Deduction Summary

As I mentioned earlier, when you examine federal income taxes you find that Uncle Sam’s definition of taxable income is exceedingly liberal, while his definition of allowable deductions is exceedingly strict. This is, of course, no surprise. But as a cash-basis taxpayer, you can still influence the outcome by using timing to help you batch deductions, thereby postponing liability, or shifting them from a year where they don’t do as much good to one where they do. Since it’s one of the only tools you have, might as well use it.

Alternative Minimum Tax

Before we conclude, I’ll mention one more thing, simply because you may hear about it every now and then and wonder what it means. It’s called the alternative minimum tax. You won’t have to actually become conversant with this parallel system of collecting income tax, because if it applies to you your tax preparation software will know what to do. But it’s still kind of interesting.

By now you’re familiar with how certain actions can change the outcome of your tax story. For example, you already know that the interest from municipal bonds isn’t taxable, and pretty soon you’ll also learn that real estate can radically reduce your tax liability. Now imagine that you’re really, really rich...say you’ve got a billion dollars. You put the entire billion into five percent municipal bonds from your home state. Result? You’re now earning $50,000,000 every year totally tax free. This would make you very happy, but it would make people who earn $75,000 a year and surrender $10,000 of it as income tax a bit miffed. This is why Uncle Sam came along in 1969 with something called the Alternative Minimum Tax, or AMT. The AMT is a totally separate way of computing your tax liability, designed specifically to ensure that rich folks don’t get to exploit tax loopholes to the extent that they don’t pay anything. The way it essentially works is to have you compute your tax liability under the regular set of rules and again under AMT rules. Then you pay whichever bill is higher. There’s no distinct set of warning whistles that would alert you to the possibility of an AMT liability, but in general people with high tax-breaks in certain key areas should be aware of the possibility. Those key areas are: personal exemptions, state and local taxes, interest on second mortgages, medical expenses, miscellaneous itemized deductions, long-term capital gains and incentive stock options.

Again, don’t worry too much about AMT. First because there’s not much you can do about it anyway. Second because your tax preparation software has already studied the subject and is waiting to help.

Conclusion: An Important Note Regarding Minutia

Aren’t you glad this subject is almost over? I can’t stand talking about income taxes, much less writing about them.

Even though I was trying to paint in broad strokes, taxes are so comically detailed that I was forced to introduce a bunch of boring details in this chapter. I hope you don’t think for a second that you’re supposed to remember all, or even part of it. Only a savant could, and only an insane savant would want to. I’ve been a CPA for more than 20 years and I just relearned practically everything you just read for the millionth time as I was writing it. And every single thing I wrote I found in a few seconds simply by plugging a few search terms into the IRS website. Why the heck would I want to attempt to memorize it?

The purpose of this chapter was simply to demystify what’s happening in Federal Income Tax Land. In other words, think of what you just read as an overview of how the internal combustion engine works, not a manual on how to rebuild one. In the age before computers, income taxes were the forte of bespectacled magicians known as tax accountants. Like the Wizards of Wall Street in Investment Land, they promised much and charged much. And we had no choice but to pay what they were asking. But that was then. The formerly insurmountable hurdle of six thousand pages of tax law is gone now. Now it’s a 10-minute walk in the park with your computer and a $20 tax-preparation program that automatically imports the necessary information from your personal finance software and transfers it to your tax return. Like it’s human counterpart, your software asks you questions to make sure you’ve taken all the deductions to which you’re entitled and claimed all the income you should. It prints a copy of your return for your records, then files it electronically for you. It even asks if you’d like to do a little tax planning for next year. If you understand the basics so you set yourself up properly, know where to go to learn more and have yourself organized so all the information is in place, what’s left for you to do? Hmmm...did I hear someone say “Jerry Springer?”