Surveys repeatedly show that taxpayers don't know a whole lot about fundamental terms and concepts. Now that's hardly a surprise, you might be thinking. So file that bombshell under Dog Bites Man.
Our national unawareness prompted these observations in an article titled "Form 1040? What's a Form 1040?" that appeared in The New York Times on April 11, 1993, just several days before the annual filing deadline: "The country is suffering from a massive case of tax illiteracy that goes beyond the inherent complexity of the system and cuts across every economic and educational stratum." Even worse, "Research shows that more than half the population does not know the meaning of a progressive tax system -- in which the more you earn, the higher your tax rate -- even when given the correct answer in a multiple-choice question."
The level of understanding, the article says, sags some more when it comes to "terms and concepts that taxpayers have to deal with in preparing returns." About 75 percent of them are unable to understand that when someone is in the 25-percent bracket, only the part of a person's income that falls into that bracket gets taxed at a 25-percent rate. And nearly 80 percent "don't know that a tax credit, rather than a tax exemption or deduction, can reduce taxes the most." More on deductions versus credits in a moment.
The Times identified the authors of the article as two top executives of "a company that simplifies government and business information. The Internal Revenue Service retained the firm to make tax forms easier to use but did not take its recommendations."
More recently, other researchers found out that there's a rough split of taxpayers who do or don't understand the difference between itemized deductions for outlays such as charitable contributions and standard deductions -- amounts that they can deduct without having to itemize. These two terms pop up continually and must be understood to complete returns and avoid losing more than necessary to the IRS.
Even affluent investors aren't savvy about basic tax rules, says Eaton Vance Corp., a Boston-based investment management firm that conducts annual nationwide surveys of investor attitudes. Consider what was revealed by Eaton's inquiry, "Inside the Mind of the 21st Century Investor: Election Implications; Optimistic Outlooks on the Market and Retirement; Tax Turmoil," a wide-ranging survey of 1,000 investors. Eaton learned that many investors know little about basic tax issues, especially current tax rates. Moreover, investors aren't getting the guidance they need and are entitled to receive from their financial advisers. Those findings don't differ from previous surveys.
How many of those surveyed aren't aware of their own tax brackets? Eaton's tally discloses a dismaying 34 percent of those with investments of less than $250,000 and 13 percent of those with investments greater than $250,000. ("Aware," in case you're unaware, isn't necessarily synonymous with "understand.") Other Eaton statistics are even more disturbing. Amazingly and appallingly, one-third of those contacted say their advisers rarely or never discuss the tax implications of their investments with them; Twenty-nine percent say that they have to raise the topic of taxes themselves.
Eaton senior vice president Duncan W. Richardson says, "Investors express concern about taxes and the tax implications of investing, but are confused by a subject that can, very quickly, become complicated. As with the weather, there is a lot of talk but, unlike the weather, investors can do something about taxes. There is a great opportunity for financial advisers to help their clients lower their tax drag by discussing tax basics, and the implications of recent tax legislation."
"Great opportunity," indeed. After all, the survey unearthed this trifecta: What percent of those questioned are aware that the law imposes top rates of 35 percent for salaries, pensions and other kinds of ordinary income; 15 percent for long-term capital gains from most sales of assets owned more than 12 months; and 15 percent for dividends? Just 26, 22 and 16, respectively.
Before I proceed further, I need to split some semantic hairs. Like other tax professionals, my experience has been that a disturbingly high percentage of individuals are clueless about the difference between "taxable income" and AGI, short for "adjusted gross income" -- some more of the terms that taxpayers need to understand if they want to determine their top tax bracket.
The starting point is gross income, which is all of your income before any allowable deductions. Gross income includes: salaries reported on W-2 forms from employers; dividends and interest reported on 1099 statements from mutual funds, stock brokerages and banks; net profits or losses (receipts minus expenses) from freelance writing and photography and other self-employed business ventures; and pensions, among other income sources. From gross income, subtract adjustments for, among other things: write-offs for funds put in traditional IRAs; alimony payments; health insurance payments by self-employed individuals; and job-related moving expenses; and one-half of the self-employment tax (as calculated on Schedule SE (Self-Employment Tax) of Form 1040), to arrive at AGI, the amount at the very bottom of page one of Form 1040.
The AGI amount is before claiming exemptions for yourself and other dependents (for 2012, the exemption amount is $3,800), as well as itemized deductions for outlays such as charitable contributions, or, if you don't itemize, the standard deduction. From AGI, subtract dependency exemptions and itemized deductions or the standard deduction to arrive at taxable income, which is the last amount you need to arrive at before looking up the amount of tax due the IRS.
Credits versus deductions. As noted previously, most taxpayers don't understand the difference between credits and deductions. Credits lower a person's taxes dollar for dollar, making them more valuable than deductions, which merely reduce the amount of income on which taxes are figured. The distinction is critical. A deduction of $1,000 saves $350 in taxes for someone in the highest bracket of 35 percent, but only $100 for someone in the lowest bracket of 10 percent. A credit of $1,000 reduces taxes by that amount, whatever someone's bracket is.
Another difference is that credits come in two flavors, nonrefundable and refundable. Nonrefundable means credits that can't be refunded to the extent that they exceed your income tax. Put another way, credits like the one for child care provide no help after your income tax becomes zero. Refundable means credits that can be refunded to the extent that they exceed your income tax. An example is the earned income credit, which is a tax rebate for lower-income workers. Another is the credit for first-time homebuyers that went off the books after 2010.
Julian Block is an attorney and author based in Larchmont, N.Y. He has been cited as: "a leading tax professional" (New York Times); "an accomplished writer on taxes" (Wall Street Journal); and "an authority on tax planning" (Financial Planning Magazine). This article is excerpted from "Julian Block's Year Round Tax Savings," available at julianblocktaxexpert.com.