Income Tax Basics

Dr. Barbara O’Neill, CFP® Rutgers Cooperative Extension

oneill@aesop.rutgers.edu

Webinar Objectives

• Increase participants’ knowledge about income tax filing process

• Provide update of 2014 and 2015 tax law changes

• Provide information about income tax resources

• Help participants save money on income taxes

Question Do you teach about income taxes? If yes, where?

Webinar Topics • Federal income tax rates

• Tax deductions and credits

• Tax filing process

• Tax avoidance vs. tax evasion

• Tax record-keeping

• Common tax errors

• Tax planning resources

2014 Income Tax “Issues” • Impact of incorrect ACA law credits on tax refunds

• Tax identity theft (expanded IRS efforts; 1.6 million affected in early 2013)

– http://www.irs.gov/uac/Newsroom/IRS-Combats-Identity-Theft-and-Refund-Fraud-on-Many-Fronts-2014

– http://www.bostonglobe.com/news/nation/2014/02/16/identity-theft-taxpayer-information-major-problem-for-irs/7SC0BarZMDvy07bbhDXwvN/story.html

• Higher tax bills for wealthy taxpayers due to “backdoor” taxes (e.g., reduced exemptions and itemized deductions)

• Net investment-income tax of 3.8% (higher incomes)

• $500 unused FSA carry-over to 3/15 of next year

Major Type of Taxes in the United States Taxes on Purchases

– Sales tax and excise tax (e.g., gas, cigarettes)

Taxes on Property – Real estate property tax – Personal property tax

Taxes on Wealth – Federal estate tax – State inheritance tax

Taxes on Earnings – Income tax and Social Security/Medicare (FICA) tax

The Progressive Nature of the Federal Income Tax

• Progressive tax – Takes a larger percentage of income from high-income taxpayers than low-income taxpayers.

– Federal income tax

• Regressive tax – Takes a decreasing percentage of income as income increases. – State sales tax

Marginal Tax Rate Is Applied to the Last Dollar Earned

• Marginal Tax Bracket (MTB) – One of six income-range segments that are taxed at increasing rates as income goes up

• Marginal Tax Rate – The tax rate applied to your last dollar of earnings

– Effective Marginal Tax Rate – Describes a person’s true marginal tax rate on income after including federal, state, and local income taxes, as well as FICA tax (Social Security and Medicare); often 40% + for middle-income earners

Federal Marginal Income Tax Rates • Established by Congress and change periodically

• Based on many things including:

• Amount and type of income

• Filing status - e.g. married, joint, single

Marginal rates: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%

• Tax rate on last dollar of income earned

• Beginning in tax year 2013, 39.6% rate was added for highest income individuals

• Rutgers fact sheet: http://njaes.rutgers.edu/money/taxinfo/

Tax Rate Schedules Figure 1. 2014 Tax Rate Schedules Single-Schedule X

Taxable Income Over But Not Over Marginal Tax 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%Head of household-Schedule Z

Taxable Income Over But Not Over Marginal Tax Rate

$0 $12,950 10%

12,950 49,400 15%

49,400 127,550 25%

127,550 206,600 28%

206,600 405,100 33%

405,100 432,200 35%

432,200 --- 39.6%Married filing jointly or Qualifying widow(er) - Schedule Y-1

Taxable Income Over But Not Over Marginal Tax 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%Married filing separately - Schedule Y-2

Taxable Income Over But Not Over Marginal Tax Rate

$0 $9,075 10%

9,075 36,900 15%

36,900 74,425 25%

74,425 113,425 28%

113,425 202,550 33%

202,550 228,800 35%

228,800 --- 39.6%

Single-Schedule X Head of Household-Schedule Z Married Filing Jointly or Qualifying Widow(er) - Schedule Y-1 Married Filing Separately - Schedule Y-2

Average Tax Rate Average tax rate = total tax due divided by

taxable income

Average tax rate < marginal tax rate

Example: – Taxable income = $40,000

– Total tax bill = $6,344

– Average tax rate = 15.9%

» ($6,344 / $40,000)

