Part I: Your Personal Taxes

Your personal situation -- amount of earnings, marital status, the number of children you have, even what you spend your money on during the year -- has a significant impact on the amount of taxes you’ll pay. First, let’s do the numbers.

The tax rate for individuals in Massachusetts will be 5.3% in 2006.

• The Federal personal exemption is $3,300 in 2006 ($3,400 in 2007).
• Standard deduction amounts are $10,300K (MFJ), $7,550 (HOH), $5,150 (S) in 2006. They move to $10,700, $7,850 and $5,350, respectively, in 2007.
• In Massachusetts, the 2006 personal exemption is $3,850 (S), $5,950 (HOH), and $7,700 (M). Massachusetts also has a $1,000 exemption for each dependent.
• The maximum earnings subject to FICA (social security) tax will be $94,200 in 2006 ($97,500 in 2007); the maximum in 2006 will therefore be $7,206 for both employees and employers.

Visit our TaxQuikGuide for the very latest on federal tax rates, exemptions, and other current data.

Be careful of the phase-out of personal exemptions and certain itemized deductions ~ What is your tax rate really ???

Many years ago Congress enacted a very sneaky tax law. Instead of raising the overall tax rates, they adjusted the amount of income taxed by "phasing out" certain deductions. In the first instance, taxpayers owe an extra .95% in taxes for each personal exemption in the following phase-out zones:

This law makes the effective tax rate for a family of four as much as 3.8% higher than their "bracket."

The second phase-out is of itemized deductions on schedule A. For all taxpayers (except married filing separate), the phase-out begins at $156,400 of adjusted gross income; for Married Filing Separately, it begins at $78,200. If you fall into that income range, you may be subject to a rule that reduces your itemized deductions on a sliding scale that could eliminate as much as 80% (but not more) of some of your itemized deductions. This phase-out adds up to 1.16% to the tax rate for both married and single taxpayers.

The net result of these two phase-out rules can move a family of four in the 35% Federal tax bracket into an effective 39.64% Federal tax bracket. Add to this the Massachusetts tax rate of 5.3% and this family is paying a whopping 44.94% combined marginal tax rate!

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The Alternative Minimum Tax (AMT)

I often characterize the AMT as the tax equivalent of Jerry Seinfeld’s “bizarro world.” It is the stealth tax of the internal revenue code. An increasing number of taxpayers are finding themselves subject to AMT, a separate tax that can apply in addition to regular income tax. It is estimated that by the year 2008, almost 9 million taxpayers could be paying AMT if the rules are not changed. The AMT rates for individuals are 26% and 28%. The IRS provides a special form for computing AMT. The computation generally requires the addition of specifically enumerated “preference” items and deductions to your taxable income. Other items on your tax return, such as depreciation, must be recomputed for AMT purposes. If the AMT calculates a higher amount than your regular tax on the 1040, you will pay the higher AMT liability. AMT applies when the resulting alternative minimum taxable income (AMTI) exceeds an exemption amount for your filing status. The exemption is phased out at higher levels of AMTI. Keep in mind that there is no way to estimate the AMT. If you think it may be an issue for you, you must do a literal pro-forma of the actual income tax form to know what the effect will be. No one can “guess-timate” the AMT. To show the growing impact of the AMT just look at the chart below published by Internal Revenue Service showing the impact of the AMT in the 2004 filing season (the most recent available data):

In 2004 taxpayers with AGI of $100K or more paid 96.5% of the total amount of AMT; those with AGI of $200K or more paid 79.3% of that total.

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How to file when married -
Married Filing Jointly or Married Filing Separately?

Usually, Married Filing Jointly is the most favorable filing status . . . but not always. Two single individuals can together have the same amount of income as a married couple and pay less total tax. If you are planning to marry in 2006 and want to avoid this "marriage penalty," think about accelerating income into 2007 to obtain a better tax result.

Example: In 2006, Robin’s taxable income was $150,000 and Ken’s was $120,000. Their combined Federal tax as single taxpayers was $53,760. If they had been married in 2006, their combined tax on $270,000 of income would have been $63,760 on a joint return. The extra $10K in tax results from the way the tax brackets are structured. Some married couples can save taxes by doing Married Filing Separately returns. This is generally true if one spouse has a large number of expenses subject to deduction limitations based on AGI (adjusted gross income). For example: medical, miscellaneous, un-reimbursed job expenses or casualty losses. By "splitting" the return the AGI drops; therefore, the deduction floor also drops, allowing you more of the deduction.

