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The Joys and Financial Challenges of Parenthood

Parenthood can be both wonderfully rewarding and frighteningly challenging. Children give gifts only a parent can understand–from sticky-finger hugs to heartfelt pleas to tag along on Saturday morning errands. You raise them with a clear goal that you secretly dread will actually take place–that someday they will be grown, independent, and ready to move out on their own, and your work will be over.

As your children travel this long and never-dull road from infancy to adulthood, you try to protect them. You want to make sure that they are financially secure, but meeting expenses can be challenging.

How expensive is raising a child?

The United States Department of Agriculture estimates that the average nationwide cost of raising one child in a two-parent family from cradle to college entrance at age 18 ranges from $174,690 to $372,210, depending on income. (Source: Expenditures on Children by Families, 2015, released January 2017)

As you raise them and make sure they get a good, strong start in life, one thing is obvious–children are expensive! Fortunately, you can take steps to prepare for the financial challenges you face.

Reassess your budget

As your family grows, you may need to make changes to your budget. Many living expenses may increase, including grocery, clothing, transportation, health-care, insurance, and housing costs. You may also need to account for new expenses, such as child care, or adjust your budget to account for a decrease in your income, if you decide to become a stay-at-home parent. Your budget may also need to expand to include new financial goals, such as saving for college or buying a home.

Making sure that your budget reflects your new financial priorities can help you stay on track.

Review your life insurance coverage

What would happen to your children if something happened to you? Life insurance is an effective way to protect your family from the uncertainty of premature death. It can help assure that a preselected amount of money will be on hand to replace your income and help your family members–your children and your spouse–maintain their standard of living. With life insurance, you can select an amount that will help your family meet living expenses, pay the mortgage, and even provide a college fund for your children. Best of all, life insurance proceeds are generally not taxable as income. Keep in mind, though, that the cost and availability of life insurance depend on factors such as age, health, and the type and amount of insurance purchased. As with most financial decisions, there are expenses associated with the purchase of life insurance.

Consider purchasing disability income insurance

If you become disabled and unable to work, disability income insurance can pay benefits–a specific percentage of your income–so you can continue meeting your financial obligations until you are back on your feet. What about Social Security? If you do become permanently and totally disabled and are unable to do work of any kind, you may be eligible for benefits, but qualifying isn’t easy. For more flexible and comprehensive protection, consider buying disability income insurance.

Start building a college fund now

According to the College Board, for the 2017/2018 school year, the average cost of one year at a four-year public college is $25,290 (for in-state students), while the average cost for one year at a four-year private college is $50,900 (the total cost of attendance includes tuition and fees, room and board, books and supplies, transportation, and other miscellaneous costs). Even if those numbers don’t go up (and they are expected to continue increasing), that would come to $101,160 for a four-year degree at a public college, and $203,600 at a private university. Oh, and don’t forget graduate school.

College costs may seem daunting, especially if you’re still paying off your own college loans, but you have about 18 years before your newborn will be a college freshman. By starting today, you can help your children become debt-free college grads. The secret is to save a little each month, take advantage of compound interest, and have a sum waiting for you when your child is ready for college.

The following chart shows how much money might be available for college when your child turns 18, if you save a certain amount each month.

Keep saving for retirement

Many well-intentioned parents put saving for retirement on hold while they save for their children’s college education. But if you do so, you’re potentially sacrificing your own financial well-being. If you postpone saving for retirement, you might miss out on years of tax-deferred growth, and it may be hard to catch up later.

Ideally, you’ll want to save regularly for both goals. but if you have limited funds, prioritize saving for retirement. Your child may receive financial aid to pay for college, but there’s no such option for you.

 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matter addressed herein.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018

Time Can Be a Strong Ally in Saving for Retirement

Father Time doesn’t always have a good reputation, particularly when it comes to birthdays. But when it comes to saving for retirement, time might be one of your strongest allies. Why? When time teams up with the growth potential of compounding, the results can be powerful.

