For many taxpayers, the drudgery of putting together a list of medical expenses is a waste of time. After all, you can only deduct medical expenses that exceed 7.5% of your adjusted gross income (AGI), which eliminates the possibility of a deduction for many. For example, if your AGI is $80,000, only medical expenses in excess of $6,000 would be deductible.

In addition, if you are employed and participate in your employer’s “cafeteria plan,” you may be setting aside, on a pre-tax basis, money from every paycheck to reimburse you for certain out-of-pocket medical expenses. This is smart financial planning, but since that deferral is pre-tax, the amount deferred is not eligible for consideration as a potentially deductible medical expense.

On the other hand, if you don’t participate in a cafeteria plan or if your medical expenses become substantial enough relative to your income, you might become eligible to claim an itemized deduction for medical costs.

Not all medical expenses qualify for deduction, although the common ones of health insurance, prescription drugs, doctors and dentists, eyeglasses, hospital costs, etc. certainly do qualify. Expenses not qualifying include over-the-counter drugs and health club dues (with some exceptions).

Qualified medical expenses you incur for yourself, your spouse or your dependent children may be deductible, but what about medical expenses you pay for someone who is not your dependent, such as an elderly parent or a married child who files a joint tax return with their spouse?

Fortunately, you can still deduct medical expenses you pay for someone who could be claimed as a dependent (such as a child or parent), but whom you actually cannot claim as a dependent due to their income being too high or because they file a joint return with their spouse.

If you are already helping your elderly parents or non-dependent adult children with their medical costs, then this is simply a reminder that you are eligible to include those expenses in your list of potentially deductible medical costs.

On the other hand, suppose your parent has the resources to pay their medical expenses, but really doesn’t benefit from claiming their medical deduction – either because their income is relatively low or because they are taking the standard deduction on their tax return. In that case, you might want to pay your parent’s medical expenses yourself and claim those expenses on your own tax return.

What if you don’t have the resources to pay those expenses, but your parents do? Consider having your parents make non-taxable gifts to you and use the gift money to pay their expenses.

North Carolina Tax Planning

Income tax planning usually focuses on federal taxes, which is logical since the federal rate can climb as high as 35% and federal taxes can be very complicated. However, it would be a mistake to ignore the impact of state income taxes, so we’re going to review the basics of the North Carolina personal income tax and look for any tax-savings opportunities.

The Basics
The NC tax rate begins at 6% and reaches 8% when taxable income reaches $120,000 (for single filers) or $200,000 (for joint filers). North Carolina uses federal taxable income as the starting point in determining your state taxable income but adjusts it with various additions or deductions. Also, while long-term capital gains and qualified dividends are subject to a maximum 15% rate for federal tax purposes, NC does not provide any special tax treatment for them. Therefore, NC taxes paid on capital gains and qualified dividends could equal about half the federal taxes paid on that same income.

Additions
NC taxable income gets increased by items such as:
• If you deducted state income or sales taxes as an itemized deduction on your federal return, they are added back to NC taxable income.

• If you took the standard deduction on your federal return there is also an addition, since the NC standard deduction is lower than the federal.  Also, unlike the federal, the NC standard deduction is not indexed for inflation, so the gap between the two widens every year.

• The NC personal exemption is also lower than the federal one, resulting in another addition to NC taxable income.

• Interest income from a NC municipal bond is free of both federal and NC taxes. However, if you own a municipal bond from another state, its interest income is reportable on your NC return.

Deductions
NC taxable income is reduced by certain items:

• A state income tax refund may be taxed on your federal return, but is not taxed by NC.

• Interest income from U.S. Government obligations, such as U.S. savings bonds, treasury notes, etc., are taxable on your federal return, but not by NC.

• Social Security benefits may be taxable on your federal return, but are not taxable by NC.

• Distributions from certain retirement plans, where the retiree had five or more years of creditable service as of 8/12/1989 are not taxable by NC. The NC Retirement System, the State 401(k) and 457 plans, as well as certain other state or federal plans may also qualify.

• Up to $4,000 in distributions from other public retirement plans or $2,000 from private retirement plans (such as IRAs) are deductible for NC tax purposes.

• Contributions to the NC 529 Plan, up to $2,500 ($5,000 on a joint return), are deductible on your NC return.

• If you claim the Hope or Lifetime Learning tax credit on your federal return, NC allows a deduction of up to $4,000.

Credits
Once your NC tax is calculated, there are a number of credits available that might reduce the final tax amount. Note that some credits phase-out, depending on your income level.

• If you paid income taxes to another state or country on income that is also taxed to NC, then you are eligible to claim a credit on your NC return for those taxes.

• NC has a credit for child-care expenses and also a credit for dependent children.

• If you claim the standard deduction on your federal return, you may claim a tax credit on your NC return for charitable contributions.

• NC has a credit for premiums paid on long-term care insurance policies.

These cover the main additions, deductions and credits for most taxpayers. NC tax is usually small compared with federal tax, but it is not insignificant.
Gerald A. Townsend, CPA/PFS, CFP^®, CFA^® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com

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