10/29/2010 1:00 PM ET|
8 types of income the IRS can't touch
Don't overpay taxes on income that's protected by the US tax code. Here are the major categories to watch, including 5 types of raises that don't add a dime to your taxable income.
Want to keep the tax man away from your money? It's easier than you think. There are lots of ways to increase your wealth without having a chunk of it gobbled up by the IRS.
It's not that the agency doesn't want your money. It's just that tax law prohibits the IRS from touching it. And with a bit of planning, you can start cutting your current tax bill and putting money in your pocket now.
Let's look at a few examples.
Interest earned on bonds issued by a state, territory, municipality or any political subdivision is free from federal taxes. These are generically called municipal bonds, and their tax benefit increases in value as your marginal tax rate goes higher. (In other words, the bonds are worth more to you as your overall income rises.)
Assume you're in the 35% bracket, the top rate through the 2010 tax year. A 5% tax-free rate becomes the equivalent of a taxable rate of 7.69%. In the 15% bracket, the taxable equivalent is only 5.88%. Go here on the site InvestingInBonds.com to compare taxable and tax-free yields. You can also find the after-tax rates on alternative investments of equivalent risk.
Some bonds may not only be tax-free at the federal level, but may also escape state and local taxes. If you're in a top bracket and live in New York City, this is one investment you definitely want to consider for your portfolio.
Commuting to work? Bring a friend -- and his wallet. If you form a carpool to carry passengers to and from work, any payment received from these passengers isn't included in your income.
Commuting costs are generally not deductible. But if you establish a carpool and you're reimbursed in amounts sufficient to cover the cost of your repairs, gas and similar items used in connection with operating your car to and from work, then you've converted personal nondeductible expenses into excludable income.
Assume you're in the 25% bracket for 20010. You have to earn $133 per month to cover a $100 monthly commuting expense. If you have a carpool arrangement with expenses being reimbursed, you've got no additional income -- but you do have an additional $133 per month in wealth.
Sell your house
Under a tax law enacted in 1997, if your house was your principal residence for two of the most-recent five years, you can exclude as much as $250,000 in gain ($500,000 on a joint return) when you sell it.
You don't have to reinvest the money, and you can claim the exclusion every two years. (If you've got $500,000 in gain every two years, I want to meet your real estate agent and go shopping!)
If you don't meet the two-year rule, you may be able to get a partial exclusion based on the time of use and ownership.
Assume you sold after only one year and had a $50,000 profit. Your exclusion is half the $250,000, not half the $50,000 profit. In this case, you'd pay zero tax on the sale.
But this partial exclusion is valid only if the sale is required because of a change in place of employment or for health reasons or unforeseen circumstances. The IRS has been very flexible with "unforeseen circumstances." Even the birth of twins or a neighbor's hostility qualifies.
When you're due for a raise, ask your company to get creative in your compensation. There are numerous ways to receive nontaxable compensation. Let's look at some of the best alternatives to taxable earned income:
- Use your health coverage. Health and hospitalization insurance premiums paid by your current or former employer are tax-free -- a huge benefit. Let's say your health insurance premiums come to $280 a month, or $3,360 a year (for an HMO policy for a family of four with a $1,500 deductible). If you're in the 25% tax bracket and have to pick up the bill, the real cost to you would be $4,480. That's $3,360 for the premiums and $1,120 for additional income taxes because you'll be paying for the coverage in after-tax dollars. Having your company pick up the cost helps both of you. Your employer doesn't have to pay the salary necessary to get you even, and it gets to write off the full cost of the coverage. Plus, neither of you has to pay the 7.65% payroll taxes on the premiums. And you, of course, boost your disposable income substantially.
- Cover your life. Group term-life insurance coverage of $50,000 or less paid for by your company isn't taxed to you. You pick the beneficiary; your company pays the premiums. Your company deducts the expense; you walk away with additional tax-free income.
- Send yourself to school. Get educated. The courses don't even have to be job-related. But they can't be for any education involving sports, games or hobbies. Your company can pay, and deduct, as much as $5,250 per year in educational assistance paid for either undergraduate or graduate courses. Again, that assistance comes to you tax-free.
- Get yourself there . . . and parked. Your company can give you discount fare cards, passes or tokens to take public transportation to work. As long as it is not worth more than $230 a month in 2010, your company can deduct it, but you, as an employee, receive it tax-free as a de minimus tax benefit. If you drive to work in 2010 and have to pay for parking, your company is now able to provide you free parking, up to a maximum value of $230 a month, tax-free. Alternatively, your employer can designate $20 per month of your pretax earnings for expenses relating to commuting by bicycle.
- Cafeteria plans. These are sometimes called flexible spending accounts. Your company makes deductible contributions under a written plan that allows you to select between taxable and nontaxable benefits. To the extent you choose nontaxable benefits, you have no additional income. Available nontaxable benefits may include group life insurance, disability benefits, dependent care and/or accident and health benefits. Your individual plan details the options. You make your choices among the items on the cafeteria menu.
Note that 2010 is the last year you can use your flexible spending account money for nonprescription drugs.
You get the idea. Any time you can convert taxable income into nontaxable income, you've given yourself a raise. And when both you and your company save money, it's a win-win situation.
Jeff Schnepper is the author of the best-selling book "How to Pay Zero Taxes," which is in its 30th edition. He is a former professor of taxation, accounting and finance. Schnepper now has a full-time tax planning and legal practice in Cherry Hill, N.J. Click here to find Schnepper's most recent articles.
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