Test Your Powers of Deduction, Earn Extra Credit! (Income Tax: The Sequel)
Looking to put your powers of deduction to the test? Want to rack up some extra credit?
Your powers of tax deduction, that is. And by credit, I mean tax credits. And by tax credits, I mean a lower tax bill and keeping more of your money in the bank.
If so, then you have come to the right place! This is part two of my discussion of income taxes. If you didn’t read my last post (part 1) you might want to take a detour and look at that before tackling part 2.
In this post I will review deductions, credits, Social Security/Medicare taxes, and state income tax, as well as provide filing tips, references for further learning, and my personal anecdotes.
I’ll jump right into it, but first, here’s a little challenge for you. Bonus question for ten points: What does Johnny Cash have to do with calculating your income? Keep reading to find out.
The difference between deductions and credits is that deductions reduce your taxable income, while credits reduce your tax.
Deductions and credits
A deduction is not the same thing as a credit, although both can lower your tax bill. The difference between deductions and credits is that deductions reduce your taxable income, while credits reduce your tax.
There are two ways to claim tax deductions: Take the standard deduction or itemize deductions. Both are subtracted from your income so you pay taxes on less earnings.
Itemized deductions usually arise from your expenses, whereas the standard deduction is a flat-dollar, no-questions-asked reduction in your adjusted gross income. The amount you qualify for depends on your filing status. For the 2020 tax year, the standard deduction for a single filer is $12,400 and for those married, filing jointly it’s $24,800. And here’s one of the advantages of getting old: you get a bigger standard deduction! People age 65 or older or who are blind can deduct an additional $1,650 if filing single and $1,300 for each spouse if married, filing jointly.
Itemized deductions include mortgage interest, charitable donations, and unreimbursed medical expenses over 10% of your adjusted gross income. It also includes state and local taxes (e.g., property tax as well as state and local income taxes) up to $10,000. When you itemize, you report each qualified deduction on the Schedule A tax form. Claiming the standard deduction doesn’t require filling out another form so takes less effort. If your standard deduction is more than the sum of your itemized deductions (as it is for most people since the standard deduction was substantially increased in 2018), you will save more money by taking the standard deduction.
Deductions are categorized as “above the line” and “below the line.” Some common “above the line deductions” are contributions to a traditional IRA, contributions to a health savings account (HSA), and interest paid on student loans. The “below the line” deductions are those that are itemized.
QBI deduction or “Section 199 deduction”
The QBI deduction was created by the Tax Cuts and Jobs Act of 2017, a major reform of the federal tax code. Section 199A details the deduction, so you may also see it called the “Section 199A deduction.” If you are the owner of a business that is a “pass-through” entity (i.e., does not pay the corporate income tax rates, but instead, the business’ income is passed on to the individual owners, who divide it up and pay tax on it on their individual tax returns, along with any other personal income they have), you may be eligible for a qualified business income (QBI) /199A deduction. Such businesses include a sole proprietorship, partnership, S-corporation, or an LLC taxed as any of the above. This deduction allows you to deduct up to 20 percent of your QBI (as well as 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, but I won’t get into that in this post). Income earned by a C corporation or by providing services as an employee isn’t eligible for the deduction.
You can claim the 199A deduction whether you take the standard deduction or itemize. As long as you qualify for the deduction, you can take it.
Eligibility for the 199A deduction depends upon whether the type of business operated by the owner is Restricted or Non-restricted. The first category consists of any business involving the performance of services in the fields of health (e.g., radiologists and other physicians), law, accounting, actuarial science, performing arts, consulting, financial science or any business where the principal asset is the reputation or skill of its employees or owners. The second category consists of all other businesses.
Owners of Non-Restricted Businesses are entitled to claim the 199A deduction regardless of their taxable income (subject to certain limitations). Owners of Restricted Businesses (which includes physicians), however, can fully benefit from the 199A deduction only if their taxable income is below an income cap of $210,700 if filing single ($421,400 other taxpayers) in 2019, and $213,300 ($426,600 other taxpayers) in 2020. Below these levels, the 199A deduction is phased-out.
The QBI deduction is not considered an “above the line” deduction because it is subtracted after adjusted gross income is calculated. But it is also not an itemized deduction; that is, you can claim it as well as the standard deduction in a given year.
The sum of your total income minus above the line deductions equals your adjusted gross income (AGI), referred to as “the line.”
How do you calculate taxable income?
