Twenty-One Items to Consider Before Filing Your 1998 Tax Return

According to IRS, taxpayers are receiving refunds this year averaging $1,741. This $250 increase over last year is attributable to several first-time credits available to lower and middle income filers. Single filers with adjusted gross income ("AGI") under $40,000 and married taxpayers filing jointly with AGI’s under $80,000 qualify for most of the new tax breaks.

Most new tax provisions contained in the Taxpayer’s Relief Act of 1997 ("Act") went into effect in 1998. Therefore, taxpayers must consider whether they qualify for these new credits. Under the Act, many of the tax breaks which began January 1, 1998, will be phased out (reduced ratably over a range of income) when a taxpayer's AGI reaches certain levels.

When calculating your 1998 tax bite, start with your total income. From total income, there are certain "above-the-line" deductions (IRA, SEP and Keogh contributions, moving expenses, self-employed health insurance and alimony payments) which may be taken to arrive at AGI. These deductions are permitted whether or not you itemize deductions. AGI becomes you’re your focal point for potential tax benefits.

Here are the 21 most important issues to consider when filing your 1998 tax return:

1. Filing Techniques

Always double-check: (1) math; (2) names, addresses and social security numbers; and (3) lines on the forms where you entered information. Send your return by certified mail, return receipt requested.

Place your social security number on any checks you send IRS and always keep a copy of your return and a copy of the canceled check with your tax records.

Note: The minimum requirement for retaining business receipts has been increased from $25 to $75. For expenditures under $75.00 written diary entries will suffice as proof.

Tax records should be maintained in separate folders for each calendar year. Keep your return, any W-2 forms, Forms 1099 and copies of receipts and canceled checks evidencing deductions in the folder. Records should be maintained for at least 6 years, however, records involving the purchase of a capital asset (such as the closing statement for the purchase of real estate) should be retained as long as you own the asset, plus 6 years.

Note: In general, individuals with gross incomes under $6,800 and joint filers under $12,200 are not required to file; nevertheless, they should file to claim a refund if they had taxes withheld.

Dependent identification numbers (social security numbers for U.S. citizens and residents) must be on your return to claim a dependent exemption and child care credits. The IRS may disallow these tax benefits for missing or incorrect numbers, unless the dependent was born in December 1997. Apply with Form SS-5.

Those over age 65 or who are blind may be eligible to claim an additional standard deduction. You may qualify for lower tax rates as head of household or surviving spouse with dependent child if you are single and have a dependent living with you.

A married taxpayer filing a joint return may be eligible for the earned income credit if (1) the taxpayer is between the ages of 25 and 65; and (2) the combined AGI is less than $10,000 with no qualifying child, $26,450 with one qualifying child and $30,095with more than one qualifying child.

Double-check all W-2 employee compensation forms and Form 1099 for accuracy. If you worked multiple jobs, make sure you do not overpay social security taxes. Also, if you are receiving social security and your modified AGI is less than $25,000 ($32,000 for joint filers), benefits are not taxable.

Review last year’s tax return for losses or deductions (especially business losses, capital losses, charitable contributions and passive loss limitations) that may be carried forward to this year’s return.

If you regularly receive large tax refunds, you are over-withholding on your income. Reduce your withholding by fling a W-4 with your employer to increase your take-home pay. Also, if your refunds are subject to levy by the IRS for unpaid taxes or by any other government agency, consider correcting your W-4 to eliminate the refund.

2. Prepare and File Your Returns On-Line

Don’t hassle with tax forms and rushing to the post office at midnight. Filing on-line offers the same benefits that apply to the Internet generally: fast, simple, convenient and less expensive transactions. Check out some of the tax preparation and filing services on the Internet. Check out my February 1999 Hot Topics for access to tax gateways, advice, preparation services and federal and state forms.

Caution: For many taxpayers with complicated tax returns, the risks of avoiding a qualified tax preparer could far outweigh the benefits. [Tax preparers include commercial tax preparation services, enrolled agents, CPAs and tax attorneys. Which to choose generally depends on the complexity of the return and potential risks on audit].

Filing a tax return is as easy as purchasing an inexpensive book or do-it-yourself software over the Internet. Preparing and filing an accurate tax return, however, is required by federal law and executed under penalty of perjury. If you are audited by IRS or California’s Franchise Tax Board (FTB), a range of penalties could face you -- from civil negligence or fraud (monetary penalties only) to felony criminal charges, in egregious cases. IRS and FTB share information; additional taxes charged by IRS must be reported to the FTB.

