One of the most confusing questions asked by many people: Is it taxable as income? To help provide greater clarity around this question, let’s refer to the law utilized for the determination of individual income tax computations. The Internal Revenue Code of 1986, as amended, provides guidance for such quandaries. By reviewing the sections of the IRC, one will quickly surmise that everything is income unless specifically exempted by the “Code”.
Does that clear it up a bit? Clearly, your wages earned from a job are taxable but what about reimbursements from your Health Savings Account for medical care paid out of pocket? This is the type of question that many taxpayers struggle with understanding.
Tax-exempt interest is not taxable if derived from investing in certain types of debt securities. Some of the securities may be exempt from both federal and state income taxes. Sounding pretty good, right? The issue is understanding what you are investing in and how it is structured. Placing your money in an interest-bearing bank account will pay you a return. The earnings on the account are taxable. However, investing money in a municipal bond may generate non-taxable income for federal purposes but be taxable for state purposes. Or you may wish to invest in U.S. Government bonds. Interest earned on these types of bonds are taxable on your federal return but not on your state return. Confused yet?
Many taxpayers wish to save a few dollars by preparing their own income tax returns. The IRS website provides a link called “Free File” for individuals to utilize a platform that electronically files their return to the IRS. However, and I mean this in the most compassionate manner of speaking, if the wrong amount or type of income is placed in the wrong field on the return, you will have trouble by receiving a letter from the IRS informing you of such error.
What if you bought a piece of equipment such as a lawnmower? You used this mower to keep your personal lawn looking great. After a few years, you decide to sell the mower to buy a larger model. Is the $150 you received from the sale of your $400 mower taxable to you? Of course not. You have a basis in the mower of $400, the original purchase price. When you sell the mower for $150, you suffer a $250 capital loss. Therefore, you wouldn’t include the $150 in your income.
Another example of this mistake was made by a client of ours that purchased a pickup for work in his sole-proprietorship. He depreciated (i.e., wrote off the basis of his truck over time as a deduction against his income from the business) the vehicle for five years. His basis was very little after the depreciation claimed on his previous tax returns. The vehicle originally cost him $60,000 and he had depreciated $52,000 over the period of time he owned the vehicle. When he sold the truck for $21,000, he told me he didn’t “make any money” on the sale. I looked at him with a big grin on my face and corrected his statement. “You actually incurred an ordinary gain on the sale of the truck in the amount of $13,000,” I explained. His smile was reduced to a frown.
Income and expenses are allowed only as stipulated in the Internal Revenue Code or your state statutes. It is critical that you understand the ramifications of failing to report income or claiming deductions that you cannot substantiate. Failing to report income is called tax evasion. If you omit a substantial amount of income from your tax returns, you may be prosecuted in federal court and ordered to pay a large fine and possibly imprisonment.
Understanding tax law is difficult. Planning and filing your income tax return does not have to be. Contact a CERTIFIED FINANCIAL PLANNER™ professional to guide you in the proper manner of filing and paying your income taxes. Life is more enjoyable when you don’t worry about it. Go ahead. Live a life by design and allow someone else to worry for you. Tell Santa I said “hi”!