Updated: 10/29/2010 9:00 AM ET|
6 tax myths that can cost you money
We all think we know the parts of the tax code that affect us. But do we really? If you believe some of these myths, you could pay more tax than you should.
Santa Claus. The tooth fairy. Babe Ruth pointing to where he would hit a home run in the 1932 World Series. Someone who knocks on your door, smiles and announces, "I'm from the government, and I'm here to help you."
Our culture is full of myths. And our tax system is full of myths, half-truths and untruths that can cost you big bucks if you don't understand the rules.
So let's have a look at some of the bigger myths about taxes. If I've done my job properly, I'll show you how they can trap you and how you can save money by separating myth from reality. If you find you need more help, consult a tax professional.
Myth 1: Students are exempt
Lots of people believe there's an exemption for students that excludes them from income tax. Wrong, scholarship breath!
There's no special tax status afforded to students. They are subject to tax on all their income, regardless of how many credits they're taking or whether or not they're fully matriculated.
Students do get special tax credits, the Lifetime Learning Credit and the new American Opportunity Credit, which has replaced the Hope Credit for 2009 and 2010. In addition, distributions from a Section 529 plan are tax-free. But their income is subject to tax, just like everyone else's.
Many students who work over the summer check the box "exempt" on their W-4's. If they had no taxable income the previous year and don't expect to have any the current year, that's OK. But let's say a student earned more than $5,700 in 2010. And let's say she is claimed as a dependent on her parents' return. She will owe tax and penalties if she owes more than $1,000 or actually fails to file. Don't get caught in this trap.
Myth 2: My child is working, so I can't claim him as my dependent
Again, pure myth. As long as you provide more than half that child's support (and meet other qualifications such as citizenship and relationship), the child qualifies as your dependent, and you can deduct, for example, all the medical costs you paid for that child.
Remember, support is what's spent, not what's earned. So, let's say your child makes millions as a teenage fashion model. If she banks all the cash and you actually shell out the dough to support her profession, you've provided 100% of that child's support.
You can also qualify for a personal exemption for that child if the child doesn't earn more than the value of that exemption -- $3,650 in 2010. This income test doesn't apply to whether the child qualifies as your dependent for, say, medical expenses, nor does it apply if the child is under age 19 or is a full-time student under age 24.
A child qualifies as a full-time student if, during each of any five months of the calendar year, he or she (a) is in full-time attendance at an educational institution or (b) is taking a full-time course of instructional or farm training.
Myth 3: I'm over age 55, so I can sell my house tax-free
Wrong again, graybeard! You're thinking old law.
It used to be that if you were older than 55, you could exclude as much as $125,000 in gains from taxes, but only once. Now the rules are even better.
Under current law, age no longer matters. If the property sold was your principal residence for at least two out of the last five years, you can exclude from tax as much as $250,000 in gain (and $500,000 in gain on a joint return).
Your age is irrelevant, and you can take the gain exclusion every two years if you qualify. By the same token, if your property appreciates by $250,000 to $500,000 every two years, give me a call. I could use your help in finding a new house.
Myth 4: I had to buy my first house to be a first-time homebuyer
Surprise! You don't have to be a first-time homeowner to get the first-time homebuyer credit of up to $8,000. You qualify if neither you nor your spouse had an interest in a principal residence for the three years prior to closing on the new house (which had to happen before September 2010).
Alternatively, you may qualify for a credit up to $6,500 if you owned and used a home as a principal residence for at least five consecutive years out of the eight year period ending on the date of the purchase of the new home.
Both qualify as "first-time homebuyers."
Myth 5: I can deduct my sales taxes
This one was once up there with the Loch Ness monster, but the deduction has made a comeback of sorts.
Starting in 2004 and renewed through the 2009 tax year (Congress is expected to extend this through 2010 but has not yet done so as of the date of this update), you can deduct either your personal sales taxes or your state income taxes from your federal income return, but not both. In those states with an income tax, you're far more likely to pay more in income tax than sales tax, so the sales tax deduction remains a rare sighting. But if you live in one of the seven states without its own income tax -- Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming -- congratulations. You get a nice deduction.
Don't get too chummy with this break if you live in one of those states, though. Congress likely will renew the deduction, but that action could get hung up in political fights.
Now, what about sales taxes paid on purchases made in the course of business? Easy: If you pay sales tax on an item bought for business and if the item itself would be allowed as a business deduction, then the sales tax on that item would be allowed as well -- no matter what.
Myth 6: I'm married, so I have to file a joint return
Again, not true. If you're married, you can always file "married filing separately." That normally results in you having to pay more in taxes. But in some situations, it can be to your advantage.
For example, if one spouse has substantial medical or miscellaneous deductions, those deductions are subject to the 7.5% and 2% floors, respectively. That is, only medical expenses above 7.5% of adjusted gross income and miscellaneous deductions of more than 2% of adjusted gross income are deductible. If I had $10,000 in income and my spouse had $90,000 in income, and we filed jointly, the first $7,500 in medical expenses and the first $2,000 in miscellaneous expenses aren't allowed.
But if I filed as "married filing separately," the disallowance would apply only to the first $750 in medical expenses and the first $200 in miscellaneous itemized expenses. The potential availability of $8,550 ($7,500 plus $2,000, less the sum of $750 and $200) in additional deductions could offset the bracket and other limitations of filing separately.
Try it both ways to see which gives you the lower total tax. You can change your filing status annually.
I should add a caveat on this filing myth: If you're married, you normally can't file as single or head of household. Let's say, though, that you're married but separated, and you have a child. There's a special rule that will let you file as a head of household.
You can qualify as an "abandoned spouse" if your spouse didn't live with you for the last six months of the year and you have a child living with you who qualifies as your dependent. If so, you can file as head of household rather than jointly or married filing separately.
Run the numbers to see which produces the lowest tax bill.
Our tax code is complicated and changes with painful regularity. Many of the old rules are poorly remembered and distorted into myths. Don't get caught in the trap of using the wrong rules. That can cost you big.
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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