The Difference Between Tax Exemptions, Deductions, and Credits

Mike Piper the Oblivious Investor writes: Many taxpayers are confused as to the difference between exemptions, deductions, and credits. Essentially, the difference is that deductions and exemptions both reduce your taxable income, while credits reduce your tax.

Exemptions

Exemptions reduce your taxable income. For 2011, you are entitled to an exemption of $3,700 for yourself, one for your spouse, and one for each of your dependents.

EXAMPLE: Kevin and Jennifer are married, and they have four children, whom they claim as dependents. They will be allowed six exemptions. As a result, their taxable income will be reduced by $22,200.

Deductions

Deductions generally arise from your expenses. For example, a deduction is allowed for interest paid on student loans.

EXAMPLE: Carlos is in the 25% tax bracket in 2011. Over the course of the year, he paid $1,600 in student loan interest. This $1,600 decrease in his taxable income will save him $400 in taxes ($1,600 x 25%).

Itemized Deductions or Standard Deduction?

Several deductions (such as charitable contributions or the interest on your home mortgage) fall into the category known as “itemized” deductions. Sometimes, these are known as “below the line” deductions (more on that in the next section). Every year, you have the choice to use either:

1. The sum of all of your itemized deductions, or
2. The standard deduction ($5,800 for a single taxpayer in 2011, or $11,600 for a married couple filing jointly).

For the most part, this decision is pretty easy. Simply add up all of your itemized deductions, and compare it to the standard deduction you would be allowed. Then simply take whichever option allows you a larger deduction.

Above the Line vs. Below the Line Deductions

If a deduction does not fall into the category of itemized, or “below the line,” it must be what is known as an “above the line” deduction. Above the line deductions are unique in that you can claim them regardless of whether you choose to use the standard deduction or your itemized deductions.

Some common above the line deductions include contributions to a traditional IRA, interest paid on student loans, or contributions to a Health Savings Account.

In contrast to above the line deductions, which are always useful, below the line/itemized deductions are only valuable if and to the extent that they (in total) exceed your standard deduction amount. Here’s how it looks mathematically:

Gross Income (sum of all your sources of income)
— Above the line deductions
=  Adjusted Gross Income ← “The Line”
— Standard Deduction or Itemized Deductions
— Exemptions
=  Taxable Income

EXAMPLE: Eddie is a single taxpayer. During the year he contributes $3,000 to a traditional IRA, and he makes a charitable contribution of $1,000 to Kiva.org (his favorite non-profit). He has no other deductions, and his income (before deductions) is $50,000.

The IRA contribution is an above the line deduction, and the charitable donation is a below the line (a.k.a. itemized) deduction.
Plugging this into the above equation, we get this:
$50,000 Gross Income
— $3,000 Above the line deductions
=  $47,000 Adjusted Gross Income ← “the line”
— $3,700 Exemption
— $5,800 Standard deduction
=  $37,500 Taxable Income

Important observations:

1. Eddie’s itemized deductions ($1,000) are less in total than his standard deduction ($5,800). As such, Eddie’s charitable contribution doesn’t provide him with any tax benefit, because he’ll elect to use his standard deduction instead of his itemized deductions.
2. Eddie’s above the line deduction provides a tax benefit even though he’s using the standard deduction.

Again, itemized/below the line deductions only help when they add up to an amount greater than your standard deduction. Above the line deductions, on the other hand, are always beneficial.

Credits

Unlike deductions and exemptions, credits reduce your taxes directly, dollar for dollar. After determining the total amount of tax you owe, you then subtract the dollar value of the credits for which you are eligible. This makes credits particularly valuable.

Credits arise from a number of things. Most often, though, they are the result of the taxpayer doing something that Congress has decided is beneficial for the community. For example, you are allowed a credit of up to $2,500 for paying “qualified education expenses” for one of your dependents. If you meet the requirements to claim the maximum credit, your tax (not taxable income) will be reduced by $2,500.

“Pre-Tax Money”

You’ll often hear the term “pre-tax money,” generally in a context along the lines of “You can pay for [something] with pre-tax money.” This means one of two things:

1. The item is deductible, or
2. The item can be paid for automatically in the form of a deduction from your paycheck.

The reason these situations are sometimes referred to as “pre-tax” is that you get to spend this money before the government takes their cut. This makes it more cost-effective for you.