Time and money can work together

The premise behind compounding is fairly simple. Your retirement plan contributions are deducted from your paycheck and invested either in the options you select or in your plan’s default investments. Your contribution dollars may earn returns from those investments, then those returns may earn returns themselves–and so on. That’s compounding.

Compounding in action

To see the process at work, consider the following hypothetical example: Say you invest $1,000 and earn a return of 7%–or $70–in one year. You now have $1,070 in your account. In year two, that $1,070 earns another 7%, and this time the amount earned is $74.90, bringing the total value of your account to $1,144.90. Over time, if your account continues to earn positive returns, the process can gather steam and add up.

Now consider how compounding might work in your retirement plan. Say $120 is automatically deducted from your paycheck and contributed to your plan account on a biweekly basis. Assuming you earn a 7% rate of return each year, after 10 years, you would have invested $31,200 and your account would be worth $45,100. That’s not too bad. If you kept investing the same amount, after 20 years, you’d have invested $62,400 and your account would be worth $135,835. And after just 10 more years–for a total investment time horizon of 30 years and a total invested amount of $93,600–you’d have $318,381. That’s the power of compounding at work.

Keep in mind that these examples are hypothetical, for illustrative purposes only, and do not represent the performance of any actual investment. Returns will change from year to year, and are not guaranteed. You may also lose money in your retirement plan investments. But that’s why when you’re saving for retirement, it’s important to stay focused on long-term results.

Also, these examples do not take into account plan fees, which will impact total returns, and taxes. When you withdraw money from your traditional (i.e., non-Roth) retirement plan account, you will have to pay taxes on your withdrawals at then-current rates. Early withdrawals before age 59½ (age 55 for certain distributions from employer plans) may be subject to a 10% penalty tax, unless an exception applies. Nonqualified withdrawals from a Roth account may also be subject to regular income and penalty taxes (on the earnings only–you receive your Roth contributions tax free).

 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matter addressed herein.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018

Decisions, Decisions: Choosing Among Retirement Plan Contribution Types

If your employer-sponsored 401(k) or 403(b) plan offers pre-tax, Roth, and/or non-Roth after-tax contributions, which should you choose? How do you know which one might be appropriate for your needs? Start by understanding the features of each.

Pre-tax: For those who want lower taxes now

With pre-tax contributions, the money is deducted from your paycheck before taxes, which helps reduce your taxable income and the amount of taxes you pay now. Consider the following example, which is hypothetical and has been simplified for illustrative purposes.

Example(s): Frank earns $2,000 every two weeks before taxes. If he contributes nothing to his retirement plan on a pre-tax basis, the amount of his pay that will be subject to income taxes will be the full $2,000. If he was in the 25% federal tax bracket, he would pay $500 in federal income taxes, reducing his take-home pay to $1,500. On the other hand, if he contributes 10% of his income to the plan on a pre-tax basis — or $200 — he would reduce the amount of his taxable pay to $1,800. That would reduce the amount of taxes to $450. After accounting for both federal taxes and his plan contribution, Frank’s take-home pay would be $1,350. The bottom line? Frank would be able to invest $200 toward his future by reducing his take-home pay by just $150. That’s the benefit of pre-tax contributions.

In addition, any earnings made on pre-tax contributions grow on a tax-deferred basis. That means you don’t have to pay taxes on any gains each year as you would in a taxable investment account. However, those tax benefits won’t go on forever. Any money withdrawn from a tax-deferred account is subject to ordinary income taxes, and if the withdrawal takes place prior to age 59½ (or in some cases, age 50 or 55), you may be subject to a 10% penalty on the total amount of the distribution.

Roth: For those who prefer tax-free income later

On the other hand, contributing to a Roth account offers different benefits. Roth contributions are considered “after-tax,” so you won’t reduce the amount of current income subject to taxes. But qualified distributions down the road will be tax-free.

A qualified Roth distribution is one that occurs:

  • After a five-year holding period and
  • Upon death, disability, or reaching age 59½

Distributions of Roth contributions are always tax-free because they were made on an after-tax basis. And distributions of earnings on those contributions are tax-free as long as they’re qualified. Nonqualified distributions of earnings are subject to regular income taxes and a possible 10% penalty tax. If, at some point, you need to take a nonqualified withdrawal from a Roth account — due to an unexpected emergency, for example — only the pro-rata portion of the total amount representing earnings will be taxable.