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The Education Tax Incentives:
The Hope and Lifetime Learning Credits:

The Hope Income Tax Credit is provided for qualified tuition and related expenses (i.e., tuition and fees, but not books or room and board) for the first two years of a taxpayer's, spouse's, or dependent's post-secondary education.  This is a per-child credit. The credit is nonrefundable and is available for up to 100% of the first $1,100, and 50% of the next $1,100 of eligible expenses.

The nonrefundable Lifetime Learning Tax Credit is equal to 20% of up to $10,000 of qualified expenses (ex: $10,000 x 20% = $2,000). It is available to students enrolled in classes at eligible educational institutions to acquire or improve job skills. This applies to students in degree and non-degree programs. This is a per-family credit. The maximum LLC is $2K per tax return, regardless of the number of students.

Both of these credits are phased out for joint filers with modified AGI between $90,000 and $110,000, and for single taxpayers with modified AGI of between $45,000 and $55,000. Taxpayers, their spouses, and their dependents may take either the Hope credit or the Lifetime Learning credit, but not both for the same student in a single year.

In 2006 there is also a deduction for education expenses. Following rules similar to the HOPE credit, the taxpayer can choose to take a tax deduction of up to $4,000 (page 1 of the Federal 1040) instead of the credit if that allows them a greater tax benefit. This deduction is phased out when modified AGI is between $65,000 and $80,000 for single and HOH filers, and between $130,000 and $160,000 for Married Filing Jointly.

Education in Massachusetts: The deduction for tuition payments paid by you, for yourself or a dependent, to a qualifying two- or four-year college was repealed starting in 2006.

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Your Children and Other Dependents

Who Is Your Dependent? Your dependent is anyone who:

1. Has less than $3,300 of gross income for the 2006 ($3,400 in 2007), (not including children who are under 19 or full-time students under age 24);
2. Receives more than 50% of his or her support from you (some exceptions apply);
3. Is a relative (the tax law lists the allowable relationships) or lives in your home and is a member of your household for the entire year;
4. Does not file a joint return with a spouse (with the exception for certain married children); and
5. Is a United States citizen, national, or resident; a resident of Canada or Mexico at some time during the year; or an alien child adopted by and living with you as a member of your household for the whole year.

Dependents may save you taxes because you can claim an exemption for each one. In 2006, this exemption is $3,300; it is adjusted for inflation annually ($3,400 in 2007). When parents are divorced, generally the custodial parent can claim the exemptions for the children. However, this rule doesn’t apply when a multiple support agreement or a pre-1985 agreement designates otherwise, or when the custodial parent releases the exemption to the non-custodial parent.

You also may claim exemptions for yourself (as long as you are not someone else's dependent), your spouse (on a joint return), and each of your other dependents.

You are required to show a Social Security number on your tax return for any dependents that you claim, regardless of age. Your parent or other relative need not live with you to qualify as your dependent. If you and your siblings provide your parent or another relative with more than half of his or her support for the year but none of you individually meets the support test, one of you may still claim the exemption, if otherwise qualified. The person claiming the exemption must provide more than 10% of the parent’s (or other relative’s) total support. The others providing more than 10% of the support must sign a "Multiple Support Declaration" agreeing not to claim the exemption that year.

Legislative Update:

Starting in 2005 the Internal Revenue Service has instituted new rules and definitions regarding who is a "qualifying child" and "qualifying relative." These changes have altered the definition of who can be a dependent.

Child Credit: For the tax year 2006, a tax credit of $1,000 is available for each qualifying dependent under age 17. This credit is available for a taxpayer's son, daughter, grandchild, or eligible foster child. A taxpayer's child credits are phased out for joint filers with modified AGI exceeding $110,000 ($75,000 for Singles and Heads of Household; $55,000 for Married Filing Separately). The credit is generally nonrefundable, but families with three or more children are allowed a refundable credit to the extent of certain employee-paid payroll taxes, less the earned income credit claimed.

Adoption Tax Credit: If you adopt a child in 2006, you may be able to take advantage of the $10,960-per-child tax credit for qualified adoption expenses (this moves to $11,390 in 2007). This credit is generally effective the year in which the adoption is final. You can also exclude from your income certain employer-provided adoption assistance of up to $10,850 per child. Both the credit and the exclusion are phased out ratably for taxpayers with modified adjusted gross income (AGI)) between $164,410 and $204,410.

Adoption in Massachusetts: in 2006 there is a deduction for the full amount of adoption fees paid to "licensed adoption agencies." The deduction is in the year paid.

