Friday, March 03, 2006

Taxes Filed; Refund Coming

I filed my federal and state taxes this week. I experienced a few unexpected twists this year. Nothing major, but I think they are worthy enough to blog about.

First, we bought a house this year. With that comes being able to itemize tax deductions. Moving is also a great time to go through your belongings and donate to charity what is no longer needed.

With that in mind, I bought Turbo Tax's It's Deductible to track and itemize my deductions. Overall, this was a very valuable tool. (Editor's Note: I reserve judgement until the statute of limitations expires - if it does at all - due to the valuations of the items donated.) Overall, the program is useful. It is a bit clunky with respect to editing or changing things after the donation.

To enter in a donation, you have to select a charity and the date. I assumed that the charity I was taking my stuff to would accept it. Turns out they didnt'. No, the stuff wasn't garbage, but their bins were full and the staff was overwhelmed. I had to go to another charity down the street.

As soon as I came home, I ran over to my computer, fired up It's Deductible to make the change in charities. Turns out that this was not an option. So, I had to rekey in the donation under the new charity.

As much as I planned ahead, I wasn't able to get my withholdings down to a level where I would get little back. Maybe I was lazy or a bit nervous. By the 4th quarter, my federal/state w/h's were $65/week combined...and I still got a refund in excess of $1k.

I learned that getting a state tax refund could be a costly check. Why? The amount you can claim for federal taxes is the amount withheld, not owed. If you get a refund in year 1, it becomes taxable in year 2. If you marginal rate in year 2 is higher than year 1, this will raise your taxable income.

Fortunately, you can deduct state/local sales taxes. While each situation is unique, mine was such that claiming the sales tax deduction was a better deal when looking at both years.

As for e-filing, the feds won't accept certain returns. My return had more than one page of charitable donation listings and I had to snail mail my return. I don't really mind, except that the processing/refund time increases.

Overall, tax year 2005 was a good learning experience. My estimated taxes for 05 were less than the actual refunds, but not by much. The major lesson learned: don't get a state tax refund (that's taxable income in the following year), especially if you expect your marginal rate to be highger. Taking the sales tax deduction made more sense for me.

Wednesday, March 01, 2006

Too Clever by Half or The Law of Unintended Consequences?

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Prior to 2004, there were five definitions of a 'child' for tax purposes. Wanting to simplify the tax code, Congress passed (and the President signed) into law one definition of a child for the five tax breaks.
The changes to the child-definition law streamlined the definitions of a child for five different tax breaks -- the dependency exemption, child-tax credit, earned-income credit, dependent-care credit and head-of-household filing status. They are among the new twists and turns taxpayers have to grapple with as they fill out returns for last year.
For every tweaking of the tax code, chances are there are unintended consequences, as in this case. Let's take a step back for a minute and think about the tax code and consider what it really is.

Taxation is a necessary function of government. Congress passes the tax laws. Tax laws are written by different people, in different eras, and to achieve certain outcomes. Over time, the tax code becomes a Frankenstein-like creature. This analogy helps partly to explain how, over time, there became five definitions of a 'child'.

Getting back to the defintion. In order to simplify the situation, a standard definition of a child was passed into law. On the surface, this seems quite logical: using one definition of a child for the various tests. However, nobody in the IRS, Congressional Committiees, or White House foresaw the loophole they had created.

Most families probably won't be affected by the change. But for some high-income earners the law could be a boon. This is especially true for wealthy families with two or more children living at home, where one or more of the kids has taxable income, especially income from a job.
Ms Degen proffers an example:

Francis Degen, president of the National Association of Enrolled Agents, which represents about 40,000 private-sector tax specialists, offered this example: A couple with two children living at home -- a 14-year-old daughter and a 22-year-old son -- file a joint return with adjusted gross income of $400,000. At that level of income, the parents don't get any tax benefit from claiming the daughter as a dependent. On the other hand, the son, who has $15,000 in wages and isn't a full-time student, can claim his sister, enabling him to receive the child-tax credit and earned-income tax credit. Assuming he had no tax withheld, this turns what would have been a balance due of $683 on his return to a federal income-tax refund of $3,158.

While the children of the rich are getting richer, the poor are getting screwed. (Editors note: while this is sarcasm, a complex tax code punishes families with little means to hire a CPA to help them file a tax return that considers all available tax credits and deductions. My sarcasm is directed at the cliche rich/poor class warfare theme, not at the plight of the poor and navigating the tax code.)

This broad definition can also work against some lower-income taxpayers, according to Treasury officials, who offered this example in a recent report: A 20-year-old woman who works at a minimum-wage job and attends school full time is the legal guardian of her 15-year-old brother. Because of complex rules in the new tax law, the woman can't claim her younger brother for the earned-income tax credit, even though she would have been able to do so under the old tax law. However, the woman may still be able to claim other child-related tax benefits.

There you have it. Congress, with the best of intentions, put forth a bill that has produced unintended windfalls for rich families. Bottom line: a simple tax code is a fair tax code and a hell of a lot easier to 'manage', but what would politicians use as a carrot/stick when running for elections if they couldn't promise favors via the tax code?

And therein lies the problem.

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