Taxes are dues we pay for membership in our society; they’re the cost of living in this country. Federal, state, and local tax receipts fund government activities and a wide variety of public services, from national defense to local libraries. Administering and enforcing federal tax laws is the responsibility of the IRS, a part of the U.S. Department of Treasury. Because federal income tax is generally the largest tax you’ll pay, you are wise to make tax planning an important part of personal financial planning. A typical American family currently pays more than one-third of its gross income in taxes: federal income and Social Security taxes and numerous state and local income, sales, and property taxes. You may think of tax planning as an activity to do between January, when tax forms arrive in the mail, and April 15, the filing deadline, but you should make tax planning a year-round activity. You should always consider tax consequences when preparing and revising your financial plans and making major financial decisions, such as buying a home and making any investment decisions at all. The overriding objective of tax planning is simple: to maximize the amount of money you keep by minimizing the amount of taxes you pay. As long as it’s done honestly and within the tax codes, there is nothing immoral, illegal, or unethical about trying to minimize your tax bill.
Most tax planning focuses on ways to minimize income and estate taxesAlthough you may currently pay little or no taxes, we use a midcareer couple to demonstrate the key aspects of individual taxation. This approach will give you a good understanding of your future tax situation and allow you to develop realistic financial plans. In addition to federal income tax, there are other forms of taxes to contend with. For example, additional federal taxes may be levied on self-employment or outside consulting income and on certain types of transactions. At the state and local levels, sales transactions, income, property ownership, and licenses may be taxed. Because most individuals have to pay many of these other types of taxes, you should evaluate their impact on your financial decisions. Thus, a person saving to purchase a new automobile costing $25,000 should realize that the state and local sales taxes, as well as the cost of license plates and registration, may add another $2,200 or more to the total cost of the car.
Because tax laws are complicated and subject to frequent revision, present key concepts and show how they apply to common tax situations. Provisions of the tax code may change annually for tax rates, amounts and types of deductions and personal exemptions, and similar items. The tax tables, calculations, and sample tax returns presented in this chapter are based on the tax laws applicable to the calendar year 2008. The 2009 tax laws were being finalized at the time this book was being revised. We present the 2008 treatment because in 2009 there was a one-year only financial crisis-related tax credit that is not representative of normal tax treatments. Although tax rates and other provisions will change, the basic procedures will remain the same. Before preparing your tax returns, be sure to review the current regulations; IRS publications and other tax preparation guides may be helpful.
The Economics of Income Taxes
Not surprisingly, most people simply don’t like to pay taxes. Some of this feeling likely stems from the widely held perception that a lot of government spending amounts to little more than bureaucratic waste. But a good deal of this feeling is probably because taxpayers get nothing tangible in return for their money. After all, paying taxes isn’t like spending $7,000 on furniture, a boat, or a European vacation. The fact is, we too often tend to overlook or take for granted the many services provided by the taxes we pay public schools and state colleges, roads and highways, and parks and recreational facilities, not to mention police and fire protection, retirement benefits, and many other health and social services. Income taxes are the major source of revenue for the federal government. Personal income taxes are scaled on progressive rates. To illustrate how this progressive tax structure works, we’ll use the following data for single taxpayers filing 2008 returns:
Because tax laws are complicated and subject to frequent revision, present key concepts and show how they apply to common tax situations. Provisions of the tax code may change annually for tax rates, amounts and types of deductions and personal exemptions, and similar items. The tax tables, calculations, and sample tax returns presented in this chapter are based on the tax laws applicable to the calendar year 2008. The 2009 tax laws were being finalized at the time this book was being revised. We present the 2008 treatment because in 2009 there was a one-year only financial crisis-related tax credit that is not representative of normal tax treatments. Although tax rates and other provisions will change, the basic procedures will remain the same. Before preparing your tax returns, be sure to review the current regulations; IRS publications and other tax preparation guides may be helpful.
The Economics of Income Taxes
Not surprisingly, most people simply don’t like to pay taxes. Some of this feeling likely stems from the widely held perception that a lot of government spending amounts to little more than bureaucratic waste. But a good deal of this feeling is probably because taxpayers get nothing tangible in return for their money. After all, paying taxes isn’t like spending $7,000 on furniture, a boat, or a European vacation. The fact is, we too often tend to overlook or take for granted the many services provided by the taxes we pay public schools and state colleges, roads and highways, and parks and recreational facilities, not to mention police and fire protection, retirement benefits, and many other health and social services. Income taxes are the major source of revenue for the federal government. Personal income taxes are scaled on progressive rates. To illustrate how this progressive tax structure works, we’ll use the following data for single taxpayers filing 2008 returns:
Of course, any nontaxable income can be viewed as being in the 0% tax bracket. As taxable income moves from a lower to a higher bracket, the higher rate applies only to the additional taxable income in that bracket and not to the entire taxable income. For example, consider two single brothers, Will and Robert, whose taxable incomes are $45,000 and $90,000, respectively:
Note that Will pays the 25% rate only on that portion of the $45,000 in taxable income that exceeds $32,550. Due to this kind of progressive scale, the more money you make, the progressively more you pay in taxes: although Robert’s taxable income is twice that of Jason’s, his income tax is about 21⁄2 times higher than his brother’s. The tax rate for each bracket—10%, 15%, 25%, 28%, 33%, and 35%—is called the marginal tax rate, or the rate applied to the next dollar of taxable income. When you relate the tax liability to the level of taxable income earned, the tax rate, called the average tax rate, drops considerably. Will’s average tax rate, calculated by dividing the tax liability by taxable income, is about 16.9% ($7,595/$45,000). Robert’s average tax rate is about 21.31% ($19,179/$90,000). Clearly, taxes are still progressive, and the average size of the bite is not as bad as the stated tax rate might suggest.