Example(s): In order to meet an unexpected emergency financial need of $8,000, Holly decides to take a nonqualified hardship withdrawal from her Roth account. Of the $20,000 total value of the account, $18,400 represents after-tax Roth contributions and $1,600 is attributed to investment earnings. Because earnings represent 8% of the total account value ($1,600 ÷ $20,000 = 0.08), this same percent of Holly’s $8,000 distribution — or $640 ($8,000 x 0.08) — will be considered earnings subject to both income taxes and a 10% potential penalty tax.

Keep in mind that tapping your account before retirement defeats its purpose. If you need money in a pinch, try to exhaust all other possibilities before taking a distribution. Always bear in mind that the most important benefit of a Roth account is the opportunity to build a nest egg of tax-free income for retirement. Finally, not all plans allow in-service withdrawals.

After-tax: For those who are able to exceed the limits

Finally, some 401(k) and 403(b) plans allow you to make additional, non-Roth after-tax contributions. This plan feature helps those who want to make contributions exceeding the annual total limit on pre-tax and Roth accounts (in 2017, the limit is $18,000; $24,000 for those age 50 or older).1 As with a traditional pre-tax account, earnings on after-tax contributions grow on a tax-deferred basis.

If this option is offered (check your plan documents), keep in mind that total employee and employer contributions cannot exceed $54,000, or $60,000 for those age 50 or older (2017 limits).

Another benefit of making after-tax contributions is that when you leave your job or retire, they can be rolled over tax-free to a Roth IRA, which also allows for potential tax-free growth from that point forward. Some higher-income individuals may welcome this potential benefit if their income affects their ability to directly fund a Roth IRA. [In addition to rolling the proceeds to a Roth IRA, you may also (1) leave the assets in the original plan (if allowed), (2) transfer assets to a new employer’s plan (if allowed), or (3) withdraw the funds.]2

Which to choose?

Determining which types of plan contributions to make is a strategic decision based on your household’s needs and tax situation. Because non-Roth after-tax contributions are generally most appropriate only to those who wish to exceed the contribution limits on pre-tax and/or Roth accounts, it may be best to focus on maxing out those accounts first.

If your plan offers both pre-tax and Roth contributions (check your plan documents), the general rule is to consider whether you will benefit more from the tax break today than you would in retirement. Specifically, if you think you’ll be in a higher tax bracket in retirement, Roth contributions may be more beneficial in the long run.

Also, regardless of whether you choose pre-tax or Roth contributions, be sure to strive for contributing at least enough to receive any employer match that may be offered. Matching contributions represent money that your employer offers to help you pursue your savings goal. If you don’t contribute enough to take advantage of the full amount of the match, you are essentially turning down free money.

Keep in mind that employer matching contributions are made on a pre-tax basis. Distributions representing employer matching dollars and related earnings will always be subject to regular income taxes and a potential 10% tax penalty if distributed prior to age 59½ (or, in some cases, age 50 or 55).3

Once the annual contribution limit has been reached for pre-tax and/or Roth contributions, it may be time to consider non-Roth after-tax contributions if your plan permits them.

For more information specific to your situation, consult a qualified tax professional. (Working with a tax professional cannot guarantee financial success.)

1Section 403(b) plans may allow employees with 15 or more years of service to make special catch-up contributions in addition to the age 50 catch-up contribution. Under this special rule, the maximum additional catch-up contributions in any year is $3,000 and the lifetime aggregate special catch-up contribution is $15,000.

2Keep in mind that distributions of earnings on non-Roth after-tax contributions will be subject to regular income taxes and possibly penalty taxes if the money is not rolled over to a traditional IRA. IRS Notice 2014-54 clarifies the rules regarding rollovers of non-Roth after-tax plan contributions to a Roth IRA.