You will, from time to time, run across people who seem to be under the impression that something is free simply because it’s deductible or because they were allowed to spend pre-tax money on it. This is a severe misunderstanding. Being able to spend pre-tax money on something is much more akin to getting a discount on it than it is to getting the item free.

Simple Summary

• You are entitled to one exemption for yourself, one for your spouse, and one for each of your dependents. In 2011, each exemption reduces your taxable income by $3,700.
• Deductions arise from your expenses, and they reduce your taxable income.
• Each year, you can use either your standard deduction or the sum of all your itemized (below the line) deductions.
• Above the line deductions are particularly valuable because you can use them regardless of whether you use your standard deduction or itemized deductions.
• Credits, unlike deductions and exemptions, reduce your tax directly (as opposed to reducing your taxable income). Therefore, a credit is more valuable than a deduction of the same amount.

529 Plan Benefits: An Education for Your Student, Tax Breaks for You

Wells Fargo Advisors writes: With the pace of higher-education costs rising faster than the general Consumer Price Index (CPI), it's easy to understand why saving enough money to fund a child's college education has become a financial challenge for many parents and grandparents. The numbers tell the story: The first-year college tuition bill in 2020 is projected to be $32,803 for an in-state average public education institution and $66,036 for an average private institution.* So whether college for your child or grandchild is years away or right around the corner, put time on your side — consider the benefits of contributing to a 529 plan for a student (beneficiary) in your family.

Made possible by federal legislation, 529 plans (named after section 529 of the Internal Revenue Code, 26 U.S.C. §529) are implemented at the state or institution level. Nearly all states have approved and adopted these qualified tuition assistance programs. Most states let nonresidents participate in their plans, although the tax benefits may be greater for residents than for non residents.

The student can use 529 plan account balances at any participating accredited postsecondary school in the United States or certain schools abroad for tuition, room and board, books, equipment, and supplies. Qualified expenses also include computer technology, related equipment and Internet-access costs.

As the owner, you retain control of the assets and can change beneficiaries within the designated student’s family at any time without penalty. A qualified family member generally includes siblings, descendants, ancestors, aunts, uncles and first cousins. Other key advantages of these plans include:

Federal-income-tax-free qualified distributions. The student may be able to take qualified distributions federal-income-tax-free.

No income limitations for participation. There is no income limit for contributing to a 529 plan, which is a benefit for higher-income families.

Substantial contribution amounts. Contribution limits are significantly higher than those allowed for other education savings plans. Maximum account balance limits vary from state to state.

Significant estate-planning benefits. A single person can contribute up to $65,000 in one year per beneficiary; a married couple can contribute up to $130,000 in one year per beneficiary with no gift-tax consequences. Such a contribution will be considered a five-year accelerated annual-exclusion gift, so no additional gifts can be made for that beneficiary for the next four years without incurring gift-tax implications unless the annual exclusion gift increases. The gift amount and subsequent appreciation, however, are removed from your taxable estate. (A portion of the contribution amount may be included in the donor’s taxable-estate calculation if the donor should die within the five-year period.)

No burden of investment decisions. The plan's chosen investment manager will be responsible for portfolio management of all contributions. Initially, some plans may let you select from several asset-allocation-model alternatives, which generally may be changed once every calendar year and/or with a beneficiary change.

If for some reason the account balance is not used for qualified higher education expenses, every withdrawal from a 529 plan is separated into two components: an "earnings" portion and a "return of your investment" portion. If a withdrawal is not used for qualified higher-education expenses, the "earnings" portion of the withdrawal is subject to federal income tax and potentially a 10 percent IRS penalty. The "return of your investment" portion in the 529 plan is never subject to federal income tax or IRS penalty. (State laws regarding taxes and penalties can vary from state to state, however, and may apply; you should always check with your tax professional before making this type of withdrawal.) If the beneficiary dies, becomes disabled or receives a tax-free scholarship, you may take penalty-free withdrawals from the 529 balance within that same calendar year.

Keep in mind that 529 plan investment balances may affect eligibility for financial aid:

• If a parent owns the 529 account, up to 5.64 percent of the value is included in Expected Family Contribution (EFC) as a parental asset. Any 529 accounts owned by a dependent student, or by a custodian for the student, are reported on the Free Application for Federal Student Aid (FAFSA) as a parental asset. Any qualified withdrawals from these accounts are not included as income to the student.