Tax software programs are no substitute for understanding how taxes work and, more importantly, how to structure your business or investments to lower taxes. Also, if you owe taxes in more than one state, get professional advice on how to file these returns.

The benefit of the professional tax preparer is their updated knowledge, experience and training before any numbers are placed on your return. Generally, a tax preparer focuses on two main goals: (1) whether you are claiming all entitled deductions, exemptions and credits, thus paying the lowest legal amount in taxes; and (2) if audited, whether your return can withstand scrutiny by IRS or FTB. The first involves understanding the law, issue-spotting and tax planning; and the second requires knowledge of the documentation necessary to support your claimed income and deductions.

3. File by Telephone

If you meet certain requirements, IRS encourages filing by touch-tone phone. IRS reports a 25% increase in usage of this method through January, 1999.

The "Tele-File" program is designed for simple Form 1040EZ filers who, in general, earn less than $50,000 a year in wages, salaries, tips and interest income (limited to less than $400), filing either as a single person or jointly. Evidently the program has difficulty with additional dependents and exemptions since you cannot Tele-File if you have dependents, are over age 65 on January 1, 1999 or are blind.

Complete the Tele-File form (TEL-1) before calling IRS (the toll-free number is on the form). You do not mail anything and IRS claims the process takes about 10 minutes. IRS gives you a confirmation number which you record on your Tel-File form as proof of filing your return. If you owe money, there is a payment voucher inside your Tel-File package (Form 8855-V). California has a Telefile program with similar requirements and restrictions.

4. Filing for an Extension to File Your Taxes

If you can't file your federal tax return on time, you may apply for an automatic extension but you must complete Form 4868. Then, you’ll have until Monday, August 16, 1999 to file your return. You must pay at least 90% of the eventual tax due to avoid penalties. If you live outside the U.S., you receive an automatic 2-month extension without filing the Form 4868, but you must attach a statement that you live outside the U.S. on your tax return.

California requires you to pay 100% of the taxes due, but will grant you an automatic 6-month extension. Make additional tax payments to California’s Franchise Tax Board with Form 3519.

There’s a two-fold benefit available: (1) tax software should go on sale after April 15th; and (2) instead of doing your taxes, take advantage of the restaurant specials during the first two weeks of April.

5. Child  Credit

Commencing for tax year 1998, there will be a $400 per child credit (rising to $500 in 1999) for children under age 17. The credit will phase out for an AGI of $75,000 for individuals and $100,000 for couples. The phase-out rate is $50 for each $1,000 over these thresholds. In other words, an individual whose AGI is $80,000 ($5,000 over the threshold) with one child will lose $250 of the credit ($5,000 = 5 X 50 = $250). These thresholds are not indexed for inflation. Low income families earning at least $18,000, but who pay little or no tax, will receive the benefit of the per-child credit as a refund.

6. Creative Use of the Dependency Exemption

You may claim a dependency exemption if you supply more than 50% of the support for a U.S. citizen or resident, or a resident of Mexico or Canada, provided that person lived in your home as part of your household during the entire year, and whose gross income (excluding nontaxable income) was less than $2,700. The person does not have to be related to you. Thus, a dependency exemption may be claimed in same-sex living situations, when one partner earns less than $2,700, provided the relationship does not violate local law.

7. Education Credits – HOPE Scholarship and Lifetime Learning Credit

HOPE Scholarship: Families get a maximum credit of $1,500 for a student's first two years of college (100% of the first $1,000 in expenses and 50% of the next $1,000) at an "eligible educational institution."

Lifetime Learning Credit: For the next two years and for graduate students, the maximum credit will be $1,000 (20% of the first $5,000 in expenses).

Both credits are phased out for individuals with AGI of $50,000 to $60,000 and couples with AGI of $80,000 to $100,000 -- which might preclude most full-time working couples in the Bay Area. This credit is available for tuition and fees required for attendance. Books, meals, lodging, student activities, athletics, insurance, transportation and similar personal, living or family expenses are not included.

To illustrate: If a student pays $1,500 in tuition and $400 in books, the credit is $1,250 ($1,000 + ½ of $500 = $1,250; books are not eligible for the credit).

