TAX TIPS FOR THE 1999 GRADUATE

Client: Very well. She'll be graduating next month.

Accountant: Those four years really flew by. What are her plans for the future?

Client: She's accepted a position with a pharmaceutical company. That reminds me--she asked about her taxes. Do you have any materials that might help Julie better understand her tax situation?

This booklet is an attempt to answer the question posed by the client. It recognizes that, as inexperienced preparers of Federal income tax returns, many 1999 graduates may find it difficult to file a return which will result in paying the lowest possible tax. Our effort involves introducing the 1999 graduate to some common tax considerations that could be beneficial in reducing the dreaded "tax-bite."

A set of basic facts will be assumed and worked with throughout. The assumptions are:

State and/or Local Tax Rate = 4%

Since the job will commence on July 1, the total salary earned during 1999 will be $15,000 (i.e., $2,500/month for 6 months).

A salary of $2,500 per month doesn't mean that a newly-employed graduate will have this amount to spend each month. There are several tax-related items which will be deducted from each paycheck by the employer. These include federal withholding, Social Security/Medicare (also known as F.I.C.A.) and, in most cases, a state income tax. As a single person, our assumed taxpayer will fill out a Form W-4 for the employer and probably claim one exemption. This will result in "take-home" pay of $1,901 (see Table 1). Since income will only be earned for six months, this will create an "over-withholding" situation. In other words, too much will be deducted monthly from the paycheck since the paycheck is converted to an assumed annual salary (i.e., $30,000) and total deductions are calculated based on this inflated figure. To alleviate this situation, the 1999 graduate should claim two dependents which will increase the "number of allowances" on the W-4 to three. This will increase "take-home" pay by $69 (see Table 1) and still generate a refund when filing the return for 1999. Early in 2000, fill out a new W-4, changing the claimed "number of allowances" back to one.

If Tax Tip #1 is followed, there is an excellent chance that our taxpayer will qualify for a refund of Federal income taxes when filing a 1999 tax return. If all of the graduate's income is from the job, federal income tax liability will be approximately $1,195.¹ Fortunately, his or her employer withheld $1,434 and he or she will be eligible for a tax refund.

Some graduates will be able to report and deduct expenses which are allowed if they itemize their deductions. This occurs when the total itemized deductions exceed the standard deduction amount (e.g., $4,300 for "singles" and $7,200 for "marrieds" are the 1999 figures). Taxpayers such as married graduates who own a home (and are paying mortgage interest and real estate taxes) and/or find themselves in states with high income tax rates (e.g., California, Massachusetts, New York, Wisconsin) would be the most likely candidates for itemizing. Other expenses that may be included in the itemized deduction category include employee expenses, such as overnight travel and meal expenses.

Out-of-pocket costs that can be deducted regardless of the taxpayer's ability to itemize deductions are referred to as "above the line" deductions. The most likely "above the line" components for the 1999 graduate are the deduction for student loan interest and the moving expenses deduction.

Interest on a Student Loan

Thanks to the Taxpayer Relief Act of 1997, interest paid on a student loan will be deductible for the first 60 months where required interest payments must be made. The interest must be on a "qualified education loan" which includes debt used to cover higher education expenses such as tuition, books, fees, room and board. A deduction "above the line" (i.e., subtracted in computing Adjusting Gross Income) is allowed with a maximum figure of $1,000 applying to 1999.

Since the 1999 graduate may have other types of interest expense (e.g., advance pay from employer, credit card, personal residence, vehicle loan), it is important that the source and reason for the interest is documented. Only the interest on a "qualified education loan" is deductible as the 1999 graduate determines his or her Adjusted Gross Income.

