1 CHAPTER 3 Taxes in Your Financial Plan President Bush’s tax cuts on investment income reduced tax bills by an average of $500,000 on incomes of more than $10 million. (The New York Times) “In this world, nothing is certain but death and taxes.” – Benjamin Franklin, Statesman, Inventor, Author “Only the little people pay taxes.” – Leona Helmsley, Hotel Owner, Fashion Designer, Prison Inmate “Taxes are the price we pay for a civilized society.” – Oliver Wendell Holmes, Jr., Civil War veteran, Supreme Court Judge
C HAPTER 3. Taxes in Your Financial Plan. “In this world, nothing is certain but death and taxes.” – Benjamin Franklin, Statesman, Inventor, Author. “Taxes are the price we pay for a civilized society.” – Oliver Wendell Holmes, Jr., Civil War veteran, Supreme Court Judge. - PowerPoint PPT Presentation
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CHAPTER 3Taxes in Your Financial Plan
President Bush’s tax cuts on investment income reduced tax bills by an average of $500,000 on incomes of more than $10 million. (The New York Times)
It was part of his “Leave No Billionaire Behind” program …
“In this world, nothing is certain but death and taxes.”– Benjamin Franklin, Statesman, Inventor, Author
“Only the little people pay taxes.”– Leona Helmsley, Hotel Owner, Fashion Designer, Prison Inmate
“Taxes are the price we pay for a civilized society.”– Oliver Wendell Holmes, Jr., Civil War veteran, Supreme Court Judge
2
Taxes and Financial Planning About one-third of each dollar you earn goes
to pay taxes (May Day has become Tax Freedom Day)
Understanding tax rules and regulations can help you reduce your tax liability
To help you cope with the many types of taxes you should... Know current tax laws as they affect you Make purchase and investment decisions that
reduce your tax liability (But be careful: Not all tax-advantaged investments are good deals)
Maintain complete tax records
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Four Types of Taxes
Taxes on purchases Sales tax & excise tax
Taxes on property Property tax (on real estate) Personal property tax (DMV)
Taxes on wealth Federal estate tax and gift tax State inheritance tax
Taxes on earnings Income tax
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Fifth Type of “Tax” Social Security “Taxes”
6.20% of Gross Salary Medicare “Taxes”
1.45% of Gross Salary If self-unemployed, almost twice this
amount! The self-employed pay the employer’s portion
as well as their own (They are their own employer)
Social Security and Medicare contributions are not technically taxes but for personal financial planning, it makes sense for us
to think of them as taxes. They are often called “payroll taxes.”
Who Must File? Single $10,000; Married $20,000; etc. But in reality, anyone who earned income and
paid taxes should file (If only to get a refund or to claim the Earned Income Credit!)
There are five filing status categories Single or legally separated Married, filing jointly Married, filing separately Head of household Qualifying widow or widower
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Which Tax Form Should You Use?
Single or married filing jointly, under age 65 and with no dependents
Income consisted of wages, salaries, and tips, and no more than $1,500 of taxable interest
Taxable income is less than $100,000 No adjustments to income (retirement accts) No itemized deductions No income tax credits
1040EZ
Some folks were even eligible to file using the telephone.
IRS got rid of this program.
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Decide Which Tax Form to Use(continued)
Taxable income less than $100,000 Some adjustments to income are allowed Some tax credits are allowed such as the
child care and dependent care credits
Required to use this form if income is over $100,000 – Must use if you itemize deductions
1040A
1040
The 1040A form is just a tad bit easier than the 1040 form. My advice is to always use the 1040 form.
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What Tax Records to Keep
Current tax forms and instruction booklets Social security numbers Copy of previous year’s returns W-2 form from employer 1099 forms (interest, self employment) 1098 (mortgage interest paid) Receipts, documentation Investment & business expense documents
11 How Long Should You Keep Tax Records? The IRS sez…
“3 years from the date the return was due or filed, or,
2 years from the date the tax was paid, whichever is longer”
But then the IRS also sez… “You should keep some records longer” But they don’t say which records or how long Thanks a lot, guys!
