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 “Only the little people pay taxes.” – Leona Helmsley, Hotel Owner, Fashion Designer, Prison Inmate

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 …

1

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 2

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

3

Fifth Type of “Tax”

  Social Security “Taxes”  6.20% of Gross Salary Medicare “Taxes”  1.45% of Gross Salary

For 2011 and the first 2 months of 2012, there is a 2% reduction in Social Security and Medicare contributions.

 If self-

un

employed, 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.”

4

Effect of Taxes

Or “

How Much Does It Really Cost?”

Price of Stereo California State Sales Tax – 7.75% $299.00

23.17

Subtotal – “Out of Pocket”: $322.17

5 Federal Income Tax – 25% $133.46

California State Income Tax – 7% 37.37

Subtotal – Income Taxes: $170.83

Total – “Out of Pocket” & Taxes: $493.00

And what if we add in Social Security?

$533.84

Let’s calculate how much it really costs

6

“Out of Pocket” Expense Actual Expense= ——————————— ( 1 – Marginal Tax Rate) $322.17

$533.84 = ————————————— ( 1 – (25% + 7% + 7.65%) )

And you thought I was exaggerating, didn’t you?

Filing Your Federal Income Tax Return

7  Who Must File?

 Single $9,500; Married $19,000; 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

Which Tax Form Should You Use?

1040EZ

 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

Some folks were even eligible to file using the telephone.

IRS got rid of this program.

8

Decide Which Tax Form to Use

(continued)

1040A

 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

1040

 Required to use this form if income is over $100,000 – Must use if you itemize deductions

The 1040A form is just a tad bit easier than the 1040 form. My advice is to always use the 1040 form.

9

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 10

How Long Should You Keep Tax Records?

11  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

But they don’t say

which

records

longer

” records or

how

long   I sez… 

Thanks a lot, guys!

“Keep ‘em forever!”

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.

12

Computing Adjusted Gross Income

Income Adjustments to Income

(line 7 – W2)

Earned Income + Business Income

(line 22)

+ Investment Income, etc.

Total Income

(line 36)

Retirement contributions + Alimony + Student loan expenses, etc.

(lines 37 & 38)

Total Adjustments to Income AGI

Adjusted Gross Income

Total Income – Total Adjustments Form 1040 – Page 1 13

Income Tax Fundamentals



Tax Deductions

– Amount subtracted from AGI to arrive at Taxable Income   

Standard Deductions for 2011

single, $11,600 married,

or

– currently $5,800

Itemized Deductions

– Schedule A (medical expenses, mortgage interest, gifts to charities, property & state taxes) ,

and

Personal Exemptions

– Deductions for you, your spouse & dependents – $3,700 per person for 2011

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).

14

Computing Taxable Income

Adj Gross Inc - Std Deductions - Pers Exemptions Taxable Income

or line 40 line 42 line 43

Adj Gross Income - Itemized Deductions - Personal Exemptions Taxable Income 15   Standard Deduction  $5,800 for singles, $11,600 for married couples Itemized Deductions   Only used if greater than Standard Deduction Deductions reported on Schedule A

(lines 44 & 46)

Taxable Income is then used to compute Tax Form 1040 – Top of Page 2

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%

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)

16 Form 1040 – Top of Page 2

2012 Marginal Tax Rates

Single $0 $8,700 8,700 35,350 35,350 85,650 85,650 178,650 388,350 178,650 388,350 Rate 10% 15% 25% 28% 33% 35% Married $0 $17,400 17,400 70,700 70,700 142,700 142,700 217,450 388,350 217,450 388,350 Rate 10% 15% 25% 28% 33% 35%

These rates are temporary. Traditionally, every few years, Congress monkeys around with the rates. Hence, the last few times they have changed them, they simply made them temporary anticipating that they would be modified later. Plus each year they are adjusted for inflation.

17

2011 Marginal Tax Rates

Single $0 $8,500 8,500 34,500 34,500 83,600 83,600 174,400 379,150 174,400 379,150 Rate 10% 15% 25% 28% 33% 35% Married $0 $17,000 17,000 69,000 69,000 139,350 139,350 212,300 379,150 212,300 379,150 Rate 10% 15% 25% 28% 33% 35%

The percentage rates do not change. The tax brackets are simply adjusted upward according to the inflation rate. The 2010 brackets were lower than the 2011, the 2009 lower than the 2010, etc.

18

Example: Computing Tax Due Using 2012 Marginal Tax Rates

19 Example: You are single with $36,350 of taxable income Single $0 $8,700 8,700 35,350 35,350 85,650 83,600 178,650 388,350 178,650 388,350 Rate 10% 15% 25% 28% 33% 35% Computations $8,700 * 10% ($35,350-8,700) * 15% ($36,350-35,350) * 25% Tax $870.00

$3,997.50

$250.00

Total Tax: $5,117.50

The first $8,700 is taxed at the first marginal rate of 10% Between $8,701 and $35,350 is taxed at the second rate of 15% Any amount over $35,350 (in this case, $36,350 – $35,350 = $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.

The Average Tax Rate

Example: The single taxpayer from the previous slide had $36,350 of taxable income and $5,117.50 of taxes due The

Average Tax Rate

is therefore:

$5,117.50 ÷ $36,350 = 0.14078 ≈ 14.1%

Discussion: Who would win and who would lose with a “Flat Tax?”