Students must be enrolled at least half time in school and cannot have a federal or state felony conviction for possession or distribution of a controlled substance. In other words, if you have a felony conviction for marijuana, you are ineligible -- murderers, rapists and child molesters are, nevertheless, free to qualify for these student credits!

This rule unfairly impacts the minority communities, where lack of financial resources to hire attorneys to plea bargain down drug possession offense could render a large number of potential students ineligible. Consequently, this restriction discriminates against those segments of society the tax credit for education is supposed to help.

Eligible educational institutions include accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, graduate-level or professional degree, or other recognized post-secondary credential. Certain proprietary and post-secondary vocational institutions are also included.

8. Student Loan Interest

Student loan interest on a "qualified education loan", which is repaid during the first 60 months after payments are required, will now be partially deductible to eligible borrowers -- to a maximum of $1,000 for tax year 1998 (rising by $500 annual increments to $2,500 in 2001) -- whether or not the taxpayer itemizes deductions. This provision phases out ratably for individuals with AGIs between $40,000 and $55,000 ($60,000 and $75,000 for joint filers). The maximum deduction is not adjusted for inflation. The deduction is allowed to the person who pays the interest, but no deduction is allowed to an individual claimed as a dependent on another's tax return.

A qualified education loan is generally indebtedness incurred to pay for the "qualified education expenses" of the taxpayer, the taxpayer's spouse, or any dependent as of the time the indebtedness was incurred. Qualified indebtedness expenses mean tuition, fees, room and board and related expenses reduced by, in general, tax-free scholarships or educational benefits or other amounts which are excluded from gross income. The indebtedness must be incurred to attend post-secondary educational institutions and certain vocational schools (defined in section 481 of the Higher Education Act of 1965).

The AGI phase-out limits will be adjusted for inflation, starting in 2003. Strangely, amounts excluded from gross income under the qualified adoption expense exclusion (IRC Sec. 137) are added to AGI for purposes of determining the student loan deduction. The provision is effective for interest payments due and paid after December 31, 1997.

9. Student Loan Forgiveness

Under current law, student loan forgiveness does not constitute income to the taxpayer, if he worked for a certain period of time in certain professions for a broad class of employers (See IRC Sec. 108(f)). The new law expands these provisions to certain tax-exempt charitable organizations as lenders, such as educational organizations or private foundations if the loan proceeds are used to pay the costs of education or to refinance outstanding student loans, provided the borrower is not employed by the lender. For loans made by charitable organizations, the student's work must fulfill a public service requirement. This provision is effective for loan forgiveness occurring after the date of enactment.

10. Creative Use of Individual Retirement Accounts

Roth IRA

The Roth IRS is an IRA with a twist: Investors cannot deduct the contributions, but earnings accumulate tax-free. However, unlike a traditional IRA which had distributions that were tax deferred, the IRA Plus distributions will never be taxed. Withdrawals must commence at age 59½ and the account must be at least 5 years old. The annual contribution limits are $2,000 for individuals and $4,000 for couples. There is a phase-out of eligibility starting at AGIs of $95,000 to $110,000 for individuals and $150,000 to $160,000 for couples. Early withdrawal is permitted for first-time homebuyer expenses, subject to a $10,000 lifetime cap and educational expenses.

Those with regular IRAs may convert them to a Roth account. The conversion will be taxed as an IRA distribution, but without penalty for early withdrawal. Only taxpayers with less than $100,000 in AGI (determined prior to the conversion) are eligible to rollover an IRA into a Roth.

Traditional IRAs

AGI limitations on contributions to IRAs (currently $25,000 for individuals and $40,000 for couples) will increase $5,000 for individuals and $10,000/year for couples in 1998, 2002, 2003 and 2004. After 2004, the AGI limitations will be $50,000 for individuals and $80,000 for joint filers. Also, penalty-free withdrawals are permitted for first-time home purchases to a maximum of $10,000, or educational expenses without limitation.

If one spouse is an active participant in an employer-sponsored retirement plan, the other spouse is now eligible for an IRA deduction to a maximum of $2,000. This benefit phases out for couples with AGI between $150,000 and $160,000.

On January 1, 1998, the general prohibition against investment in collectibles was lifted for permitted certain platinum coins and certain gold, silver, platinum or palladium bullion.

