The post Refundable Tax Credit and Non-Refundable Tax Credit is one of those posts. Let me try again with some charts.

The first chart above shows a person’s withholding and tax liability before any tax credit. Because this person didn’t withhold enough, he or she will owe some taxes at the time of filing.

This second chart shows after non-refundable tax credits (red block) are applied, the taxpayer will get a small refund instead of owing taxes. The non-refundable tax credits are capped by the tax liability. The best a person can do with non-refundable tax credits is to get all the withholding back. A non-refundable tax credit can increase your tax refund after all; it’s just the refund can’t exceed your withholding.

As you might have guessed, the refundable tax credits are not capped by one’s tax liability, as shown in this third chart. The refund can exceed the withholding.

So how did I do? Are these charts clearer than what I tried to convey before in words?

Once again, here’s the table that shows if a tax credit is refundable or not.

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Schedule L is used for claiming (a) the additional $500 or $1,000 tax deduction for property tax paid, (b) the sales tax paid on a new car purchased between Feb. 17, 2009 and December 31, 2009, and (c) a net disaster loss (together with Form 4684).

Schedule M is used for claiming the Making Work Pay tax credit. Making Work Pay tax credit is the $400/$800 tax credit added in the economic stimulus law.

While we are at it, here’s a list of the tax forms you will need for the various new tax incentives for 2009 tax year.

If you qualify for these incentives, make sure your tax return includes these forms and schedules.

Now, here’s a quiz about the $400-per-worker Making Work Pay tax credit. As you may know, the IRS changed the tax withholding tables in February 2009 to reflect this credit. In effect, people have already received this $400 credit through lower withholding and bigger paychecks. If you fill out a Schedule M and ask for the tax credit, are you double-dipping on the credit? Why and why not?

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Because the traditional IRA had mostly non-deductible contributions, I will not pay much tax for this conversion. I plan to do the same contribute-then-convert move in 2011 and beyond unless Congress changes the law.

Having a solo 401k made things easy for me. This post is a sidebar about the history of solo 401k.

Solo 401k came about in 2002 after Congress passed Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA added this small paragraph to the tax code (26 USC 404(n)):

(n) Elective deferrals not taken into account for purposes of deduction limits

Elective deferrals (as defined in section 402(g)(3)) shall not be subject to any limitation contained in paragraph (3), (7), or (9) of subsection (a) or paragraph (1)(C) of subsection (h) and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions.

That one small paragraph put forward the solo 401k as the preferred retirement plan for self-employed persons.

Before EGTRRA, a self-employed person was also able to set up a 401k plan just for him- or herself. However, there wasn’t a good reason to do so, because the deduction limit for a 401k plan was the same as that for a SEP-IRA. A SEP-IRA is easier to set up and administer than a 401k plan.

The small paragraph EGTRRA added basically says the employee contributions to a 401k plan does not count toward the deduction limit. As a result, a self-employed person can contribute more money to a solo 401k than to a SEP-IRA. Because business owners are usually interested in maximizing all available tax deductions for retirement, a solo 401k plan became preferred to a SEP-IRA.

EGTRRA also affected corporate 401k plans. Before EGTRRA, employers usually limited employee contributions to no more than 15% of compensation. Together with the company match, the total contributions would stay below the deduction limit, which is 25% of payroll. After EGTRRA, employee contributions no longer count toward the 25% limit. Many companies responded by increasing the employee contribution maximum to 50% of compensation or more. This has allowed lower-income employees to contribute the maximum dollar amount allowed under the law known as the 402(g)(3) elective deferrals limit, currently $16,500 per year.

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The marginal tax rate is the tax you pay on your last dollar earned. It’s an important number to know because at the end of the day, if you earn one extra dollar, what you can put into your own pocket or spend after taxes are paid is what really counts. That number would be 1 – marginal  tax rate.

If my marginal tax rate is 95%, I will not bother putting in the effort to earn that one extra dollar because it’s just not worth it for me  to net only 5 cents. I’d rather relax and enjoy my leisure.

