By Ken Clark
One of the most important but misunderstood concepts in tax planning is the mechanics of the
Under the progressive tax system, a taxpayer's income is actually taxed in progressively higher blocks called "brackets". This model can be thought of as filling individual glasses (brackets) from a pitcher of water (income). As the income fills each bracket, only that amount is taxed at that particular rate - once it overflows you need a new glass and a new tax rate.
This is important for a couple of tax planning reasons. First, if you have any control over the timing of your income or expenses toward the end of the year, it may make sense to push the income or expense into one year or another. Naturally, you'd want to push income into the year where you expect to be in a lower income bracket. Likewise, you'd want to push the expense into the year where you expect to be in a higher income tax bracket.
Second, it's important for taxpayers to realize that due to the bracket system, a deduction may not be worth as much as they think. This can occur when a taxpayer only has a small amount of income falling in that top bracket, resulting in most of one or more of their deductions being applied at the next (lower) bracket.
A Suzy Taxpayer (whose top tax bracket is 25%) may think that donating $1,000 to charity will save her $250 ($1,000 x 25%) at tax time. However, since only $500 of her income fell in the 25% income tax bracket, only $500 will experience a savings at that bracket. The rest will experience a tax savings at the next lowest bracket of 10% bracket, making the overall deduction only worth $175 [($500 x .25) + ($500 x 10%)].
Tax Deduction vs. Tax Credits
Another important but commonly confused distinction by most taxpayers, is the difference between a tax deductions and a tax credit. Understanding the difference is crucial, since the tax strategies that you adopt now can favor one over the other and yield substantially different tax savings. (To learn more read, Give Your Taxes Some Credit.)
A tax deduction is an expense that is subtracted from a taxpayer's income, before taxes are calculated on the amount. A tax credit however, is an amount actually subtracted from the taxes that are owed once they've been calculated. Thus, a $1,000 tax credit is often worth more than a $1,000 deduction.
If Bob The Taxpayer is in the 25% marginal income tax bracket, a $1,000 deduction would save a maximum of $250 in taxes from his bottom line ($1,000 less in income that will not be taxed at 25%). However, if he were in the 25% marginal income tax, he would receive a $1,000 tax credit, and he will have $1,000 subtracted directly from the amount that he\'ll ultimately owe the IRS.
Understanding the Bottom Line
One of the primary goals of getting ready for tax season is to eliminate nasty surprises. For most people, sitting down at your accountant's desk or hitting the "calculate" button on your tax software is like waiting for the doctor to tell you if you're going to live or die. People cross their fingers, close their eyes and say a prayer, usually with no real idea what the outcome is going to be. But, since the IRS expects any balances owed to be paid when you file your return, April 14 is a horrible time to find out you're a few thousand short. Likewise, as hard as it is to believe, it's also a horrible time to find out you're getting a few thousand back - meaning you just gave the government a tax-free loan on that money for the year, instead of having it earning money for you.
There really is no mystery to the bottom line (what you owe or what you are owed) of your tax return. In simple terms, your taxes or refund due is figured by reducing your income by your deductions, calculating the tax liability on that remaining amount, and then comparing that liability against what you've already paid through your payroll deductions throughout the year. If you've paid more than you owe, you get money back. If you've paid less, it's time to get out your checkbook.
Needless to say, it's well worth the time and money to sit down with a calculator or your tax preparer in the last few months of each year to estimate where you'll be at tax time. If you're going to owe, you'll be able to begin adjusting your budget now to try and save a little extra each month to pay your bill. If you're getting money back, you can breathe a sigh of relief and begin making other plans to pay off debts or save for your long-term goals. If this is the second year in a row you'll receive a refund, you'll want to look at adjusting your withholding and stop giving Uncle Sam an interest-free loan. (To learn more see, How To Owe Nothing On Your Federal Tax Return and Tax Credits You Shouldn't Miss.)
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