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Children and Taxes

To help you take advantage of your child's lower tax bracket, you might consider the following strategies:

• Give your child age 18 or older income-producing property. For the 2006 tax year, the 10% tax rate is applied to the first $7,550 of a single person’s income (this amount will be adjusted for inflation thereafter). Annual gifts of $12,000 (starting 1/1/2006) or less to each individual are gift-tax-free. When your spouse agrees to “split” a gift, you can gift $24,000.
• Be alert to the “kiddie tax,” a tax levied at your top rate on your under-age-18 child’s unearned income over $1,700 in 2006 (remaining at $1,700 in 2007). Think about limiting gifts to younger children to assets that will yield annual taxable income of $1,700 or less.
• If you own an unincorporated business, you may be able to improve the family’s tax situation by hiring your children to work for you (they must be legitimate employees). In 2006, a dependent could earn up to $5,150 in wages tax free because of the standard deduction. You will be able to deduct the child’s wages as a business expense and he or she will pay tax on any income over the standard deduction amount at his or her own rate. Moreover, no Social Security or Medicare taxes apply to an under-age-18 child’s wages paid by an unincorporated business.

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Other Deduction Planning

Here’s how your spending choices can affect your taxes. Every expense you can deduct on your tax return lowers your taxes. Knowing which expenses, and how much of those expenses, you may deduct is crucial to effective tax planning.

Deduction floors: Certain expenses are deductible only to the extent they exceed set income "floors." For example, medical expenses are deductible only when they exceed 7.5% of your AGI. Miscellaneous deductions must exceed 2% of AGI. If you are close to these income floors, try to bunch payment of as many expenses as possible into one tax year to secure a deduction. It may help to charge some payments of deductible expenses. If you use a credit card, payment is generally considered made in the year you make the charge.

Self-employed health insurance: For 2005, the deduction for the health insurance expenses of self-employed individuals and their spouses and dependents is 100%.

Investment interest expense: Investment interest includes interest you pay your broker on a margin loan and interest you pay on other loans that enable you to hold investment assets. This interest is deductible up to the amount of your net investment income. You can carry over any excess interest expense and deduct it in later years, subject to the same limitation.

Charitable contributions: Giving to qualified charities can cut your taxes significantly. To claim a deduction for a gift of $250 or more, you'll need a written receipt containing specific information. And remember: if you receive goods or services in exchange for your contribution, you can deduct only the "gift" portion of your contribution, the amount exceeding the value of those goods or services. When your total donations other than cash are greater than $5,000 ($10,000 for certain publicly traded securities), you'll need to attach an appraisal summary to your tax return.

If you donate a car to a qualified organization after December 31, 2004, your deduction is limited to the gross proceeds from its sale by the organization. This rule applies if the claimed value of the donated vehicle is more than $500. However, if the organization makes significant intervening use of or materially improves the car, you generally can deduct its fair market value.

All donations of clothing and household goods made after August 17, 2006, are subject to all of the regular rules on substantiation, plus the taxpayer must prove that they are items in at least good condition. Starting August 18, 2006, only clothing and household goods in at least good condition qualify for a deduction.

There is only one exception to the "good-or-better" quality exception:

1. a deduction of more than $500 is claimed for the single clothing or household item, and
2. you include a qualified appraisal with respect to the item with the tax return on which the deduction is claimed.

Donations of Boats, aircraft, and other vehicles: These rules also apply to donations of boats, aircraft, and any vehicle manufactured mainly for use on public streets, roads, and highways.
Acknowledgement required: If the claimed value of the car is more than $500, you must have a written acknowledgement of your donation from the organization and must attach it to your return. If you do not have an acknowledgement, you cannot deduct your contribution.

Instead of making a cash donation, consider giving appreciated property you’ve owned for more than one year. You’ll avoid capital gains tax on the property’s increase in value and you can deduct the full fair market value of the property within tax law limits.

• Setting up a charitable remainder trust can give you substantial tax breaks while you’re benefiting a favorite charity. You transfer assets -- preferably highly appreciated assets -- to the trust and receive an income from the trust for life or a period of years. At your death or when the trust’s term ends, the trust assets pass to the charity you’ve selected. When all requirements are met, you can deduct the value of the charity’s future interest in the property as a current charitable donation. If the trust sells the assets, it will pay no capital gains tax. This can give you a larger income. Moreover, the assets you contribute escape gift and estate taxes.
• Selling an asset that has lost value and donating the proceeds may be preferable to donating the asset itself. You may generate both a deductible capital loss and a charitable deduction. Donating the property would give you a deduction for its market value on the date of the gift, but you’d get no tax benefit from the property’s decline in value while you owned it

Hybrid Vehicle Credit - The Energy Policy Act of 2005 provides a credit for taxpayers who purchase certain energy efficient vehicles, including Qualified Hybrid vehicles.  Generally, for a passenger car or light truck that is a qualified hybrid vehicle, a taxpayer may rely on the manufacturer’s certification that a specific make, model, and model year vehicle qualifies for the credit and the amount of the credit for which it qualifies.

