Like most of middle-class America, Julie and Kevin Jones find taxes confusing.
The couple moved from North Carolina to D.C. last summer, where they both are now first-year MBA students at Kogod. As they are full-time students, Julie and Kevin are not currently employed, but they collectively had earned about $50-60,000 in 2010 before returning to school. Since the couple resided in two states in 2010 and owns property in North Carolina, they will have to file four tax returns in April.
Confusing? We thought so. That’s why Don Williamson, director of the Master’s in Taxation program at Kogod and a self-proclaimed “tax therapist,” sat down with the couple to give them – and you – helpful tax tips. As executive director of Kogod’s new Tax Center, he will oversee the center’s research on federal tax policy and provisions that impact the middle class and small businesses.
Q: What tax breaks do we qualify for as graduate students?
A: You won’t qualify for the American Opportunity Credit – which is $2,500 per person for undergraduate students – because you already have undergraduate degrees. But you could qualify for the Lifetime Learning Credit. That credit can give you a maximum of $2,000 per household on the first $10,000 of tuition. Any individual paying “qualified tuition” at a postsecondary school can qualify for the credit each year, even if you are only taking one college course.
Q: Should we start putting money into an Individual Retirement Account (IRA)?
A: At that $50-60,000 earned income range, you have the opportunity to make a contribution to an IRA if you have the spare cash; it’s always about the cash.
Since you’re young, you may want to consider a Roth IRA. It’s not deductible, but all of the money earned in the account from that point forward in the Roth IRA is tax-free, if you withdraw it after age 59.5 and the account has been open at least five years. At your ages, you’re going to have 30 years of income earned in the account that’s tax-free.
Contributions to the deductible IRA could even be refundable. The maximum amount you could contribute is up to $5,000 each. But $5,000 is a lot of money for a couple making $50-60,000. Where do you get the cash?
If you have savings accounts that earn interest, you could transfer some of the balance of that savings account into an IRA. That could be a “deduction above the line” that would reduce your “adjusted gross income” (AGI). It is that AGI threshold that can trigger a lot of other tax benefits, like education credits on Form 8863.
In this scenario, if we make deductible IRA contributions, bringing the $50-60,000 in taxable income to $40-50,000. You’d get a standard deduction for a joint return of $10,400, and personal exemptions of $3,650 per person. So your taxable income is down to $25-30,000. That $30,000 is taxed at a marginal rate of 15 percent, resulting in a total tax of around $3,000. Then you claim the $2,000 Lifetime Learning Credit against that $3,000. So maybe you’d have a maximum tax of less than $1,000 on the $50-60,000 of income. That’s very, very good.
Q: Does being married penalize you when it comes to taxes?
A: There’s no question about it, being married costs successful couples money. While you qualify for the standard deduction of $10,400 – twice the standard deduction for single people – your combined earnings are likely to move you into higher marginal tax rates than if you remained single.
Q: We are taking out loans to pay for school, but we also have some money in a 401K plan. Can we use some money from our 401K to help pay for college?
A: I wouldn’t want to tap my retirement plan. I would rather borrow the money because you can deduct the interest on those loans – in arriving at your Adjusted Gross Income. And the interest rates are very low right now.
The basic problem with young people is they don’t save. You guys do, but generally people don’t save. If you can get a 401K, you never see the money; it just goes straight in the plan. If you don’t have that money, if you don’t see it, if it’s not in your pocket, then you won’t spend it and you’ll save. With time, you’re going to make money on that 401K. You just have to forget about it; it doesn’t exist.
I wouldn’t touch the 401K. I would actually choose to attend school part-time and work before taking money from the 401K.
Q: We own a condo in North Carolina and are renting it out. Right now, we’re barely breaking even. Will we see benefits in the future?
A: You’ll lose money on the house, and that’s actually a good thing. Even if you’re breaking even in the cash and the out-of-pocket costs, you’ll be depreciating the home. Since it’s a residential property, it will depreciate the same amount each year over 27.5 years.
Don’t expect thousands and thousands of dollars of tax deductions, but in the first year, a property costing $100,000 will earn $2,700 in depreciation deductions. In the 15% tax rate bracket, that will save you about $400.
Generally, that depreciation loss won’t be deducted from the $50-60,000 because the loss is what we call a passive activity loss. Passive activity losses go on an 8582 form and can offset other income as long as your AGI is less than $150,000, otherwise it is suspended and used to offset income if you ever have a net rental profit, or when you sell the house.
Q: We lived in North Carolina for part of 2010 and D.C. for the rest. Which tax forms do we need to file?
A: Your $50-60,000 for 2010 was earned in North Carolina, so that will go on a North Carolina return. So you would file a part-year North Carolina return from, say, January 1 to September 1.
You’d also have a part-year D.C. return from September 1 to the end of the year. But mind you, you have no income on that return, so you might not even have to file one. Generally, I advise people to file even if they don’t have to. The tax authorities will see your D.C. address on the form and ask, why does someone live in D.C. and not file a D.C. return?
So you’ll have a part-year North Carolina resident form, a part-year D.C. resident form, a part-year North Carolina non-resident who owns rental property form, and a federal return. So here we’re talking folks making $50-60,000 and I’ve got you filing four returns. And that’s what’s wrong with the system, because $50-60,000 is middle class. That’s the purpose of the Kogod Tax Center, to deal with issues of the middle class, issues of inordinate complexity relative to the income and lifestyle of the taxpayers
The point is middle-class Americans can’t have legions of CPAs doing tax planning for them; it’s uneconomical. But the way the rules are designed, they are as applicable to you middle class guys as they are to the million-dollar guy. And that’s probably wrong. But nevertheless, it’s there.