The Tax Laws are both complicated and ever changing. Major changes to these Laws have occurred nearly each of the past fifty years. The last major change was one of the most significant overhauls in modern times!
Yet as the famous Jurist Judge Learned Hand once stated (in the 1934 case of Helvering v. Gregory):
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing Sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike, and all do right, for nobody owes any public duty to pay more than the law demands.” Even a President (Trump that is!). Therefore, everyone is encouraged to take steps that will reduce what you pay each year to the IRS!
There are several rules to keep in mind:
1. You must report all “your” income unless a specific law allows you to exclude it, exempt it, or defer it (so that it is taxed at a later time).
2. You can claim deductions only when and to the extent allowed by law. Deductions are considered a matter of legislative grace as Congress doesn’t have to create them. It does so only for some specific purpose like encouraging economic activity or to balance a perceived inequity.
3. Tax credits are worth more than tax deductions. A credit reduces your tax payment on a dollar for dollar basis. By way of example, a $1,000 tax credit reduces your tax bill by $1,000; whereas an equivalent deduction benefits you relative to the highest tax bracket that you fall into. Let’s suppose you have a $1,000 deduction and are in the 24% income tax bracket. That deduction will only save you $240 ($1000 x .24) on your tax bill.
4. Even if your income is modest you may have to file a form 1040 (the long form) in order to claim certain available tax benefits.
5. In a number of cases, different deduction rules apply to the alternative minimum tax (AMT). This is a shadow tax system that ensures you pay at least some tax if your regular income is lower than it would have been without certain deductions.
Tax Favored Items
There are five (5) types of tax advantaged items that receive preferential treatment under the tax laws:
1. Tax Free Income – this is income you can receive without any current or future tax concerns. Tax free income may be in the form of exclusions or exemptions from tax. In many cases, tax free items do not even have to be reported in any way on your return.
2. Capital Gains – these are profits on the sale or exchange of property held for more than one year. Long term capital gains are subject to lower tax rates than the rates on other income, such as salary and interest income, and in some cases are tax free. Ordinary dividends on stocks and capital gain distributions from stock mutual funds are taxed at the same low rates as long term capital gains.
3. Tax Deferred Income – income that isn’t currently taxed. Since the income builds up without any reduction for current tax, you may accumulate more over time. However, at some point in the future the income becomes taxable. At that juncture you are expected to be in a lower tax bracket thereby benefiting from the deferred taxation of your accumulated earnings and its earning.
4. Deductions- these include items you can subtract from your income to reduce the amount of income subject to tax. There are two classes of deductions: those above the line which are subtracted directly from gross income, and those below the line, which can be claimed only if you itemize deductions instead of claiming the standard deduction.
Credits- these are items you can use to offset your tax on a dollar for dollar basis. There are two (2) types of tax credits: one that can be used only to offset tax liability (called a non refundable credit) and one that can be claimed even if it exceeds the liability and you receive a refund ( called a refundable credit). You must usually complete a special tax form for each credit you claim.