The Potts Report

Tax Tip – Use Your Credit Cards to Generate Tax Deductions

Individuals, except in very rare circumstances, are cash basis taxpayers.  Many businesses have elected to be taxed on the cash basis of accounting. For income taxes, this means your deduction is allowed when the expense is paid, not when the expense is incurred. For example, if you went to the dentist on December 16th but didn’t pay the bill until January 15th, the medical deduction would be allowable in 2011, not 2010. Or if you bought operating supplies for your business and charged them on your account in December 2010 and didn’t pay the invoice until January 2011, the expense would be deductible in 2011, not in 2010.

If you find yourself short of cash as the year ends but have tax deductible expenses that could be paid if you had the money, check the available balance on your credit cards. If you charge the expense on your credit card in 2010, it is counted as paid in 2010 even if you don’t pay the credit card bill until 2011. A credit card is a line of credit, debt. When you borrow money to pay deductible expenses, the timing of the deduction is when the expense is paid to the vendor, not when the debt to the creditor is paid back. Therefore, by charging deductible expense to your credit card before December 31, you can accelerate the timing of the deduction into 2010 rather than when you actually pay the bill (via paying the credit card) in 2011. This works for business expenses as well as personal deductions such as medical bills or charitable donations.

Where Are You?

The best way to begin planning what options you have to lower your income tax burden is to determine where you are, or where you will be at the end of the year, tax wise. In other words, start your tax plan by projecting what your taxable income will be by year’s end if you continue on your current path without making any tax planning moves. In most cases your projected taxable income won’t be exact, but this late in the year you should be able to get a reliable estimate.

What is taxable income? Look at last years income tax return. For individuals, 2009’s taxable income can be found on page 2, line 43 of your Form 1040. If you look at the design of the Form 1040, you will see that to calculate taxable income you begin with gross income, subtract adjustments to gross income (e.g. traditional IRA contributions); subtract the higher of your itemized deductions or the standard deduction; and finally you subtract your exemptions. (It’s simple math, right? It is just the rules of what is “taxable” income and “taxable” deductions that are complex.) Once you have projected your taxable income for 2010, look at the tax rate schedules to determine your incremental tax bracket.

Once you have determined your incremental tax bracket, you are able to ask yourself and answer questions such as “if I give the church an additional $1,000 this year, how much will it really cost me?”. If you are in a 25% federal income tax bracket, your after tax cost, if you can itemize deductions, would be $750 rather than $1,000. And we are ignoring the additional tax savings potential on a state income tax return. In Arkansas this contribution would generally give you another 7% in tax savings.

Another benefit of projecting your taxable income? You can determine an accurate estimate of your 2010 income tax so you know whether you will get a refund or owe income taxes in April 2011. If you are unfortunate enough to owe additional income tax and lack cash to pay them, you will have plenty of time to prepare for April 15th rather than have an unpleasant surprise at the last moment. Of course your primary objective is to achieve the lowest possible income tax possible. Depending on your income tax situation, it might be wise for you to ask for professional help. There are many nuances to consider in achieving the best possible tax position. Planning your income taxes BEFORE December 31 is where a CPA can really earn his fee and save his client money. If you need help call me. 1-479-648-2846.

Tax Planning: A Guessing Game?

The election is over and the result was a shift in power in Washington D.C., a shift that caused Obama to change his tune somewhat regarding income tax increases. A shift influenced by the unofficial Tea Party whose candidates promised change: lower income taxes, lower budget deficits, repeal of the recently passed heath care bill. Will they be able to change anything with a Democratic president? Who knows. The country could experience a couple of years of gridlock. Maybe gridlock is good. I really don’t know and I don’t have a Ouija board so I won’t predict the future.

Tax planning is about making choices that are available to you to hopefully affect a lower income tax liability. Stability helps make the right choices; stability in the economy and stability in the Internal Revenue Code. As we end 2010, stability in our economy and our tax laws seems absent. What should you do? Over the next few weeks, The Potts Report will discuss options for you to consider to lower your income tax liability. Stay tuned.