taxes in your financial plan

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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

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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.”

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Effect of Taxes Price of Stereo $299.00

California State Sales Tax – 8.0% 23.92

Subtotal – “Out of Pocket”: $322.92

Federal Income Tax – 25% $133.77

California State Income Tax – 7% 37.46

Subtotal – Income Taxes: $172.23

Total – “Out of Pocket” & Taxes: $494.15

And what if we add in Social Security? $535.08

Or “How Much Does It Really Cost?”

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Let’s calculate how much it really costs

“Out of Pocket” ExpenseActual Expense= ——————————— ( 1 – Marginal Tax Rate)

$322.92$535.08 = ————————————— ( 1 – (25% + 7% + 7.65%) )

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

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Filing Your Federal Income Tax Return

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.

Total Income

Adjustments Retirement contributionsto + Alimony paidIncome + Student loan expenses, etc.

Total Adjustments to Income

AGI Total Income – Total Adjustments

Form 1040 – Page 1

(line 22)

(line 36)

(lines 37 & 38)

Adjusted Gross Income

(line 7 – W2)

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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

savings account withdrawals Household employment taxes

Taxes After Credits + Other Taxes

Total Taxes Due

Form 1040 – Middle of Page 2

line 55

+ line 56-60

line 61

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Determine tax withheld

W-2 Form

1 Control number 3 Employer's Identification number 4 Employer's State numberCopy B to be filed with

employee's FEDERAL tax return

This information is being furnished to theInternal Revenue Service

5 Statutory De- Legal 942 Sub- Void Employee ceased rep. emp. total

2 Employer's name, address, and ZIP code

8 Employee's social sec. number 9 Federal Income tax withheld 10 Wages, tips, other comp 11 Soc sec tax withheld

12 Employee's name, address, and ZIP code 13 Social security wages 14 Social security tips

16 16a Fr ben. incl in Box 10

17 State income tax 18 St wages, tips, etc 19 Name of State

20 Local income tax 21 Loc wgs, tips, etc 22 Name of localityDepartment of the Treasury Internal Revenue Service OMB No. 1545-000816-0331690

Information Data, Inc.9834 Collins Blvd.Benton, NJ 08734

123-45-6789 2,678.93

W-2 Wage andTax Statement

23,972.09 1,725.99

23,972.09Barbara Victor124 Harper LaneParmont, NJ 07819

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.

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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

(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

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Single Married


Itemized Deductions 19,000 19,000

Subtotal: 31,000 31,000



Taxes with Home Deduction:

$3,623 $2,591

2013 Taxes With Home Deduction

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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


Standard Deduction 6,100 12,200

Subtotal: 73,900 67,800



Tax with no Home Deduction:

$13,435 $8,111

2013 Taxes With No Home Deduction

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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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Single Married


Itemized Deductions 37,000 37,000

Subtotal: 43,000 43,000



Taxes with Home Deduction:

$5,710 $4,391

2013 Taxes With Home Deduction

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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

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“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 …)

taxes in your financial plan

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