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Gain insights into the complex world of taxes. Understand the philosophies, rates, types, and how taxation impacts your life. Learn about IRS workings, taxpayer compliance, audits, and essential tips for dealing with tax matters.
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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 6.3: 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