20

The 2012 “Marriage Penalty”

Single $0 8,700 $8,700 35,350 35,350 85,650 178,650 388,350 85,650 178,650 388,350 Married $0 $17,400 17,400 70,700 70,700 142,700 217,450 388,350 142,700 217,450 388,350 Rate 10% 15% 25% 28% 33% 35% Rate 10% 15% 25% 28% 33% 35%

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 has extended it several times, the last time until the end of 2012.

21

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 22

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

line 46 - line 54 line 55

23 Form 1040 – Upper middle portion of Page 2

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 Taxes

A tax credit is worth more than a tax deduction.

24

Other Taxes

(Wait! There might be more!)

   

Self-employment Taxes

– Social Security & Medicare taxes on the self-

un

employed Social Security & Medicare taxes on tips Penalty Taxes on retirement and medical savings account withdrawals Household employment taxes 25 Taxes After Credits + Other Taxes Total Taxes Due Form 1040 – Middle of Page 2

line 55 + line 56-60 line 61

Making Tax Payments - Withholding

W-2 Form 26

1 Control number 3 Employer's Identification number 2 Employer's name, address, and ZIP code Information Data, Inc.

9834 Collins Blvd.

Benton, NJ 08734 4 Employer's State number Copy B to be filed with employee's FEDERAL tax return W-2 Wage and Tax Statement This information is being furnished to the Internal Revenue Service 5 Statutory De- Legal 942 Sub- Void Employee ceased rep. emp. total 8 Employee's social sec. number



Determine tax withheld 9 Federal Income tax withheld 10 Wages, tips, other comp 123-45-6789 2,678.93

23,972.09

12 Employee's name, address, and ZIP code Barbara Victor 124 Harper Lane Parmont, NJ 07819 16 13 Social security wages 23,972.09

11 Soc sec tax withheld 1,725.99

14 Social security tips 16a Fr ben. incl in Box 10 17 State income tax 20 Local income tax Department of the Treasury Internal Revenue Service OMB No. 1545-0008 16-0331690 18 St wages, tips, etc 21 Loc wgs, tips, etc 19 Name of State 22 Name of locality

Payments

(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 27 Total Taxes Due Payments Overpaid

or

Amount You Owe Form 1040 – Bottom of Page 2

line 61 - line 72 ִ ִ line 73 or 76

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

28

“Uh, Oh!”

If you find you have made a mistake, should you…

29 A.

B.

C.

D.

Leave The Country?

Commit Suicide?

Pretend It Didn’t Happen?

File Form 1040X?

The correct answer is (D). File Form 1040X.

And Don’t Forget the State of CA

30  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)

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 31

Tax Information Sources

(continued)

 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 32

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.

Tax Information Sources

(continued)

 Tax preparation services  Tax Preparers, Enrolled Agents (government 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

The IRS has created a registration and testing process for tax preparers.

33

34

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 for minor questions Office audit takes place at an IRS office Field 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

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 35

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)

Tax-Planning Strategies

(continued)

 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)

36

Tax-Planning Strategies

(continued)

    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) Let’s look at some home and business tax-planning examples…

37

Home Ownership Example 1

2012 Taxes With No Home Deduction

Adjusted Gross Income Standard Deduction Subtotal: Personal Exemptions Taxable Income: Taxes

with no

Home Deduction: Single $50,000 5,800 44,200 3,700 40,500 Married $50,000 11,600 38,400 7,400 31,000 $6,155 $3,780 38

Home Ownership Example 1

(continued)

Itemized Deductions from Home Ownership

State Income Tax

Real Estate Property Tax

DMV Property Tax

Mortgage Interest ($288,000*5%)

Gifts to Charity Total Itemized Deductions: Deduction $1,000

2,900

200

14,400

500 $19,000 39

Home Ownership Example 1

(continued)

2012 Taxes With Home Deduction

Adjusted Gross Income

Itemized Deductions

Subtotal: Personal Exemptions Taxable Income: Taxes

with

Home Deduction: Single $50,000

19,000

31,000 3,700 27,300 Married $50,000

19,000

31,000 7,400 23,600 $3,660 $2,670 40

Home Ownership Example 1

(continued)

Tax Savings for $50,000 Incomes

Without Home Deduction With Home Deduction Tax Savings: Single $6,155 3,660 $2,495 Married $3,780 2,670 $1,110 41

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.

Home Ownership Example 2

2012 Taxes With No Home Deduction

Adjusted Gross Income Standard Deduction Subtotal: Personal Exemptions Taxable Income: Tax

with no

Home Deduction: Single $80,000 5,800 74,200 3,700 70,500 Married $80,000 11,600 68,400 7,400 61,000 $13,655 $8,280 42

Home Ownership Example 2

(continued)

Itemized Deductions from Home Ownership

State Income Tax

Real Estate Property Tax

DMV Property Tax

Mortgage Interest ($576,000*5%)

Gifts to Charity Total Itemized Deductions: Deduction $2,000

5,000

400

28,800

800 $37,000 43

Home Ownership Example 2

(continued)

44

2012 Taxes With Home Deduction

Adjusted Gross Income

Itemized Deductions

Subtotal: Personal Exemptions Taxable Income: Taxes

with

Home Deduction: Single $80,000

37,000

43,000 3,700 39,300 Married $80,000

37,000

43,000 7,400 35,600 $5,855 $4,470

Home Ownership Example 2

(continued)

45

Tax Savings for $80,000 Incomes

Without Home Deduction With Home Deduction Tax Savings: Single $13,655 5,855 $7,800 Married $8,280 4,470 $3,810

Once your income reaches the middle to upper-middle class level, a home is normally a very good tax shelter.

Home Business Example



Remember that $299 stereo that cost us $539? 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?

46

“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 47

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 …) 48