• If a 529 account is owned by a grandparent (or someone other than a parent or the student), the value of the 529 plan is not reportable as an asset on the FAFSA.

However, any distributions from these third-party accounts are considered financial support to the student and are reportable on the following year's FAFSA as student income. Student income is assessed at the student's rate of 50 percent.

There are many 529 plan choices — discuss college-funding alternatives with your financial adviser and choose the one that best fits your needs.

An investment in a 529 plan will fluctuate such that the shares when redeemed may be worth more or less than the original investment. There are no guarantees that an investment in a 529 plan will cover higher-education expenses. Investors should consult the plan's offering document for the fees and expenses associated with that plan. You should consider a 529 plan's investment objectives, risks, charges and expenses carefully before investing. The plan's official statement, which contains this and other important information, should be read carefully before investing.

BIG TAX BREAKS EQUAL BIG CASH FOR THE TOP 1%

Author: Mattea Kramer  in Taxes & Revenue

Source: OMB, CBO. Click here for the full, interactive version of these charts.

The tax code is so full of tax breaks that this year it will cost the federal government more than $1 trillion – as much as all discretionary spending in the federal budget. Tax breaks are all different kinds of credits, deductions, and exclusions that allow people to reduce the amount they owe in taxes. But not everyone benefits equally. The top 10 tax breaks – which total more than $750 billion this year – heavily benefit the top 1 percent of earners. For instance:

• The popular home mortgage interest deduction allows wealthy taxpayers to deduct the mortgage interest for second and third homes – and even yachts classified as homes. That deduction will cost the federal government around $93 billion this year, and 15 percent of that total will go to the top 1 percent.
• Taxpayers are allowed to deduct the amount they spend on state and local taxes from their federal tax liability, and that tax break will cost the federal government around $44 billion this year. Thirty percent of that total will go to the top 1 percent.
• There's a special low tax rate on capital gains and dividends that mean taxpayers pay a lower rate on investment income than on regular wages. That tax break will cost the federal government $83 billion this year, and a staggering 68 percent of that total will go to the top 1 percent.

"S" or "C" Corporation for Your Spine (medical) Practice: Maximize Tax Deductions by Using Both!

 David B. Mandell, JD, MBA and Carole C. Foos, CPA, OJM Group write Choosing the form and structure of one's medical practice is an important decision. Most advisors to medical practices believe that the avoidance of potential double taxation makes the S Corporation the logical choice. This "conventional wisdom" overlooks the potential benefits a C Corporation can offer. If you want to explore ways to reduce unnecessary taxes without subjecting the practice or its owners to double taxation AND would like to see how you can do this without having to change any of your insurance provider or Medicare provider numbers, this article is ideal for you.

The Basics of Corporations
First, let's assume that the spine practice is taxed as either an S or C Corporation. There is little reason to practice as a sole proprietorship or partnership. This can result in unnecessary lawsuit risk, in addition to the inability to take advantage of many valuable tax-deductible business expenses mentioned in this article.

Second, we need to compare and contrast C Corporations and S Corporations. All businesses that incorporate are automatically C Corporations absent an election to become an S Corporation. Both S and C Corporations have separate tax ID numbers and are required to file tax returns with the federal and appropriate state tax agencies. Both entities have shareholders. Both entities can be created in any state in the country.

When a C Corporation earns profit, it must pay tax at the corporate level. Profit is the difference between income and expenses. Compensation paid to physicians, as long as it is reasonable, is deductible by the corporation on its tax return (and is therefore not taxable to the corporation).

The salary received by the owner is taxable to the owner as wages. After the C Corporation pays taxes, distributions of earnings already taxed at the corporate level can be paid to the owners in the form of dividends. These would generally be taxed to the owners as qualified dividends, thus leading to the "double taxation" of such earnings. As you will see below, this drawback is often overrated.

An S Corporation is also a separate entity that must file its own tax return. However, the S Corporation is often referred to as a "pass through" entity. Rather than paying tax at the corporate level, all income and deductions pass through to the shareholders and the shareholders must pay tax on any S Corp income at their individual rates. Whether the income to an S Corp is paid to the owners as salary or as a distribution will not impact the federal or state income tax rates that will be applied to that income for the owner. There is never any tax to the corporation; therefore there is no "double taxation" in an S Corporation.

