The federal income tax rules have changed every year for the past decade, and this year is no exception. Fortunately, Congress decided to hold the line on tax hikes for at least two years and to throw in a two-percentage-point cut in the Social Security payrolltax, too.
Still, in your quest for a smaller tax bill or a bigger refund, you need to make sure you're armed with the latest information when you tackle your 2010 tax return. If you're a procrastinator, you'll be happy that you have an extra weekend to sweat the details. Your 2010 tax return is due April 18, 2011 -- three days later than usual. In the meantime, we have answers to your most pressing questions.
What's new this year?
High-income taxpayers get a big break on their 2010 return: There's no cap on the itemized deductions and personal exemption amounts they can claim to reduce their taxable income. Over the past 20 years, the wealthiest Americans have had to forfeit some or all of their personal exemptions and up to 80% of their itemized deductions when their income topped certain thresholds.
All taxpayers can choose between claiming the standard deduction and itemizing deductible expenses -- such as mortgage interest, real estate taxes, state income taxes, charitable contributions and, in some cases, a portion of their out-of-pocket medical costs and certain miscellaneous expenses.
For 2010, the standard deduction is $5,700 for individuals, $8,400 for heads of households and $11,400 for married couples. If your deductible expenses exceed the standard deduction, it makes sense to itemize.
Normally, the squeeze on itemized deductions begins when adjusted gross income tops about $83,000 for individuals or $167,000 for married couples (amounts have been indexed for inflation each year). But this year is different. High earners may use the full value of their itemized deductions to reduce their taxable income. (Deductions for charitable contributions still can't exceed 50% of adjusted gross income, but excess deductions may be carried over to future years.)
Personal exemptions, worth $3,650 each in 2010, are now available to every taxpayer, spouse and dependent, regardless of household income. Previously, the personal exemption phase-out kicked in when income exceeded roughly $200,000 for individuals and $250,000 for married couples filing jointly. Now a family of four, for example, can subtract $14,600 from their AGI when calculating their taxes for 2010, no matter how wealthy they are.
Originally, the high-earner tax-squeeze relief was scheduled for 2010 only, but Congress extended it through 2012 as part of the massive tax package approved just before Christmas. That gives upper-income taxpayers a two-year window to accelerate their charitable giving and other itemized deductions.
Q: I converted my traditional IRA to a Roth IRA last year. When do I pay the tax?
You must pay income taxes at your ordinary tax rate on the entire amount you convert from a traditional IRA to a Roth IRA, except for any nondeductible contributions. But for 2010 conversions only, you have a choice of when to report and pay the tax: all at once when you file your 2010 tax return, or half on your 2011 tax return and the balance on your 2012 return.
Now that Congress has extended current income tax rates through 2012, you can easily estimate how much your conversion will cost under each scenario. File Form 8606 to report your Roth conversion on your 2010 return (or to calculate what you'll have to report on your 2011 and 2012 returns). And you have until October 17, 2011 -- the due date of the tax-filing extension for 2010 returns -- to change your mind and undo, or "recharacterize," a 2010 Roth conversion without paying any tax.
Q:How do I claim the home buyer's tax credit?
If you bought your first home between January 1 and April 30, 2010 (or entered into a binding contract by then and went to settlement by September 30, 2010), you can claim the First-Time Homebuyer Credit for 10% of the cost of the house, up to a maximum of $8,000. You're eligible for the full credit if you are single and your AGI is $125,000 or less, and you can get a partial credit if your income is as high as $145,000. For married couples, the income limit for the full credit is $225,000, and up to $245,000 for a partial credit.
Longtime homeowners who closed on a new home by September 30, 2010, are also eligible for a 10% tax credit, up to $6,500. They must have lived in the same principal residence for at least five consecutive years out of the past eight; the income-eligibility guidelines are the same as for first-time buyers. To claim either break, you must file Form 5405, "First-Time Homebuyer Credit and Repayment of the Credit," and attach a copy of your settlement statement or certificate of occupancy for a newly constructed home.
Longtime homeowners must also attach proof of five consecutive years of ownership, such as mortgage interest statements, property tax records or homeowners insurance. Because of the requirements for documentation, you can't file your tax return electronically if you claim the home buyer's credit. You'll need to mail your paper forms.
For taxpayers who took advantage of the original home buyer's credit in 2008, it's time to pay the piper. In its initial form, the maximum $7,500 credit was essentially an interest-free loan that had to be repaid in installments. The first repayment is due with your 2010 return. If you claimed the full $7,500 credit, for example, you'll owe $500 a year for each of the next 15 years. (If you sell the house before then, you'll have to repay the balance of the credit all at once.) Record your payment amount on Form 5405. No repayment is required for the tax credit given to those who purchased their homes in 2009 or 2010.
