Number 160, January-February 2005:
2004 Federal Tax Return Tips for Reserve and National Guard Members

BY LT MARC J. SOSS, SC, USNR*

Reservists and members of the National Guard (hereinafter “Reservists”) have two full-time employers: civilian and the federal and/or state government. Their civilian job allows them to provide for family, while their military or National Guard service allows the opportunity to serve and protect the United States and their state. From a tax perspective, both of these affiliations are a trade or business and qualify their expenses as tax deductible.

The following is meant to assist Reservists in filing their 2004 Federal Income Tax Return (Form 1040), to make them aware of available tax credits and deductions, and to lower, to the extent legal, their tax burden. It is important to understand that non-reimbursed expenses incurred while performing duties as a Reservist are tax deductible.

PREPARING YOUR 2004 FEDERAL INCOME TAX RETURN

Your 2004 Federal Income Tax Return must be filed with the Internal Revenue Service on or before April 15, 2005. Extensions for filing are available, especially for those serving in a combat zone. The following will assist you in preparing your 2004 Form 1040 Federal Income Tax Return.

o Filing Status-This section of the return notifies the IRS of the type of taxpayer(s) who is filing the return: single; married filing jointly; married filing separate return; head of a household; or qualifying widow with dependent child.

o Exemptions-This section identifies the number of individuals (single, married couple and dependents) claimed on the return and information about them, including their Social Security number(s) and relationship to you. You may be able to deduct $3,100 for each exemption listed on the return.

o Income-This section provides the IRS with information about your total 2004 income and benefits. It consists of the following: civilian job salary or wages, military remuneration, tips, taxable and tax-exempt interest, capital gains and losses, foreign earned income (exclusion amount applicable), bonus, back pay, dividend income, alimony received, deferred compensation, dependent-care benefits provided by your employer, education expenses reimbursed by your employer, business expense reimbursements, pensions and annuities, rental real-estate income, royalties, business income (S-Corporation, Partnership, Limited Liability Company or Sole Proprietorship), trust income, employer contributions to medical savings accounts, employer-provided vehicles, Social Security benefits, excess salary deferrals, moving expense reimbursements, severance pay, sick pay, and unemployment benefits received.

o Exclusions-If you served in a war zone (qualified hazardous duty area) or were serving in support of the war zone, the combat pay you received is not includable in your W-2 income. Military personnel below the grade of commissioned officer may exclude from gross income all compensation they receive while serving in a combat zone (IRC section 112(a)). For commissioned officers, the exclusion is limited to the maximum enlisted amount of combat-zone pay (IRC section 112(b)). The income exclusion applies to military pay earned for all or any part of the month of their service in a combat zone. It is important to understand that any income (salary-full or partial-and bonuses) received from sources other then the military will not be tax exempt.

The combat-zone income exemption will apply to the following military members: (1) those serving directly inside a combat zone and those who participate in operations within the zone, including the airspace over it; (2) any military pay received by a member who is hospitalized as a result of injuries sustained while serving in a combat zone, subject to a two-year limitation. (The two-year limitation period begins to run on the date of termination of service in the combat zone.); (3) annual leave payments upon discharge from the service to the extent the leave was accrued during any month in any part of which the member served in a combat zone; and (4) a re-enlistment bonus received in a month that the member is outside the combat zone if he/she completed the necessary action for entitlement to the re-enlistment bonus in a month during which they served in the combat zone. To be eligible for the income-tax exclusion, your service branch must certify your entitlement to the military pay exclusion on your Form W-2.

Annual leave payments to enlisted members of the armed forces upon discharge from the service are excluded from gross income to the extent the leave was accrued during any month in any part of which the member served in a combat zone. In addition, a re-enlistment bonus that is earned as a direct result of the completion of actions necessary for its entitlement in a combat zone will be excluded from gross income. This exclusion will apply even if the bonus is received in a month that you are outside the combat zone.

METHODS TO REDUCE TAXABLE INCOME

Individual Retirement Account: Reservists are permitted to participate in an Individual Retirement Account (IRA). This decision is premised upon the fact that the Reservist (not serving more than 90 days of active duty) is not considered covered by U.S. government or state retirement plans. Contributions, to be deductible, are subject to various limitations (filing status and amount of Modified Adjusted Gross Income, AGI). As a result of the limitations, you may be entitled to deduct all, part or none of the contribution based upon your AGI and your employment plans (if any).

If you or your spouse are covered by a pension or profit-sharing plan at your civilian employment, you will only be able to deduct your contributions to an IRA if you meet certain income guidelines. All others may make contributions to an IRA on a non-deductible basis. In addition, deductible IRA contributions up to $3,000 (plus a $500 makeup allowance for those over the age of 50) may be made for each spouse (including a non-income-producing spouse) as long as the combined compensation of both spouses at least equals the contributed amount.

Thrift Savings Plan: Reservists are eligible to make deductible contributions to a Thrift Savings Plan (TSP). You have 60 days from the date you enter the Reserve or Guard to make your initial election. The amount you may contribute is based upon the applicable annual IRC contribution limit, which changes annually. In 2004, the IRS elective deferral limit is $13,000. If you are over 50 years of age you may also make an additional catch-up contribution of $3,000. Those who contribute to the TSP from their basic pay may also contribute from their incentive or special pay (including bonus pay).

DEDUCTIONS

This section lists deductions (standard or itemized) to the income and benefits calculated above.

Standard Deductions: The 2004 standard deduction amounts are as follows: $4,850 for single or married filing separately; $9,700 for married filing jointly or qualified widow; and $7,150 for head of household.

