Solving the IRS Puzzle
Ninety-five billion dollars in tax breaks await America’s 120 million taxpayers.
That’s the value of tax cuts that Congress promised when it passed a massive tax overhaul in 1997. However, as Americans now get their first chance to claim the bulk of this remarkable tax largess on their 1998 tax forms, they’ll probably find the process complex, stressful and--for many--fruitless.
Some taxpayers--mainly those with big families, medium incomes, higher-education expenses and substantial investments in homes or stocks--will be able to cobble together myriad new deductions and credits that can result in a windfall. But millions of other taxpayers will find that their circumstances prevent them from getting even a sliver.
Consider, for example, the Ricks family of Los Angeles. Thanks to 1998 tax changes, Alan and Deborah Ricks’ tax refund will be $2,000 larger this year. Better still, their tax breaks will probably get bigger each year for the next several years.
Their secret: Young kids. Five of them. Spaced two years apart and apparently all bound for college. Kids and college costs will land the Ricks family credits--which are dollar-for-dollar reductions in the tax owed--in copious quantities. (See Personal Finance, C1.)
But in Orange County, recent retiree Stephen Lee is having no such luck. Although his income is almost identical to the Rickses’, he has no dependent children and no college costs. He doesn’t own his own business. He doesn’t even have enough earned income to contribute to an individual retirement account, and his gains in both stock investments and his home are too modest to count. In other words, all of the new tax breaks elude him.
“At least I’m used to it,” Lee says of getting the tax shaft. “I can’t remember the last time I got a federal tax refund.”
On the bright side, Lee will be able to complete his tax return with a minimum of fuss. The majority of Americans who are able to claim some of the new tax breaks can’t say the same.
“I would not want to be the average person out there trying to file their own return,” says James Rivin, a partner at accounting firm Rivin, Wenzel & Co. in Woodland Hills.
Sure, that’s an accountant’s view. But this year is indeed more complicated. For one thing, taking advantage of these breaks means you can’t use a copy of your previous year’s return to crib. Although the numbers change, you’d normally be filling out roughly the same lines, schedules and forms.
But this is not a normal year. Indeed, the IRS was forced to revise 177 forms and publications and create 11 more because of all the changes that hit in 1998. Individual filers will also run into an abundance of work sheets.
The work sheets are the result of income-based “phaseouts,” which were aimed at stripping the upper crust of tax breaks. Unfortunately for the rest of the taxpaying public, Congress never could decide what income level makes you too rich for tax breaks. (In most cases, these limits refer to adjusted gross income, which includes wages, salaries and tips but not contributions to certain employee benefit and retirement plans, such as 401[k]s and IRAs.)
For certain Social Security tax breaks, “high” income starts at $25,000 for singles and $32,000 for married couples. Yes, that’s annual income.
If you’re paying college expenses and looking to claim one of the new education tax credits, the high-income range starts at $40,000 for singles and $80,000 for marrieds.
But if college is in your past and now you’re just hoping to deduct some student loan interest expenses, your deductions start getting eliminated the moment you earn more than $60,000 if you’re married and $40,000 if you’re single.
You start getting too rich for the new child tax credit when you earn more than $75,000 singly or $110,000 married and filing jointly.
Want a Roth IRA? You’re not too rich for full contributions unless you earn more than $95,000 on your own or $150,000 as a couple. But if you want to convert a traditional IRA to a Roth, you’re too wealthy once your income exceeds $100,000 regardless of whether you are married or single.
The list goes on.
However, the crux of it is this: If you are a middle-income taxpayer, you probably will face a blizzard of forms and work sheets to figure out whether you’re eligible for additional tax breaks. That can literally add hours to the time it takes to file a fairly standard return. The IRS recently estimated that the average taxpayer who has both investment income and deductions will spend about four more hours filing a tax return this year than last. That’s on top of the 20 hours it takes the average taxpayer to gather records and learn enough about the law to file accurately.
Major Changes for Individuals Few
On the bright side, although the forms and many of the work sheets are new, there are only about a half-dozen major tax changes that affect individuals. If you can quickly identify the tax breaks you don’t qualify for, you may be able to skip some or all of the forms and spend that saved time playing ball with your kids or visiting a friend or watching a movie--or doing virtually anything that gives you more joy than filling out federal tax forms.
What are the new provisions?
* Tax breaks for kids: Starting in 1998, if you support a child who is under age 17, you may qualify for a $400-per-child credit. However, if you earn more than $75,000 and are single or more than $110,000 and are married filing jointly, you begin to lose $50 of the credit for every $1,000 that your income exceeds the threshold.
That means you lose the value of one $400 child tax credit with every $8,000 that you earn over the threshold. If you have just one child, your credit evaporates completely once you earn more than $83,000 if single or $118,000 if married. If you have more children, the threshold rises so you can earn a bit more and still claim the credit.
* Tax breaks for college expenses: Two new tax credits were also launched to help families recoup part of the cost of sending a child to college. The Hope tax credit gives up to $1,500 to parents of college freshmen and sophomores. The Lifetime Learning credit gives up to $1,000 in credits for those paying college costs--regardless of the year of study--for themselves or a dependent.