The sum of your total income minus above the line deductions equals your adjusted gross income (AGI), referred to as “the line.”
As an aside, to “walk the line” means to behave in an authorized or socially accepted manner (e.g., by paying your taxes). Or, in the inimitable words of Johnny Cash:
As sure as night is dark and day is light
I keep you on my mind both day and night
And happiness I’ve known proves that it’s right
Because you’re mine, I walk the line.
I’ll now be resuming normal programming.
Your taxable income is your AGI minus your standard deductions or itemized deductions.
You can see how above the line deductions are always valuable. You can claim them regardless of whether you use your standard deduction or itemized deductions, whereas itemized deductions are only valuable if they exceed your allowable standard deduction.
A tax credit is a dollar-for-dollar reduction in your actual tax bill and therefore is much more valuable than a deduction of the same amount because it makes a much bigger dent in your tax bill. A few credits are even refundable, which are the most beneficial type of credit because they’re paid out in full. This means regardless of your income or tax liability, if you qualify for the credit, you are entitled to the entire amount of the credit. If the refundable tax credit reduces the tax liability to below $0, you get a refund. For example, if you owe $250 in taxes but qualify for a $1,000 credit, you’ll get a check for the difference of $750. That’s an extra $750 in your pocket! Sadly, most tax credits aren’t refundable.
Here are a few tax credits that may apply to radiology residents or practicing radiologists:
Earned income credit
This is a tax break for working people whom Congress has determined to be lower-income taxpayers. The average radiology resident salary in 2019 was $63,200, which is too high to qualify for the earned income credit (EIC). But the average salary of first year residents (all specialties) was $55,200. As you can see from the IRS chart below, to be eligible for EIC in 2020, a radiology resident would need to be married, file jointly, and claim three or more children:
Eligible Income Caps Based on Number of Children Claimed
|Single, Head of Household, or Widowed||$15,820||$41,756||$47,440||$50,594|
|Married Filing Jointly||$21,710||$47,646||$53,330||$56,844|
Investment income must be $3,650 or less for the year.
The maximum amount of credit for tax year 2020 is:
- $6,660 with three or more qualifying children
- $5,920 with two qualifying children
- $3,584 with one qualifying child
- $538 with no qualifying children
Child Tax Credit
The Child Tax Credit was designed to offset the cost of raising children. To qualify for this credit, you must have a dependent who is under the age of 17 on December 31 and is a United States citizen. The child must be your own or a stepchild, foster child, sibling, stepsibling, half sibling, or a descendant of any of the above. Also, the dependent must have lived with you for half the year (183 nights) and not provided more than half of their support. The Child Tax Credit can be worth as much as $2,000 per child. Up to $1,400 of the credit can be refunded for each child. That means that even if you don’t owe any money to the IRS, and you earned at least $2,500, you can get that money back as a refund. However, the credit begins to phase out once you reach a modified adjusted gross income (MAGI) of $200,000 ($400,000 for married filing jointly).
Child and Dependent Care Credit
If you are a parent and use a daycare or child care service, you may be eligible for the federal Child and Dependent Care Tax Credit (CDCTC) of up to 35% of these out-of-pocket costs up to $3,000 for one child or up to $6,000 for two or more. This is another tax credit that is refundable up to $1,400, so if you don’t owe the IRS any money and you apply this credit, you’ll get up to $1,400 back. This credit is available to all those who earned income (or are disabled and unable to work), have a qualifying dependent, and paid someone to provide care for a qualifying person. If you’re married, your spouse must also have earned income. And the payments must be to someone who can’t be claimed as your dependent (e.g., paying your 16-year-old son to watch your 5-year-old daughter doesn’t count). In addition, the payment can’t be made to the parent of the child for whom the care is being provided.
The credit does have some limitations. It only applies to children under 13, or if you have older children with mental or physical disabilities who are unable to care for themselves. The percentage you can deduct ranges from 20% up to 35%, depending on your income level. The more you earn, the less you can deduct.
If you welcomed a new child to your family via adoption, there’s a credit for you as well. For the 2020 tax season, you can get a tax credit for all qualifying adoption expenses up to $14,300 per child. Those expenses include reasonable adoption fees, court costs and travel expenses.
If you adopt a special needs child from within the U.S., you can claim the entire credit, even if your adoption costs were less than $14,300. Keep in mind that adopting a child of your spouse, however, doesn’t count toward the credit. Also, this credit is nonrefundable and is reduced or eliminated if your MAGI exceeds a cap (in 2020 the credit phases out completely at a MAGI of $254,520 or more). In addition, there is an income exclusion for employer-provided adoption assistance.
