Taxes are an everyday financial fact of life. You pay some taxes every time you get a paycheck or make a purchase. However, most people concern themselves with taxes only in April. With about one-third of each dollar you earn going for taxes, an effective tax strategy is vital for successful financial planning. Understanding tax rules and regulations can help you reduce your tax liability.
To help you cope with these taxes, common goals related to tax planning include
Knowing the current tax laws and regulations that affect you.
Maintaining complete and appropriate tax records.
Making purchase and investment decisions that can reduce your tax liability.
The principal purpose of taxes is to finance government activities. As citizens, we expect government to provide services such as police and fire protection, schools, road maintenance, parks and libraries, and safety inspection of food, drugs, and other products.
Most people pay taxes in four major categories: taxes on purchases, taxes on property, taxes on wealth, and taxes on earnings.
Taxes on Purchases-you probably pay sales tax on many of your purchases. This state and local tax is added to the purchase prices of products. Many states exempt food and drugs from sales tax to reduce the economic burden of this tax on the poor. In recent years, all but five states (Alaska, Delaware, Montana, New Hampshire, and Oregon) have had a general sales tax.
An excise tax is imposed by the federal and state governments on specific goods and services, such as gasoline, cigarettes, alcoholic beverages, tires, air travel, and telephone service.
Taxes on Property-real estate property tax is a major source of revenue for local governments. This tax is based on the value of land and buildings. The increasing amount of real estate property taxes is a major concern of homeowners. Retired people with limited pension incomes may encounter financial difficulties if local property taxes increase rapidly.
Some areas also impose personal property taxes. State and local governments may assess taxes on the value of automobiles, boats, furniture, and farm equipment.
Taxes on Wealth-an estate tax is imposed on the value of a person's property at the time of his or her death. This federal tax is based on the fair market value of the deceased individual's investments, property, and bank accounts less allowable deductions and other taxes.
Money and property passed on to heirs may also be subject to a state tax. An inheritance tax is levied on the value of property bequeathed by a deceased person. This tax is paid for the right to acquire the inherited property.
Individuals are allowed to give money or items valued at $10,000 or less in a year to a person without being subject to taxes. Gift amounts greater than $10,000 are subject to federal tax. Amounts given for the payment of tuition or medical expenses are not subject to federal gift taxes. Some states impose a gift tax on amounts that a person, before his or her death, transfers to another person since the action may have been intended to avoid estate and inheritance taxes.
Each year, millions of Americans are required to pay their share of income taxes to the federal government. The process involves computing taxable income, determining the amount of income tax owed, and comparing this amount with the income tax payments withheld or made during the year.
Step 1: Determining Adjusted Gross Income
Taxable income is the net amount of income, after allowable deductions, on which income tax is computed.
Types of Income Most, but not all, income is subject to taxation. Your gross, or total, income can consist of three main components:
Earned income is money received for personal effort. Earned income is usually in the form of wages, salary, commission, fees, tips, or bonuses.
Investment income (sometimes referred to as portfolio income) is money received in the form of dividends, interest, or rent from investments.
Passive income results from business activities in which you do not actively participate, such as a limited partnership.
Total income is also affected by exclusions. An exclusion is an amount not included in gross income. For example, the foreign income exclusion allows U.S. citizens working and living in another country to exclude a certain portion ($74,000) of their incomes from federal income taxes.
Exclusions are also referred to as tax-exempt income, or income that is not subject to tax. For example, interest earned on most state and city bonds is exempt from federal income tax.
Tax-deferred income is income that will be taxed at a later date. The earnings on an individual retirement account (IRA) are an example of tax-deferred income. While these earnings are credited to the account now, you do not pay taxes on them until you withdraw them from the account.
Deductions. A tax deduction is an amount subtracted from adjusted gross income to arrive at taxable income. Every taxpayer receives at least the standard deduction, a set amount on which no taxes are paid. Blind people and individuals 65 and older receive higher standard deductions.
Many people qualify for more than the standard deduction. Itemized deductions are expenses a taxpayer is allowed to deduct from adjusted gross income. Common itemized deductions include the following:
Medical and dental expenses, including doctors' fees, prescription medications, hospital expenses, medical insurance premiums, hearing aids, eyeglasses, and medical travel that has not been reimbursed or paid by others.
