4 Common Income Tax Misunderstandings

During my time spent in public accounting I had the opportunity to work daily on something most people don’t even like to see once a year: income tax returns.  While my day job no longer requires that I fill out clients’ 1040′s, 1120′s, and 990′s, I have managed to retain a few nuggets of tax knowledge.  And fortunately, I never had to worry about these types of tax issues.

With the individual filing deadline less than one month away, I’d like to share four of the most common income tax return misunderstandings that you’ve likely come across or will in the near future.

1. Getting “bumped up to the next tax bracket.” Years ago, a close friend of mine was complaining about his recent pay raise.  He told me, “Yeah, I got a ‘raise’, but I’m taking home less money now because I got bumped up to the next tax bracket!”  His thought process was not unusual, but I went on to explain how the federal graduated tax brackets work. Essentially, rather than his entire taxable income being taxed at a higher bracket, only the portion of income that exceeds the previous bracket ceiling is taxed at the new rate. More simply, if he was single and his taxable income (line 43 on 2009 Form 1040) was $60k in 2008, his tax would be calculated as follows:
   

   (a) First $8,025 of taxable income is taxed at 10%,
   (b) Next $25,425 is taxed at 15%,
   (c) Final $26,550 is taxed at 25%.

   The graduated brackets result in a tax of roughly $11k, not the $15k he was expecting.  His real “problem” had more to do with the next misunderstanding.

2. Income tax withholdings. Initially, I was confused by my friend’s issue discussed above, but eventually I figured out what likely happened was a simple increase in the income tax withholdings from his paycheck.  These are initially determined when you start a new job and fill out the mysterious Form W-4 from the Admin department.  This form determines your “personal allowances” for the year, which plays a huge role in determining how much income tax is withheld from your paycheck each pay period.  Having “2” allowances is typical for a married individual, “3” is standard for a single person, and if you’re married with two children, “5” or “6” are the most common selections.

Basically, the higher the number of personal allowances you select, the lower the amount is withheld for income taxes from your paycheck.  So, if you find yourself owing the IRS too much at year-end or are getting too big of a refund (yes, getting an unexpected refund is nice, but you could have had that money in your pocket earlier), consider meeting with Human Resources and adjusting your personal allowances to find a better balance.

3. Tax-deductible donations. Even in these tough economic times, people find it in their hearts to make donations to their church, their alma mater, The Leukemia & Lymphoma Society, and millions of other worthwhile causes.  Many individuals work this giving into their year-end tax planning, thereby benefitting both the donee’s projects and the donor’s income tax return.  However, these donations are not always tax-deductible.  These are the first two hurdles to taking a deduction for your gift:
   • You must file a Schedule A with your Form 1040.  If your standard deduction exceeds your potential itemized deduction from Schedule A, you won’t receive a tax benefit from your donation.  By no means am I suggesting that you should stop gifting just because you won’t receive a deduction to your income taxes, but it’s something to be aware of; and
   • The charity you are donating to must have an approved “charitable status.”  According to Schedule A instructions, “You can deduct contributions or gifts you gave to organizations that are religious, charitable, educational, scientific, or literary in purpose…also…organizations that prevent cruelty to children or animals.”  However, to verify the organization’s charitable status, obtain verification directly from the entity or review IRS Publication 78 for a full list of most qualified organizations.
4. Taxability of stimulus checks. In the early part of 2008, most Americans received a stimulus check/payment/refund (whatever you would like to call it) from the federal government and many individuals are confused about the taxability of this mini-windfall.  As confirmed by FactCheck.org, the stimulus payments are not taxable on a federal or state level.

The Internal Revenue Code can be over-technical and bloated, but hopefully we have explained some of the most common issues you will come across. If you’re looking for more information, check out our tax resources or send us an email.

- Matt

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UPDATE (3/31):  If you’re looking for more specific information on how to adjust your tax withholdings, take a look at IRS Publication 919.