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How About Another Tax Break?

By: Investor Solutions

By: Investor Solutions, Inc.

If you’ve itemized your tax deductions in the past, then it’s no surprise that you’ve probably been able to deduct your mortgage interest, state & local income taxes paid, and real estate taxes just to name a few. But what about the possibility to have the opportunity to deduct state and local general sales taxes or contributions to health savings accounts on your federal return? Well, the Working Families Tax Relief Act of 2004 (WFTRA) which was signed into law by President Bush on October 4, 2004 may have just made your wish come true.

For 2004 and 2005, taxpayers are entitled to elect to deduct state and local general sales taxes on Schedule A in lieu of the itemized deduction for state and local income taxes. The election is generally intended to benefit taxpayers in states that do not have an income tax, but anyone can make the election. For residents of states that pay no state income tax such as: Florida, Texas, Nevada, Alaska, Wyoming, South Dakota, and Washington, the decision is a no-brainer. However, residents of other states-such as California (whose state income tax could be as high as 9.3%) will have to determine which write-off will be more beneficial- the state income tax or state sales tax.

The IRS realizes that saving every receipt for each purchase to calculate your actual sales tax paid is a chore upon itself, so the agency is developing state-by-state tables estimating how much tax families of different sizes and incomes pay during the year. As the taxpayer, you will then be able to match up your actual saved receipts with the standard table amount and take the larger deduction. Purchases such as an automobile, boat, or any other big-ticket item could easily put you over the table estimates. Back in 1986, the last year a sales-tax deduction was on the books, IRS tables allowed a Florida family of four with income (including tax-free income) of $50,000 to deduct $655. A couple with four or more children and $100,000 or more of income got to write off $1,096.[1]

Besides the ability to deduct sales tax for 2004, the IRS has also made it possible for eligible individuals covered by a high deductible health plan to make deductible contributions to a Health Savings Account (HSA) up to the lesser of the plan deductible or $2,160 for individual coverage or $5,150 for family coverage. The HSA plan allows individuals to save for health-care costs on a tax-free basis in an IRA-like account. The account can basically serve as a tax-sheltered vehicle to be used to pay routine medical expenses that fall below the deductible set by your current high-deductible health plan.

Another hot tax area is the taxation of long-term gains and dividends for 2004. Dividends will be categorized as either “ordinary” or “qualified” for tax reporting purposes. Ordinary dividends will be treated just like short-term gains and reported in box 1a of the 1099-DIV Form, they will be taxed at the taxpayer’s ordinary income tax level. On the other hand, qualified dividends will have the same tax rates that are applicable to net long-term capital gains, they will be reported in box 1b of the 1099-DIV Form. For taxpayers whose top tax bracket is 25, 28, 33, or 35 percent the qualified dividend and long-term capital gain rate is 15%. For those taxpayers in the 10 or 15 percent tax bracket, the qualified and long-term capital gain rate drops to 5%.

The dividends received by individuals from most domestic corporations and many foreign corporations will be eligible for the favorable qualified dividend rate. However, the reduced rate does not apply unless the dividend is received on stock held at least 60 days during the 121-day period beginning 60 days before the ex-dividend date. Generally, the distributions on preferred stock will not be eligible for the qualified dividend treatment because preferred stock is a hybrid security that is treated as debt and not stock. Dividends paid by a real estate investment trust or REIT generally are not eligible, since mutual fund dividends that represent interest earnings are not eligible for the reduced rate. If the REIT distribution is attributable to corporate tax at the REIT level or which represent qualified dividends received by the REIT and passed through to shareholders they will qualify for the favorable rate. Don-t sweat it, your custodian will provide you with the actual breakdown on the required IRS Form (i.e. 1099-DIV, etc&)

Some of the other tax cuts included for individuals under the new tax bill include the extension of the $1,000 child tax credit, the full elimination of the marriage penalty in the standard deduction, the increase in the size of the 10% tax bracket, and the extension of higher alternative minimum tax exemptions through 2005. The new tax bill provisions seek to give away tax dollars that otherwise had been scheduled to be collected- more than $132 billion worth over the next five years. Many economists forecast that the cost of the cuts will be paid by the public one way or another by an increase in taxes in the future or a cut in spending for social services. Now if you’re drinking out of the positive glass, you’ll most likely challenge those in question and claim that the economic prosperity created from the cuts will pay for the tax revenues lost. In either case, most taxpayers can count on receiving some type of economic benefit from the new relief act.

[1]Kiplinger’s Personal Finance, “nother break for No-Tax States” December 2004