This is the most common kind of income. It is also the easiest to keep track of because the law demands that your employer send you and the government a W-2 form showing how much you were paid. In addition to your salary, this includes commissions, bonuses, vacation pay, sick pay or severance pay. It also shows amounts that are not included in your take-home pay, such as the 7.65% of earnings withheld to pay your share of the Social Security and Medicare tax.
If you receive a cash payment based on your years of service, the payment is taxable.
If you receive more than $20 a month from tips, the income is not only taxable but also is subject to withholding. You're supposed to report tips to your employer, who takes them into account when figuring how much to withhold from your wages.
Because Congress is concerned that a lot of tip income goes unreported, there are special rules to encourage voluntary compliance. Basically, the law assumes customers tip at an average rate of 8%. If restaurant and bar employees don't report to their employer tips totaling at least 8% of the establishment's gross receipts, the employer has to do it for them.
The shortfall between what's reported to the employer and the 8% level is allocated among the employees—but only for the purpose of a report to the IRS. No money will change hands, and waiters and waitresses are still expected to report their actual tip income, whether it's more or less than their share of the 8% kitty. Those who report less, however, should be more prepared than ever for questions from the IRS. (The tip-allocation rule applies only to establishments with ten or more employees where tipping is customary.)
Q. In addition to my job as a carpenter, I do a little work on the side. Last year, I made about $1,000 doing odd jobs for neighbors. I know it's taxable but am not sure where to report it. Do I count it as "other income'' on the Form 1040?
A. No. It is self-employment income and should be reported on a Schedule C. On the plus side, that will also permit you to deduct the cost of any materials you used, plus the cost of transportation to and from the jobs. On the other hand, since your self-employment income was more than $400, you also have to file a Schedule SE and pay Social Security and Medicare taxes on the income. Work through the interview on self-employment income. TaxCut will handle the forms.
Alimony payments you receive are taxable income.
The tax distinction between alimony and child support is enormous. Payments that qualify as alimony are deductible by the ex-spouse who pays them and taxed as income to the one who receives the money. Child support, on the other hand, is neither deductible nor taxed.
To qualify for the deduction alimony must be paid to the former spouse or to a third party on behalf of the former spouse. Also it must be required by a written divorce or separation agreement. The payer must be obligated to make the payments to earn the tax deductions.
There are rules to prevent transfers that should be classified as child support or property settlements — neither of which is deductible — from being deducted as alimony.
Until a few years ago, support payments from one spouse to the other could be treated as alimony unless the payments were specifically called child support. Now, regardless of how payments are classified in the divorce agreement, they are treated as nondeductible child support if the payment is contingent on a future occurrence involving the child. If the payment will be reduced or eliminated when a child reaches a certain age or completes school, for example, that part of the payment can never be claimed as alimony.
In the past, alimony was usually a long-term obligation to pay an ex-spouse, often until he or she remarried or died. The trend now, however, is toward so-called rehabilitative maintenance for only a few years. Such payments are often designed to help the recipient get training and then a job.
Although the government has nothing against such arrangements, there is concern that big payments in the first few years after a divorce may really be an attempt to disguise a nondeductible property settlement as deductible alimony. To prevent that, the law provides for "recapture" of alimony deductions under certain circumstances, depending on how much the payments to the ex-spouse vary during the first three years.
You don't have to worry about recapture at all if alimony payments are $15,000 or less a year. As long as you meet the other requirements for alimony, the payments are fully deductible. A single $15,000 cash payment can qualify as deductible alimony. When larger payments are involved, however, the recapture rules may be triggered. If the payment in the first year exceeds the average payment in years two and three by more than $15,000, the excess is recaptured. Also, if the payment in the second year exceeds the payment in the third by more than $15,000, the excess is recaptured.
The impact is best explained with an illustration. Assume a divorce settlement calls for a $50,000 payment in the first year and no payments in years two or three. If the entire $50,000 was deducted as alimony in the first year, $35,000 of it would be recaptured in the third year—the amount by which $50,000 exceeds by more than $15,000 the average payment in the second and third years ($0 in this example). Under the rules, the payer would have to report the $35,000 as taxable income. And the recipient—who had to report the entire $50,000 in year one—gets to claim a $35,000 deduction to even things out.
