Taxes in Your Financial Plan

1
Taxes in Your Financial Plan
CHAPTER 3
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 Bushs 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
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

3
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

4
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 employers 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.
5
Effect of Taxes
Or How Much Does It Really Cost?
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
6
Lets calculate how much it really costs

• Out of Pocket
  Expense
• Actual Expense
• ( 1 Marginal Tax
  Rate)
• 322.92
• 535.08
• ( 1 (25 7 7.65) )

And you thought I was exaggerating, didnt you?
7
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

8
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.
9
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
• Required to use this form if income is over
  100,000 Must use if you itemize deductions

1040
The 1040A form is just a tad bit easier than the
1040 form. My advice is to always use the 1040
form.
10
What Tax Records to Keep

• Current tax forms and instruction booklets
• Social security numbers
• Copy of previous years 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 dont say which records or how long
• Thanks a lot, guys!
• I sez
• Keep em forever!

12
Lets 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.
13
Computing Adjusted Gross Income
(line 7 W2)

• Income Earned Income
• Business Income
• Investment Income, etc.
• Total Income
• Adjustments Retirement contributions
• to Alimony paid
• Income Student loan expenses, etc.
• Total Adjustments to Income
• AGI Total Income Total Adjustments

(line 22)
(line 36)
(lines 37 38)
Adjusted Gross Income
Form 1040 Page 1
14
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).
15
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 Tax

line 40 line 42 line 43
(lines 44 46)
Form 1040 Top of Page 2
16
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
17
2014 Marginal Tax Rates
Single 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 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.
18
2013 Marginal Tax Rates
Single Single 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 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 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.
20
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?
21
The Marriage Penalty
Single 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 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
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.
22
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 1960s, 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

23
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
Form 1040 Upper middle portion of Page 2
24
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.
25
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

line 55 line 56-60 line 61
Form 1040 Middle of Page 2
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W-2 Form

• Determine tax withheld

Making 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 Payments
• Overpaid or Amount You Owe

line 61 - line 72? ? line 73 or 76
Form 1040 Bottom of Page 2
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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
29
Uh, Oh!

• If you find you have made a mistake, should you
  
• Leave The Country?
• Commit Suicide?
• Pretend It Didnt Happen?
• File Form 1040X?

The correct answer is (D). File Form 1040X.
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And Dont Forget the State of CA

• Once the Federal 1040 is finished, you get to
  tackle the State of Californias 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 Lassers Your Income Tax
• The Internet
• www.irs.gov (Very useful especially for
  downloading forms)
• There are literally thousands of tax-related web
  sites

32
Tax Information Sources
(continued)

• Tax preparation software and electronic filing
• Intuits 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

I use TurboTax to check my own numbers and to do
returns for my family and friends. I bought
Tax-Cut (now called HR 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.
33
Tax Information Sources
(continued)

• Tax preparation services
• Tax Preparers, Enrolled Agents (government-approve
  d 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.
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 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
  accountants office (avoid this type at all
  costs!)
• You have audit rights including time to prepare
  for the audit

35
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)
36
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 were 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)

37
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)

Lets look at some home and business tax-planning
examples
38
Home Ownership Example 1
2013 Taxes With No Home Deduction
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
39
Home Ownership Example 1 (continued)
Itemized Deductions from Home Ownership
Deduction
State Income Tax 1,000
Real Estate Property Tax 2,900
DMV Property Tax 200
Mortgage Interest (360,0004) 14,400
Gifts to Charity 500
Total Itemized Deductions 19,000
40
Home Ownership Example 1 (continued)
2013 Taxes With Home Deduction
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
41
Home Ownership Example 1 (continued)
Tax Savings for 50,000 Incomes
Single Married
Without Home Deduction 5,935 3,611
With Home Deduction 3,623 2,591
Tax Savings 2,312 1,020
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.
42
Home Ownership Example 2
2013 Taxes With No Home Deduction
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
43
Home Ownership Example 2 (continued)
Itemized Deductions from Home Ownership
Deduction
State Income Tax 2,000
Real Estate Property Tax 5,000
DMV Property Tax 400
Mortgage Interest (720,0004) 28,800
Gifts to Charity 800
Total Itemized Deductions 37,000
44
Home Ownership Example 2 (continued)
2013 Taxes With Home Deduction
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
45
Home Ownership Example 2 (continued)
Tax Savings for 80,000 Incomes
Single Married
Without Home Deduction 13,435 8,111
With Home Deduction 5,710 4,391
Tax Savings 7,725 3,720
Once your income reaches the middle to
upper-middle class level, a home is normally a
very good tax shelter.
46
Home Business Example

• 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?
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 dont 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

48
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 dont hold your breath )