I sez… “Keep ‘em forever!”
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Let’s Start on the 1040 Form Income (top half of page 1)
Wages, interest, investments returns, business profit, real estate profit, pension fund income, etc.
Adjustments to Income (bottom half of page 1) Student expenses, retirement contributions, etc.
Adjusted Gross Income (AGI) – (bottom of page 1) Gross income (wages, etc.) minus adjustments to
income (retirement accts, alimony, etc.) Bottom line on front page of Form 1040 and top line on
back page of Form 1040
The AGI is an important number. Many tax items are tied to AGI such as the ability to contribute to retirement accounts
or utilize certain deductions and personal exemptions.
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Computing Adjusted Gross Income
Income Earned Income + Business Income + Investment Income, etc.
Income Tax Fundamentals Tax Deductions – Amount subtracted from AGI
to arrive at Taxable Income Standard Deductions for 2013 – $6,100 single,
$12,200 married, or Itemized Deductions – Schedule A (medical
expenses, mortgage interest, gifts to charities, property & state taxes) , and
Personal Exemptions – Deductions for you, your spouse & dependents – $3,900 per person for 2013
You get to claim the Standard Deduction or the Itemized Deductions. But you can not claim both! This is a great
source of confusion for many people. Everyone gets to claim the Personal Exemptions (unless your AGI is too much).
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Computing Taxable Income Adj Gross Inc or Adj Gross Income- Std Deductions - Itemized Deductions- Pers Exemptions - Personal
Exemptions Taxable Income Taxable Income
Standard Deduction (Tax year 2013) $6,100 for singles, $12,200 for married couples
Itemized Deductions Only used if greater than Standard Deduction Deductions reported on Schedule A
Taxable Income is then used to compute TaxForm 1040 – Top of Page 2
line 40line 42line 43
(lines 44 & 46)
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Computing Tax Due Taxable Income is used to compute Tax
Tax Tables (up to $100,000; for most people) Tax Rate Schedules One of the other methods (Schedule D, etc.)
Marginal Tax Rate – The rate used to calculate the tax due on the next dollar of Taxable Income The rates are 10%, 15%, 25%, 28%, 33%, 35%
The 39.6% rate was reintroduced starting in 2013 Average Tax Rate – Total Tax Due divided by
the Taxable Income (not really very important but good to be aware of − if only to debunk the flat-tax advocates)
Form 1040 – Top of Page 2
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2014 Marginal Tax RatesSingle Rate
$0 $9,075 10%
9,075 36,900 15%
36,900 89,350 25%
89,350 186,350 28%
186,350 405,100 33%
405,100 406,750 35%
406,750 39.6%
Married Rate
$0 $18,150 10%
18,150 73,800 15%
73,800 148,850 25%
148,850 226,850 28%
226,850 405,100 33%
405,100 457,600 35%
457,600 39.6%
The 39.6% rate was reintroduced in 2013 after years of fighting between the two parties. Since 2001, the rates
were temporary. After the “fiscal cliff” fight at the end of 2012, the rates became permanent … until the next clash.
Plus each year they are adjusted for inflation.
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2013 Marginal Tax RatesSingle Rate
$0 $8,925 10%
8,925 36,250 15%
36,250 87,850 25%
87,850 183,250 28%
183,250 398,350 33%
398,350 400,000 35%
400,000 39.6%
Married Rate
$0 $17,850 10%
17,850 72,500 15%
72,500 146,400 25%
146,400 223,050 28%
223,050 398,350 33%
398,350 450,000 35%
450,000 39.6%
The percentage rates do not change. The tax brackets are simply adjusted upward according to the inflation rate. The 2012 brackets were lower than the 2013, the 2011
lower than the 2012, etc.