Example: Mariah is examining the interest she paid during 1999:

Since the loans from Carey College and Falcon Savings & Loan meet the "qualified education loan" criteria, Mariah may deduct the interest on those loans on her 1999 return. However, the deduction is limited to $1,000 (the 1999 "cap") even though the actual interest payments were $1,330.²

Moving Expenses

This special provision allows a taxpayer to deduct the costs involved in moving to his or her "first job" if specific distance-of-move and time-of-employment criteria are met. However, the job must be secured before moving to the new area. The distance-of-move test is a 50-mile factor while the time-of-employment requirement is met by working at least 39 weeks in the first 12 months after the move. The deductible expenses include those incurred for the transportation of the taxpayer to his or her new location, the cost of moving personal effects and household goods as well as any cost for lodging while traveling. These expenses are only limited by their "reasonableness." The costs of temporary living expenses (for up to 30 days) at the new job location are no longer deductible.

Since employers may report the moving expense reimbursement to the Internal Revenue Service, 1999 graduates should maintain the necessary records to verify the amount spent on moving expenses.

When an individual's employment calls for considerable travel away from the usual business place overnight, taxpayers may be entitled to deduct travel expenses from their Adjusted Gross Income (AGI). The circumstances allowing this treatment include (a) the out-of-pocket expenses which exceed any employer reimbursement and (b) the reporting of the reimbursement as income by the taxpayer. Since the costs are greater than the reimbursement, the unreimbursed costs would be possible deductions since they are included in the compilation of miscellaneous itemized deductions.³ Amounts spent for lodging and meals while away from home on business are deductible. However, meal costs may be limited to 50% deductibility, if they are not reimbursed. Also deductible are such items as baggage charges, reasonable cleaning and laundry expenses, telephone, telegraph and fax machine expenses, and others. Any substantiated travel expenses that are fully reimbursed by one's employer are treated as neither income nor a deduction and therefore these items would not appear on the individual's W-2 and tax return.

Other Business Expenses

As part of one's job, it may be necessary to entertain a customer or client. In some instances, a miscellaneous itemized deduction will be generated to the extent that the expenses exceed any reimbursement. If the reimbursement equals the expenditures, neither is reported on the tax return as long as a proper accounting of the expenses was provided to the employer. In other instances, the comparison of actual expenses to the reimbursement can lead to income recognition (where the reimbursement exceeds the expense and the reimbursement is reported on the W-2) or a combination of a miscellaneous itemized deduction and a non-deductible portion (where the reimbursement is less than the expense). Those who qualify as "outside salespeople" (i.e., employees who do selling away from the employer's place of business) may be permitted special treatment since they are allowed to report all outside income and the related expenses on Schedule C. As a result of this provision, the "outside salesperson" may avoid the 2% of AGI hurdle that pertains to miscellaneous itemized deductions. Entertainment expenses include disbursements incurred at restaurants, cocktail lounges, country clubs, other similar establishments and sporting events. However, any club dues (including airline, country club and hotel facility dues) are not deductible. Unreimbursed entertainment expense deductions are limited to 50% of their total and must exceed 2% of AGI when totaled with other miscellaneous deductions to be included in total itemized deductions.

Bob--Reports $200 (i.e., $1,200-1,000) of other income based on Form 2106 instructions.⁴

Betty--Since the allowance equals the expenses, there is no need to report either the

allowance or the expenditures assuming that a proper accounting to the employer

occurs.⁵

Brad--A deduction of $200 is permitted (i.e., 50% of the unreimbursed $400). The

$200 is included as a miscellaneous itemized deduction. Thus, it may not be

deductible if (1) Brad is not able to itemize or (2) Brad's total miscellaneous itemized

deductions do not exceed 2% of his Adjusted Gross Income (AGI).

Most graduates will not be itemizing deductions during their first years as wage-earners due to the substantial standard deduction which is available.⁶ To derive any tax benefit from itemizing deductions, the total of these deductions must exceed the standard deduction amount.

The possibility of itemizing deductions increases when a taxpayer resides in a high income tax state (e.g., California, Massachusetts, New York, Wisconsin), has had sizeable uninsured or unreimbursed medical expenses and/or when he or she owns a home and incurs interest on a mortgage and pays real estate taxes. Medical expenses (within percentage limitations), personal property taxes, and real estate property taxes are included in the list of itemized deductions along with state income taxes, charitable contributions and casualty losses. Teaching supplies, journal subscriptions and further educational costs are included in the miscellaneous itemized deduction category. An expanded discussion of educational expenses is included in a later section.

