What is taxable income?
Now we come to the part of Form 1040 where we start to put in numbers. For starters, you need to report your income.
A lot of people take this part for granted. They just fill in their income, as reported on W-2s or 1099s, and then spend all their time worrying about deductions.
This is probably a mistake. To try to reduce your income taxes, you should understand what income is taxable, and what is tax exempt.
Almost all forms of income are taxable
Unfortunately, according to the Internal Revenue Code, almost all forms of income are subject to tax, except for those items specifically exempted by the code.
This means that almost all forms of income from wages, tips, interest, dividends, bartering, prizes, gambling and pensions are subject to tax. We'll go into more detail about what is taxable, but let's spend a moment talking about what is not taxable.
What isn't taxable
For starters, gifts that you received aren't taxable to you. You won't have to pay federal income tax on any gift that you receive, but if you receive more than $10,000 as a gift the donor may have to pay federal gift taxes.
The IRS views inheritances as a form of a gift, so you won't have to pay any federal income taxes on anything you inherit. However, the estate of the donor may have to pay federal estate taxes if the estate was valued at over $600,000.
If you bought your own disability insurance, any proceeds you receive from the policy are free from income tax. However, if your employer paid for the policy, disability insurance proceeds are taxable.
Any life insurance proceeds you receive are also free from income tax, but life insurance is not exempt from estate taxes. Interest from most municipal bonds is exempt from federal income tax.
Scholarships also are exempt from tax. And if you work, you can receive about $5,000 in tax-exempt employer-paid tuition for an undergraduate college degree. This exemption changes constantly, so be careful with this. But if you're working on an undergraduate degree, see if your employer can give you a hand here.
There are also several fringe benefits that you, as an employee, can receive income tax free.
Employer paid health insurance is not taxable
Health insurance is by far the biggest tax-free benefit. Each year a company can give its employees thousands of dollars worth of health insurance. This is a deductible expense to the company, but doesn't show up as income to the worker.
When the Clintons tried to nationalize our nation's health care system in 1993, they had to find ways to pay for it. One of the ways was to tax the health insurance benefits that workers currently receive tax-free.
Now I don't have any problem with including health insurance in everyone's taxable income, but if they broaden the definition of taxable income but don't lower tax rates, you've given a tax increase to millions of Americans.
Although employer-provided health insurance is the largest tax-free fringe benefit, there are others worth mentioning.
Employer provided child care is not taxable
Perhaps the best of the rest is the dependent care fringe benefit. If your employer offers this benefit, you can exclude up to $5,000 of payments which go to a care provider. This benefit is worth something.
Assume that you have a child, and a local day care provider wants $2,000 per year to watch your child after school. If your federal and state taxes put you in the 33 percent bracket, you'd have to earn $3,000 in pre-tax dollars to pay the $2,000 fee.
If, however, your employer offered a dependent care assistance plan, the employer would only have to reimburse you $2,000 to pay the $2,000 fee because a qualified reimbursement would be tax free. With fringe benefits, it's easy to see how both you and your employer can work out something that will benefit you both.
There are other tax-exempt fringe benefits like $50,000 in term life insurance, employee discounts, and employee athletic centers. These all offer tax savings, but they also make the tax system more complicated than it needs to be.
Welfare payments are tax free
Finally, state provided welfare payments are tax exempt. Strangely enough, however, unemployment compensation is taxable. With this kind of set up, it's not hard to see that there's an incentive to not work.
If you're currently on welfare, you receive a number of payments for housing, food, and free medical care. This is all tax free. However, if you start working, you lose over 7 percent of your pay to Social Security or FICA taxes from your first dollar of income. Further, you're subject to income taxes after about the first $7,000 dollars of income.
W-2s
But if you're a typical worker, most of your income will come in the form of wages or salary. This number is reported to the IRS on your W-2 form.
If you haven't figured it out yet, your Social Security number is your key identifier, and the IRS uses information supplied under your Social Security number to check the correctness of your return.
Your employer is required to send a copy of the W-2 to the IRS, to local tax authorities and to you. If the wages you report on your 1040 don't match the number supplied by your employer to the IRS, the IRS computers will find the discrepancy and you'll be receiving a computer-generated letter in the mail.
So for any W-2 or 1099 you receive, it's critical that you check the reported numbers. And remember that sometimes these numbers are wrong.
I've seen plenty of cases where a 1099 reported the wrong amount of interest or an incorrect payment. If you receive a 1099 that says you earned $500 in interest, but your records show you only received $100 in interest, contact the bank and have them send a corrected 1099 to you and to the IRS as soon as possible.
Some people have criticized the IRS' archaic computer systems, but their income matching system is fairly good. If there's a discrepancy in W-2 or 1099 numbers, you can almost be assured that you'll be getting a letter from the IRS. Big brother may not be watching your every move, but the IRS sure is watching your income.
W-2 : 401(k) Contributions
Although fringe benefits are a great way to get tax-free income, 401(k), 403(b) or similar retirement plans are another good way to reduce your taxable income. If you use a 401(k) or similar plan, you may have noticed that your income reported on your W-2 under "wages, tips or other compensation" and your so-called "Social Security wages" will be different.
This is because amounts saved under a 401(k) plan don't even show up on your W-2 as taxable income. This is how you get the immediate tax savings from a 401(k).
The amount diverted to your 401(k) doesn't appear on your taxable income, so your total tax liability for the year is lowered. Of course, you'll have to pay taxes later when you withdraw the money from the account, usually after you've retired.
However, you must pay Social Security taxes on all your wages, including the amount saved under a 401(k) plan. Thus, if you participate in a 401(k) or similar plan, your so-called Social Security wages should be higher than your wages subject to federal income taxes.