19 Example: Computing Tax Due Using 2014 Marginal Tax Rates
Example: You are single with $37,900 of taxable income
Single Rate Computations Tax
$0 $9,075 10% $9,075 * 10% $907.50
9,075 36,900 15% ($36,900-9,075) * 15% $4,173.75
36,900 89,350 25% ($37,900-36,900) * 25% $250.00
89,350 186,350 28%
186,350 405,100 33%
405,100 406,750 35%
406,750 39.6% Total Tax: $5,331.25
The first $9,075 is taxed at the first marginal rate of 10%Between $9,075 and $36,900 you are taxed at the second rate of 15%Any amount over $36,900 (in this case, $37,900 – $36,900 = $1,000)
is taxed at the third marginal rate bracket of 25%The next dollar you make is always taxed at your current marginal rate.
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The Average Tax Rate
Example: The single taxpayer from the previous slide had $37,900 of taxable income and $5,331.25 of taxes due
The Average Tax Rate is therefore:
$5,331.25 ÷ $37,900 = 0.14067 ≈ 14.1%
Discussion: Who would win and who would lose with a “Flat Tax?”
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The “Marriage Penalty”
If the marginal rates are higher for single taxpayers, how come we sometimes hear people complain about the so-called “marriage penalty?”
Because the second wage-earner in the family pays their taxes at the highest marginal rate. They do not get to take advantage of the lower tax brackets.
Actually, married couples with only one wage-earner get rewarded, not punished. But, of course, they need more money because they are two.
In 2003, Congress removed the marriage penalty for the first two brackets and extended it several times, making it permanent during the “fiscal cliff” fight of
December 2012 … until the next Congressional tax confrontation.
Single Rate
$0 $9,075 10%
9,075 36,900 15%
36,900 89,350 25%
89,350 186,350 28%
186,350 405,100 33%
405,100 406,750 35%
406,750 39.6%
Married Rate
$0 $18,150 10%
18,150 73,800 15%
73,800 148,850 25%
148,850 226,850 28%
226,850 405,100 33%
405,100 457,600 35%
457,600 39.6%
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The Dreaded AMT! Alternative Minimum Tax – Line 45
Originally meant to make sure everyone who could afford to pay would pay some taxes
Originally targeted to the very wealthy However, the AMT was and is still not indexed to
inflation When it was created in the late 1960’s, $100,000
was a very unusual and substantial income The AMT will continue to affect more and more of
the middle class as wages climb with inflation Especially two-income families
Always talk in Congress about eliminating it But would add over $1.5 trillion to the budget deficit
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Tax Credits (Are you still with us?)
Tax Credit – An amount subtracted directly from the amount of taxes due Foreign tax credits (47) & Education credits (49) Child care credits (48) & Child tax credits (51) Retirement savings contribution credit (50) Energy & Other Credits (52 & 53) Earned Income Credit (Not until line 64a)
Taxes Due - Total Credits
Taxes Due after Credits
Form 1040 – Upper middle portion of Page 2
line 46
- line 54
line 55
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Tax Credit versus Tax Deduction
$100 Tax Credit Reduces your tax by $100 – “dollar for dollar”
$100 Tax Deduction Reduces your tax by the marginal tax bracket
Example – Tax Deduction 25% Tax Bracket $100 * 25% = $25 reduction in Federal taxes $100 * 7% = $7 reduction in California taxes $32 total tax reduction
Never a reduction in Social Security taxesA tax credit is worth more than a tax deduction.
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Other Taxes (Wait! There might be more!)
Self-employment Taxes – Social Security & Medicare taxes on the self-unemployed
Social Security & Medicare taxes on tips Penalty Taxes on retirement and medical
Making Tax Payments - WithholdingMaking Tax Payments - Withholding
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Payments (Relax. We are in the home stretch…)
Withholding – “Pay As You Go” sez the IRS “Forced savings” or “But I like a big tax refund”
means you are giving the Feds a free loan Do your best to estimate tax bill (90%, 100%)
Estimated Payments – Quarterly Self-employed Other income not subject to withholding
Total Taxes Due - Total PaymentsOverpaid or Amount You Owe
Form 1040 – Bottom of Page 2
line 61
- line 72ִִ
line 73 or 76
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How to Avoid Common Filing Errors
Check your arithmetic, twice Attach necessary documentation Put your Social Security number, the tax year
and form number on the check Make your check payable to the United States
Treasury Keep a photocopy of your return Put proper postage on your mailing envelope Finally, check everything again If you need more time, file an extension!