There is no recapture if payments drop off in the second or third year because the recipient dies or remarries.
Although conventional wisdom suggests that support payments should be classified whenever possible as alimony—because traditionally the payer was in a higher tax bracket than the recipient—it's not necessarily so these days. With more working couples and fewer tax brackets, it's more and more likely both spouses will be in the same tax bracket—no more writing off alimony in the 50% bracket and reporting it in the 20% bracket. If there is no overall tax advantage to classifying payments as alimony, the recipient may be particularly resistant to having to pay tax on the support payments.
The law gives divorcing taxpayers the leeway to decide that qualifying payments will not be considered alimony. That means the payer can't deduct the payments and the recipient doesn't have to report them as income. The recipient, of course, may be willing to accept smaller payments if they're tax-free. Since the deduction is worth less to the payer in a lower tax bracket, a profitable compromise may be attainable. You need to work out the best overall deal with your attorneys.
If you pay alimony during the year, you can deduct it whether or not you itemize your other deductions. It's considered an "adjustment to income" and is reported on the front of the Form 1040—reducing your taxable income before the standard deduction or itemized deductions come into play. You must include your ex-spouse's name and Social Security number on your tax return. That demand is designed to insure that if you're claiming a deduction, somebody is reporting the same amount as income. There's a $50 fine if you fail to include your ex's Social Security number. (The interview on this topic requests the appropriate information and carries it to the proper place on the form.)
Unemployment benefits are fully taxable. You can even request that income taxes be withheld from the payments. (You use a Form W4-V to do so.) Withholding is voluntary, but eliminates the need to make estimated tax payments.
Besides earning from your job and investments, here are the other principal kinds of taxable earnings.
Payment you receive for doing your public duty is taxable, but you get a deduction for any part of the fees you pay over to your employer in exchange for continuing your salary while you are on the jury.
These are generally taxed, although a portion may be tax-free (for example, annuities purchased with after-tax dollars). Work through the Interview for IRA, Pension Income to be sure you don't overpay.
An award you receive for your work on the job is generally taxable. If you get goods or services — such as an all-expense-paid trip to Fargo, N.D. — include the fair market value in your income. An exception permits tax-free gifts of property—such as a gold watch—worth up to $1,600 in recognition of length of service or safety achievement. Cash or gift certificates don't qualify for this exception.
If you receive property or services in exchange for your work, you're expected to report as taxable income the fair market value of what you received. If you belong to a barter exchange, you should have received a 1099-B form reporting the taxable amount.
Taxability of disability depends on who paid for the insurance that's paying the benefits. If the benefits are financed by your employer, they are generally fully taxable. If you paid the premiums for disability insurance, benefits are tax-free. Veterans' disability benefits and workers' compensation are also tax-free. The Interview for IRA, Pension Income covers disability payments.
Gambling winnings are all taxable. This includes everything from multimillion dollar lottery winnings to the value of small items won by raffle. You do get to deduct your gambling losses, which include the cost of raffle tickets, up to the amount that you report as gambling winnings, if you itemize your deductions.
See the Gambling Winnings and Bonuses topic.
From the Nobel prize to the value of your winnings on game shows, prizes are taxable.
Auto rebates are tax-free because the IRS considers them a reduction in the car's price rather than income to you.
Payments you receive from fellow workers you drive to and from work are considered tax-free reimbursement of your expenses.
Unlike alimony, child-support is tax-free. See Alimony and Child-Support for more information.
Reimbursements for a losses such as after an auto accident or a home fire are almost always tax-free.
All pay for enlisted personnel and non-commissioned officers while serving in a combat zone is tax free, as is up to $6,529 a month of pay received by commissioned officers. (That's the 2005 limit; it will increase in the future.)
Payments for damages for physical injury or sickness, damage to your character or alienation of affection are generally tax-free. Damages that compensate you for lost income or profit are generally taxable, as are punitive damages.