$100 Tax Credit Reduces Your Taxes by $100

$100 Tax Deduction Amount Your Taxes are Reduced

is Based on Your Tax Bracket Example: $5,000 x .25 (25%tax bracket) = $1,250 of tax savings; $3,750 net cost

Types of Deductions Deduction = Amount subtracted from gross income to reduce the amount of income subject to tax. • Standard Deduction- Amount established each year

by tax code; no need to itemize deductions; amount is based on a taxpayer's filing status, age, etc; no receipts needed

• Itemized Deduction- Specific amounts spent on certain goods and services throughout the year; allowed deductions are outlined by the IRS and include such expenditures as mortgage interest, state and local taxes, charitable donations

www.investopedia.com/terms/i/itemizeddeduction.asp#ixzz1zxopAxpP

Itemizing Required for Charitable Gift Tax Benefits • You can give thousands of dollars, but if you claim

the standard deduction on your tax return, charitable gifts will do you no tax good.

• You must itemize expenses on Schedule A to deduct charitable donations.

• Donors' deductions are limited to 50% of adjusted gross income; rollover of excess for up to 5 years

http://www.bankrate.com/finance/taxes/get-a-tax-deduction-for-charitable-giving-1.aspx

Who Itemizes Deductions? • The percentage of tax filers who itemize increases as

we move up the income scale • The value of deductions depend on a taxpayer’s tax

bracket. Example: a $1,000 deduction is worth $150 in the 15% bracket, and $396 for someone in the top 39.6% bracket.

Overall, only about a third of taxpayers itemize deductions http://www.irs.com/articles/it-worth-it-itemize-your-taxes

Refundable and Non-Refundable Tax Credits

• Refundable: When tax credits are greater than the amount of tax you owe, the IRS sends you a tax refund for the difference – Example: Earned Income Tax Credit (EITC)

• Non-Refundable: Credit can’t be used to increase your tax refund or to create a tax refund when you wouldn’t have already had one. In other words, your savings cannot exceed the amount of tax you owe. – Example: Child and Dependent Care Expenses Credit

Earned Income Tax Credit (EITC)

• A special subsidy credit paid to low-income workers with qualifying child(ren), or in some cases, workers with no children

• Maximum EITC credit (2014) is – $490 for a family with no children

– $3,305 for a family with one qualifying child

– $5,460 for a family with two qualifying children

– $6,143 with 3+ qualifying children

EITC Income Limits (2014) Adjusted gross income (AGI) must be less than:

• $46,997 ($52,427 married filing jointly) with three or more qualifying children

• $43,756 ($49,186 married filing jointly) with two qualifying children

• $38,511 ($43,941 married filing jointly) with one qualifying child

• $14,590 ($20,020 married filing jointly) with no qualifying children

Child and Dependent Care Credit

• Available for workers who pay employment-related expenses for the care of their child(ren) while they are working, seeking work, or in school full time; non-refundable (i.e., can use up to amount of tax owed)

• Total expenses that may be used to calculate the credit are capped at $3,000 (for one qualifying individual) or at $6,000 (for 2+ qualifying individuals)

Child Tax Credit • A $1,000 credit is available for each qualifying

child under the age of 17 (at the end of 2014) claimed as a dependent

• The Child Tax Credit is non-refundable

http://www.irs.gov/uac/Newsroom/The-Child-Tax-Credit-May-Cut-Your-Tax

Retirement Savings Credit (Saver’s Tax Credit)

• Singles with adjusted gross incomes of $30,000 or less and joint filers earning $60,000 or less can claim this credit (in 2014)

• Credit is 10%, 20%, or 50% of every dollar contributed to an IRA or employer-sponsored retirement savings plan, up to $2,000, depending on income range

http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-Retirement-Savings-Contributions-Credit-(Saver%E2%80%99s-Credit)

Recommended Resource

“The Bible”: Annual Limits Relating to Financial Planning (College for Financial Planning): http://www.cffpinfo.com/annual-limits/

