Tax Tips : 5 tax myths that can cost you money

We all think we know the parts of the tax code that affect us. But do we really? If you believe some of these myths, you could pay more tax than you should.

Santa Claus. The tooth fairy. Babe Ruth pointing to where he would hit a home run in the 1932 World Series. Someone who knocks on your door, smiles and announces, “I’m from the government, and I’m here to help you.”

Our culture is full of myths. And our tax system is full of myths, half-truths and untruths that can cost you big bucks if you don’t understand the rules.

So, let’s have a look at some of the bigger myths about taxes. If I’ve done my job properly, I’ll show you how they can trap you and how you can save money by separating myth from reality. And if you find you need more help, check the MSN Money site for more information, or consult a tax professional.

Myth 1: Students are exempt.

Lots of people believe there’s an exemption for students that excludes them from tax. Wrong, scholarship breath!

There’s no special tax status afforded to students. They are subject to tax on all their income, regardless of how many credits they’re taking or whether or not they’re fully matriculated.

Students do get special tax credits, the Hope Credit and the Lifetime Learning Credit. In addition, distributions from a Section 529 Plan are now tax-free. But their income is subject to tax, just like the rest of us.

Many a student who works over the summer checks the box “exempt” on her W-4. If she had no taxable income last year and doesn’t expect to have any this year, that’s OK. But let’s say she earns more than $5,350 in 2007 and $5,450 in 2008. And let’s say she is claimed as a dependent on her parents’ return. She will owe tax and penalties if she owes more than $1,000 or actually fails to file. Don’t get caught in this trap.

Myth 2. My child is working. So, I can’t claim him as my dependent.

Again, pure myth. As long as you provide more than half that child’s support (and meet other qualifications such as citizenship and relationship), the child qualifies as your dependent, and you can deduct, for example, all the medical costs you paid for that child.

Remember, support is what’s spent, not what’s earned. So, let’s say your child makes millions as a teenage fashion model. If she banks all the cash and you actually shell out the dough to support her profession, you’ve provided 100% of that child’s support.

You can also qualify for a personal exemption for that child if the child doesn’t earn more than the value of that exemption — $3,400 for 2007 and $3,500 for 2008. This income test doesn’t apply to whether the child qualifies as your dependent, nor does it apply if the child is under age 19 or is a full-time student under age 24.

A child qualifies as a full-time student if, during each of any five months of the calendar year, he or she (a) is in full-time attendance at an educational institution or (b) is taking a full-time course of instructional or farm training.

Myth 3. I’m over age 55, so I can sell my house tax-free.

Wrong again, graybeard! You’re thinking old law.

It used to be that if you were older than 55, you could exclude as much as $125,000 in gains from taxes, but only once. Now the rules are even better.

Under current law, age no longer matters. If the property sold was your principal residence for at least two out of the last five years, then you can exclude from tax as much as $250,000 in gain (and $500,000 on a joint return).

Your age is irrelevant, and you can take the gain exclusion every two years if you qualify. By the same token, if your property appreciates by $250,000 to $500,000 every two years, give me a call. I could use your help in finding a new house.

Myth 4. I can deduct my sales taxes.

This is a funny one. You hadn’t been able to deduct any sales taxes for purchases made for personal use since 1986.

But the deduction has made a comeback of sorts. Starting in 2004 and renewed for returns filed for 2006 and 2007, you can deduct your sales taxes from your taxes or your state income taxes but not both. If you live in seven states — Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming — you just got a nice deduction. You don’t pay income taxes in those states.

Don’t get too chummy with this break if you live in one of those states. Congress will be asked to renew it before the end of 2008. It probably will happen, but, if the last renewal is any guide, it may get hung up in political fights.

Now, what about sales taxes paid on purchases made in the course of business? Easy. If you pay sales tax on an item bought for business and if the item itself would be allowed as a business deduction, then the sales tax on that item would be allowed as well — no matter what.

Myth 5. I’m married, so I have to file a joint return.

Again, not true. If you’re married, you can always file “Married Filing Separately.” That normally results in your paying more in taxes. But in some situations, it can be to your advantage.

For example, if one spouse has substantial medical or miscellaneous deductions, those deductions are subject to the 7.5% and 2% floors respectively. That is, only medical expenses over 7.5% of adjusted gross income and miscellaneous deductions over 2% of adjusted gross income are deductible. If I had $10,000 in income and my spouse had $90,000 in income, the first $7,500 in medical expenses and the first $2,000 in miscellaneous expenses aren’t allowed.

But if I filed as “Married Filing Separately,” the disallowance would only apply to the first $750 in medical expenses and the first $200 in miscellaneous itemized expenses. The potential availability of $8,550 ($7,500 plus $2,000, less the sum of $750 and $200) in additional deductions could offset the bracket and other limitations of filing separately.

Do it both ways, and see which gives you the lowest total tax. You can change your filing status annually.

I should add a caveat on this filing myth. If you’re married, you normally can’t file as single or head of household. But let’s say you’re married but separated, and you have a child. There’s a special rule that will let you file as a head of household.

You can qualify as an “abandoned spouse” if your spouse didn’t live with you for the last six months of the year and you have a child living with you who qualifies as your dependent. If so, you can file as head of household rather than jointly or married filing separately.

Run the numbers and see which produces the lowest tax bill.

Our tax code is complicated and changes with painful regularity. Many of the old rules are remembered and distorted into myths. Don’t get caught in the trap of using the wrong rules. That can cost you big!

Source: 5 tax myths that can cost you money