Forgiven Mortgage Debt On Non-Primary Homes
Normally any mortgage debt forgiven is included as taxable income. The Mortgage Forgiveness Relief Act of 2007 allows individuals to exclude certain types of forgiven debt from income for tax years 2007 through 2012. The exclusion applies to such items as mortgage debt used to finance or improve their primary home.

It is a welcome relief to homeowners whose mortgages were modified as well as foreclosure victims. But, the exclusion does not include debt on non-primary residences. Debt cancelled on vacation homes or rental property may not qualify for the exclusion and is thus added to taxable income.

Roth IRA Conversions
Investors seeking future tax-free retirement distributions may choose to convert from traditional to Roth IRAs. Distributions from a traditional IRA rolled over to a Roth IRA may be taxable unless it was considered a return of basis.

Investors can spread out the tax burden of the rollover by setting up scheduled annual distributions from their traditional IRA into the Roth. (If you are moving assets from a Traditional IRA to a Roth IRA, you need to know the associated tax rules. Find out more in Did Your Roth IRA Conversion Pass or Fail?)

Unemployment Compensation
Only the first $2,400 of state unemployment insurance benefits is excluded from federal income taxes. If a previous employer paid a severance package from an unemployment fund, the amount would be taxable as wages and income and may also be subject to Social Security and Medicare withholding.

Laid-off workers should make sure the appropriate withholding exemptions are applied to benefits paid by former employers.

Various Employee Benefits
Generous employee perks such as dependent care reimbursements and adoption stipends are taxable as income. Employers often issue statements of total compensation detailing wages, employer retirement contributions, and other benefits to show the total cost of employment. W2 forms indicate which benefits are taxable.

Retirement Plan Distributions Issued To A Child
Qualified Domestic Relations Orders (QDRO) requiring a distribution from a retirement plan are taxable to the plan participant. According to IRS Publication 575, "Pension and Annuity Income," the plan participant must include the distribution as a taxable event. Retirement distributions to a spouse or former spouse are treated as though they were the plan participant (taxable if withdrawn, not taxable if rolled into a tax-deferred plan).

Repayment Of Homebuyer Credit
The Worker, Homeownership and Business Assistance Act Of 2009 granted tax credits of up to $8,000 to new homebuyers and long-time homeowners who purchased new homes. The new home must be the primary residence for three years. Homebuyers who received the homebuyer credit must repay the credit if the house is sold or it is no longer the primary residence.

The Bottom Line
It's worth the effort to understand which transactions trigger higher taxes. While some taxable actions may be unavoidable, adjusting tax withholdings may prevent surprises at tax time. (Follow these simple steps to get you ready for April 15 in 10 Steps To Tax Preparation.)

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