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Slides by Pamela L. Hall

Western Washington University

Understanding Taxes

Chapter 6

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Introduction

Many Americans don’t understand the tax system (or the forms)

For most people, taxes represent the biggest single expense they have—as much as housing or food

Since you pay (or will pay) so much of your income in taxes, you should understand the tax laws, and what you can/cannot deduct

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What are Taxes?A payment required by a state, local or

federal government of individuals and organizations having property, receiving income, or engaging in various activities Example: Own property, pay property taxes; buy

goods, pay sales taxTaxes are collected by governments to raise

money to cover operating costs and to pay for goods and services (roads, police, parks, etc.) May also be used to influence behavior (i.e., tax

on tobacco products)

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Philosophies of Taxation

Benefits-received philosophy Those who receive the benefits should

pay the costs Example: gasoline taxes go to pay for

highway repairs and new road construction

Ability-to-pay philosophy Those who can afford to pay more

should (on a proportional basis)

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Progressive and Regressive Taxes

Progressive tax requires that those who earn more money pay progressively more in taxes Example: Federal income taxes

With a regressive tax, as income rises the payee pays a smaller percentage (because the tax itself is a fixed amount) Example: gasoline, sales and property

taxes are pre-established percentages

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Average and Marginal Tax Rates

Marginal tax rate is the tax rate applied to the last dollar of earnings Marginal tax rate tells you how much of extra

earnings you’ll get to keep after taxes

Average tax rate represents the total taxes paid divided by the total taxable income

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Types of Taxes Income Taxes (progressive)

Levied by federal government, most state governments, few local governments Federal Income Tax

Federal government gets about 45% of revenues from income taxes

Largest single tax that most Americans pay (average two-wage family pays $5,000/year)

State and Local Income Taxes 41 states have an income tax Income taxes are less important to states as a revenue

source

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Types of Taxes

Social Security and Medicare Taxes Listed on pay stub as FICA (Federal

Insurance Contributions Act) You pay ½ and employer pays other half

15.3% of first $83,500 and 2.9% of wages in excess of that

Can be a significant household expense

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Types of TaxesProperty Taxes

Real estate is the most often taxed property Some states tax automobiles and boats Tax is typically based on the fair market value

of item Tax percentage varies across the U.S.

Sales Taxes 45 states have a sales tax

Tax on the retail prices of goods and services What’s taxable varies across states

Some states provide an exemption for items such as food, medication and medical care

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Types of TaxesExcise Taxes

Tax levied on the consumption/purchase of specific items Gasoline, airline tickets, etc.

State and Local Licensing Fees Hunting/fishing, driving, getting

married/divorced, dog tag, etc.Estate and Gift Taxes

Estate may be subject to federal estate tax Recipient of a gift pays no federal taxes, but

giver may have to pay federal gift tax

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How Much People Pay in Taxes

Average one wage-earner pays $7,700 in taxes per year

Average two wage-earner pays $16,000 in taxes per year

Federal income taxes are the largest amount

Social Security/Medicare taxes are the second

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Figure 6.2: Median Taxes Paid by American Households

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Figure 6.3: Distribution of Taxes Paid by Americans in 2001 (per capita)

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The Federal Income Tax SystemAdministered by the Internal Revenue

Service (IRS)Employs over 100,000 people

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How the IRS Works

Returns are received by 10 service centers across U.S. Clerks sort return (refund vs. owe), input data,

gather/deposit checks, etc. IRS personnel briefly review each return to

weed out outrageous deductions Once data is inputted, information is compared

to that sent in by employers, banks, etc. Computer will ‘spit out’ returns that warrant

further investigation (audit)

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Taxpayer Compliance

Tax Audit Thorough examination of return (specific portion,

such as itemized deductions) or the entire return Generally IRS will not audit a return if it is more

than 3 years since filed An audit can be conducted via correspondence or

in person IRS collects an additional $2,000 per audit on

average About 1% of all returns are audited every year

Depends on your income and complexity of return

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Dealing with the IRSWhat should you do if you receive an automated

adjustment letter or get called in for an audit? DO NOT assume automatically that the IRS is correct You should be ok if you didn’t misrepresent the facts

and you have documentation supporting the choices you made

You have 60 days to respond to an automated adjustment notice

There are avenues of appeal available to you Tax court, federal district court, U.S. Court of Claims

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Commonsense Tips for Dealing with an IRS AuditYou MUST provide documentation for your

claimsAsk questions to make sure you understand

everything—don’t let the auditor bully you Be polite but firm You have the right to stop the audit to prepare

further, but it will simply delay your audit to another date

Never volunteer any additional informationThe IRS settles, on average, for 50% of what it

claims audited taxpayers owed See if you can negotiate reduced taxes or penalties

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Commonsense Tips for Dealing with an IRS Audit You may be asked to sign a Form 870 Waiver, but if

you sign it your rights to future appeals may be limited

If you don’t agree, don’t sign If you get called in for a face-to-face audit, ask for a

correspondence audit if you prefer one You may find it less stressful If you must have a face-to-face audit, do it at the IRS office

If you are found to owe additional taxes that you cannot pay, ask for an installment payment plan

You have the right to have a tax accountant or attorney present during the audit (or to even go in your place)

You also have the right to temporarily stop the audit and consult with your representative in private

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Recent and Proposed Changes to the Federal Tax System Federal tax code is over 10,000 pages long Estimated cost of simply preparing and filling out

forms for federal income taxes is estimated to be $600 billion (total for businesses and individuals)