There are several tax credits that the 1999 graduate will be eligible for including the child and dependent care credit, the recently enacted child tax credit and the Lifetime Learning Credit. Unless the 1999 graduate has a child or is paying for the care of a child or other dependent (e.g., aging parent), the Lifetime Learning Credit is the most likely candidate for inclusion on the 1999 return.

The Lifetime Learning Credit is determined by multiplying 20% of the first $5,000 spent in 1999 to take one or more courses (including graduate level offerings) at an "eligible education institution." Thus, the 1999 diploma winner could reduce his or her taxes by up to $1,000 as long as he or she paid as much as $5,000 of tuition and fees during 1999. If one's parent(s) paid the education bills, the Lifetime Learning Credit will be reported on the tax return of the parent(s) subject to a phase-out rule that is triggered when AGI is above $40,000 for a single or head of household taxpayer or $80,000 when the return indicates a married filing jointly filing status.

TAX TIP #7

Many taxpayers feel that tax planning can only be carried out by taxpayers whose income is in the six-figure category. However, the 1999 graduate can also do some planning which will minimize his/her tax burden as well as that of the graduate's parent(s). Two specific areas include the timing of income and the protection of the dependency exemption on the parental 1999 return.

Timing of Income

It is wise tax-planning to move as much income into 1999 (i.e., the year of graduation) as possible since the highest marginal tax rate (i.e., the highest tax bracket applied against those last dollars of income) will probably be lower in 1999 (when you will be earning an income for less than a full year) than in the next year (when you will most likely be employed during the entire year). Since the potential marginal rate in 2000 of 28%, 31% or 36% is significantly higher than the likely 1999 rate of 15%, this type of planning should not be taken lightly. The types of income that can be shifted include interest on U.S. Savings Bonds, capital gains, proceeds from an insurance policy that is redeemed, and overtime pay that certain organizations (e.g., CPA firms) allow employees to "bank." For example, shifting $500 into 1999 could create a tax savings of $75 or more. Granted such activity would trim the refund discussed above in Tax Tip #2 but such income movement might make a lot of tax sense.

Dependency Exemption for Graduate's Parent(s)

For over twenty years, the tax returns filed by the parent(s) of the 1999 graduate included his or her name and a dependency exemption which reduced the parental tax liability. The graduation year return can continue to carry this tax benefit if the graduate is less than 24 years old at the end of 1999 and careful records are maintained. There are several criteria which must be met in order to qualify as a dependent on the parental return. In the year of graduation, two must be watched closely. First, the graduate cannot file a married filing joint return for any reason other than to garner a full refund. Second, the parent(s) must be able to prove that parental resources provided more than fifty percent of the graduate's support (i.e., parental funds must have been used for over half of the clothing, health care, education, food and shelter costs). Proof of this type of spending will be based on records kept by the graduate and his or her parent(s). Also, the graduate must have been a "full-time" student during at least all or part of five months of the tax year.¹⁰

Assuming that the graduate's earnings and paying for upkeep starts in July, his or her 1999 expenditures can determine whether or not Mom and Dad will be able to claim the recent alum as a dependency exemption. For example, if the parents are paying all educational and other expenses until July 1, it would not be unreasonable to assume a spending level of $6,000 for that six-month period. If the graduate spends less than $6,000 on support during the final half of the year of graduation, the parents can claim him or her as a dependency exemption on their return. The resulting tax savings would be based on the highest marginal tax bracket applicable to the parents. The good news (for the parents) is that they will cut their tax bill based on their marginal tax bracket multiplied by the dependency deduction (e.g., $2,750 for 1999). The bad news is that the graduate cannot claim the same dependency deduction on his or her return. Referring to the example on page two, parental use of the exemption would impact the Form W-4 choice (i.e., graduating individual should claim 1 exemption), take-home pay and the expected refund (see Table 2). Nonetheless, the overall result is a tax savings (assuming a 31% marginal rate for the parents and a 15% rate for the graduate while using a $2,750 figure) as follows:

Parent savings 31% x $2,750 = $ 852.50

Graduate's cost 15% x $2,750 = (412.50)

Net result--Save $ 440.00

There are several other situations to be discussed. Let's take a closer look at three areas--education expenses, non-deductible expenses and Individual Retirement Accounts (IRAs).