3Employer matching contributions may be subject to a vesting schedule. Plan participants earn rights to the employer matching contributions, and earnings on those contributions, over a period of time. Employer matching contributions are not offered in all plans. Check your plan documents.

 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matter addressed herein.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018

Record Keeping for Your Own Business

Keeping good business records will not only help you stay in business but may also help you increase profits. Your business records let you analyze where your business is and where it’s going. They point out potential trouble spots and serve as a guide to where you want your business to be.

Your ideal office manager: criteria for record-keeping systems

Like a valued office manager, your record-keeping system should have good work habits. It should be easy to use. If it’s too complicated, it might be neglected, defeating its purpose. It should reflect information accurately, completely, and consistently throughout all of its applications, and it should do so in a timely fashion; you don’t want to base important business decisions on partial or outdated information. Finally, it should present results in an easily understandable manner. If you can’t comprehend the data that your record-keeping system provides, you might ignore their implications.

Some commercial record-keeping systems are generic in format and applicable to many types of business. Others are designed for specific types of business operations (e.g., retail sales and manufacturing). Most generally will offer the ability to summarize your business activity with appropriate periodic financial reports. Many websites allow you to see a demonstration version of the software before you purchase the software.

You can decide whether to keep your own books or hire someone to do it for you. Your decision depends in part on how much time and ability you have for the task. You can hire a company that specializes in payroll services to handle the paperwork and withholdings for your employees. Most small-business advisors suggest that you have an accountant prepare your tax returns and year-end statements. In many cases, an accountant can also offer advice on various aspects of financial management, such as cash flow analysis, borrowing for the business, tax considerations, and suggestions for which software to buy for record keeping. Whichever way you go, you should stay involved in the record-keeping process. After all, it’s your business, and ultimately you are responsible for its success or failure.

What your records should do for you

Like a medical diagnostic tool, your records help you assess the health of your business.

  • Bank statements measure cash on hand, and accounts receivable predict future income. Together, these records help determine cash flow requirements and may point to a need for short-term borrowing.
  • In addition to providing income tax information to your employees, payroll records help you determine the appropriateness of your pricing and customer billing policies.
  • If your business keeps merchandise on hand, your records help you manage the size of your inventory, thus avoiding the loss of profits from obsolescence, deterioration, or simply being out of stock.
  • Expense records help you plan to meet obligations in a timely fashion. They also help you assess whether the income generated supports the expense involved.
  • Statements of income, or profit and loss statements, help pinpoint unprofitable departments, products, or services, alerting you to make changes or eliminations if necessary.
  • The balance sheet captures the condition of your business at a given moment in time, allowing you to measure its reality against either your own budget projections or similar businesses.

Be prepared: the taxman cometh

One of the most important functions of business records is to prepare you (or your accountant) for filing tax returns for the business. Thus, you may want to set up a record-keeping system that captures information in a way that matches the demands of the IRS. If you are a sole proprietor, you’ll want to familiarize yourself with the requirements for completing Form 1040, Schedule C.

Here are some tax considerations to remember in relation to your record-keeping system design (for more information, see IRS Publication 334, “Tax Guide for Small Business”):