Saver’s Tax Credit
To qualify for the Saver’s Tax Credit, otherwise known as the Retirement Savings Contributions Credit, you must not be a full-time student, are not somebody else’s dependent, and you contributed to either an IRA (of any kind) or a retirement plan at work, such as a 401(k) or 403(b). If you qualify, you can claim 50%, 20%, or 10% of the first $2,000 you put into a qualifying retirement account ($4,000 if married filing jointly). The credit maxes out at $1,000 ($2,000 if you are married filing jointly). Most radiologists will not qualify for this credit, but married residents with earned income of $65,000 or less may qualify for a partial benefit. The amount you can claim in 2020 depends on your income as shown below:
|Credit Percentage||Single or Married Separate||Head of Household||Married Joint|
|50% of contribution||$0 to $19,500||$0 to $29,250||$0 to $39,000|
|20% of contribution||$19,501 to $21,250||$29,251 to $31,875||$39,001 to $42,500|
|10% of contribution||$21,251 to $32,500||$31,876 to $48,750||$42,501 to $65,000|
What makes the saver’s tax credit so great is that it rewards you for doing something that is beneficial to do anyway. It can reduce your income tax in two ways. First, the contribution to the plan itself qualifies as a tax deduction (unless you contribute to a Roth account, which is not tax deductible). Second, the saver’s credit reduces the actual taxes owed, dollar for dollar.
Lifetime learning credit
You may be eligible for this credit if you pay postsecondary education expenses for a student. The credit is calculated as 20% of the first $10,000 of qualified educational expenses that you pay in a given year (i.e., maximum credit per tax return is $2,000). You are only eligible if your MAGI in 2020 is $68,000 or less ($136,000 if married filing jointly). The credit phases out for taxpayers with income between $59,000 and $68,000 ($118,000 and $136,000 for married filing jointly).
Energy and Appliance Tax Credits
If you have made improvements that make your home more environmentally friendly and energy-efficient, then you may qualify for a tax credit on the cost of those upgrades. Homeowners can receive a credit equal to 30% of the cost of qualified energy-efficient improvements in 2019 such as solar electric systems and water heaters, wind energy equipment, and geothermal heat pumps.
To utilize these credits you should get written certification from the manufacturer stating that their product qualifies for a tax credit. This information may be found on the company’s website or the product’s packaging and should be kept with your tax records. Also, note that this credit is planned to phase out after 2019 and cease after 2021.
Social security and Medicare withholding
In addition to withholding part of your earnings for federal income tax, employers also withhold payment for social security and Medicare taxes (and often state income taxes). Social Security tax is the tax levied on both employers and employees to fund the Social Security program. It (in addition to Medicare tax) is collected in the form of a payroll tax mandated by the Federal Insurance Contributions Act (FICA) or a self-employment tax mandated by the Self-Employed Contributions Act (SECA).
The Social Security tax is applied to income earned by employees and self-employed taxpayers. Employers usually withhold this tax from employees’ paychecks and forward it to the government. The funds collected from employees for Social Security are not put into a trust for the individual employee currently paying into the fund, but rather are used to pay existing retirees in a “pay-as-you-go” system. Social Security tax is also collected to support individuals who are entitled to survivorship benefits—benefits paid to a widow or widower upon the death of a spouse or to a dependent child upon the death of a parent.
Unlike income tax, the Social Security tax is a regressive tax, meaning that a larger portion of lower-income earners’ total income is withheld, compared to that of higher-income earners. As of 2020, the Social Security tax rate is 12.4%. Half of the tax, or 6.2%, is paid by the employer, and the employee is responsible for paying the other 6.2%. The Social Security tax rate is assessed on all types of income earned by an employee, including salaries, wages, and bonuses. However, there is an income limit to which the tax rate is applied. For 2020, the Social Security tax is taken from income up to an annual limit of $137,700. Any amount earned above $137,700 is not subject to Social Security tax. This is what makes it a regressive tax.
Medicare tax is calculated as 1.45% of your earnings, and is not capped as is social security tax. In addition, many radiologists will also pay an “Additional Medicare Tax” (added by the Affordable Care Act in 2013) of 0.9%, which applies to wages and self-employment income over certain thresholds ($200,000 for those filing single and $250,000 for married couples filing jointly).
