What Your 2007 Tax Return Is Telling You

Thank goodness tax season is over for another year. It's tempting to just send in your return, put a copy in the drawer, and forget about taxes until next April. But while taxes are fresh on your mind, try taking a proactive look at your return to see if you can learn anything about what you can do this year to make the next tax season a little more palatable.

Focus your attention on the following.

Line 7: Wages, Salaries, Tips, Etc.

Compare 2007's wages to the prior year's. If you see an increasing trend, give yourself a pat on the back. If your wages have been flat or declining, maybe it's time to ask for a raise or potentially look for a job where your skills would be appreciated through greater monetary reward. After all, inflation is on the rise. That means that even if your salary stays even, you'll still fall behind once you factor in higher food and gas costs.

Line 7 may also lead you back to your W-2 for the year, which will show if you maximized your retirement-plan contributions. The maximum for 2007 was $15,500 for a 401(k) ($20,500 if you're over age 50), and those limits will remain in place for 2008 as well. By increasing your retirement-plan contribution, you will lower the amount in Line 7 and Line 37 (adjusted gross income). By lowering your AGI, you may be eligible for more tax-planning opportunities like converting part or all of a traditional IRA to a Roth IRA. (A conversion is only available if AGI is less than $100,000.)

Lines 8a and 8b: Taxable and Tax-Exempt Interest

Historically, the rule of thumb was that if you were in the 28% marginal tax bracket or higher, you should be looking at municipal securities, which are exempt from federal and in some cases state taxes, as a means of reducing taxable income. But for a variety of reasons, munis have been depressed of late, making their yields attractive even to investors in lower tax brackets. (Bond prices are inversely related to yield.) You can invest in tax-exempt money markets, and your bond investments can also be tax-exempt. Take a closer look at Schedule B to see exactly which investment vehicles are contributing taxable interest and consider repositioning your portfolio this year to put more emphasis on tax-exempt investments. Use Morningstar's Bond Calculator to help you in this process, and check out our list of Fund Analyst Picks for specific muni-fund ideas.

Line 13: Capital Gain (or Loss)

If you had capital gains in 2007, it generally means your portfolio did well and you took some of that profit. So give yourself a round of applause, because it wasn't a great year for U.S. stocks. (International stocks did much better, and many international funds dished out big capital gains payouts.) If you had capital gains in 2007 and didn't offset those gains by realizing losses elsewhere in your portfolio, you may need to plan better this year. You can net out an unlimited amount of capital gains and losses in a year. Typically you should look at where you stand with realized capital gains and losses in the fourth quarter and see if you need to do any "tax harvesting" (offsetting gains with losses to lower your taxable net gains) before year-end. If you own mutual funds in your taxable account, consider tax-managed funds, which strive to limit capital gains payouts.

If you see losses of $3,000 on Line 13, it may mean that you have capital loss carryforwards from Schedule D. Instead of feeling bad about losing money on your investments, try to look at these losses as a silver lining. When your portfolio generates gains in the future (think positively!), you'll be able to take those profits and net out at least a portion of the taxable gains thanks to those loss carryforwards.

Line 28: Self-Employed SEP, SIMPLE, and Qualified Plans

If you are self-employed and you didn't take the $45,000 maximum deduction for 2007, talk to your accountant about how you can increase that number for 2008. (The maximum deduction this year is $46,000.)

Line 37: Adjusted Gross Income

AGI determines whether you'll lose any itemized deductions or exemptions, whether you can contribute to or convert to a Roth IRA, and whether you can deduct miscellaneous and/or medical expenses. So it's an important number.

Itemized Deductions

If you had more than $10,700 in deductions in 2007 (the standard deduction for married taxpayers filing jointly; it's $5,350 for single taxpayers), you probably filed a Schedule A to itemize each deduction. Married couples filing jointly who had AGI of more than $156,400 in 2007 ($78,200 for married filing separately) started to lose these itemized deductions. For each dollar you're over that threshold, you lose a portion of your deductions.

For 2008 planning purposes, the standard deduction for married taxpayers filing jointly will be $10,900 ($5,450 for singles). The phase-out point will be $159,950 ($79,975 for married couples filing separately).

Personal Exemptions

The personal exemption amount for 2007 was $3,400 per person. That increases to $3,500 in 2008. If your 2007 AGI was over $234,600 (married filing jointly; the amount is $156,400 for singles), you lost 2% of your exemption for each $2,500 you are over the limit. (The limit is $1,250 for married couples filing separately.) The good news is that these phase-outs were reduced by one third in 2006 and 2007, and will be reduced by two thirds for 2008 and 2009--a phase out of the phase out. (Can someone pass the aspirin?)

For 2008 planning purposes, the threshold for married taxpayers filing jointly will be $239,950 ($159,950 for singles).

Medical Deductions

In order to take medical deductions, they have to exceed 7.5% of AGI.

Miscellaneous Deductions

You can deduct miscellaneous deductions as long as they total to more than 2% of AGI.

Roth IRA Contributions

If AGI was more than $166,000 in 2007 (for married couples filing jointly; that figure is $114,000 for singles), you are not eligible to contribute to a Roth IRA. For 2008, the Roth income limit increases to $169,000 for married couples filing jointly and $116,000 for singles. (The same is not true of contributions to a Roth 401(k), which has no income limitations.) If AGI in 2008 is between $159,000 and $169,000 for married couples, there is a phase-out of how much you can contribute to a Roth. (That range is $101,000 to $116,000 for singles.)

Roth Conversions

If AGI is over $100,000, you can't covert a traditional IRA to a Roth IRA. That's scheduled to change in 2010; not only will you be able to make a conversion regardless of income level, but you'll be able to spread the tax hit over 2011 and 2012.

Lines 43: (Taxable Income) and 63: (Total Tax)

Divide Line 63 by Line 43 and you'll calculate your "effective" tax bracket. This is the true measure of how much of your income you're giving up in tax.

The U.S. 1040 Federal Tax Return can be one of the most important sources of good information to use in many types of personal finance planning. So it pays to take some time to analyze those numbers.