Your Filing Status
The taxes you pay depend in part on your filing status, which is based on your marital status and family situation on the last day of your tax year (usually December 31). Filing status affects whether you’re required to file an income tax return, the amount of your standard deduction, and your tax rate. If you have a choice of filing status, you should calculate your taxes both ways and choose the status that results in the lower tax liability.
There are five different filing status categories.
Your Filing Status
The taxes you pay depend in part on your filing status, which is based on your marital status and family situation on the last day of your tax year (usually December 31). Filing status affects whether you’re required to file an income tax return, the amount of your standard deduction, and your tax rate. If you have a choice of filing status, you should calculate your taxes both ways and choose the status that results in the lower tax liability.
There are five different filing status categories.
- Single taxpayers: Unmarried or legally separated from their spouses by either a separation or final divorce decree.
- Married filing jointly: Married couples who combine their income and allowable deductions and file one tax return
- Married filing separately: Each spouse files his or her own return, reporting only his or her income, deductions, and exemptions.
- Head of household: A taxpayer who is unmarried or considered unmarried and pays more than half of the cost of keeping up a home for himself or herself and an eligible dependent child or relative.
- Qualifying widow or widower with dependent child: A person whose spouse died within 2 years of the tax year (for example, in 2006 or 2007 for the 2008 tax year) and who supports a dependent child may use joint return tax rates and is eligible for the highest standard deduction. (After the 2-year period, such a person may file under the head of household status if he or she qualifies.)
The tax brackets (rates) and payments for married couples filing separately are now typically close to the same as for joint filers. However, because the spouses rarely account for equal amounts of taxable income and deductions, in some cases it may be advantageous for spouses to file separate returns. For instance, if one spouse has a moderate income and substantial medical expenses and the other has a low income and no medical expenses, then filing separately may provide a tax savings. It’s worth your time to calculate your taxes using both scenarios to see which results in the lower amount.
Every individual or married couple who earns a specified level of income is required to file a tax return. For example: for those under 65, a single person who earned more than $8,950 and a married couple with a combined income of more than $17,900 must file a tax return (for 2008). Like the personal tax rates, these minimums are adjusted annually based on the annual rate of inflation, and they’re published in the instructions accompanying each year’s tax forms. If your income falls below the current minimum levels, you’re not required to file a tax return. But if you had any income tax withheld during the year, you must file a tax return even if your income falls below minimum filing amounts to receive a refund of the income tax withheld.
Your Take-Home Pay
Although many of us don’t give much thought to taxes until April 15th approaches, we actually pay taxes as we earn income throughout the year. Under this pay-asyou go system, your employer withholds (deducts) a portion of your income every pay period and sends it to the IRS to be credited to your own tax account. Selfemployed persons must also prepay their taxes by forwarding part of their income to the IRS at four dates each year (referred to as quarterly estimated tax payments). The amounts withheld are based on a taxpayer’s estimated tax liability. After the close of the taxable year, you calculate the actual taxes you owe and file your tax return. When you file, you receive full credit for the amount of taxes withheld (including estimated tax payments) from your income during the year and either (1) receive a refund from the IRS (if too much tax was withheld from your paycheck and/or prepaid in estimated taxes) or (2) have to pay additional taxes (if the amount withheld/prepaid didn’t cover your tax liability). Your employer normally withholds funds not only for federal income taxes but also for FICA (Social Security) taxes and, if applicable, state and local income taxes. In addition to taxes, you may have other deductions for items such as life and health insurance, savings plans, retirement programs, professional or union dues, or charitable contributions all of which lower your take-home pay. Your take-home pay is what you’re left with after subtracting the amount withheld from your gross earnings.
Federal Withholding Taxes
The amount of federal withholding taxes deducted from your gross earnings each pay period depends on both the level of your earnings and the number of withholding allowances you have claimed on a form called a W-4, which you must complete for your employer. Withholding allowances reduce the amount of taxes withheld from your income. A taxpayer is entitled to one allowance for himself or herself, one for a nonworking spouse (if filing jointly), and one for each dependent claimed (children or parents being supported mainly by the taxpayers). In addition, you qualify for a special allowance if (1) you’re single and have only one job; (2) you’re married, have only one job, and have a nonworking spouse; or (3) your wages from a second job or your spouse’s wages (or the total of both) are $1,000 or less. Additional withholding allowances can be claimed by (1) heads of households, (2) those with at least $1,500 of child or dependent care expenses for which they plan to claim a credit, and (3) those with an unusually large amount of deductions (mortgage interest, charitable contributions, real estate taxes or state income taxes). Likewise, taxpayers may have to decrease their withholding allowances during the tax year if they get a part-time job, get divorced, have a child who turns 19 years old, and so on. Of course, you can also elect to have your employer withhold amounts greater than those prescribed by the withholding tables.