Education IRA

Contributions of a maximum of $500 per year per beneficiary may be made to an Education IRA. The contribution limit is phased out ratably for individuals with AGIs between $95,000 and $110,000 and joint filers with AGIs between $150,000 and $160,000. These IRA's are created for post secondary tuition, fees, books, supplies, equipment, and certain room and board expenses; elementary or secondary school expenses are not eligible. Earnings in the IRA and distributions to the beneficiary are tax-free, provided the distribution does not exceed the qualified higher education expenses incurred by the beneficiary. Excess distributions will be taxed to the beneficiary (who might not have any other taxable income).

Any balance remaining in the IRA when the beneficiary becomes 30 years old must be distributed and the earnings portion of the distribution will be subject to ordinary income tax plus a 10% penalty; however, the IRA may be rolled over tax free to another Education IRA for the benefit of another member of the family (using the dependency definition), provided the rollover occurs before the current beneficiary reaches age 30.

The HOPE credit or the Lifetime Learning credit cannot be used in the same year that an Education IRA is distributed to a beneficiary.

Eligible students must be enrolled at least half time in a degree certificate undergraduate or graduate program at an eligible educational institution. Also, the student cannot have a felony conviction for possession or distribution of a controlled substance.

The Education IRA began after December 31, 1997.

11. Sale of a Principal Residence

If you sold your home prior to May 6, 1997, you fall under the old residency rollover rules. To avoid tax, you must acquire a new residence for equal or greater cost than your old one. Also, the once-in-a-lifetime exclusion of $125,000 in profits applies to those over age 55 who elect to use it. Because of the new law, those who were eligible to elect the exclusion in 1995, 1996 or 1997, but failed to do so might want to amend their old returns and claim the benefit.

For sales after May 6, 1997, you may exclude $250,000 as an individual and $500,000 filing jointly if you have lived and used your home as a principal residence for two of the past five years prior to sale. If you acquired your home less than two years ago, but used Internal Revenue Code Section 1034 to roll over the gain from your prior home, then you may add on the ownership and use of the prior home to meet the two-year requirement.

Note: The exclusion does not apply to depreciation allowable in connection with rental or business use of your home after May 6, 1997. Be careful in claiming depreciation for an office in the home.

12. Capital Gains

For investment assets (other than collectibles) sold after May 6, 1997 and held 12months or longer( 12-months for assets sold between May 7, and July 28th), a new 20% capital gains rate applies. For those in the 15% bracket, the capital gains rate is 10%. Real estate depreciation is taxed at 25% for properties sold after May 6, 1997.

Mutual fund distributions are now reported on Schedule D to account for the new rates. Distributions that were automatically reinvested in the fund increase your adjusted basis. This will reduce your gain and increase your loss.

Note: Make sure that you have properly accounted for the basis in mutual fund shares that were sold.

13. Employer-Paid Educational Assistance

There is an exclusion for employer-paid undergraduate educational assistance you receive (up to $5,250 per individual) for tuition, books, fees and supplies. The exclusion does not apply for tools or supplies retained after the course or for meals, transportation or lodging. Graduate-level courses starting after June 30, 1996, no longer qualify for the exclusion.

14. Deducting Adult-Education Expenses

If your employer did not pay for educational expenses or if you are taking graduate study courses, remember educational expenses may be deducted if they are either mandated by your employer or incurred to maintain or enhance your present skills. You cannot deduct educational expenses if the courses qualify or retrain you for a new trade or profession or are part of "entry level" education, such as the minimum educational requirements to become a teacher, doctor or attorney.

15. Exclusion for Student Scholarships

A scholarship for tuition and supplies for a student earning a degree from a qualified educational organization are tax-free. The same applies to a tuition reduction to employees of a qualified educational organization and to payments for teaching, research or other services performed as a condition of receiving the scholarship or tuition reduction. Athletic scholarships received by students who are expected, but not required, to participate in sports, will qualify for the exclusion.

16. Opening an IRA At the Last Minute to Reduce Your Taxes

One of the last tax breaks open to you before April 15th is an Individual Retirement Account. As long as you open such an account before the due date of your return, you can place money in an IRA and deduct the payment (within the limits pertaining to IRA deductions) in tax year 1997. You can also contribute to an existing IRA prior to the due date of your return. You may make a $2,000 contribution to an IRA for a non-working spouse.