Taxes-state and local income tax, real estate property tax, and state or local personal property tax.
Interest-mortgage interest, home equity loan interest, and investment interest expense up to an amount equal to investment income.
Contributions of cash or property to qualified charitable organizations. Contribution totals greater than 20 percent of adjusted gross income are subject to limitations.
Casualty and theft losses-financial losses resulting from natural disasters, accidents, or unlawful acts. Deductions are for the amount exceeding 10 percent of AGI, less $100, for losses not reimbursed by an insurance company or other source. California residents commonly report casualty losses due to earthquake damage.
Moving expenses when a change in residence is associated with a new job that is at least 50 miles farther from your former home than your old main job location.
Step 3: Calculating Taxes Owed-your taxable income is the basis for computing the amount of your income tax. The use of tax rates and the benefits of tax credits are the final phase of the tax computation process.
Taxpayers who benefit from the special treatment given to certain income and receive special deductions may be subject to an additional tax. The alternative minimum tax (AMT) is designed to ensure that those who receive tax breaks also pay their fair share of taxes.
Tax Credits. The tax owed may be reduced by a tax credit, an amount subtracted directly from the amount of taxes owed. One example of a tax credit is the credit given for child care and dependent care expenses. This amount lowers the tax owed by an individual or a couple.
A tax credit differs from a deduction in that a tax credit has a full dollar effect in lowering taxes, whereas a deduction reduces the taxable income on which the tax liability is computed.
Low-income workers can benefit from the earned-income credit (EIC). This federal tax regulation, for working parents with taxable income under a certain amount, can result in a tax credit of more than $2,500. Families that do not earn enough to owe federal income taxes are also eligible for the EIC.
Making Tax Payments
The pay-as-you-go system requires an employer to deduct federal income tax from your pay and send it to the government. The withheld amount is based on the number of exemptions and the expected deductions claimed on the W-4 form.
A copy of the W-2 form is filed with your tax return to document your earnings and the amount you have paid in taxes. The difference between the amount withheld and the tax owed is either the additional amount you must pay or the refund you will receive.
Estimated Payments People with income from savings, investments, independent contracting, royalties, and lump-sum payments from pensions or retirement plans have their earnings reported on Form 1099. People in these situations and others who do not have taxes withheld may be required to make tax payments during the year (April 15, June 15, September 15, and January 15 as the last payment for the previous tax year).
Deadlines and Penalties-most people are required to file their federal income tax return each April 15. If you are not able to file on time, you can use Form 4868 to obtain an automatic four-month extension. This extension is for the 1040 form and other documents, but it does not delay your payment liability.
Every citizen or resident of the United States and every U.S. citizen who is a resident of Puerto Rico is required to file a federal income tax return if his or her income is above a certain amount. The amount is based on the person's filing status and other factors such as age. For example, single persons under 65 had to file a return on April 15, 2000 (for tax year 1999), if their gross income exceeded $7,050; single persons over 65 had to file if their gross income exceeded $8,100. The amount at which you are required to file will change each year based on changes in the standard deduction and in the allowed personal exemptions. If your gross income is less than this amount but taxes were withheld from your earnings, you will need to file a return to obtain a refund.
Your filing status is affected by such factors as marital status and dependents. The five filing status categories are as follows:
Single-never-married, divorced, or legally separated individuals with no dependents.
Married, filing joint return-combines the income of a husband and a wife.
Married, filing separate returns-each spouse is responsible for his or her own tax. Under certain conditions, a married couple can benefit from this filing status.
Head of household-an unmarried individual or a surviving spouse who maintains a household (paying for more than half of the costs) for a child or a dependent relative.
Form 1040X This form is used to amend a previously filed tax return. If you discovered income that was not reported, or if you found additional deductions, you should file Form 1040X to pay the additional tax or obtain a refund.
Publications. The IRS offers hundreds of free booklets and pamphlets. You can obtain these publications at a local IRS office, by mail request, or by a telephone call to the office listed in your tax packet or your local telephone directory. Especially helpful is Your Federal Income Tax (IRS Publication 17).You may obtain IRS publication and tax forms by calling 1-800-TAX-FORM or online at www.irs.gov
Recorded messages. The IRS Tele-Tax system allows you access to about 150 telephone tax tips covering everything from filing requirements to reporting gambling income. Your push-button phone gives you 24-hour-a-day access to this recorded information. Telephone numbers can be found in your tax packet or your telephone directory, or call 1-800-829-4477.