The correct answer to the question "what is your marginal tax rate?" has to include at least two another questions:

1. On what income?
2. What will I do with it?

The tax system is complex. That’s an understatement. We get taxed differently depending on how the income is earned and how it’s used. When you have income from multiple sources, which dollar is exactly your last dollar earned? When you put your money into different use, which dollar is exactly your last dollar?

I can think of many kinds of taxes:

• federal income tax
• state income tax
• local income tax
• Social Security tax
• Medicare tax
• mental health tax (for some lucky souls in California)
• disability insurance tax (in some states)

I probably left out quite a few more taxes.

Depending on whether your income is wages, self-employment income, interest, dividends, capital gains, Social Security, pension, withdrawals from different types of accounts, and depending on the exact circumstance of such income (capital gains from selling qualified primary residence versus selling a stock you held for less than 12 months; withdrawal from a Roth IRA versus from a traditional 401k plan; and so on), one or more of the taxes above don’t apply or apply at different rates.

If you use your last dollar earned on some preferred items, you get a zero rate or even a negative rate on some of the taxes above. Those are the tax deductions and tax credits, plus a few more that don’t show up on the tax forms, like contributions to a retirement plan or contributions to a health care flexible spending account.

On the other hand, you will pay even more taxes if you use your last dollar earned on some other things. Those are the sales tax, use tax, and excise tax. The rates are different depending on what you buy and where you buy.

• buy products in stores (rates for groceries and prescription drugs can be different)
• buy cigarettes
• buy gasoline
• stay at a hotel
• rent a car
• make a telephone call
• use electricity

That’s just a tip of an iceberg. When all is said and done, how many different taxes do you pay in a year? I would guess at least 20. Maybe over 100.

Have you figured out what your marginal tax rate is yet?

Sorry about the trick question. There isn’t a single marginal tax rate. If you create combinations like "income from wages donated to charity" and "interest from Treasury bills contributed to a 529 plan in New Mexico" you can probably come up with hundreds of different marginal tax rates just for one person.

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The mirror image of the marriage tax penalty is the marriage tax bonus, that is when two spouses have disparate income or one spouse decides to stay at home, they pay less tax than they do if they don’t marry.

I touched on the topic of marriage tax penalty in two previous posts:

• Tax Proposals in Obama’s 2010 Budget Outline
• 2009 AMT Tax Brackets

It turns out that marriage tax penalty and marriage tax bonus have been studied extensively by economics professors. It’s well known within the academic circles that three desirable objectives can’t be satisfied at the same time:

1. Horizontal Equity: households with the same income pay the same tax
2. Progressivity: higher income pays a higher rate of tax
3. Marriage Neutrality: the tax system should stay neutral to the decision to marry

It’s very similar to the time-cost-quality triangle: you can have any two but not all three.

A key concept is called the unit of taxation, in other words, whether taxes are levied on an individual person or on a family.

The current US tax system uses a family as the unit of taxation. It achieves objectives #1 and #2, but it fails in objective #3. Some people receive a tax incentive to marry while others are penalized for marrying.

Most other developed countries use the individual as the unit of taxation. The same person pay the same tax whether they are single or married. This system achieves objectives #2 and #3, but not #1. Under this system, a one-earner household pays a higher tax than a two-earner household with the same income.

Although it seems unfair under an individual unit of taxation system to tax a one-earner family more than a two-earner family with the same income, it’s actually fair. When you recognize the value of the household work taken up by the stay-at-home spouse, the one-earner family produces more and therefore should be taxed more.

According to a research paper I read, Canada, UK, Japan all base their taxes on individuals. Only 9 countries in 30 OECD countries base their taxes on families. In the last 30 years, several countries also moved away from joint taxation like in the US to individual taxation.

The United States is once again in the minority relative to the rest of the world on this issue. Why am I not surprised?

Reference:

Alm, James, 2005. Thinking About The “Marriage Penalty”, a PowerPoint presentation.

Alm, James and Mikhail I. Melnik, 2004. Taxing The “Family” In The Individual Income Tax, Public Finance and Management, Vol. 5, No. 1

Cleveland, Gordon and Michael Krashinsky, 1999. Tax Fairness for One-Earner and Two-Earner Families: An Examination of the Issues. CPRN Discussion Paper No. F07.

