4 Often Misunderstood Tax Terms

Tax season is the time when so many of our clients bemoan their lack of tax expertise. The fact is that the code is thousands of pages long, and changes frequently. We highly recommend the use of a certified public accountant when filing your taxes. But even the best accountants need input from you as far as your current financial situation.  Beyond that, a sound financial strategy for long-term success is something you should have in place, no matter the season.

Here are four often misunderstood tax terms, explained:

Tax Credit vs. Tax Deduction.  Do you really know the difference?  If so, you are in the minority, because this these two terms are very often confused. A deduction (charitable contributions, moving expenses, mortgage interest, medical expenses, etc.) allows you to deduct an amount from your overall gross income.  Income tax then applies to what remains. A tax credit, on the other hand (for hybrid/electric car, solar panels, child care, etc.) allows you to subtract from the amount of tax you owe.  A deduction is good while a tax credit is even better. Make sure you’re getting the most out of your credits or your deductions.  A good CPA can also help you find others you may not have considered.

Marginal tax rate. If you think this is the amount that determines an overall rate of taxation that applies to all of your money, you would be wrong.  Marginal tax rate is the tax rate that applies to the last dollar you earn. It’s the percentage taken from your next dollar of taxable income above a pre-defined income threshold. Once you reach a higher tax bracket, only income earned above that figure is taxed at that rate – not all of your income together. This is important not only for figuring up your tax bill, but also for financial planning.  You need to know your marginal tax rate, so you and your investment advisor can calculate what amount of your raise or bonus (if applicable) you’ll get to keep after taxes, or whether it’s a better idea to contribute more to your tax-advantaged retirement account. As with most investment practices, it’s part of the whole picture that must be considered.

Deducting State and Local Taxes. Our clients in Texas have no state income tax to claim. If you are itemizing, you do have the option of claiming state and local sales taxes instead. There are three ways to do this:

  1. Claim the amount on the IRS table based on the taxpayer’s location, income and exemptions;
  2. Claim the amount from the table plus certain specific items, such as a motor vehicle, a boat or a major home improvement; or
  3. Claim actual sales taxes paid for all items.

If the total sales tax paid on a motor vehicle is higher than the general sales tax rate, you are allowed to include only the amount of tax you would have paid at the general sales tax rate. For boats and aircraft, if the sales tax paid exceeds the general sales tax rate, no deduction is allowed.

Student Loan Interest. If you ever feel like you have to go back to school to understand the tax deductions around student loans, you are not alone!  Many of our clients don’t completely grasp this concept. This becomes particularly tricky if your modified adjusted gross income is $80,000 or more.

You can claim student loan interest as a deduction, up to $2,500, if your modified adjusted gross income is $65,000 or less. The deduction is reduced when your modified adjusted gross income is between $65,000 and $80,000, and you can’t claim a deduction if your modified adjusted gross income is $80,000 or more. If you are married and filing jointly, the limits on modified adjusted gross income rises to $160,000 or more.

Tax implications should play a role in anyone’s long-term financial strategy.  Contact Lake Point Advisory Group today to find out how to make the most of your hard-earned money now and later.

Leave a Comment