## Friday, January 30, 2009

### Tax Hacks, Part 1: Give yourself some credit

Before we get into the glory of tax credits, let's cover some basics.

Tax brackets are based on your taxable income only (we'll get to figuring exactly what that is later) and determine how much tax you should pay for that year (called tax liability). For obvious reasons, I'm only going to cover the bottom three brackets here. Also, unless otherwise stated, calculations and figures are for the independent, single, and non self-employed, though I will talk about self-employment tax in a later post.

For a taxable income of \$7,825 or less the tax is 10%. So if your taxable income is \$5,000, your tax liability is \$500. This doesn't mean, of course, that you suddenly owe the federal government 500 bucks. All of these taxes (and likely more) have probably already been withheld from your paychecks. The reason we get those wonderful tax return checks is that we've overpaid, i.e. we've withheld more than our tax liability.

Moving on... for taxable incomes of \$7,826-\$31,850, the tax is \$782.50 + 15% of the excess after \$7,825. In other words, 15% of however much you make over the preceding tax bracket plus the assigned base amount. It works this same way going all the way up the tax ladder. For taxable incomes \$31,851-\$77,100 the tax is \$4386.25 + 25% of the excess over \$31,850. Say your taxable income from last year was \$30,000. You're in what's called the 15% bracket, and your tax is \$782.50 + .15 x (30,000-7,825). Remember your order of operations here, kids. That means the tax on your earned income is \$4,108.75.

The point here is to reduce your taxable income so that you reduce your income tax. We do that with deductions, exemptions, and credits. And that's where today's hacks come in.

The standard deduction for singles is \$5,350; everybody gets that. But there are additional deductions and credits galore. Seriously, there are whole books that do nothing but list possible deductions. I'm not going to go into itemizing in this post, perhaps in a later one; I'm just going to mention a few credits that are particular to people under 30 years old (or thereabouts).

But first, let's talk about the difference between deductions and credits. Deductions reduce your taxable income, but credits reduce your actual tax. For example, say you have \$1,000 that you can deduct. Sticking with our original example, the tax you would save would be \$150 (\$1,000 x 15%) because you'd be reducing your taxable income by \$1,000, thereby saving the 15% you would have been charged on it. However, say you have a \$1,000 expenditure that qualifies for a 50% credit. You would directly save \$500 (\$1,000 x 50%). It's the percentage of the credit that's important. If the \$1,000 was only eligible for a 10% credit, the deduction would save you more.

Now, credit can be either refundable or non-refundable, which refers to the ability of the credit to count past your tax liability--in other words, if the amount of the credit exceeded the amount of your tax liability, for you to actually get a check from Uncle Sam for the excess credit. For example, if your tax liability is \$3,000, but you get a refundable credit for \$3,500, you'd get \$500 back from the fed. Sadly, the vast majority of credits are non-refundable.
1. Hope Credit (nonrefundable, up to \$1,650 of tuition and mandatory fees actually paid in 2008, e.g. not including tuition covered by scholarship money, etc.). This one only applies to those of you who are freshman, sophomores, or juniors now and were enrolled at least half-time in 2008. You can only claim the Hope Credit for your first two years of undergrad.

2. Lifetime Learning Credit (nonrefundable, up to \$2,000). Cannot be claimed in the same tax year as the Hope Credit. It's calculated as 20% of a maximum of \$10,000 of tuition and mandatory fees actually paid in 2008. There's no limit to the number of years you can claim this, and you just have to be enrolled in at least one course (credit or noncredit, degree or non-degree, any level) at a qualifying college or university.

Note: If you're eligible for the Hope credit but paid more than \$8,250, you'll save more by claiming the Lifetime Learning credit instead.

Both these credits are reduced if your adjusted gross income (a figure somewhere between your net income and your taxable income) is above \$47,000. Nothing about taxes is simple; check the links for more details. To claim either of these credits, you will need Form 8863.

Coming Up: Saver's Credit, Earned Income Credit, and more.

Tax Hacks, Part 1: Give yourself some credit

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