Understanding Taxes

Understanding Taxes Chapter 6

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

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 tax • Taxes 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)

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)

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

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

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

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

Types of Taxes • Property 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

Types of Taxes • Excise 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

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

Figure 6.2: Median Taxes Paid by American Households

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

The Federal Income Tax System • Administered by the Internal Revenue Service (IRS) • Employs over 100,000 people

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)

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

Dealing with the IRS • What 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

Commonsense Tips for Dealing with an IRS Audit • You MUST provide documentation for your claims • Ask 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 information • The IRS settles, on average, for 50% of what it claims audited taxpayers owed • See if you can negotiate reduced taxes or penalties

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

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

Recent and Proposed Changes to the Federal Tax System • Still 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

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

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

Determining Whether You Have to File and Filing Status • Don’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

Deciding Which Form to Use • Three 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

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

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

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

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

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

Help From the IRS • Invaluable source of information • Contact via mail or telephone, local IRS office, website • Will not complete form for you • Goal 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

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

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

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

Web Links • IRS Website • http://www.irs.ustreas.gov/ • Your Federal Income Tax (IRS Publication No. 17) • http://www.irs.gov/pub/irs-pdf/p17.pdf

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

Tax Planning • You 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 paycheck • You also don’t want to have a huge refund • Your money doesn’t earn interest • Remember, tax planning is just that—a plan • Tax tables, deductions, etc. change every year, so your numbers (estimates) may not be entirely accurate

Some Tax-Saving Tips • Pay 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

Some Tax-Saving Tips • Deduct 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

Understanding Taxes