SAN FRANCISCO – In the real world, you see a way to save money, and you go for it, right? That's where the real world and the world of the U.S. tax code diverge.
When you're doing your taxes, sometimes it makes sense to give up even the most popular tax breaks.
"We know in general you should do X and everyone rushes and does it," said Bob Scharin, a New York-based senior tax analyst with RIA, of Thomson Tax and Accounting.
But "sometimes using an alternative approach can give you tax savings," he said.
Forgo personal exemption to gain tuition credit
Personal exemptions are valuable tax reducers, but some higher-income parents may be better off not claiming that perk for their college-age student; that is, not claiming their dependent child as a dependent, Scharin said.
Here's why: The valuable Hope Scholarship or Lifetime Learning credits — which can reduce your tax bill by up to $2,000 — phase out for people with incomes in the $90,000 to $110,000 range for married-filing jointly, and $45,000 to $55,000 range for single filers.
"Tuition credits get a lot of publicity, but because they're targeted to certain income levels not everyone who is paying tuition is eligible to claim them," Scharin said.
If you don't claim your student as a dependent, your student might be eligible for one of the tuition credits, even if you paid the tuition, Scharin said. The student can use the tuition credit to offset taxable income from earnings and investment income.
The question is: How much of a tax benefit do you lose if you give up that personal exemption you'd otherwise claim for your child? There's a $3,300 exemption for each dependent in 2006. (Personal exemptions act like deductions: They reduce the amount of income subject to tax.) But those exemptions, too, come with income phase-outs. The exemption starts decreasing once your income hits $225,750 for married-filing-joint filers.
If you're going to lose some of that exemption because of the income phase-out, it might make sense to "let the child at least get the college credit," Scharin said.
You take the high road; I'll go this way
Often, married couples save money by filing their return jointly. After all, if spouses have disparate income, they may find they're taxed at a lower overall rate if they file jointly, and those who file separately lose out on tax perks such as college tuition credits.
But there are exceptions to the general adage that filing jointly will save you money. For instance, some deductions require your expenses exceed a certain percentage of your adjusted gross income.
For the medical-expense deduction, your medical expenses have to exceed 7.5 percent of adjusted gross income before you can enjoy the deduction; there's a 2 percent threshold to claim the miscellaneous itemized deduction.
"If you file a joint return, then the income used for these floors is the joint income. If you file a separate return, then you could look at your income separately. If a spouse with a lower income has high medical bills, the tax savings can be greater by filing separately," Scharin said.
Still, "you have to look at it both ways," he said. "If the income difference is large enough, putting the higher-income spouse into a higher tax bracket, it might not work out."
Take a smaller deduction?
Usually, taxpayers are well-advised to take the larger of either the standard deduction or the total of their itemized deductions. "There are some exceptions," Scharin said.
For instance, he said, if your itemized deductions are larger solely because you overpaid your state income tax, then it might be better to take the standard deduction this year.
"If you claim the [state tax] payment as a deduction, then the refund is taxable income," Scharin said. "You will have to pay tax on the state income tax refund that you receive next year. So if you plan to be in a higher tax bracket next year, you could be better off having claimed the standard deduction [this year] and then not having to pay tax on the refund."
Don't claim that home-sale tax perk
Consider carefully before claiming your home-sale exclusion. That tax perk allows you to exclude up to $250,000 ($500,000 for married-filing-jointly) of the gain from your sale, but if you have another home that you might sell next year, you might want to preserve that tax perk.
Here's why: One rule for the home-sale exclusion is that you've lived in the home for at least two out of the past five years. Another rule is usually you're limited to claiming it once every two years, Scharin said (there are exceptions).
There are times when claiming that healthy tax perk isn't so smart. Scharin offered this example: Say you move out of your Connecticut home to retire to your vacation home, a small condo in a warmer climate. But then, you realize it's too small. You sell the small condo for a bigger property. Then, the following year, you decide you don't want to maintain the upkeep on your original home back in Connecticut, so you sell it — for a much larger gain.
If you'd claimed the exclusion on your gain on the smaller condo in the previous year, you'd be out of luck claiming the exclusion on your bigger gain for the sale of the Connecticut home.
"If you have the feeling you're going to be having a large eligible gain next year, then you should refrain from claiming the home-sale exclusion this year," Scharin said.
Give your exemption away
Another strategy, for the 2006 tax year at least, is to essentially "give away" one of your personal exemptions. Higher-income parents with two kids might consider giving up the personal exemption available to them for their younger child — and letting their older child use that exemption to decrease her tax bill, Scharin said.
That is, the older child claims her younger sibling as a dependent. The parents are giving away something that may not be worth a lot to them anyway — if their income is high enough to cause the personal exemption phase-out — and it could benefit their older child.
This strategy is possible currently thanks to a new definition of dependent, Scharin said, but Congress is looking at closing the loophole. Note that the experts call this an aggressive tax position. Be sure to check with your tax adviser before taking this route.
There are caveats. The older sibling has to be self-supporting and unable to be claimed as a dependent herself (if you are a dependent you can't claim a dependent). "It would be someone who graduates from college and has a job but is still living at home," Scharin said.
But the older sibling doesn't have to be supporting the younger child. "The test that has to be met is they have the same principal place of abode for more than half of the year," Scharin said. Also, the younger child, the one being claimed as a dependent, needs to be under age 19 (under age 24 if a full-time student), and must not have provided more than half of his or her own support during the year.
If you follow all the rules, it's even possible that the older sibling could claim the earned income tax credit, along with the personal exemption. Again, talk to an adviser first. The fact that you no longer count your younger child as your dependent may affect his health-insurance coverage and college financial-aid situation.
That make-or-break dollar
Sometimes just one additional dollar of income will lose you many dollars worth of tax breaks.
"Normally, you think 'my top marginal rate is 35 percent, so the most I'm going to lose on an additional dollar is 35 cents,' but that may in fact not be true," said Mark Luscombe, a principal analyst with CCH Inc., a Riverwoods, Ill., tax publisher.
In some cases, "an additional dollar of income can result in you incurring more than an additional dollar of taxes," he said.
"Let's say you qualify for the child tax credit and your adjusted gross income is $110,000. If you increase that by one dollar to $110,001, you actually lose $50 of child tax credit. An additional dollar of income has cost you $50 of taxes," Luscombe said.
Not all income phase-outs work the same way, so this is not true for all tax breaks. But for tax breaks with phase-outs that either end abruptly at a particular income figure, or those that phase out "for every additional $1,000 of income or fraction thereof," you'll see a similar effect, Luscombe said.
Who could forget the AMT?
Then there's the AMT, which tends to raise a whole slew of unlikely tax strategies.
Here's one example: Under the regular tax, it's generally a good idea to postpone income into the next year and pull deductions into the current year (to reduce your current-year tax bill). For instance, it often makes sense to pay your Jan. 15 state income tax payment in the preceding December so you can deduct it in that year.
But, "if you're accelerating deductions that are not allowed for AMT purposes, you can put yourself into an AMT situation," Luscombe said.
"State income tax is a deduction that's not allowed for AMT purposes. If you're in an AMT situation, accelerating that would not help you any and if you're on the cusp of being in an AMT situation, than accelerating that could actually put you into an AMT situation.
Copyright (c) 2006 MarketWatch, Inc.