  • If your small business is one that carries no inventory, then you can generally use the cash method of accounting.
  • If you produce, purchase, or sell merchandise, you typically must keep an inventory and use the accrual method of accounting. However, there are exceptions to this rule if you are a “qualifying taxpayer” or a “qualifying small business taxpayer.” You are a qualifying taxpayer if your average annual gross receipts are $1 million or less and your business is not a tax shelter. You are a qualifying small business taxpayer if: your average annual gross receipts are less than $10 million; you are not prohibited from using the cash method as defined by Section 448 of the Internal Revenue Code; and your business is an eligible business as defined in IRS Publication 538.
  • The business-related portion of deductible car or truck expenses may be the actual expenses incurred (including gas, oil, tires, repairs, insurance, depreciation, and rent or lease payments), or you may elect to take the standard mileage rate (53.5 cents per mile for 2017, down from 54 cents per mile for 2016).
  • Depreciation may be taken on property that is used in the business or held to produce income, provided it has “substantial” and “determinable” useful life. This means that it has a life beyond the year in which it was purchased but will also become obsolete or wear out over time. Examples include business cars, computers, and office furniture.
  • Through 2017, an additional first-year “bonus” depreciation deduction is available, equal to 50% of the adjusted basis of qualified property placed in service during the year. The deduction amount decreases to 40% in 2018 and 30% in 2019. The basis of the property and the regular depreciation allowances in the year the property is placed in service and later years are adjusted accordingly. Alternatively, instead of claiming the bonus depreciation, companies may elect to accelerate alternative minimum tax credits.
  • Some businesses may elect under IRC Section 179 to expense the cost of qualifying property purchased and put into use during a designated year, rather than to recover such costs through depreciation deductions. The limit is $500,000, with a phase-out that starts when purchases exceed $2,000,000. (Note that since 2016, the dollar limit and phaseout threshold have been indexed for inflation. In 2017, the limit is $510,000 and the phaseout threshold rises to $2,030,000.)
  • You may deduct any contributions to employee benefit plans (such as health insurance plans and other fringe benefits) or contributions to pension or profit-sharing plans that are for the benefit of employees.
  • You may deduct real estate or personal property taxes on business assets, Social Security and Medicaid taxes paid to match required withholdings on employee wages, state disability and federal and state unemployment taxes paid. Sales tax should be treated as part of the cost of goods or merchandise purchased.
  • Depending on whether you use your home or other real estate for business purposes, you may deduct some or all of any mortgage interest paid, as well as some or all of the maintenance and repair expenses associated with the property.
  • You may deduct the cost of business supplies purchased during the tax year.
  • You may deduct the cost of utilities associated with business use.
  • Also, if you have a home office used exclusively for business purposes, you may be able to take advantage of a simplified way to calculate the home office deduction. Under this method, instead of determining and allocating actual expenses such as mortgage interest and utilities, you would simply multiply the square footage of the office by $5.00. The maximum allowed is $1,500 (or 300 square feet). For more information on this deduction, see IRS Publication 587, “Business Use of Your Home.”
  • You can deduct professional fees, such as those paid to your accountant.
  • You may deduct 50 percent of meal and entertainment expenses directly associated with the conduct of your business. You may be able to deduct the full amount of other travel-related expenses.

Remember to save any records and underlying documentation, such as invoices or receipts, relevant to your tax return for at least three years. Ask your accountant how long he or she suggests keeping the documentation.

Managing your business records

Records management is vital to any business. You should have a good system in place that will ensure that both your paper (physical) records and your electronic or digital records are retained as long as they need to be. Make sure your records are easily identifiable and accessible, and keep them well-organized. Shred (and recycle) paper records that you do not need or no longer need. Keep your electronic records safe and secure by adding a firewall to your computer and using software that provides adequate security. Back up your computer regularly using a CD, external hard drive, or an online remote back-up service (i.e., in the “cloud”), and be sure to use logins and passwords that are secure. Dispose of e-records carefully.

 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matter addressed herein.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018

Maintaining Your Financial Records: The Importance of Being Organized

An important part of managing your personal finances is keeping your financial records organized. Whether it’s a utility bill to show proof of residency or a Social Security card for wage reporting purposes, there may be times when you need to locate a financial record or document–and you’ll need to locate it relatively quickly.

By taking the time to clear out and organize your financial records, you’ll be able to find what you need exactly when you need it.

What should you keep?

If you tend to keep stuff because you “might need it someday,” your desk or home office is probably overflowing with nonessential documents. One of the first steps in determining what records to keep is to ask yourself, “Why do I need to keep this?”

Documents you should keep are likely to be those that are difficult to obtain, such as:

  • Tax returns
  • Legal contracts
  • Insurance claims
  • Proof of identity

On the other hand, if you have documents and records that are easily duplicated elsewhere, such as online banking and credit-card statements, you probably do not need to keep paper copies of the same information.

How long should you keep your records?

