I JUST COMPLETED my fourth year preparing tax returns as part of the federal government’s Volunteer Income Tax Assistance (VITA) program. I’ve seen first-hand how confusing our tax code can be for many taxpayers. Here are the 10 areas of confusion I’ve encountered most often:
1. Income. Anyone looking through a tax return will see multiple definitions of income. There’s total income, adjusted gross income (AGI), modified adjusted gross income, provisional income and taxable income. Each is slightly different and used for a different purpose. AGI is arguably the most well-known; the government uses it to determine eligibility for numerous tax credits.
2. Social Security taxation. Social Security benefits can be taxed if you meet certain income thresholds. For this purpose, your income is calculated by taking your AGI, and adding back any nontaxable interest and one-half of your Social Security benefit. The IRS then uses a formula to determine what percentage of your benefit is included in taxable income. That amount can range from 0% to 85%. I’ve had taxpayers shocked that their benefits are taxed at all, and I’ve had others who were convinced that 85% of their benefits would be lost to taxes.
3. Refundable vs. nonrefundable tax credits. A tax credit directly reduces your tax bill. But there are two types: A nonrefundable credit can reduce the bill down to zero, while a refundable credit can actually create a tax refund. Refundable tax credits can be especially valuable to low-income taxpayers because they can put money in their pocket.
4. Earned income tax credit. The EITC is a refundable credit designed to help low- to moderate-income taxpayers. Since this is a credit that encourages work, the taxpayer must first have earned income. In 2021, a married couple with three dependent children could earn up to $57,414 and still be eligible for a $6,728 credit. Recent changes have broadened the age range for this credit. Many seniors with modest earnings were elated to see it applied to their 2021 tax return.
5. Premium tax credit. This is a refundable credit designed to help taxpayers who purchase medical coverage through a government health-care insurance marketplace. In most years, a taxpayer’s income must be below 400% of the federal poverty level. The trick, however, is that you qualify for this credit at the beginning of the year based on your estimated annual income. If your actual income exceeds the limit, you might have to pay back part of the credit. I once worked with a self-employed client whose income exceeded the limit. While preparing his return, we showed him that making a deductible IRA contribution would reduce his taxable income enough to stay under the threshold. It’s highly unlikely he would have figured that out on his own.
6. Itemized deductions. Many seniors come to us with stacks of receipts for medical expenses and charitable contributions. They don’t realize that 2017’s tax law made these receipts obsolete for many taxpayers, because their total itemized deductions are less than today’s higher standard deduction.
7. Child tax credit. This credit—the subject of ongoing political negotiation—is designed to relieve the tax burden of parents and guardians. Recent changes have broadened who can qualify and boosted the credit from $400 to $2,000. The phaseout now begins at $150,000 of income for joint filers.
8. Education credits. There are two similar credits that provide tax relief for education expenses: the American Opportunity Tax Credit and the Lifetime Learning Credit. These have subtle differences, so taxpayers must pay careful attention to apply them correctly. I recently prepared an amended return for a college student who hadn’t tallied her education expenses when she filed. She later returned with the proper documentation. Her return changed dramatically: She went from a shortfall of several hundred dollars to a refund of more than $2,000.
9. Tax liability vs. tax refund. One of the most common misconceptions I see concerns the difference between a person’s tax liability and tax refund. Many taxpayers still think of a sizable tax refund as a windfall. In truth, getting a refund or not depends on whether you properly accounted for taxes throughout the year. I’ve had people who were upset that their refund was significantly smaller than the previous year. Even so, it sometimes turns out that their total tax liability was actually lower than it had been the year before. This doesn’t always mollify someone counting on a large refund.
10. Alternative minimum tax. As the name implies, the AMT is an alternative method of calculating someone’s tax liability. It was created to ensure that all taxpayers pay a minimum amount of tax. This parallel tax system uses a different set of rules to arrive at a minimum taxable income and a tentative minimum tax (TMT). The taxpayer then pays the greater of the standard tax liability or the TMT. The system originally targeted wealthier taxpayers, but it sometimes affects taxpayers at lower income levels. Taxpayers who pay AMT for the first time feel like they’ve experienced a nasty surprise.
A primary reason taxpayers get confused is because the rules keep changing. Consider that the legislation passed by Congress in 2017, 2020 and 2021 all included tax-related changes. The trend of never-ending changes seems destined to continue. Major provisions of 2017’s tax law will expire on Dec. 31, 2025—just as many taxpayers are becoming comfortable with them.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.