The Internal Revenue Service (IRS) considers a self-employed individual to be both an employer and an employee.
You’re self-employed if you’re a sole proprietor (which includes performing radiology services as an independent contractor), a partner in a partnership (including a member of a multi-member limited liability company (LLC) that is treated as a partnership for federal tax purposes), or are otherwise in business for yourself. Earnings from self-employment are subject to the same income tax rates as wages or salaries. However, instead of being subject to the normal Social Security and Medicare payroll taxes, self-employment earnings are subject to the self-employment tax.
The self-employment tax is made up of the Social Security tax and Medicare tax. The Internal Revenue Service (IRS) considers a self-employed individual to be both an employer and an employee. Thus, if you do radiology work under contract (not as an employee), you have to pay the full 12.4% Social Security tax up to the wage limit and Medicare tax of 2.9%, for a total self-employment tax of 15.3%. The additional Medicare tax also applies as explained above.
Generally, the amount subject to self-employment tax is 92.35% of your net earnings from self-employment. Half of the self-employment tax can be claimed as an above-the-line deduction, in effect a partial refund on the employer portion.
Alternative Minimum Tax (AMT)
This tax prevents high-income taxpayers from being able to take advantage of so many deductions and credits that they pay very little income tax. The calculation of the AMT is a bit complicated, and beyond the scope of this post, but suffice it to say that you’re required to pay the greater of either 1) your regular income tax, or 2) your AMT.
Simply, the AMT is calculated by making several adjustments to your gross income, adding back a few “preference” items (such as state and local tax deductions), and subtracting a large exemption. The resulting figure is taxed at 26% or 28% depending on the level of income.
State income tax
State income tax is required alongside federal income tax, but can often be deducted from federal taxes. State income tax varies widely among states. As of 2020, seven states—Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming—levy no personal income tax. Two others, New Hampshire and Tennessee don’t tax wages. They do currently tax investment income and interest, but both are set to eliminate those taxes soon. That will bring the number of states with no income tax to nine by 2025.
The three states with the highest income tax rates in 2019 are California with 13.3%, Hawaii with 11%, and Oregon with 9.9%. The three states with the lowest income tax rates in 2019 are Pennsylvania with 3.07%, North Dakota with 3.22% and Indiana with 3.40%.
State income tax returns are shorter and easier to prepare compared with federal income tax returns because the taxable income from your federal Form 1040A is used for the state returns, without having to be recalculated. It’s then usually subjected to a few adjustments, depending on the state’s allowable deductions. After making these adjustments, you can calculate your state income tax from a state tax table.
Getting professional help
If “shrink” was the first thing that just popped into your mind after reading to this point, it may be a sign you should consider hiring an accountant or tax pro. If you don’t want to prepare your tax returns on your own, I still recommend you become familiar with the information in this and my prior post and understand how it applies to you. By doing so, you will be able to judge whether someone you hire to do your taxes for you is doing a good job. If you want to do it on your own, even just once to learn as much as you can about taxation, you can use the popular TurboTax software, although you will probably learn more by working through the forms on your own. Alternatively, you can do your own taxes and take them to a tax preparer to bless your work if you aren’t confident in your abilities. It should cost less if you’ve done much of the work already.
Here’s a personal example of how a tax advisor helped me:
When I retired from clinical practice, I hadn’t yet decided whether to fully retire or not. I was still earning royalty and honorarium income from editorial work, receiving research income, and getting paid as a visiting professor. I received a postcard from the OH Revenue Service, letting me know that small business owners could deduct their income from state taxes. This included sole proprietors, I read, a term which was new to me at the time. I almost threw away the card, thinking it didn’t apply to me. As fate would have it, I got curious as to what “sole proprietor” meant and discovered this definition:
A business that legally has no separate existence from its owner. Income and losses are taxed on the individual’s personal income tax return.
No formal filing or event is required to form a sole proprietorship; it is a status that arises automatically from one’s business activity.
The income I was earning was reported on Schedule C, along with the standard Form 1040. This is the form used to calculate and report a business’s profit or loss if you run a business as a sole proprietor!
I was a sole proprietor!!! I contacted my tax advisor and asked her to confirm this. It turned out that I was eligible to deduct my “net business income” as a sole proprietor on my OH income taxes. I was up for that!