Even though a manufacturer has certified a vehicle, a taxpayer must meet the following requirements to qualify for the credit:

1. The vehicle must be placed in service after 12-31-05 and purchased on or before 12/31/10.
2. The original use of the vehicle must begin with the taxpayer claiming the credit.
   
   a. The credit may only be claimed by the original owner of a new, qualifying, hybrid vehicle and does not apply to a used hybrid vehicle.
3. The vehicle must be acquired for use or lease by the taxpayer claiming the credit.
   
   a. The credit is only available to the original purchaser of a qualifying hybrid vehicle. If a qualifying vehicle is leased to a consumer, the leasing company may claim the credit.
   
   b. For qualifying vehicles used by a tax-exempt entity, the person who sold the qualifying vehicle to the person or entity using the vehicle is eligible to claim the credit, but only if the seller clearly discloses in a document to the tax-exempt entity the amount of credit.
4. The vehicle must be used predominantly within the United States.

The Internal Revenue Service publishes the list of qualified cars and the amount of credit available.  This information is also available from you auto dealer. 

Student Loan Interest: An "above the line" deduction (one deducted in arriving at a taxpayer's AGI) of up to $2,500 is available for interest due and paid on qualified education loans in 2006. A taxpayer may claim the interest deduction only if he/she is not claimed as a dependent by another taxpayer for the tax year. The deduction is phased out for taxpayers with modified AGI of between $100,000 and $130,000 for joint return filers ($50,000 and $65,000 for Singles and Heads of Household). The deduction is not available for a student’s expenses if a Hope Scholarship or Lifetime Learning tax credit is claimed for the student’s expenses that year.

In Massachusetts all interest paid by the taxpayer on education debt during the 2006 taxable year is 100% deductible.

Taxes: You may generally deduct most state, local and foreign income or real estate taxes and state and local personal property taxes (i.e., Massachusetts excise taxes). Paying your last quarterly state tax estimate before the end of the year or increasing the withholding from your compensation late in the year are ways to increase your 2006 deduction for taxes, but be careful of the AMT effect. In 2006 and 2007 taxpayers who itemize have the choice of deducting either state and local income taxes or state sales tax. Internal Revenue Service Publication 600 gives state sales tax tables to which taxpayers may add taxes paid on motor vehicles and boats.

The following chart shows the average itemized deduction claimed on 2004 federal income tax returns (the last year available) in each income (AGI) range. Remember that you can only deduct what you actually pay! This list is not a formula for schedule A tax deductions:

Estimated Taxes: 2007 taxpayers who had adjusted gross incomes over $150,000 in 2006 must pre-pay at least 110% -- or over 90% -- of the 2006 liability to avoid a penalty. Folks with incomes under $150,000 in 2006 must simply pre-pay either 100% of their 2006 liability of 90% of the current year’s tax. You must owe more then $1,000 in unpaid taxes before you have an estimated tax requirement.

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In Massachusetts

Earned Income Credit: A refundable tax credit is available to certain low-income individuals who have earned income and meet federal requirements for the Federal EIC. The taxpayers must qualify for and claim the Federal EIC allowed under Internal Revenue Service Code sec.32. If the credit exceeds the tax imposed, the taxpayer receives the difference in the form of a refund check.

Dependent Member of Household under the age of 12: This deduction is $3,600 for a single dependent and $7,200 for two or more dependents in 2006. If you pay more than $2,400/$4,800 in dependent care expenses and file the appropriate Federal Form 2441, you can take that higher amount as a deduction instead of the above pre-set amounts. In Massachusetts you are not limited to the IRS-stipulated $3K/$6K maximum amounts for the dependent care credits. In 2006, you are allowed a deduction for dependent care of $4,800 for one child and $9,600 for two children.

Medical Expenses and Employee Business Expenses: Massachusetts allows a carryover deduction in these two areas for any amounts the taxpayer is allowed on the Federal Schedule A. To get the carryover for employee business expenses you must file Federal Form 2106.

Rent Paid: The Massachusetts tax return allows for a deduction for rent paid on a principal residence within the state.  This deduction is 50% of rent paid, up to a maximum of $3,000.  You must include the name and address of the landlord to take this deduction