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In preparation for converting my non-deductible IRA contributions to Roth IRA in 2010, I’m rolling over the pre-tax portion of my traditional IRA to my solo 401k. I set up the solo 401k last year primarily for this purpose — to provide a harbor for my pre-tax IRA money so I won’t get taxed proportionally on my Roth conversion. After the rollover, I should have only one small IRA, consisting of my non-deductible contributions plus or minus market fluctuations from now until I convert in January 2010.

I have my solo 401k with Fidelity. When I called them about the rollover procedures, to my surprise, the rep actually discouraged me from doing so. To his credit, he made valid points. He knew what he was talking about. Fidelity trained them well.

He said the 401k has more restrictive rules on withdrawals. Before I reach 59-1/2, I can withdraw from a traditional IRA for any reason. I just have to pay tax and the 10% early withdrawal penalty. Not that people should do that but that option is there. If I put the money into the solo 401k, I have to qualify for specific hardship events before I’m allowed to withdraw and pay the tax and the 10% penalty. Fidelity’s solo 401k plan does not allow loans.

He also said rolling over money in an IRA to a solo 401k will get the solo 401k closer to an IRS reporting threshold. When a solo 401k plan’s assets reach $250,000, the plan administrator will have to file a Form 5500-EZ with the IRS every year. I can avoid the extra paperwork for more years if I don’t rollover IRA money into my solo 401k.

I would agree with him if I’m not preparing for the Roth conversion. I decided the benefits of low taxes on Roth conversion outweigh the restrictions on withdrawals and the extra paperwork.

The actual rollover consists of two steps. Because I’d like to keep the assets in my IRA, I would transfer in-kind to a new Fidelity Rollover IRA as a bridge. After that’s done, Fidelity needs a letter from me as the administrator of my solo 401k to accept the rollover from my Fidelity Rollover IRA. Then the bridge rollover IRA will be closed. Fidelity will not charge the usual $50 IRA closing fee.

I initiated the partial rollover online with Fidelity last Wednesday. I mailed the transfer of assets form on Thursday. By Tuesday, the rollover is completed. Four business days. Fidelity did a very good job.

With the rollover, I said goodbye to Vanguard Brokerage Service. Vanguard is a great mutual fund company, but its brokerage service is substandard. In order to avoid complications with the rollover, I wanted to change my dividend reinvestment election from automatically reinvest to taking the dividend in cash. I got this nice message when I tried to do so:

Vanguard Brokerage Service is saying their computers for processing dividend reinvestment elections go off their shift at 5 p.m. Eastern time. I honestly cannot think of any reason why computers work only a day shift.

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The government gives tax credits for buying a "green" car. If you are not buying a "green" car, you don’t get a tax credit, but you still get a tax deduction for the sales tax. See previous post Tax Deductions: Above-the-Line, Standard, Itemized, and Miscellaneous for the difference between a tax credit and a tax deduction.

The tax credit is called Alternative Motor Vehicle Credit. It’s been available for a few years now. There are four categories of vehicles under the program. For the average consumers, the two most relevant categories are basically hybrid and clean diesel cars. These cars must be purchased new. Leasing does not get you the credit.

For hybrid and clean diesel cars, once a manufacturer sells 60,000 units under the program, the credit starts to phase out. As a result, the popular Toyota and Honda hybrid cars no longer qualify. For cars that still qualify, the IRS has specific lists of makes and models and tax credit amounts:

• 2009 model year hybrid
• 2010 model year hybrid
• diesel models

To calculate and claim the credit, use IRS Form 8910. The bottom line on Form 8910 feeds to a line on Form 1040.

This tax credit is non-refundable, which means you must have enough tax liability to benefit from it. There is no upper income limit for the credit. It’s not limited to one car either. However, if you are subject to AMT, you effectively don’t get the credit. Unused credit cannot be carried over.

As far as I can tell, if you qualify, you can claim both this Alternative Motor Vehicle tax credit for buying a hybrid or diesel car and the tax deduction for the sales tax paid.

