A significant change in your salary or other income could have tax implications. Knowing what to look for and what to do in these situations can help you make the most of this change. Keep an eye on your adjusted gross income (AGI) to see how your deductions and credits will be affected. Consider these examples:
- You file as Single. You earn $55,000 per year and you're repaying a student loan. If you get a $2,000 year-end bonus, you lose part of your deduction for student loan interest.
- You're filing Married Filing Jointly. You and your spouse earned $98,000 in 2009. You earned $101,000 for 2010. Because your income now exceeds $100,000, you can't convert a traditional IRA to a Roth IRA.
- You file as Single. Your income increased from $52,000 in 2009 to $59,000 in 2010. You're no longer eligible to claim an education credit.
In some situations, you'll need to take corrective action. For example, you're younger than 50 and you contributed $5,000 (the maximum) to a Roth IRA because you assumed your income would be less than $101,000 for the year. But an unexpected bonus increased your income to $105,000. You'll need to withdraw some of your Roth IRA contribution (plus income or reduced by losses, if any) to avoid the penalty for excess contributions to a Roth IRA.
Decrease in Income
Similarly, a decrease in income could put you in a position to take advantage of tax breaks for which you were previously not eligible. For example, you file as Single, normally make $55,000 per year, and you were covered by your employer's retirement plan. Because of a layoff, you were unemployed for 3 months and your income for the year is now $46,000. You can now deduct some of your traditional IRA contributions that would not have been deductible had you been employed all year.
Timing is Everything
If an increase in income late in the year would adversely affect your tax return, try to defer the income to the following year. For example, you can ask your boss to defer your bonus until the next calendar year. If you're self-employed and you use the cash method of accounting, you can bill in January for work performed in December.
The withholding amount on your W-4 assumes you'll be working for the same salary all year. If your salary goes up or down dramatically and it affects some of your deductions or credits, be sure to adjust your withholding so you don't have an unexpected balance due or unexpectedly large refund come tax time.
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