Q:What is Schedule M, and who needs to file it?
Most taxpayers with earned income from a job or self-employment should file Schedule M to claim the Making Work Pay Credit, worth up to $400 for individuals and $800 for married couples. (If you file the 1040EZ, use the worksheet on the back of the form to figure your credit.)
Schedule M will help you determine whether you have received the full credit in your paycheck throughout the year or if you are due more money -- which could result in a refund. But some people may have to give back what they have already received. You cannot claim the credit -- and you don't have to file Schedule M -- if your income tops $95,000 if you are single or $190,000 if you are married filing jointly, or if you can be claimed as a dependent on someone else's tax return.
Q:Can I write off college expenses?
Yes, some of them. You have several ways to do it. For taxpayers who qualify, the American Opportunity Credit, which Congress extended through 2012, is probably the best choice.
The American Opportunity Credit is worth up to $2,500 per student per year during the first four years of college. It covers 100% of the first $2,000 of expenses, including tuition, fees and books, and 25% of the next $2,000. You can claim the full credit if you are single and your AGI is $80,000 or less ($160,000 if you're married filing jointly). You get a partial credit if you are single with income up to $90,000 ($180,000 for joint filers).
Use Form 8863. A portion of the credit -- 40% of up to $1,000 -- is refundable, meaning you could get money back if the credit exceeds your tax bill. If you're paying for graduate school, the American Opportunity Credit won't help you because it applies only to the first four years of college. But you have other options. You can choose between claiming the Lifetime Learning credit or a tuition tax deduction.
The Lifetime Learning credit covers 20% of the cost of any postÐhigh school classes, up to a maximum of $2,000 per tax return. For the full credit, your income can't top $50,000 if you're single ($100,000 if you're married). A partial credit is available to those with income up to $60,000 ($120,000 if married). Claim it on Form 8863.
If your income is too high to claim the Lifetime Learning credit, consider claiming a tuition deduction worth up to $2,000 or $4,000, depending on your income. Unlike a tax credit, which reduces your tax bill dollar-for-dollar, a tax deduction merely reduces the amount of income that is taxed. For example, if you're in the 25% bracket, a $2,000 deduction reduces your taxes by just $500, but a $2,000 credit reduces your taxes by the full $2,000. You can claim the full $4,000 tuition deduction if you earn less than $65,000 ($130,000 if you're married filing jointly). The deduction is limited to $2,000 if your income is between $65,000 and $80,000 ($130,000 and $160,000 if married filing jointly). Use Form 8917.
Q:I installed replacement windows last year. How do I claim the home-energy tax credit?
You may claim a credit for 30% of the cost of eligible energy-efficient home improvements on your principal residence, up to a maximum of $1,500. The credit applies to insulation, exterior doors and windows, heat pumps, furnaces, central air conditioners and water heaters. Use Form 5695 to claim the credit, but note that the $1,500 maximum applies to 2009 and 2010; if you claimed the full credit on your 2009 return, you are not eligible in 2010.
Q:Who qualifies for tax-free capital gains?
Investors in the two lowest income tax brackets will pay no taxes on their long-term gains and qualified dividends again this year. That means if you held an investment, such as a stock or mutual fund, for more than a year and you sold it at a profit in 2010, you will owe no tax on your gains if your taxable income doesn't exceed $34,000 if you are single or $68,000 if you are married filing jointly. (This provision does not apply to investments held in retirement accounts.) Any gains that lift your income above that level would be taxed at the maximum 15% capital-gains rate. Use the Schedule D tax worksheet to compute your capital-gains tax.
Q:Are the unemployment benefits I got last year taxable?
Yes, all the unemployment benefits you received last year are taxable. In 2009, up to $2,400 of unemployment benefits was tax-free, but that tax break was not extended for 2010. A few other popular tax breaks also expired. You won't find a property tax deduction for nonitemizers or a special sales tax deduction for the purchase of a new car (unless you paid the tax in 2010 on a car you bought in 2009). But itemizers will still be able to choose between deducting their state income tax and their state sales tax.
Q:Is there anything else I can do to lower my tax bill for 2010?
If you haven't done so already, you can contribute up to $5,000 to an IRA ($6,000 if you are 50 or older by the end of 2010) and may be able to deduct the contribution on your 2010 tax return. Even if you participate in an employer-provided retirement plan, you can still deduct some or all of your IRA contribution if you are single and your income doesn't exceed $66,000 or if you are married and your joint income doesn't top $109,000. And if you're not covered by a retirement plan at work but your spouse is, you can deduct some or all of your IRA contribution as long as your joint income doesn't exceed $177,000. You have until April 18 to make a contribution.