Some people have proposed a ‘flat tax’ Would no longer be a progressive system, which some

people dislike Would eliminate deductions, which some people dislike

Some have proposed a modified flat tax Some deductions would be retained (such as home

mortgage interest and charitable contributions) Tax rates would rise as income rises Would still simplify tax system

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Recent and Proposed Changes to the Federal Tax SystemStill others like the idea of a complete

elimination of the federal income tax—to be replaced with a national sales tax or value-added tax Supporters argue that it would encourage

people to save because when they spend money they would be taxed

Opponents argue that it would be burdensome to businesses to collect and would be highly regressive

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Preparing a Federal Tax Return

You should learn the rules that apply to you so you can figure out how to legally minimize your taxes

By taking some of the responsibility you an understand the importance of tax planning year round

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Completing Your Tax Return Determine whether you have to file and your filing

status Decide which form to use Adding up your income Subtracting any adjustments Subtracting either the standard or itemized deductions Subtracting personal exemption(s) Calculating your tax liability Subtracting the amount of taxes withheld and other

credits Determining amount of refund or how much extra you

owe

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Determining Whether You Have to File and Filing StatusDon’t have to file if:

Single and earn less than $7,450 Married and earn less than $13,400

These change yearly, so make sure you know the current rules

Filing Status Single Married, filing jointly Married, filing separately Head of household

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Deciding Which Form to UseThree basic forms

1040, AKA long form Everyone can use this form

1040A, AKA short form Taxable income must be less than $50,000 Cannot itemize deductions

1040EZ Must be single or married, filing jointly with no

dependents Taxable income of $50,000 or less No more than $400 in interest income Cannot itemize deductions or claim any adjustments to

income

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Subtracting the Standard Deduction of Your Itemized Deductions

General rule of thumb Itemize only if the itemized deductions

exceed the standard deduction

If you itemize you must use Form 1040 and Schedule A

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Subtracting the Amount of Taxes Withheld and Other Tax Credits

A credit is a dollar for dollar reduction in the amount of taxes owed

Federal income taxes withheld by employer are reported in box 2 on W-2

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Filing Your Tax Return

Generally, return must be filed by April 15th of each year Can obtain an extension by filing Form

4868 by April 15th If you owe taxes you must make a good faith

estimate of the amount owed and send it in along with Form 4868

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Electronic Filing

Many Americans file returns electronically and use software to prepare return

Benefits include Better accuracy Faster refunds Information is sent directly to IRS computers

Some businesses advertise “rapid refunds” Really just short-term loan with very high

interest rate

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Getting Help With Your Taxes Many Americans don’t like to do their own taxes

Too complicated Takes too much time Worried about making an error

Who needs a tax professional Some people who need it don’t get it Many people who don’t need it use it

Generally if you make less than $100,000 a year and have no extraordinary deductions (even if you earn interest and dividend income) you can probably do your own return

Word of caution Different tax advisors may come up with different estimates

of the same tax situation

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Help From the IRS

Invaluable source of information Contact via mail or telephone, local IRS

office, websiteWill not complete form for youGoal is to help you understand so

that in future you can do your own taxes without help

Advice will be conservative Don’t expect “creative” deductions

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Using a Tax Preparation Firm

H&R Block & others Charge an average of $75 If you use one of these firms, you can

probably do your return yourself Many of the employees have little

experience Not as likely to take slightly

questionable (but legal) deductions if they agree to pay penalty charges

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Using a Tax Accountant or Other Specialist May want to use if you have more complex issues

Divorce Own rental property Bought/sold property Have a Home Office, etc.

CPAs are expensive ($175/hour) so have everything organized when you go in to see them

Can legally represent you at a tax hearing Can offer expert advice on how to minimize your taxes—use them

for help throughout the year What records should you be saving as allowable deductions

An enrolled agent is accredited by IRS but not as expensive as a CPA

Many charge a flat rate Can legally represent you at a tax hearing

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Tax Information Sources

Lots of publications available, including Your Federal Income Tax (IRS

Publication No. 17)Lists common deductions that are

overlooked, etc.Free—available at IRS website

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Web Links

IRS Websitehttp://www.irs.ustreas.gov/

Your Federal Income Tax (IRS Publication No. 17)

http://www.irs.gov/pub/irs-pdf/p17.pdf

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Tax Planning

Objective: Pay the absolute minimum in taxes that you legally can (AKA as tax avoidance)

Tax evasion is illegally hiding taxable income or falsely claiming deductions, etc.

Virtually all taxpayers should perform tax planning, although its importance increases with income

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Tax PlanningYou need to periodically review your situation

to make certain that you are not going to owe taxes on April 15th

Could have to pay a penalty You may want to have an additional amount

withheld from your paycheckYou also don’t want to have a huge refund

Your money doesn’t earn interestRemember, tax planning is just that—a plan

Tax tables, deductions, etc. change every year, so your numbers (estimates) may not be entirely accurate

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Some Tax-Saving TipsPay all your deductible state and local taxes

before the end of the year so you can deduct them from this year’s return

Make sure you deduct all home mortgage interest

Consider replacing credit card debt and auto loans with a home equity loan as interest is tax deductible

Deduct legitimate medical expenses ‘Normal’ medical expenses, plus cosmetic surgery,

treatment for addictions, special equipment

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Some Tax-Saving TipsDeduct for casualty and theft losses

Amount that exceeds 10% of AGI + $100 per loss

Contribute as much as you can to your retirement plan

Don’t overlook miscellaneous deductions Tax preparation fees, work uniforms, union

dues, subscriptions to professional publications, professional organizational memberships, etc.

Don’t be afraid to challenge a property tax bill