Miscellaneous Deductions: Miscellaneous expenses are grouped into two separate and distinct allowable tax deductions. These deductions phase out at $142,700 for single and joint tax filers and at $71,350 for separate returns filed by a married individual. Itemized deductions may also be reduced by 3 percent of the amount by which the taxpayer's AGI exceeds the income threshold up to a maximum of 80 percent of allowable deductions. The following is a list of the available deductions and their respective limits, if any:

Deductions Not Subject to the 2 Percent Limitation: Gambling losses (up to the amount of winnings); expenses for handicapped individuals; federal estate tax payments; bond premiums; unrecovered cost from a decedent's pension; educator expense ($250 deduction if certain qualifications are met); business expenses (Reservists, performing artists and certain government officials); $2,500 student loan interest deduction (subject to an AGI phase-out of $130,000 for married filing jointly and $65,000 for all others); health savings account deduction; moving expenses; one-half of self-employment tax; real estate taxes; self-employed health insurance deduction; Keogh Retirement Plan, Self-Employed SEP and SIMPLE contribution deduction; alimony payments; penalty on early withdrawal of savings; mortgage interest paid (subject to limitations); state and local income tax or state and local sales tax (actual purchase amount or pursuant to an IRS-created table, which was not created as of the date this article went to print); tuition and fees (maximum deduction of $4,000 if AGI does not exceed $65,000 ($130,000 on a joint return) or $2,000 if AGI is between $65,000 and $80,000 ($130,000 and $160,000 on a joint return); charitable contributions (church, temple, United Charities, etc.); contributions made to your ship, post, Reserve center, or station (if funds are used solely for recreation, amusement or welfare-MWR-of service personnel); and capital loss carryover (up to $3,000, $1,500 if married filing separately, of capital losses).

Civilian Deductions Subject to 2 Percent Limitation: Legal fees; appraisal fees; investment expenses; tax preparation fees; cost of education that improves/maintains job skills; cost of safe deposit box; job-seeking expenses (in the same field as your current job); unreimbursed work-related expenses (subscriptions, union dues, initiation fees, business liability insurance, cost of tools of your trade, cost of safety equipment and clothing); and hobby expenses.

Reservist Deductions Subject to 2 Percent Limitation: Unreimbursed military or National Guard travel expenses (if location is fewer than 100 miles away); commuting to temporary drill site; expenses in excess of Travel Code 3 reimbursements; transportation expense calculation (mileage or actual vehicle operating expenses); lodging not furnished by the military or Guard; out of pocket meals (reduced by 50 percent); uniforms, uniform accessories, and maintenance of uniforms; dues to professional societies; subscriptions to related periodicals; computer expense (subject to limitations); and expenses of representing a national or local military or Guard organization or chapter at meeting(s).

Deductions Subject to 7.5 Percent Limitation: Medical expenses must total at least 7.5 percent of AGI, to be deductible. Deductible expenses include the following: doctor, dentist and chiropractors fees, lab fees, contact lenses and eyeglasses, and medical supplies. Health insurance premiums may be included to reach the deductible limitation unless paid by an employer.

EXCEPTIONS

Business Expense Deduction: Provides eligible Reservists an above-the-line deduction for transportation, meals and lodging expenses (not reimbursed) incurred when traveling more than 100 miles away from home and staying overnight to attend meetings. The deduction amount will be calculated at the maximum travel-rate expense allowed for federal government employees. This deduction benefits all applicable Reservists regardless of whether they itemize on their income tax returns. To receive the deduction, you must complete Form 2106, Employee Business Expenses, or Form 2106-EZ, Unreimbursed Employee Business Expenses. Be sure to include the amount from Form 2106 or Form 2106-EZ on line 24 of Form 1040. Write “RC” and the amount of expense in the space to the left of line 24 on Form 1040.

Withholding Tax Credit: Applicable to Reservists with more than one employer, wages in excess of $87,900, and each employer withholding Social Security tax on your wages. You may claim the excess FICA amount as a credit against any income tax that is owed on your Form 1040.

NON-DEDUCTIBLE EXPENSES

The following is a list of common expenses that are often considered tax deductible and are not: Broker commissions paid in connection with your IRA or other investment property; burial or funeral expenses (including cost of cemetery lot); capital expenses; fees and licenses (automobile, marriage and dog tags); hobby losses; home repairs; insurance; rent; losses from the sale of your home; furniture; personal automobile; personal disability insurance premiums; and personal family expenses.

OTHER TAXES

Alternative Minimum Tax. A separately figured tax that eliminates many deductions and credits, thus increasing tax liability for an individual who would otherwise pay less tax. The exemption amounts are the following: $58,000 for married (filing jointly) and surviving spouses; $40,250 for single or head of household filers; and $29,000 for married (filing separately). The tentative minimum tax rates on ordinary income are 26 percent (on the first $175,000) and 28 percent (excess amount).

Kiddies Tax (Form 8814). This tax applies to unearned income, in excess of $800, of a child under age 14. The child's investment income over $800 will be taxed at the marginal income-tax rate of parent or parents.

Tax Credits consist of the following: Foreign Tax Credit (Form 1116); Credit for Child and Dependent Care Expenses (Form 2441); Credit for the Elderly or Disabled (Schedule R); Child Tax Credit (increased to $1,000 per qualifying child and subject to AGI phase out); Adoption Credit (Form 8839); Mortgage Interest Credit (Home Loan Mortgage Interest up to $1,000,000 and Home Equity Loan Interest up to $100,000, $50,000 if married filing separately); Prior Year Minimum Tax; Qualified Electric Vehicle; and Earned Income Tax Credit (EITC).

Payments include: Federal Income Tax withheld (W-2 and 1099); Estimated tax payments (2004 payments and amounts applied from 2003); Earned income credit; Excess Social Security; Medicare, and RRTA tax withheld; additional child tax credit; and any amounts paid with an extension request.