15 Tax-Return Factors Not to Overlook

The extent to which you wrestle with your tax return each year is usually determined by whether you itemize your deductions or not. One CPA suggests trying this strategy to limit your itemization headaches to every other year and to potentially reap hundreds of dollars in savings: Adopt an "odd/even" tax plan whereby you itemize your expenses in odd years, paying as much of your tax-deductible expenses as possible, then take as few deductions as possible in the even years in order to opt for the standard deduction ($4,750/individual filer, $9,500/joint filers), advises Frederick, Md.-based CPA Alice Orzechowski. That means donating items to charity, paying your real estate taxes and sending off any fourth-quarter estimated state income taxes before Dec. 31 in odd years. Orzechowski says that this tactic may be especially beneficial to couples who have paid off their mortgages. Older couples in the 27 percent tax bracket can yield approximately $1,100 in savings every other year, she says.

Of course, consult with your accountant on the many details of your own tax situation, and check out the IRS's Older Americans' Tax Guide (PDF). Here are 15 potential deductions, as well as sources of income, not to overlook:

Social Security income
Numerous factors dictate how much income tax you have to pay on Social Security benefits, if any at all. Bottom line: individual filers with adjusted gross income (AGI) over $25,000 and joint filers with AGI over $32,000 may pay income tax on half of their Social Security benefits. Individual filers making more than $34,000 and couples with earnings exceeding $44,000 pay income tax on up to 85 percent of their Social Security benefits.

• Check out IRS Publication 915 (PDF).

Dividend income and capital gains
The 2003 tax law made significant changes here, including reducing the tax on dividend income to 15 percent (instead of an individual's highest marginal rate) and reducing taxes on capital gains from 20 percent to 15 percent on investment assets held for longer than a year and sold after May 5, 2003. Through 2007, dividend income and long-term capital gains are taxed at 5 percent for those taxpayers in the 10 percent and 15 percent marginal tax brackets. "We're emphasizing that dividend income is preferable to interest income in today's marketplace because dividend income is taxed at only 15 percent…superior to interest income which can be taxed at rates as high as 35 percent," says Stephan Cassaday, president of McLean, Va.'s Cassaday & Co. Inc., an independent financial planning firm.

• Check out IRS Publication 550 (PDF).

Pensions
The distribution amounts received from an employee pension during retirement are fully taxable. However, individual contributions in the form of after-tax earnings to a pension can be recovered as a cost after pension payments begin. But traditional pensions are not typically funded with employee after-tax dollars, says James Leonard, a CPA and director of financial planning for R.A. Bench, Inc., a Seattle-based firm that provides wealth management services.

• Check out IRS Publication 575 and IRS Tax Topic 410 .

Annuities
The portion of an annuity that is subject to tax depends on the portion of the annuity contributions made with after-tax dollars, says Leonard. For example, someone who invests in a tax-sheltered annuity and contributes $100,000 to an annuity plan in after-tax dollars and who begins taking annuity payments when the value reached $150,000 would pay tax only on one-third of the annuity payments received each month.

• Check out IRS Publication 575 and IRS Tax Topic 410 .

IRAs/annuity income
Amounts distributed from a traditional IRA account or annuity before age 59.5 may be subject to at least a 10 percent penalty tax, and early distributions are taxed as part of your gross income. Taxable amounts distributed from an IRA, retirement plan or annuities are subject to ordinary income tax after age 59.5. Owners of a traditional IRA must receive the entire balance in the account or begin getting periodic distributions from the IRA by April 1 of the year you turn 70.5, or be faced with a 50 percent excise tax in years where distributions are less than required minimums.

• Check out IRS Publication 590 (PDF).

Charitable contributions
The key here is keeping a list of items you donate and getting a receipt from the charity. And don't overlook donating appreciated stock to charities, advises Leonard. Selling stock first will trigger a tax obligation and leave you less to donate. But donating the same stock directly allows the organization to receive full cash value of the asset, while giving the individual a bigger charitable contribution without a tax hit.

• Check out IRS Publication 526 (PDF).

Volunteering-related expenses
No deductions here for time spent volunteering. But you can deduct expenses related to that work, such as use of your vehicle, items purchased that are needed by the organization and travel costs. "It's pretty basic, and you have to be careful," says Dennis Gurtz, senior financial advisor with American Express Financial Advisors Inc. in Bethesda, Md. "You can't deduct blood [donations]."

• Check out IRS Publication 526 (PDF).

Health care expenses
Numerous medical and dental expenses incurred by you, your spouse and dependents can be deducted as itemized expenses. However, the expenses—including medical insurance premiums, Medicare B premiums, medical care costs incurred while in a long-term care facility, certain transportation costs and other expenses—must total more than 7.5 percent of adjusted gross income.

• Check out IRS Publication 502 (PDF).

Rental income and real estate tax deductions
"The old saying, 'your best investment is dirt,' meaning real estate, is very appropriate, especially rental real estate," says Palo Alto, Calif., CPA Robert J. Ravano. "The tax regulations allow a deduction for all ordinary and necessary expenses incurred to operate and maintain the income producing property." That even includes expenses such as personal telephone use, postage and travel to/from the rental property.

• Check out IRS Publication 527 (PDF).

Gifts to children/grandchildren
Individuals may gift up to $11,000 per person annually without having to file IRS forms. Married couples can gift up to $22,000 per person annually. "Gifts to children and grandchildren are an excellent way to reduce your estate and reduce the potential estate taxes," Ravano says. You can also make an unlimited gift (without it being classified as a gift) and take an excellent tax break when making tuition payments directly to an educational organization on behalf of grandkids. Also, Sec. 529 college-saving plan contributions come with tax breaks (see instructions for Qualified Tuition Programs in form 709 and item below).

• Check out IRS Instructions for Form 709 (PDF).

Education credits/expenses
For baby boomers or retirees going back to school, a number of tax credits, including the Hope or lifetime learning credit, can be claimed for tuition and related expenses in pursuit of a college, graduate or vocational degree. Meanwhile, a contribution to a loved one's future education via a Sec. 529 plan allows you to move tens of thousands of dollars out of your estate, possibly obtaining a tax deduction on your state return and avoiding income taxes on the account earnings, Orzechowski points out. And you, not the beneficiary, retain control of the assets, allowing you to take the funds back or give them to someone else later without jeopardizing the previous tax benefits enjoyed under the Sec. 529 plan.

• Check out IRS Publication 970 (PDF).

Credit for the elderly or disabled
A credit up to $1,125 is available for individuals age 65 and older and for disabled individuals who meet a variety of conditions. The credit is largely available to lower- and modest-income individuals and families. Be sure to check eligibility requirements.

• Check out IRS Publication 524 (PDF).

Credits/deductions for grandparents raising grandkids
First, you need to see if you can claim the child as a dependent. [See IRS Publication 503 (PDF) for guidance.] Additionally, you may be eligible for a child or dependent care credit if you pay for someone to care for your dependent so you can work or look for work, Leonard says. The credit can be up to 35 percent of eligible expenses, and grandparents may be eligible for this tax credit when providing more than half the support of their grandkids. What's more, the earned income credit may be available to persons with or without a qualifying child (grandchild).

• Check out IRS Publication 596 (PDF).

Caregiving credits/expenses
Tax benefits exist for caregivers, such as adult children caring for an ill parent, who can claim head of household status. The dependent care credit described above also extends in certain circumstances to a working spouse responsible for a partner who is not able to care for him or herself.

• Check out IRS Publication 503 (PDF).

Unemployment income
Call it insult added to injury, but you must identify all unemployment compensation that you received as taxable income.

• Check out IRS Publication 525 (PDF).