Both of these credits are reduced for those who earn more than $40,000 individually or $80,000 jointly. Once single income hits $50,000 and joint income hits $100,000, the credits are completely eliminated.
Up to $1,000 in student loan interest also became deductible for certain taxpayers. However, if you earn more than $40,000 if single or $60,000 if married, your deductions are limited. The deductions phase out completely once single income exceeds $55,000 or joint income hits $75,000.
* Individual retirement accounts: IRAs became more widely available last year as the result of three significant changes: First, nonworking spouses were given the right to contribute a full $2,000 per year. Before this change, nonworking spouses were limited to $250 annual contributions.
(You can make a 1998 contribution to an IRA until April 15 this year, so if you need another deduction and you haven’t made your maximum IRA contributions yet, there’s still time.)
Second, IRA deduction thresholds were raised. Until 1998, if you were covered by another pension, you could fully deduct contributions to an IRA only if your income was less than $25,000 if single or less than $40,000 if married filing jointly. Now full contributions are available to those earning up to $30,000 if single and up to $50,000 if married filing jointly. You can make partially deductible contributions until your income exceeds $40,000 if single and $60,000 if married.
Finally, Congress created the Roth. Contributions to a Roth IRA are not tax-deductible going in, but--if you follow all the rules--the money will be tax-free when it is withdrawn.
However, a complication that will probably affect millions of taxpayers this year is the so-called Roth conversion, says Jeff Pretsfelder, managing editor of Research Institute of America Group, a New York-based tax research and publishing firm.
Those who had traditional IRAs were given the ability to convert their traditional IRA to a Roth. The catch: When you convert, you must take the converted money into income and pay tax on it.
However, there was a special break for those who converted in 1998. They got to spread the conversion income over a four-year period, and thus spread out the income tax pain.
Special Roth Conversion Rules
As a result, millions of Americans converted their IRAs last year, Pretsfelder says. That will force them to fill out the unpleasant 29-line Form 8606, which aims to determine what portion of your IRA distribution is taxable. If you simply converted 100% of a deductible IRA, filling out the form isn’t too difficult, he notes. But if you converted only part of an IRA account or if you converted an account that had both deductible and nondeductible contributions, it’s a bear.
“If you are a very meticulous person, you can probably figure it out,” Pretsfelder adds. “But this is one of those times that you may want to get somebody to help. Unless you are a person who really understands the law, you are not going to know whether you got it right at the end or not.”
* Investment changes: The rules related to profits on investments in both stocks and real estate actually changed in 1997. However, some taxpayers may still find the changes unfamiliar because 1998 is the first full year that the changes have been in effect.
In a nutshell, long-term capital gains rates dropped to a maximum of 20% from 28%. That rate applies to any investment held more than a year. (A short-lived law boosted the so-called “holding period” to qualify for long-term capital gains tax rates to 18 months in 1997. However, the holding period change caused such furor that it was changed back to one year in 1998.)
The catch to the capital gains break is that everyone who has any capital gains--no matter how incidental--must fill out the 54-line Schedule D. If you have investment gains and don’t fill out this form, the IRS will kick your return back to you.
Also under rules enacted in mid-1997, homeowners who sell can exclude up to $250,000 per person--$500,000 per married couple--in gains on their personal residence from tax. (See “If You Sold Your Home in ‘98, It’s Time to Address the Tax Changes,” published in last Sunday’s Times and available on The Times’ Web site at https://www.latimes.com/taxes.)
If you sold a home in 1998 and your profit was less than the exclusion amounts, you don’t need to do anything. However, if your profit exceeds the exclusion amount, you must report the profit on the Schedule D and pay the appropriate tax.
* Changes for business owners: There also were several minor changes affecting those who file Schedule C: Profit or Loss From a Business. Sole proprietors can write off a bit more of their health insurance and office equipment costs for tax-year 1998 than for 1997. And the deductions get increasingly better for business owners as time goes on.
For the 1998 tax year, self-employed individuals can write off 45%--up from 40% for 1997--of the cost of health insurance premiums paid for themselves and their dependents. For 1999, that percentage will rise to 60%. By 2003, 100% of these expenses will be deductible for business owners.
In addition, if you bought expensive office equipment, furniture and supplies in 1998, you can write off up to $18,500 of these costs on your 1998 return. However, to do so, you must elect a Section 179 expense deduction. If you don’t make this election, you must depreciate the property over either a five- or seven-year period. For 1999, the Section 179 expense limits rise to $19,000. (They’re up from $18,000 for 1997.)
Moreover, starting with tax-year 1999, it becomes simpler to claim home office deductions, which allow you to write off a portion of the cost of maintaining your home if you use a portion of your home exclusively for business. Many people may still choose not to take this deduction because it can trigger an audit and cause unpleasant repercussions when they sell their home. However, renters and others who use a significant portion of their home as an office, may decide that these deductions are worth a second look.
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Times staff writer Kathy M. Kristof can be reached by e-mail at kathy.kristof@latimes.com or by regular mail at the Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.