Form 4868
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“Uh, Oh!”If you find you have made a mistake,
should you…
A. Leave The Country?
B. Commit Suicide?
C. Pretend It Didn’t Happen?
D. File Form 1040X?
The correct answer is (D). File Form 1040X.
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And Don’t Forget the State of CA
Once the Federal 1040 is finished, you get to tackle the State of California’s Form 540
Fortunately, it is far less than ½ the work Just Two Forms (usually)
Form 540 Schedule 540CA (California Adjustments)
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Tax Information Sources The IRS has several methods of assistance
Publications and forms 1-800-TAX-FORM Recorded messages 1-800-829-4477 Phone hot line 1-800-829-1040 (much, much better)
Walk-in service at an IRS office New e-mail service (I have been impressed with this!)
Tax publications - JK Lasser’s Your Income Tax
The Internet www.irs.gov (Very useful – especially for downloading forms) There are literally thousands of tax-related web sites
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Tax preparation software and electronic filing Intuit’s TurboTax and other programs will print your
returns for mailing or send them electronically Intuit and many other companies will let you file
using your browser on the Internet Spreadsheets to maintain tax data on various
income and expense categories
(continued)Tax Information Sources
I use TurboTax to check my own numbers and to do returns for my family and friends. I bought Tax-Cut (now called H&R Block At Home) once for $10 just
to check it out. It was bad. For several years, I received a free copy of Tax-Cut in the mail. I never loaded it again. If anyone has any current experience with
Tax-Cut or TaxAct or any of the other competitors to TurboTax, would you please relate your experience to us? It would be very helpful and appreciated.
approved tax experts), Accountants (CPAs) or Tax Attorneys
If your professional tax preparer makes a mistake, you are still responsible for paying the correct amount, plus any interest and penalties
For this reason, it is important to at least understand the forms you are signing and check that the numbers are reasonable
(continued)Tax Information Sources
The IRS has created a registration and testing process for tax preparers.
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Tax Audits Just under 1.0% of all returns are audited Relax! Many are just because of arithmetic errors If you claim large or unusual deductions, you are
more likely to be audited There are three types of audits
Correspondence audit for minor questions Office audit takes place at an IRS office Field audit is the most complex, with an IRS agent
visiting your home, business or accountant’s office (avoid this type at all costs!)
You have audit rights including time to prepare for the audit
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Tax-Planning Strategies Tax Evasion
Illegally not paying all the taxes you owe, such as not reporting all income
Tax Avoidance Legitimate methods to reduce your tax
obligation to your fair share but no more
Americans avoid about $50 billion in taxes annually by hiding money in offshore accounts. As much as $1.6 trillion in North
American wealth is held offshore. (USA Today)
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Put money in tax-deferred investments Tax-deferred annuities (Only after retirement accounts
are funded to the maximum – very high fees) Series EE U.S. Treasury bonds (Yawn) Take advantage of tax-deferred retirement plans
(Now we’re talking!) 401(k), 403(b) plans (Through your employer) Traditional or Roth IRA (Roth is better) Education IRA or 529 plan (Roth is better) Keogh, SEP or SIMPLE IRA if self-employed
Long-term capital gains (Lower rates than income)
(continued)Tax-Planning Strategies
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Tax-Planning Strategies Owning a home is one of the best tax shelters
because you can deduct mortgage loan interest and property taxes when you itemize – This reduces your taxable income (Paid Advertisement from your Friendly Local Real Estate Agent)
Use your home equity line of credit to buy a car or consolidate debt (Careful! More later in Chapter 5)