Phone hot line. You can obtain information about specific problems through an IRS-staffed phone line. The appropriate telephone number is listed in your local telephone directory, or call 1-800-829-1040. You are not asked to give your name when you use this service, so your questions are anonymous.
Walk-in service. You can visit your local or district IRS office to obtain assistance with your taxes. More than 500 of these facilities are available to taxpayers. Be aware, however, that information IRS employees provide is not always reliable. Various studies in recent years have reported incorrect answers over 30 percent of the time. You can be held liable for taxes owed even if you based your calculations on information provided by IRS employees.
Tax Publications Each year, several tax guides are published and offered for sale. These publications include J. K. Lasser's Your Income Tax and Consumer Reports Books Guide to Income Tax Preparation. You can purchase them at bookstores, drugstores, or supermarkets or use them at your library.
The Internet As with other personal finance topics, extensive information may be found on the Internet, especially the World Wide Web. The Internal Revenue Service (www.irs.gov) is a good starting point. Personal finance magazines, such as Kiplinger's Personal Finance Magazine and Money, as well as other financial planning information services, offer a variety of tax information. In addition, the websites of companies that sell tax software and tax-related organizations can be useful (see the Financial Planning for Life's Situations box).
Tax services range from local, one-person operations to national firms with thousands of offices, such as H&R Block.
Enrolled agents-government-approved tax experts-prepare returns and provide tax advice. You may contact the National Association of Enrolled Agents at 1-800-424-4339 for information about enrolled agents in your area.
Many accountants offer tax assistance along with other business services. A certified public accountant (CPA) with special training in taxes can help with tax planning and the preparation of your annual tax return.
Attorneys usually do not complete tax returns; however, you can use an attorney's services when you are involved in a tax-related transaction or when you have a difference of opinion with the IRS.
Just under 1.3 percent of all tax filers-about 1.5 million people-are audited each year. While the IRS does not reveal its basis for auditing returns, several indicators are evident. People who claim large or unusual deductions increase their chances of an audit.
Tax advisers suggest including a brief explanation or a copy of receipts for deductions that may be questioned. Individuals with high incomes who report large losses due to tax shelters or partnerships, or who have had their tax returns questioned in the past, may also be targeted for an audit.
Types of Audits
The simplest and most common type of audit is the correspondence audit. This mail inquiry requires you to clarify or document minor questions about your tax return. You usually have 30 days to provide the requested information.
The office audit requires you to visit an IRS office to clarify some aspect of your tax return. This type of audit usually takes an hour or two.
The field audit is more complex. An IRS agent visits you at your home, your business, or the office of your accountant so you have access to records. A field audit may be done to verify whether an individual has an office in the home as claimed.
Your Audit Rights
When you receive an audit notice, you have the right to request time to prepare. Also, you can ask the IRS for clarification of items being questioned. When you are audited, use the following suggestions:
Decide whether you will bring your tax preparer, accountant, or lawyer.
Be on time for your appointment; bring only relevant documents.
Present tax records and receipts in a logical, calm, and confident manner; maintain a positive attitude.
Make sure the information you present is consistent with the tax law.
Keep your answers aimed at the auditor's questions. Answer questions clearly and completely. Be as brief as possible; you can never tell an auditor too little.
If you expect to have the same or a lower tax rate next year, accelerate deductions into the current year. Pay real estate property taxes or make your January mortgage payment in December. Make charitable donations by December 31.
If you expect to have a lower or the same tax rate next year, delay the receipt of income until next year. This means income will be taxed at a lower rate or at a later date.
If you expect to have a higher tax rate next year, consider delaying deductions, since they will have a greater benefit. A $1,000 deduction at 28 percent lowers your taxes $280; at 31 percent, your taxes are lowered $310.
Place of Residence. Owning a home is one of the best tax shelters. Both real estate property taxes and interest on the mortgage are deductible (as itemized deductions) and thus reduce your taxable income.
