Sunday, March 15, 2009

Form 1099-ZORK

In our income tax system, the IRS differentiates between refundable tax credits and non-refundable tax credits. This confuses many taxpayers (and worse, people giving advice to taxpayers), who believe that the distinction is related to refund checks from the IRS. When you file your income taxes, the IRS looks at a couple of different numbers: your total tax (A) and what you have paid (B). The amount you’ve paid includes any payments you’ve sent directly and federal income tax that your employer withheld from your paychecks. When B is larger than A, the IRS sends you a refund for the difference (B–A). As an example, suppose $4000 was withheld in federal taxes from your paychecks last year, and your total tax (as calculated on your 1040) is $3000. You’ll receive a refund check of $1000.

The difference between a refundable tax credit and a non-refundable tax credit is only related to your total tax (A). A refundable tax credit can reduce your total tax to less than 0, while a non-refundable tax credit cannot reduce your total tax to less than 0. Now suppose you have a tax credit of $5000 to add to the earlier example. If the tax credit is refundable, then it can reduce your total tax to –$2000 and you’ll receive a refund check of $6000 instead of $1000. If the tax credit is non-refundable, then it can only reduce your total tax to $0 and you’ll receive a refund check of $4000 instead of $1000. Even though the tax credit is called non-refundable, it still affects your refund check.

When a non-refundable tax credit can only be partly used because it’s greater than your total tax, the remainder that you didn’t use can often be carried forward to a future tax year. In the last example above, the $2000 that you didn’t get to use isn’t necessarily wasted, because you may be able to subtract that $2000 from next year’s total tax.

The tax system is full of these sorts of confusing terms: credit (reduction of taxes) vs. deduction (reduction of income on which taxes are calculated) is another one that many people get wrong, and the dollar difference can be huge. If your marginal tax rate is 15%, then a credit of $1000 is worth $1000 off your taxes while a deduction of $1000 is only worth $150 off your taxes.

I’ve always done my own income taxes as a business owner because I wanted to understand the tax implications of the decisions I have to make. It does add time, energy, and stress to the process of running a business, though. My financial position might be stronger if I let someone else deal with the taxes and I focused on trying to increase my income or reduce my expenses. Sadly, that reasoning is how our tax system got so impossible to understand. The taxpayer makes the sensible decision not to try to understand their own taxes. Once that happens, why bother to understand other people’s taxes? And if the public can’t intelligently participate in public discourse about our tax system, then why should legislators try to understand it?

I’m using both TaxCut and TurboTax in parallel this year, seeing where they agree and where they differ. Both programs give you a choice of answering questions in a friendly interview format or just entering information directly into tax forms and worksheets. Both programs strongly prefer that you follow the interview process. I’ve already run into one form in TurboTax that refuses to do any calculations and forces you to override every blank line in order to fill in numbers yourself. But if you do the interview for that form, then TurboTax is willing to fill in the form itself. TaxCut hates forms entry so much that you’re not even allowed to save your tax return while you’re entering information into a form.

Both programs present the same black box to the user if you try to figure out why the software is filling in particular numbers. TurboTax used to have a “show data source” feature which would let you trace back where a number on a tax form came from, but they decided to remove that feature a few years ago. (Bob Meighan, a VP at Intuit, says that nobody complained when they removed it, but they also removed any way for users to provide feedback.) If you select “override” for a number in TaxCut, the program then gives you four choices: Entry Info, Itemize, Goes To, and Comes From. The “Comes From” option sounds promising, but only tells you where the number came from if it was carried over from another form. For almost all lines where it should show you how the number was calculated or what worksheet the number came from, TaxCut says “This value is carried over or calculated based on the following (This entry is not carried here from another form)”. The “Goes To” option says “This entry is not carried to another form” and leads off with “Dummy”. Gee, sorry for asking.

I’m in the intensive tax period where I spend almost every waking minute on taxes for several days straight. I turned down joining a full-day Diplomacy game recently because I tend to think that I can’t focus on a game for that length of time, but it can’t really be harder than this annual Tax Game invitational. January is the collectible card game phase when I trade 1099-INTs, 1099-MISCs, 1098s, and W-2s, and occasionally find the rare MA 1099-HC. Now I’m wandering the maze of twisty little tax forms, all alike. And I’m pretty sure that if TaxCut calls me a dummy one more time, one of us is going to be killed by a grue.

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