Your Take-Home Pay
Although many of us don’t give much thought to taxes until April 15th approaches, we actually pay taxes as we earn income throughout the year. Under this pay-asyou go system, your employer withholds (deducts) a portion of your income every pay period and sends it to the IRS to be credited to your own tax account. Selfemployed persons must also prepay their taxes by forwarding part of their income to the IRS at four dates each year (referred to as quarterly estimated tax payments). The amounts withheld are based on a taxpayer’s estimated tax liability. After the close of the taxable year, you calculate the actual taxes you owe and file your tax return. When you file, you receive full credit for the amount of taxes withheld (including estimated tax payments) from your income during the year and either (1) receive a refund from the IRS (if too much tax was withheld from your paycheck and/or prepaid in estimated taxes) or (2) have to pay additional taxes (if the amount withheld/prepaid didn’t cover your tax liability). Your employer normally withholds funds not only for federal income taxes but also for FICA (Social Security) taxes and, if applicable, state and local income taxes. In addition to taxes, you may have other deductions for items such as life and health insurance, savings plans, retirement programs, professional or union dues, or charitable contributions all of which lower your take-home pay. Your take-home pay is what you’re left with after subtracting the amount withheld from your gross earnings.
Federal Withholding Taxes
The amount of federal withholding taxes deducted from your gross earnings each pay period depends on both the level of your earnings and the number of withholding allowances you have claimed on a form called a W-4, which you must complete for your employer. Withholding allowances reduce the amount of taxes withheld from your income. A taxpayer is entitled to one allowance for himself or herself, one for a nonworking spouse (if filing jointly), and one for each dependent claimed (children or parents being supported mainly by the taxpayers). In addition, you qualify for a special allowance if (1) you’re single and have only one job; (2) you’re married, have only one job, and have a nonworking spouse; or (3) your wages from a second job or your spouse’s wages (or the total of both) are $1,000 or less. Additional withholding allowances can be claimed by (1) heads of households, (2) those with at least $1,500 of child or dependent care expenses for which they plan to claim a credit, and (3) those with an unusually large amount of deductions (mortgage interest, charitable contributions, real estate taxes or state income taxes). Likewise, taxpayers may have to decrease their withholding allowances during the tax year if they get a part-time job, get divorced, have a child who turns 19 years old, and so on. Of course, you can also elect to have your employer withhold amounts greater than those prescribed by the withholding tables.
If you know you’ll work less than 8 months during a year for example, if you’re a college graduate starting your first job in the summer then you can ask your employer to calculate withholding using the part-year method. This method calculates withholding on what you actually earn in the tax year, rather than on your annual salary. For example, if you began a $45,000-per-year job on September 1, your withholding would be based not on the entire year’s salary but rather on the $15,000 you’d earn during the rest of that calendar year, resulting in substantially lower withholding.
FICA and Other Withholding Taxes
In addition to income tax withholding on earnings, all employed workers (except certain federal employees) have to pay a combined old-age, survivor’s, disability, and hospital insurance tax under provisions of the Federal Insurance Contributions Act (FICA). Known more commonly as the Social Security tax, it is paid equally by employer and employee. In 2008, the total Social Security tax rate was 15.3%, allocating 12.4% to Social Security and 2.9% to Medicare. The 12.4% applies only to the first $102,000 of an employee’s earnings (this number rises with national average wages), whereas the Medicare component is paid on all earnings. In 2008, the employer and employee each pay 7.65% (i.e., half of the 15.3% rate); self-employed persons pay the full 15.3% tax but can deduct 50% of it on their tax returns. Most states have their own income taxes, which differ from state to state. Somecities assess income taxes as well. These state and local income taxes will also bewithheld from earnings. They are deductible on federal returns, but deductibility offederal taxes on the state or local return depends on state and local laws.
FICA and Other Withholding Taxes
In addition to income tax withholding on earnings, all employed workers (except certain federal employees) have to pay a combined old-age, survivor’s, disability, and hospital insurance tax under provisions of the Federal Insurance Contributions Act (FICA). Known more commonly as the Social Security tax, it is paid equally by employer and employee. In 2008, the total Social Security tax rate was 15.3%, allocating 12.4% to Social Security and 2.9% to Medicare. The 12.4% applies only to the first $102,000 of an employee’s earnings (this number rises with national average wages), whereas the Medicare component is paid on all earnings. In 2008, the employer and employee each pay 7.65% (i.e., half of the 15.3% rate); self-employed persons pay the full 15.3% tax but can deduct 50% of it on their tax returns. Most states have their own income taxes, which differ from state to state. Somecities assess income taxes as well. These state and local income taxes will also bewithheld from earnings. They are deductible on federal returns, but deductibility offederal taxes on the state or local return depends on state and local laws.
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