Use tax-exempt investments, such as municipal bonds (Only after retirement accounts are funded to the maximum unless you are very wealthy)
Start a Business (Not a Hobby)
(continued)
Let’s look at some home and business tax-planning examples…
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Home Ownership Example 1
Single Married
Adjusted Gross Income $50,000 $50,000
Standard Deduction 6,100 12,200
Subtotal: 43,900 37,800
Personal Exemptions 3,900 7,800
Taxable Income: 40,000 30,000
Taxes with no Home Deduction:
$5,935 $3,611
2013 Taxes With No Home Deduction
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Home Ownership Example 1 (continued)
Deduction
State Income Tax $1,000
Real Estate Property Tax 2,900
DMV Property Tax 200
Mortgage Interest ($360,000*4%) 14,400
Gifts to Charity 500
Total Itemized Deductions: $19,000
Itemized Deductions from Home Ownership
40
Home Ownership Example 1 (continued)
Single Married
Adjusted Gross Income $50,000 $50,000
Itemized Deductions 19,000 19,000
Subtotal: 31,000 31,000
Personal Exemptions 3,900 7,800
Taxable Income: 27,100 23,200
Taxes with Home Deduction:
$3,623 $2,591
2013 Taxes With Home Deduction
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Home Ownership Example 1 (continued)
Single Married
Without Home Deduction $5,935 $3,611
With Home Deduction 3,623 2,591
Tax Savings: $2,312 $1,020
Tax Savings for $50,000 Incomes
For married couples buying at the low end of the housing market, the tax savings are not as large as the real estate
agents make them out to be.
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Home Ownership Example 2
Single Married
Adjusted Gross Income $80,000 $80,000
Standard Deduction 6,100 12,200
Subtotal: 73,900 67,800
Personal Exemptions 3,900 7,800
Taxable Income: 70,000 60,000
Tax with no Home Deduction:
$13,435 $8,111
2013 Taxes With No Home Deduction
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Home Ownership Example 2 (continued)
Deduction
State Income Tax $2,000
Real Estate Property Tax 5,000
DMV Property Tax 400
Mortgage Interest ($720,000*4%) 28,800
Gifts to Charity 800
Total Itemized Deductions: $37,000
Itemized Deductions from Home Ownership
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Home Ownership Example 2 (continued)
Single Married
Adjusted Gross Income $80,000 $80,000
Itemized Deductions 37,000 37,000
Subtotal: 43,000 43,000
Personal Exemptions 3,900 7,800
Taxable Income: 39,100 35,200
Taxes with Home Deduction:
$5,710 $4,391
2013 Taxes With Home Deduction
45
Home Ownership Example 2 (continued)
Single Married
Without Home Deduction $13,435 $8,111
With Home Deduction 5,710 4,391
Tax Savings: $7,725 $3,720
Tax Savings for $80,000 Incomes
Once your income reaches the middle to upper-middle class level, a home is normally a very good tax shelter.
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Remember that $299 stereo that cost us $535? Well, if it is a legitimate business expense, then that same $299 stereo costs us just $319! You still have to pay state sales tax unless
you plan to resell it as retail. But you also get to deduct the state sales tax as a business expense.
When could a stereo be a legitimate business expense?
Home Business Example
47
“Donate Your Car! Get A Tax Break!”
An all too familiar spiel we hear from charities these days is that you can donate your car and get a $2,500 tax break In the 25% bracket, a $2,500 deduction is worth $625
Of course, you might only get $50 in cash if you asked the junk man to come and get it
Not a bad deal, eh? Well, no more. The charity must now sell the car and tell
you the actual amount they received for the car However, if you don’t itemize deductions using
Schedule A and instead take the standard deduction, then you can not take the deduction anyway! Many people have been burnt by this tactic
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The Bottom Line “Death & Taxes” Benjamin Franklin
Pay Your Taxes & Quit Complainin’!
“Death, Taxes & Tax Law Changes”
And if we want real tax reform, all we really have to do is require the Senators and Representatives in Congress to do their own tax returns! (But don’t hold your breath …)