Ohio’s Business Income Deduction is entirely separate and distinct from the federal Qualified Business Income Deduction (QBID). Since the Ohio return starts with the federal adjusted gross income, the federal QBID does not factor into Ohio’s income tax calculation. Only business income earned by a sole proprietorship (that’s me!) or a pass-through entity generally qualifies for the deduction. A pass-through entity includes partnerships, S corporations and certain LLCs (limited liability companies). Note: If you haven’t read my prior post on different organizational structures, you might want to now.
After learning that I was eligible for the OH business income deduction,I submitted an amended Ohio return for 2015, claiming this deduction, and received a four-figure refund. It was quick and easy. I was able to deduct 75% of my business income in 2015 and 100% of business income in 2016 and 2017 (then I moved back to WI, which doesn’t have this deduction).
The moral of this personal story is that professional tax preparers can do most of the work of filling out your tax return, and may save you money in the process. But they don’t always know or think of everything. In my case, my tax advisor lived in WI and didn’t know all the ins and outs of the OH state income tax laws. Working together saved me money. The more you understand about your personal taxes, the more you will be able to help your tax preparer and evaluate how well she is doing. Ready to hear it again? No one will look out for you better than you.
As of this writing, the filing date for 2019 income taxes is July 15, 2020. Here are a few tips to keep in mind before you hit the “send” key.
Filing tips (particularly if you’re preparing your own taxes) based on the most common filing errors:
- Check name (did you get married and change your name?) and address – a mistake in either could delay processing of your return or result in a refund being sent to the wrong address.
- Be sure to double-check the routing and account numbers on your return if you are anticipating a refund and choose direct deposit (which is typically the fastest way to get your money).
- Report all of your income. Individuals oftentimes don’t realize they generated income that is subject to tax. Omitting income from a tax return can result in additional taxes subject to interest and various penalties. When you receive tax forms, such as 1099s or K-1s, you must report the income on those forms on your individual income tax return. The IRS will know if you don’t because they receive copies of these forms (Uncle Sam is watching you).
- File the correct status. If you were legally married during the year, don’t forget that your filing status may change from Single to Married Filing Jointly or Married Filing Separately. There are other filing statuses that you may not have considered, such as Head of Household or Qualifying Widower, that may yield certain tax benefits.
- Watch out for math errors as they are among the most common mistakes that filers make. They range from simple addition and subtraction to more complex calculations. This is when tax prep software can come in handy since it does the math automatically.
- Sign the return – an unsigned tax return isn’t valid! In most cases, both spouses must sign a joint return. Exceptions may apply for members of the armed forces or other taxpayers who have a valid power of attorney. You can avoid this error by filing your return electronically and digitally signing it before sending it to the IRS.
Taxation is a very complicated topic and it’s impossible to cover every aspect that will pertain to each person’s situation. If you find it as interesting a topic as I do, and want to learn more, here are three references that I recommend:
Piper, M. Taxes Made Simple. 2018, Simple Subjects, LLC.
This is one of Mike Piper’s “100 pages or less” series, and is a very easy read for the person who knows nothing about income taxes. Even if you never want to do your own taxes, I suggest you read this so that you’ll be able to evaluate your tax advisor and ask intelligent questions.
I would like to recommend Taxes for Dummies. The “Dummies” books have always appealed to me once I’ve learned a little bit, want more information, but don’t want the full scholarly opus. At around 400 pages in length, they’re just the right size. But, alas, Taxes for Dummies hasn’t been updated since 2008. So I’m suggesting a niche book:
Nelson SL. Maximizing Section 199A Deductions: How Pass-through Entity Owners and Real Estate Investors Can Annually Save Thousands in Income Taxes. 2019, Stephen L. Nelson, LLC.
Stephen Nelson, CPA, has written dozens of books and this one is all about the relatively new Qualified Business Income (QBI) deduction. Many radiologists will not qualify for this deduction, based on their income, but if you work part-time or have retired from clinical practice and now earn income as a sole proprietor, this book is a great resource.
J.K. Lasser’s Your Income Tax 2020: For Preparing Your 2019 Tax Return 1st Edition; Wiley.
This text is a big (896 pages), softcover book that has been updated annually for over 70 years. It’s straightforward, yet comprehensive. If you read this, there won’t be much you don’t know about income taxes. And you will learn about more than just taxes, such as how to optimize your investment strategy and other areas of your personal financial life. It’s a fantastic resource. I read the 2017 edition cover to cover.
Be sure to return for my next post on property and sales taxes (I promise you, it’s way less boring than it sounds)! Until we meet again next week. Over-n-out.