Dividends are usually a tax-free refund of an overpayment of your premium. If the total of such dividends surpasses the total of premiums paid, the excess is taxable.
Withdrawals from these accounts — originally known as Education IRAs — are tax free if the money is used to pay college bills.
There's a lot of confusion here, because almost everyone has heard of the federal gift tax. But, whether it's a few dollars or tens of thousands, a gift is tax-free to the recipient. To qualify, the gift must be given out of true generosity. A television given away by a bank as an incentive to deposit funds in a certificate of deposit, for example, doesn't count. Its value is taxable income.
On the rare occasions that the federal gift tax comes into play, the tax is owed by the giver of the gift.
Reimbursement for medical expenses or compensation for the permanent loss of the use of part of the body or permanent disfigurement is tax-free.
Withdrawals from these accounts (first available in 2004) are tax free if used to pay for qualifying medical costs.
Money or property that you inherit is tax free. However, there's an exception: If you inherit a traditional IRA or company retirement benefits, the money is generally taxable to you just as it would have been to the deceased.
When you sell inherited property, your basis — which is the amount you'll use to determine whether you have a taxable gain or a tax-saving loss —is generally the asset's value on the day your benefactor died.Benefits you receive from a life insurance policy are tax-free, but if you choose to have the insurance company pay the proceeds in installments over a number of years, the part of each year's payment that represents interest earned on your account is generally taxed. However, a surviving husband or wife whose insured spouse died before October 23, 1986, may exclude from taxable income up to $1,000 of such interest each year.
Interest on bonds issued by state and local governments is usually excluded from taxable income. Interest on certain "private purpose" bonds is taxed, however, if you're subject to the alternative minimum tax.
A survivor annuity paid under a government plan to the widow, widower or child of a public safety officer killed in the line of duty is generally tax-free. Public safety officers include law enforcement officers, firefighters and members of a rescue squad or ambulance crew.
Assuming you owned and lived in the home for two of the five years before the sale, up to $500,000 of profit is tax free on a joint return. (The tax free limit is $250,000 for a single person.) If you have a home office or rent out part of your home, however, profit attributable to depreciation deductions claimed after May 6, 1997, will be taxed at a flat 25% rate. In the past, profit attributable to the part of the house used for business purposes (as a home office, for example) was also taxed, but the IRS has changed the rule. You no longer have to break out and pay tax on the part of the profit from the home-office part of the house.
A key advantage of the Roth IRAs is that withdrawals can be tax-free. At any age, withdrawals up to the amount of your contributions are tax-free. And, once you're at least 59 1/2, withdrawals of earnings are tax free, too, if the account has been opened for at least four calendar years after the year in which the account was opened.
See Individual Retirement Accounts for more information.
The value of tuition and such related expenses as books, supplies and required equipment is tax-free. However, if a scholarship or fellowship covers room and board and any other perquisites, the value of the benefits for the later items is generally taxed.
For most recipients, benefits are totally tax free. However, for those whose income (including 50% of their benefits and tax-free interest income) exceeds $25,000 on a single return or $32,000 on a joint return, up to 85% of the benefits can be taxed. The interview for this issue will pinpoint how much of your benefits are tax-free.
This is a confusing issue for many people, particularly since state governments send out 1099-G forms reporting the refunds to taxpayers and the IRS. But don't assume your state tax refund is automatically taxable. For most taxpayers, the refunds are fully tax-free.
If you did not itemize on your federal return for the previous year, your state tax refund is sure to be tax-free. Even if you did itemize, part of the refund could be tax-free. Be sure to go through the interview on this subject to be sure you don't report income you don't have to.
V.A. disability payments are tax-free.
Compensation for a job-related injury is tax-free. If you turn the payments over to your employer who continues to pay your salary, you are taxed only on the amount by which your salary exceeds the compensation.
If you have a refund coming, we suggest you tell the IRS to send your money directly to your checking or savings account. This can save you time and hassle. You should get your refund at least a few days sooner. Also, it saves the IRS, and therefore all of us taxpayers, money. It's less expensive to electronically deposit money to a bank account than to print and mail a check. One downside: You have to check with your bank or wait for a statement to know your money has arrived.