Penalty-free IRA withdrawals for unreimbursed medical expenses exceeding 7.5% of AGI are permitted. Also, penalty-free withdrawals are permitted if you are unemployed for three months or use the funds to purchase medical insurance (no AGI limitation).

17. Retirement Benefits

Retirement benefits cannot be taxed by California if you now live in another state. You are not required to file a tax return in California. You are not required to receive retirement distributions if you are employed after age 70 1/2 and own less than 5% of the company. Also, the 15% excise tax on excess distributions from IRA and retirement plans has been eliminated.

18. Open a Non-Deductible IRA, Then Convert it to a Roth

Double-up on your Roth contributions by making a $2,000 non-deductible IRA contribution by April 15, 1999, then rolling it over to a Roth and making a $2,000 contribution to your Roth in 1999. Individuals whose AGI is less than $95,000 and joint filers with combined AGI of less than$150,000 are fully eligible to make a $2,000 Roth contribution in 1999. Joint filers each may contribute $2,000 to a non-deductible IRA and to a Roth.

Contributions to a non-deductible IRA may be made by high income individuals. Make the contribution, then use the Roth rollover rules to convert the IRA to a Roth. Even if you do not meet the rollover requirements for this year ($100,000 AGI or lower), you could meet them in subsequent years and you’ll have the rollover funds ready. The conversion of the non-deductible contribution (but not the earnings) will be tax-free when the rollover occurs.

19. Adoption Credit

As of 1996, there is a new $5,000-per-child credit for certain adoption expenses. The credit is phased out ratably, in general, for adjusted gross incomes between $75,000 to $110,000. The credit is increased to $6,000 for a U.S.-born special-needs child. Unused credits may be carried forward for 5 years. If eligible, you may forego the exclusion and receive tax-free employer-provided adoption assistance for up to $5,000 as well. Credit is applied on a per-child basis and is available in the year the adoption becomes final.

20. Non-Physical Injury Awards and Punitive Damages

Damages for physical injuries or physical sickness will continue their tax-free status, but amounts received after August 20, 1996 for non-physical injuries (emotional distress, defamation, discrimination, wrongful termination) and "punitive" damages (generally, damages which punish the wrongdoer rather than reimburse the victim) are fully taxable. This change does not apply to payments made by an agreement, court decree or mediation award in effect on or before September 13, 1995.

21. Pay by Credit Card or with Installments?

Once you determine the amount you owe on your 1998 tax return, you may make immediate payment with your credit card. The only cards currently participating in this program are MasterCard, Discovery and American Express. This option is available whether or not you file a paper return, electronically or by telephone.

The Wall St. Journal reports nine instances where individuals owing taxes of more than $1,000,000 have paid with their credit cards. The highest charge to date amounting to $9,000,000 (that's 40 first class upgrades!).

Call 1-888-2PAY-TAX (a toll-free number). Your credit card merchant sends the money directly to the IRS, but your credit card number is not disclosed to IRS. Check with your credit card company regarding their fees, some as high as a hefty three percent of your payment.

Starting February 28, 1999, those who file using Intuit tax preparation software have the option of paying their taxes by charging the balance due on a Discover Card, directly on line. This is a joint arrangement, approved by IRS, between Intuit and Discover card. Again, expect a service charge.

Use of a credit card could be expensive, considering the 1-3% fee and 15%-18% annual interest on the unpaid balance. In contrast, IRS penalties and interest will amount to 7.5% on the unpaid balance. Further, IRS applies payments to principal first, thereby reducing the principal which, in turn, reduces the interest.

If you owe taxes, but cannot pay them by April 15, you are not required to use a credit card. If you have filed and paid your taxes without an installment agreement during the previous 5 years, you are entitled to pay the balance in installments provided your balance is under $10,000 and the tax will be fully paid in 3 years.

Use a credit card in the following situations: (1) You want to earn bonus points or mileage offered by your credit card, the service fee is low and you plan to pay the balance by the next statement; (2) you cannot qualify for an installment arrangement with IRS; (3) you want IRS off your back and out of your life.

Another, and more sinister, reason for using a credit card is that the liability to the credit card company is unsecured (that’s why the interest rate is so high) and the company must take you to court to collect. IRS, on the other hand, may immediate garnish your paycheck or seize your bank account and other assets to collect taxes.