Reference:

• Form 8910 Instructions

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Certain employee benefits, like health care, are not taxable. Personal use of an employer provided BlackBerry or cell phone is not one of them. The IRS published Notice 2009-46 on June 8. It’s on pages 13-15 in Internal Revenue Bulletin 2009-23. They are asking for public comments about the three methods it’s considering.

1. Minimal Personal Use Method. There are two proposals under this method. Under the first proposal, if the employee can show to the employer that he/she carries another personal cell phone and uses that phone for personal matters, then the employee won’t have to pay taxes on the company provided  BlackBerry or cell phone. Under the second proposal, there would be a threshold of say X minutes. If the employee can show he/she used the BlackBerry or cell phone for personal purpose for no more than X minutes or he/she used it only for certain exempted types of calls (emergency for example), the employee won’t have to pay taxes for such personal use.

2. Safe Harbor Substantiation Method. Under this method, instead of getting proof from the employees or tracking how many minutes were used for personal purpose, the employer just uses an IRS-specified percentage for everybody, say 75% for business use and 25% for personal use. Employees will pay taxes on 25% of the fair market value of the service.

3. Statistical Sampling Method. Under this third method, the employer is supposed to take a sample and do some statistical analysis to figure out the percentage of personal use versus business use. Then the employer applies that percentage for everybody and adds the proportional value of the service to employees’ pay, on which the employees will pay taxes.

For more information, in case I misinterpreted something, please read Notice 2009-46 on Internal Revenue Bulletin 2009-23. If you have something to say to the IRS about these proposals, send your comments to them by mail or by e-mail. The addresses are on the last page in the notice. Be sure to include Notice 2009-46 in the subject of your comments.

What about company provided laptops or on-site fitness gym? I also wonder when the IRS will make employees account for soft drinks and snacks and team lunches.

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Bartering is apparently hot these days. The popular web site Consumerist recently quoted an Associated Press article Short on cash? Bartering making a comeback which said traffic to bartering web sites doubled in this weak economy.

Boise beautician Heather Wood has traded haircuts and pedicures for years of day care, kids’ clothes, a paint job for her car, an oil change, a set of professional portraits for her family and dental cleaning.

“It’s fun, and it builds a whole different kind of a relationship,” said Wood, who has five children. “They’re getting what they want and I’m getting what I want. I would much rather do that than make cash most of the time.”

I also found this L.A. Times article from Google: Boom times for barter.

In this tough economy, Valerie Whitlock uses two forms of currency: money and barter. The 37-year-old actress and writer from Studio City holds down sporadic film and television gigs to cover her rent, utilities, car payments and insurance. For everything else — head shots and haircuts, clothing and cut reels — she trades her handcrafted jewelry.

What’s wrong with charging money for your haircuts and pedicures or handcrafted jewelry? Whatever you can do with bartering, you can do with money. If it’s an equal exchange, everybody is even after giving and receiving money. You give a pedicure for $50 and you pay $50 for day care. It has the same effect as bartering. But you can’t do everything with bartering that you can do with money. You can’t walk up to a gas station and offer haircuts for gas. So why go through the trouble with bartering?

I can’t help wondering if it has something to do with taxes. I don’t want to accuse beautician Heather Wood or jewelry maker Valerie Whitlock in those articles of anything because I have no evidence whatsoever whether taxes are a consideration. When you receive money for your products or services, you have to pay taxes. If you are self-employed, you have to pay income tax and both the employer’s and the employee’s shares of the payroll tax (15.3%). When you use the money received to buy stuff, you may have to pay sales tax. If the person on the other side of the trade is also self-employed, the other person will have to pay the same set of taxes too. If you do bartering, you are supposed to pay taxes the same way as when you charge money. The IRS says you have to record income for the fair market value of the bartered goods or services you receive. But it’s a lot harder or perhaps impossible to track, because there is no money changing hands in bartering. There is opportunity to either not report them or report them at a much lower value. After all, the fair values of the bartered goods and services received in return are difficult to assess. Who says that paint job for your car has to be worth $600, not $200? The guy just gave you a good deal, you know?

The IRS must not be amused about all these bartering going on. They produced a video about bartering, telling people they must report their bartering income. Good luck with that.

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