Education Expenses

Since a taxpayer cannot claim more than one type of tax benefit for the same expenditure, the taxpayer will want to explore which route (i.e., deductible expense or Lifetime Learning Credit) would be the most beneficial for 1999 education expenses. Recall that tuition and fees up to $5,000 will qualify for the 20% Lifetime Learning Credit covered above.

As a general rule, the pursuit of an advanced degree or law degree will not be allowed as a deductible education expense. However, if the advanced degree is a requirement to maintain one's present position, the costs are included in miscellaneous itemized deductions (e.g., teacher seeking a master's degree based on a state requirement for retention of position). Other qualifying education expenses are those that maintain or improve skills required in one's present trade or business (e.g., salesperson enrolling in a course involving a better technical understanding of the product he/she sells, engineer studying various types of materials and their ability to withstand stress).¹¹

Disbursements included in the education expenses category are those for tuition, books, fees and supplies. In addition, transportation costs including the use of a personal vehicle to go to and from the place where the class and/or seminar is conducted also are allowed. (Note: in 1999 a rate of 31 cents/mile is permitted). Finally, 50% of the unreimbursed cost of meals is a qualifying miscellaneous deduction. Since education expenses are miscellaneous itemized deductions, there is a chance that none of the expenses will be listed on the tax return. This occurs because they must exceed, when combined with all other miscellaneous deductions, a 2% of AGI limit to be included in the final tally of itemized deductions.

Non-Deductible Expenses

Keeping correct and complete records can save a taxpayer a lot of time, trouble and dollars at tax time. Therefore, it is important to be aware of information that is not critical for tax return purposes since such activity does not generate any tax benefit. In keeping tax records, the following items are not critical since they are not deductible: non-prescription medicines, life insurance premiums, cost of a personal wardrobe, spending on personal entertainment, health club fees and spending on a personal vehicle (unless the vehicle is used for both personal and business purposes).

Discussing retirement with a 1999 graduate seems to be a ludicrous exercise until you examine the potential benefits. Illustration A in Table 3 demonstrates how a $2,000 per year contribution (the maximum allowed under current tax law) to an IRA for forty years--an overall investment of $80,000--grows to over $300,000. For the individual who feels that he or she should wait before starting to fund an IRA or similar arrangement, Illustration B in Table 3 shows that an extended delay followed by yearly contributions that amount to $80,000 will build a retirement fund that is about $190,000 less than the Illustration A results. In many instances, contributions to an IRA will be tax-deductible if the employee is not eligible to be covered by an employer-provided retirement plan. Here, we ignore the tax savings that may occur since the results are so compelling.¹²

Our tax laws are complex and constantly changing. This publication has highlighted several aspects of the Federal income tax law that are particularly applicable to the 1999 graduate and developed a list of Tax Tips (see Table 4). Hopefully, the effort can provide this type of ending to the dialogue introduced earlier:

TABLE 1

Number of Form W-4 Allowances

1 3

Salary $2,500 $2,500

Less:

(a) Federal withholding tax (308) (239)

(b) FICA (Social Security/Medicare) (191) (191)

(c) State income tax (100) (100)

"Take-home" pay $1,901 $1,970

NOTE: All numbers are rounded.

TABLE 2

Number of Form W-4 Allowance taken is 1

Salary $2,500

Less:

(a) Federal withholding tax (308)

FICA (Social Security/Medicare) - 7.65% (191)

State income tax - 4% (100)

"Take-home" pay $1,901

Federal tax withheld 6 x $308 = $1,848.00

Tax on a taxable income

of $10,700 (i.e., $15,000

minus $4,300) using a

marginal rate of 15%.^* (1,605.00)

Refund $ 243.00

(*)Numbers are rounded.

(**) Assumes that the 1999 graduate has married and he or she and his/her spouse contribute to an IRA account.

TABLE 4

ENDNOTES