Understanding Taxes

Death and taxes. There's no escape. When making decisions about taxes, older people need to consider factors such as Social Security, Medicare, investments, and retirement savings.

1. Is it better to invest in a tax-exempt investment than a taxable investment?

2. Is a tax-exempt investment ever taxable?

3. Can states tax the pensions of former residents?

4. Are Social Security benefits taxable?

5. Is it a good idea to receive a large income tax refund each year?

6. Can you take a deduction for an IRA contribution if you already participate in a company retirement plan?

7. Is the interest paid on a home-equity loan always tax deductible?

8. Does everyone have to file a federal income tax return each year?

9. Is a canceled check sufficient proof to claim a tax deduction for a charitable contribution?

10. Is a state tax refund taxable income on your federal return?

1. Is it better to invest in a tax-exempt investment than a taxable investment?
Not always. A tax-exempt investment typically pays less interest than a comparable taxable investment. A taxable investment may actually provide a better return after taxes are taken into account. It all depends on your tax bracket. The higher the tax bracket, the more valuable a tax-exempt investment.

2. Is a tax-exempt investment ever taxable?
Yes. Although the earnings from a tax-exempt investment would not be taxed, you may still incur a tax liability if you profit from the sale of a tax-exempt investment. The resulting capital gain is taxable up to a maximum rate of 28 percent for assets sold before May 7, 1997. Under the new tax law, long-term gains on assets sold after that date will be taxed at a maximum rate of 20 percent.

For gains recognized after July 29, 1997, the new tax law extends the holding period required for long-term capital treatment from 12 to 18 months. Assets held for more than 12 but fewer than 18 months continue to be taxed at the 28 percent rate. Also, income from a tax-exempt investment may be subject to state taxes. Or, the income from the investment may increase the amount of your Social Security benefits that are subject to tax.

3. Can states tax the pensions of former residents?
Not any longer. Congress eliminated the ability of states to impose a "source tax" on former residents. This taxed former residents' pensions that were funded by income they earned while living in that state. So California can no longer tax the pension of a former resident now living in New York.

4. Are Social Security benefits taxable?
It depends on your income. Single retirees with total incomes of $25,000 or more and married couples earning $32,000 or more will pay taxes on at least half their Social Security benefits.

5. Is it a good idea to receive a large income tax refund each year?
No. It amounts to giving the government an interest-free loan. It's also an inefficient means of saving money over the course of the year. By reducing the amount withheld in taxes from a paycheck, individuals can save or invest that extra income and come out ahead.

6. Can you take a deduction for an IRA contribution if you already participate in a company retirement plan?
It depends on your income. You can deduct at least part of your IRA contribution if your adjusted gross income is less than $35,000 for individuals and heads of households and $50,000 for married couples filing jointly. Those limits will eventually be raised to $50,000 for individuals and $80,000 for married couples as a result of the new tax law. To contribute to an IRA, you must have income from a job and be under age 70 1/2.

Beginning in 1998, restrictions will be removed that now prevent an individual who is not actively participating in an employer- sponsored retirement plan, but who is married to someone who is, from making deductible IRA contributions (provided the couple's joint income is less than $150,000).

7. Is the interest paid on a home-equity loan always tax deductible?
For most people it is. But interest paid on a home-equity loan used for personal purposes other than for home improvements is not deductible if you are subject to the alternative minimum tax (AMT). The AMT is designed to ensure that taxpayers don't avoid paying their fair share of taxes by taking too many deductions on their regular income tax return.

8. Does everyone have to file a federal income tax return each year?
It depends on your income and age. A person may not have to file if his or her income is below a certain level. For example, for 1996 tax returns, those limits are $6,550 for single people; $8,450 for heads of households; $11,800 for married couples filing jointly; and $9,250 for qualifying widows and widowers.

For people 65 and older, those limits are even higher. However, even if your income is below these levels, you may have to file a return if you have self-employment earnings over $400, expect a refund, or sold your home.

9. Is a canceled check sufficient proof to claim a tax deduction for a charitable contribution?
Not if a contribution to a single charity is for $250 or more. In that case, you need a receipt from the charity.

10. Is a state tax refund taxable income on your federal return?
Not necessarily. The refund is taxable only if you deducted the state tax payment on your federal return for the previous year. Even if you did deduct it, part of the refund could still be tax free.

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