Generally, a good rule of thumb is to keep financial records and documents only as long as necessary. For example, you may want to keep ATM and credit-card receipts only temporarily, until you’ve reconciled them with your bank and/or credit-card statement. On the other hand, if a document is legal in nature and/or difficult to replace, you’ll want to keep it for a longer period or even indefinitely.

Some financial records may have more specific timetables. For example, the IRS generally recommends that taxpayers keep federal tax returns and supporting documents for a minimum of three years up to seven years after the date of filing. Certain circumstances may even warrant keeping your tax records indefinitely.

Listed below are some recommendations on how long to keep specific documents:

Records to keep for one year or less:

  • Bank or credit union statements
  • Credit-card statements
  • Utility bills
  • Auto and homeowners Insurance policies

Records to keep for more than a year:

  • Tax returns and supporting documentation
  • Mortgage contracts
  • Property appraisals
  • Annual retirement and investment statements
  • Receipts for major purchases and home improvements

Records to keep indefinitely:

  • Birth, death, and marriage certificates
  • Adoption records
  • Citizenship and military discharge papers
  • Social Security card

Keep in mind that the above recommendations are general guidelines, and your personal circumstances may warrant keeping these documents for shorter or longer periods of time.

Out with the old, in with the new

An easy way to prevent paperwork from piling up is to remember the phrase “out with the old, in with the new.” For example, when you receive this year’s auto insurance policy, discard the one from last year. When you receive your annual investment statement, discard the monthly or quarterly statements you’ve been keeping. In addition, review your files at least once a year to keep your filing system on the right track.

Finally, when you are ready to get rid of certain records and documents, don’t just throw them in the garbage. To protect sensitive information, you should invest in a good quality shredder to destroy your documents, especially if they contain Social Security numbers, account numbers, or other personal information.

Where should you keep your records?

You could go the traditional route and use a simple set of labeled folders in a file drawer. More important documents should be kept in a fire-resistant file cabinet, safe, or safe-deposit box.

If space is tight and you need to reduce clutter, you might consider electronic storage for some of your financial records. You can save copies of online documents or scan documents and convert them to electronic form. You’ll want to keep backup copies on a portable storage device or hard drive and make sure that your computer files are secure.

You could also use a cloud storage service that encrypts your uploaded information and stores it remotely. If you use cloud storage, make sure to use a reliable company that has a good reputation and offers automatic backup and technical support.

Once you’ve found a place to keep your records, it may be helpful to organize and store them according to specific categories (e.g., banking, insurance, proof of identity), which will make it even easier to access what you might need.

Consider creating a personal document locator

Another option for organizing your financial records is to create a personal document locator, which is simply a detailed list of where you have stored your financial records. This list can be helpful whenever you are trying to locate a specific document and can also assist your loved ones in locating your financial records in the event of an emergency. Typically, a personal document locator will include the following information:

  • Personal information
  • Personal contacts (e.g., attorney, tax preparer, financial advisor)
  • Online accounts with username and passwords
  • List of specific locations of important documents (e.g., home, office, safe)

 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matter addressed herein.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018

Personal Deduction Planning

Taxes, like death, are inevitable. But why pay more than you have to? The trick to minimizing your federal income tax liability is to understand the rules and make the most of your tax planning opportunities. Personal deduction planning is one aspect of tax planning. Here, your goals are to use your deductions in the most efficient manner and take all deductions to which you’re entitled.

Deductions lower your taxable income

Your first step is to understand how deductions work. You subtract certain deductions from your total income to arrive at your adjusted gross income (AGI); these deductions are commonly referred to as adjustments to income or as “above-the-line” deductions. Then, you subtract other deductions and exemptions from your AGI to determine your taxable income; these deductions are sometimes referred to as “below-the- line” deductions. Your tax liability is calculated based on your taxable income. Generally speaking, therefore, the higher your deduction level, the lower your tax liability.

