Bill Bischoff for MarketWatch.com writes: You probably think you have a good understanding of our federal income tax system. But since so many of us don’t know the basics, let’s go through the not-so-simple rules.
Your filing status
What is your proper federal income tax filing status? Good question. Here are the rules in a nutshell.
Single
If you are unmarried as of Dec. 31 of the year in question, you generally must file as a single person for that year. That’s because your marital status at year-end generally determines your filing status for the entire tax year. Naturally, there are some exceptions.
Married filing jointly
If you are married at year-end, you can file a joint return with your spouse. Alternatively, you can use married filing separate status, which requires filing two separate Forms 1040 (one for each spouse), instead of just one joint return. If you lived apart from your spouse for the last six months of the year, you may also qualify for head of household status even though you were still married as of year-end (more on that later).
If your spouse dies during the year, you can still file a joint return with your deceased spouse for that year.
Qualifying widow or widower
After a spouse dies, the surviving spouse may be able to continue using the favorable joint return tax brackets for up to two years after the year of death. During those years, the surviving spouse must remain single and pay over half the cost of maintaining a home for a dependent child.
Head of household
A common (and expensive) error is filing as a single taxpayer when Head of Household, or HOH, status is allowed. HOH is better because you are entitled to looser tax brackets and a bigger standard deduction. In addition, various other tax rules are much more favorable for HOH filers than for single filers.
•If you are single and live with a qualifying child, you probably qualify for HOH status.
•If you are single and pay over half the support for a parent who can be claimed as your dependent, you qualify for HOH status if you also pay over half the cost of maintaining your parent’s home for the entire year, whether or not the parent actually lives with you.
•You generally qualify for HOH status if you are single and pay over half the cost of maintaining the principal home for yourself and a relative who lives with you for over half the year and can be claimed as your dependent.
Married filing separately
Married individuals are not required to file joint returns. Instead, each spouse can choose to file a separate Form 1040 that lists that person’s share of the couple’s income and deductions. In some cases, this can pay off. For example, say your spouse has relatively low income and high medical expenses, while you have little or no medical expenses and high income. The medical expense deduction is generally limited to the amount in excess of 10% of adjusted gross income, or AGI. If you file jointly, your high joint AGI will probably wipe out any chance for a medical expense deduction. But if you file separately, your spouse’s low AGI may permit a substantial medical expense write-off on his or her separate return. (If your spouse itemizes, you must itemize, too.)
Unfortunately, the laws of some states say that a married couple’s income is automatically split 50/50 regardless of which spouse actually earns the money. The same 50/50 split must then be used if the spouses file separate federal returns. In some states, expenses are also generally deemed to be split 50/50. So state law may effectively disallow any hoped-for tax savings from filing separate federal returns.
Finally, using married filing separate status precludes eligibility for various federal tax breaks -- including the two higher-education tax credits, the college loan interest write-off, the dependent care credit, and the adoption credit. Separate filers are also limited to a puny $1,500 net capital loss deduction (versus the normal $3,000 limit).
When all is said and done, filing separately saves taxes only in very limited circumstances. Even so, it can be a smart move if you and your spouse are estranged — because filing separately will generally shield you from any liability for your spouse’s federal income tax misdeeds, errors, omissions, or underpayments,
Unfavorable income-based phase-out rules and limitations
Unfortunately, many tax breaks are curtailed or eliminated as your income goes up the scale. When you are impacted by phase-out and limitation rules that reduce or eliminate tax benefits, your marginal federal income tax rate is higher than the advertised percentage. The following AGI-based phase-out rules are probably the most likely candidates to affect you.
•The restrictions on making deductible contributions to a traditional IRA and annual contributions to a Roth IRA.
•The American Opportunity higher-education tax credit (worth up to $2,500) and the Lifetime Learning higher-education tax credit (worth up to $2,000) are phased-out over different modified adjusted gross income (MAGI) ranges. For the American Opportunity credit, the phase-out range is between $80,000 and $90,000 for unmarried individuals and between $160,000 and $180,000 for married joint-filing couples. For the Lifetime credit, the 2014 phase-out is between $54,000 and $64,000 for unmarried individuals and between $108,000 and $128,000 for married joint-filing couples.
•For 2014, the above-the-line deduction for up to $2,500 of college loan interest is phased-out between MAGI of $65,000 and $80,000 for unmarried clients and between $130,000 and $160,000 for joint filers.
•The $1,000 tax credit for each under-age-17 dependent child is phased out starting at MAGI of $75,000 for unmarried individuals and $110,000 for married joint-filing couples.
•For 2014, personal and dependent exemption deductions are phased out starting at the following MAGI thresholds: $254,200 for single filers, $305,050 for married joint-filing couples, $279,650 for heads of household, and $152,525 for married individuals who file separately.
•For 2014, the most popular itemized deductions (including home mortgage interest, state and local taxes, and charitable donations) are partially phased out starting at the same MAGI thresholds as the phase-out rule for personal and dependent exemption deductions. Under the phase-out rule, three percent of your total itemized deduction amount (exclusive of the write-offs for medical expenses, casualty losses, investment interest, and gambling losses) is disallowed for every dollar of MAGI in excess of the threshold. However, no more than 80% of the affected deductions that you started off with can be eliminated under this phase-out rule.
The bottom line
We often hear complaints about how our federal income tax system is way too complicated. It’s true. Just look at all the complexity Congress has caused by granting tax breaks with one hand while taking them away with the other through confusing phase-out rules and limitations. While some politicians have given lip service to this concern, nothing gets done when push comes to shove.
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