Consumer Debt. Current tax laws allow homeowners to borrow for consumer purchases. You can deduct interest on loans (of up to $100,000) secured by your primary or secondary home up to the actual dollar amount you have invested in it-the difference between the market value of the home and the amount you owe on it.
A person may also claim a deduction for interest expense on qualified education loans. This deduction is allowed only for interest paid during the first 60 months in which interest payments are required.
Job-Related Expenses
Certain work expenses, such as union dues, some travel and education costs, and business tools, may be included as itemized deductions. Job search expenses are also deductible if you incur them when seeking employment in your current occupational category. Remember, only the portion of these expenses that exceeds 2 percent of adjusted gross income is deductible. Expenses related to finding your first job or obtaining work in a different field are not deductible.
Investment Decisions
Tax-Exempt Investments. Interest income from municipal bonds, which are issued by state and local governments, and other tax-exempt investments is not subject to federal income taxes. While municipal bonds have lower interest rates than other investments, the after-tax income may be higher.
Tax-Deferred Investments. Although, from a tax standpoint, tax-deferred investments, whose income will be taxed at a later date, are less beneficial than tax-exempt investments, they also have financial advantages. According to basic opportunity cost, paying a dollar in the future instead of today gives you the opportunity to invest (or spend) it now. Examples of tax-deferred investments include
Tax-deferred annuities, usually issued by insurance companies.
Series EE U.S. Treasury bonds. Interest on these bonds is exempt from federal income tax if it is used to pay tuition at a college, university, or qualified technical school.
Capital gains, profits from the sale of a capital asset such as stocks, bonds, or real estate, are also tax deferred; you do not have to pay the tax on these profits until the asset is sold. In recent years, long-term capital gains (on investments held more than 18 months) have been taxed at 20 percent.
Short-term capital gains (on investments held for less than 18 months) are taxed as ordinary income. Taxpayers in the 15 percent tax bracket have lower capital gains tax rates for both short-term and long-term investments.
The sale of an investment for less than its purchase price is, of course, a capital loss. Capital losses can be used to offset capital gains and up to $3,000 of ordinary income. Unused capital losses may be carried forward into future years to offset capital gains or ordinary income up to $3,000 per year.
Capital gains of $500,000 on the sale of a home may be excluded by a couple filing a joint return ($250,000 for singles). This exclusion is allowed each time a taxpayer sells or exchanges a principal residence-however, only once every two years.
Self-Employment
Owning your own business has certain tax advantages. Self-employed persons may deduct expenses such as health and life insurance as business costs. However, business owners have to pay self-employment tax (Social Security) in addition to the regular tax rate.
Children's Investments
In past years, parents made investments on their children's behalf and listed the children as owners. This process, known as income shifting, attempted to reduce the taxable income of parents by shifting the ownership of investments to children in lower tax brackets. A child under 14 with investment income of more than $1,300 is taxed at the parent's top rate. For investment income under $1,300, the child receives a deduction of $650 and the next $650 is taxed at his or her own rate, which is probably lower than the parent's rate. This income-shifting restriction does not apply to children 14 and older, so it is possible to take advantage of income shifting with them.
Retirement Plans
Traditional IRA. The contributions to and earnings from these accounts are not taxed until they are withdrawn. A regular IRA deduction is available only to people who do not participate in employer-sponsored retirement plans and have an adjusted gross income under a certain amount.
Roth IRA. The Roth IRA (also called the IRA Plus) allows a $2,000 annual contribution which is not tax deductible; however, the earnings on the account are tax free after five years. The funds from the Roth IRA may be withdrawn before age 591 D2 if the account owner is disabled, for educational expenses, or for the purchase of a first home. Like the regular IRA, the Roth IRA is limited to people with an adjusted gross income under a certain amount.
Education IRA The Education IRA is designed to assist parents in saving for the college education of their children. Once again, the annual contribution (limited to $500) is not tax deductible and is limited to taxpayers with an adjusted gross income under a certain amount. However, as with the Roth IRA, the earnings accumulate tax free.
Keogh Plan If you are self-employed and own your own business, you can establish a Keogh plan. This retirement plan, also called an HR10 plan, may combine a profit-sharing plan and a pension plan of other investments purchased by the employee. In general, with a Keogh, people may contribute 25 percent of their annual income, up to a maximum of $30,000, to this tax-deferred retirement plan.