You can either take a standard deduction or itemize

After you’ve computed your AGI, you’ll generally want to subtract the greater of either the standard deduction or the total of your itemized deductions. The standard deduction is a fixed dollar amount, indexed for inflation yearly, that is determined according to your filing status (e.g., married filing jointly, single) and certain circumstances. Itemized deductions are various deductions that are reported on Schedule A of your federal tax return (Form 1040). They involve certain personal expenses, such as medical expenses, mortgage interest, state taxes, charitable contributions, theft losses, and miscellaneous itemized deductions. If you have enough of these types of expenses, your itemized deductions may exceed your standard deduction. In that case, it would generally be to your advantage to itemize.

When filling out your tax return, how do you know whether to take the standard deduction or itemize? You should calculate your taxes (including any alternative minimum tax) using both methods, and go with the one that lowers your tax liability the most. Be aware that there are some limitations regarding who can use the standard deduction and who can itemize. Also, certain itemized deductions are available to you only if your expenses exceed a particular percentage of your AGI. For example, many miscellaneous itemized deductions are allowed only to the extent that they (when totaled) exceed 2 percent of your AGI. So, if your AGI is $100,000, your first $2,000 of miscellaneous itemized deductions won’t count toward your total itemized deductions. Your medical expense deduction may also be limited by your AGI. Additionally, an overall limitation on itemized deductions generally applies to individuals with high AGIs.

There may be circumstances where it is better to itemize deductions even if the standard deduction is greater than itemized deductions. For example, if you are subject to alternative minimum tax, even a small amount of some itemized deductions may be preferable to the standard deduction, which is reduced to zero for alternative minimum tax purposes.

The medical and dental expenses deduction: what it is, and how it involves your income level

The medical and dental expenses deduction is an itemized deduction that you may take (within certain limits) for unreimbursed medical and dental expenses you paid during the year for yourself, your spouse, and your dependents. You may be surprised to learn which medical and dental expenses are deductible and which are not; the line is sometimes blurry. For example, you can’t deduct your expenses for nicotine gum, but you can deduct your fee for a smoking cessation program. Many expenses qualify for this deduction, including acupuncture treatments, crutches, eyeglasses, and prescription drugs. You should obtain IRS Publication 502, Medical and Dental Expenses, for an authoritative list of eligible and nondeductible expenses. If you don’t review this list, you may miss out on some important tax-saving opportunities.

You can take this deduction only to the extent that your unreimbursed medical expenses exceed 10 percent of your AGI (7.5 percent if you or your spouse are age 65 or older). That might sound complicated, but here’s how it works. First, add up your eligible medical expenses. You can deduct only part of that total on Schedule A of your federal income tax return. The schedule will actually lead you through this calculation. On that form, you’ll multiply your AGI by 10 percent (.10). The figure you come up with will represent the amount of your medical expenses that you cannot deduct. Subtract this figure from your total eligible medical expenses. The remaining amount is your medical deduction.

Note: Prior to 2013, the threshold to deduct medical expenses was 7.5 percent of adjusted gross income. For those age 65 or older, the AGI threshold remains 7.5 percent, and will not increase to 10 percent until 2017.

Proper timing of your deductions will minimize your taxes

For most people, income is reported in the year that it’s received, while deductions are generally taken for the year in which expenses are paid. In many cases, you can control whether you incur an expense this year or next. That means that you can control the timing of your itemized deductions to some extent. If you’re in a higher income tax bracket this year than you expect to be in next year, you may want to accelerate your deductions into the current year to minimize your tax liability. You can do this by paying deductible expenses before year-end and making charitable contributions before year-end. For example, if you have major dental work scheduled for January of next year, you can reschedule for December to take advantage of the deduction this year. Here are some tips:

  • If you pay a deductible expense by check, make sure it’s dated and mailed before year-end. It needn’t clear the bank by year-end, however.
  • If you pay by credit card, the expense is deductible in the year the charge is incurred, not when the credit card bill is paid.
  • A mere pledge or promise to make a charitable contribution is not deductible.
  • Along with your cash contributions to a charity, remember to deduct noncash contributions like clothes. You can also deduct mileage if you use your car for charitable purposes.

 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matter addressed herein.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2018