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Plan Well, Retire Well

Saving and investing your money
Tax brackets 2016

What Can You Learn from Your Tax Return?

President Trump's tax returns have been front-page news this week. Perhaps it's a good reminder that we should each take a look at our own tax returns to see what we can learn from them.

Here are some questions you might want to ask. Be sure to read to the end, where I list some of the actions you can take right now.

How much of your income avoided income tax?

When President Trump's 1995 tax returns were in the news last fall, the headlines speculated about how many years of future income he would be able to offset - and avoid taxes on - as a result of the huge loss that he claimed that year.

To a lesser degree, all of us can avoid paying tax on some of our income. To start with, you can see the deductions and exemptions that you were able to subtract from your income on lines 23 to 26 and lines 39 to 42 on your 1040. That's income you don't pay taxes on.

But some of the most valuable ways of avoiding tax on income don't show up there. (If you're 70 ½ or older, be sure to read about Qualified Charitable Distributions under Do You Itemize Deductions? for another example.)

For the average working-aged Mr. or Ms. Doe, most of our income comes from wages. And employee benefits are one of the most powerful tools for us to avoid tax on those wages. To see how much of your income was "hidden" from taxes by your benefits, compare the amount in Box 1 of your W-2 with how much you know you make (or with Gross Pay on your final paystub from 2016).

Are you surprised at how small the amount in Box 1 is? That's a good thing! It means that your employee benefits reduced your reported income and saved you money on your income taxes. Example of benefits that reduce your taxes are:

Medical and dental insurance premiums are "pre-tax" deductions, meaning that you pay no income tax on that part of your income. You also avoid FICA and Medicare payroll taxes.

Flexible spending accounts (FSAs) for dependent care, health care expenses, or commuter expenses (on public transportation or parking) are also pre-tax, avoiding both income tax and payroll taxes. TIP: You must sign up with your employer during open enrollment each year to have money deducted from your paycheck for these benefits. In general, you must spend the money by the end of the year or lose it.

If you have a high deductible health plan, you would have a Health Savings Account instead of a Flexible Spending Account for health care expenses. It reduced your taxable income just like an FSA, but you can keep money in the account – there's no need to spend it down each year.

Employer retirement plans such as 401(k) and 403(b) accounts: Money you put into these accounts are either tax-deferred contributions or Roth contributions. Tax-deferred means that you don't pay income tax on the money now, but you will when you withdraw the money in retirement). You do, however, pay payroll taxes now.

Roth contributions are "after-tax", meaning that you pay tax now on this income. But the growth in the account will be tax-free as long as you follow the rules about taking the money out. In general, the account must have been open at least 5 years and you have reached age 59 ½ or are dead or disabled).

Did you itemize deductions?

Line 42 shows how much you got to subtract from your income for either the standard deduction – the amount that anyone can claim, based on their filing status – or itemized deductions that you declared on Schedule A. If your itemized deductions add up to more than the standard deduction, you get to claim the larger amount. More than two thirds of us take the standard deduction. Some of us think we're getting a tax break because of charitable contributions, property taxes, mortgage interest, and the other itemize-able items on Schedule A when we really aren't, because they don't add up to any more than the standard deduction.

If you're age 70 ½ or older and you have an IRA, you don't have to itemize in order to get a tax break for your charitable contributions. You can do what's called a Qualified Charitable Distribution, where you have the distribution from your IRA sent directly to the charity of your choice. On your 1040, you list the amount of the distribution on Line 15a. Line 15-b is the one that matters, and that one will be zero, because Qualified Charitable Distributions are not counted as income.

What's your adjusted gross income - and why does it matter?

Your Adjusted Gross Income is line 37 of the 1040. It's an important number because it determines your eligibility for many different things. So, anything that you can deduct above this line may help in more ways than just reducing your taxable income down on Line 43. Your AGI determines whether you can claim the American Opportunity Credit for college expenses, get the Savers's Credit for contributions to a retirement plan, or contribute to a Roth IRA. It also controls how much of your Social Security benefits are subject to income tax and the amount of medical expenses you must have before you can start deducting them.

What's your tax bracket?

How much income tax did you pay on the last dollar you earned in 2016? That's what we refer to as your "tax bracket." Find your taxable income on line 43 of the 1040. Click on the bar chart at the top of this post to make it larger, or go to the IRS website. Notice that you only paid this % on part of your income; you paid no tax on some of your income, 10% on some of it, 15% on some of it, and so on up to your tax bracket.

How much did you owe or get as a refund?

If you got a large refund, many people would say you should adjust your withholding and give yourself a larger paycheck during the year. But many people use their refunds as a form of forced savings to meet certain goals. I think that's OK. But what's not OK is owing too much tax when you file, because that could result in a penalty. If your income, deductions, etc. could change substantially this year – perhaps because you're retiring or switching from being an employee to being self-employed – you may need to adjust your withholding or file quarterly estimated taxes.

Things you can do:

You can still contribute to an IRA and count it for 2016, as long as you make the contribution by April 18. (It's usually April 15, because of the weekend and the Emancipation Day holiday in Washington, D.C.) If your W-2 has an X by "Retirement Plan" in Box 13, check the IRS rules to see whether you can deduct your contribution. It depends on your Adjusted Gross Income. (I told you AGI was important!)

If you're eligible to contribute to a Health Savings Account (you have a High Deductible Health Plan) but you failed to sign up for one through your employer, you can open one yourself now.

Decide now to sign up for an FSA account for next year. Even if you only expect to have $500 in medical expenses, paying them through an FSA could save you $180 if you're in the 25% tax bracket and pay state income taxes as well.

You can increase the amount of your contribution to your retirement plan at any time. You don't have to wait until open enrollment. You can also switch from tax-deferred to Roth, or vice versa.

Consider how your taxes might change this year. Maybe you're expecting a change in employment, or perhaps a change in filing status because you're getting married or divorced, or your spouse has passed away. Depending on whether you think you'll be in a higher or lower tax bracket in the future, look for ways to take income now (while you're in a lower bracket) or to delay it (until you're in a lower bracket). For example, if you're in a lower bracket now, you might choose the Roth option for your retirement plan contributions instead of making tax-deferred contributions. A retiree might consider converting some tax-deferred retirement money into a Roth, to pay tax on that income now instead of later when they take distributions.

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