Double Taxation – Much Ado About Nothing
Mistakenly, most spine physicians think of S and C Corporations as having exactly the same benefits. Since the C Corporation has a potential double taxation, many owners and their advisors elect to make an S election to avoid one more potential problem. First, the double taxation problem can be easily avoided by reducing practice profits to zero, or close to zero, at the end of the year with reasonable compensation and bonuses to the owner. Second, after you review the next section, you will see that the increased benefits the C Corporation offers spine surgery practices can far outweigh the cost (in time, not money) of zeroing out a C Corporation.

Additional Deductible Benefits of a C Corporation
Contrary to much "conventional wisdom," a C Corporation can be the right choice for many small entities because of the deductions it allows. The corporate deduction for fringe benefits paid to employees is generally limited for shareholders owning more than 2 percent of an S Corporation. However, a C Corporation enjoys a full deduction for the cost of employees' (including owner employees) health insurance, group term life insurance of up to $50,000 per employee, and even long term care premiums without regard to aged based limitations. The C Corporation can also deduct the costs of a medical reimbursement plan. If one has a small corporation and a lot of medical expenses that aren't covered by insurance, the corporation can establish a plan that results in all of those expenses being tax deductible. Fringe benefits such as employer provided vehicles and public transportation passes are also deductible.

In contrast, health insurance paid by an S Corporation for a more than 2 percent shareholder is not deductible by the corporation. The shareholder must generally take a self-employed health insurance deduction on his personal return. Long term care premiums paid through an S Corporation are also not deductible with regard to these shareholders. The shareholders, in deducting them personally, are subject to the age based limitations.  

Lower Tax Rates for C Corporations
C Corporations enjoy their own graduated rates. The first $50,000 of taxable income in the C Corporation is taxed at a 15 percent federal rate versus the top marginal rate of the shareholder (currently 35 percent) that the owner of an S Corporation will be taxed. Even if the owner of a C Corporation forgot to "zero out" the corporation and left $50,000 in the entity, the corporate tax would be only $7,500. A dividend of the remaining $42,500 would only be taxed at a rate of 15 percent – resulting in taxes of another $6,375 – leaving $36,125 (or 72.2 percent). If that $50,000 had been in an S Corporation and the owner had annual income over $300,000, the federal tax rate would have been 35 percent (or $17,500). In this example, leaving $50,000 to be taxed in a C Corporation would actually have SAVED the owner over $3,600 in taxes!

Personal service corporations (PSCs), such as attorneys, doctors and accountants, do not receive the benefit of these graduated rates since PSCs are taxed at a flat 35 percent rate. Therefore, PSCs do not enjoy the same benefits of the graduated C Corporation rate structure that other types of businesses will enjoy. However, PSCs can take advantage of the full Section 179 expense deduction in writing off furniture and equipment in the year of purchase. C Corporations are afforded their own Section 179 deduction limitation. Shareholders of an S Corporation must accumulate the Section 179 deduction among each of their pass through entities, thus they could be limited in a given year.

If the practice has rental activity, a C Corporation which is not a PSC has the advantage of using rental losses to offset operating income. Shareholders of an S Corporation must treat rental losses as a passive activity subject to the passive loss and at risk rules.

"S" Corporations May Become Obsolete for Many Small Medical Practices
There were discussions in Congress recently that could have limited much of the tax benefit of an S corporation for service professionals. The benefit at issue is the ability, in an "S" corporation, for doctor-owners of medical practices to save Medicare taxes on their distributions, as opposed to their salaries. By paying themselves a "reasonable salary" and taking the remainder of their business income as distributions, physician-owners can save thousands of dollars each year in Medicare taxes. The proposal in Congress would have eliminated this benefit.

Get the Best of Both Worlds – Why Not Use Both?
Many spine practices can take advantage of both the C Corporation and the S Corporation by setting up two distinct entities to operate different aspects of their practice. Perhaps the S Corporation will be used for the operating side of the spine surgery practice (providing of services) while the C Corporation will be used for management functions (billing and administration). In this way, the practice as a whole can take advantage of both the tax deductions afforded a C Corporation and the "flow through" advantages of an S Corporation. This may also provide some additional asset protection. As long as all formalities of incorporation are followed, as well as compliance with rules for employee participation in all benefit plans, spine surgery practices can benefit from this "dual" corporate structure.