Determining

Your Tax Liability

Source: Kapoor, Dlabay, & Hughes (2013). Focus on Personal Finance

Key 2014 Tax Numbers

• Personal exemption: $3,950 • Standard deduction: $6,200- single; $12,400- mfj • Exemption and itemized deduction AGI phase-out

ranges: $254,200-$376,700- single; $305,050-$427,550- mfj

• SS earnings limit below FRA: $15,480

Completing the Federal Income Tax Return

Filing status and exemptions Income Adjustments to income Tax computation Tax credits Other taxes (such as from self-employment) Payments (total withholding and other payments) Refund or amount you owe

• Refunds can be directly deposited to a bank account • Payments may be directly debited from a bank account

Signature (most common filing error)

Tax-Rate Schedules and Tax Tables

• Tax-Rate Schedules – Used by persons with a taxable income of $100,000 or more; requires a mathematical computation to determine tax liability

• Tax Tables – Used to look up one’s tax liability in a table organized according to tax filing status and income range

Federal Income

Tax Table Filing Status

Taxable Income Tax Liability

Alternative Minimum Tax (AMT)

– Paid by taxpayers with high amounts of certain deductions and various types of income

– Designed to ensure that those who receive tax breaks also pay their fair share of taxes

– Has increasingly been affecting less affluent taxpayers, especially in high-tax states (e.g., NJ)

– A high proportion of long-term capital gains to ordinary income can trigger the AMT

Tax Avoidance and Tax Evasion

Tax Avoidance (Minimization) – Legitimate methods to reduce your tax obligation to your fair

share but no more (e.g., deductions, credits, tax-deferred/tax-free investing) – Decisions related to purchasing, investing, and retirement

planning are heavily affected by tax laws (e.g., home, IRAs) – Keep good tax records (W-2s, 1099s, receipts, copies)

Tax Evasion – Illegally not paying taxes you owe, such as not reporting all

income or overstating deductions

Taxable vs. Tax-Deferred Investing

27,6

00

31,3

00

48,3

00

58,6

00 75,8

00 98,8

00

112,

200

157,

900

160,

300

244,

700

$0

$50,000

$100,000

$150,000

$200,000

$250,000

10yrs 15yrs 20yrs 25yrs 30yrs

Garman/Forgue, PERSONAL FINANCE, Fifth Edition, Tax-Sheltered Returns are Greater than Taxable Returns (Illustration: 8% Annual Return and $2,000 Annual Contribution)

Calculator: http://www.calcxml.com/do/inv07

W-4 Form Determines Taxes Withheld

• Typically completed on first day of job

• Employer uses information on W-4 to determine how much tax to withhold

• Recommended practice: review number of withholding allowances each year

• Can add “extra” tax withholding amounts through employer to cover “marriage tax penalty” and/or investment, unemployment, or consulting income

Impact of W4 Form on Net Pay 0 allowances = max taxes deducted* =

Smaller take home pay =

Larger tax refund

+ allowances = less taxes deducted =

Larger take home pay = Smaller tax refund

NOTE: Taxpayers can add extra withholding beyond “0” allowances; e.g., +$50 more)

Is it a good idea to get a big tax refund ($500 +)? Cons:

Taxpayer is not earning interest on the money

Government has had an interest-free loan

Pros:

Some people see it as discipline to save a large lump sum

BIGGEST ISSUE: High incidence of tax refund identity theft: https://www.youtube.com/watch?v=Ensq6NRtzpk

Tax Refunds

Question What is your opinion about income tax over-withholding?

IRS Time Limitations on Tax-Related Actions

According to IRS, IF YOU Limitation

Owe additional tax 3 years

Do not report income that you should and it is more than 25% of the gross income shown on your return 6 years

File a fraudulent return No limit

Do not file a return No limit

File a claim for credit or refund after you filed your return

The later of 3 years or 2 years after tax was paid

Record Retention • How Long to Keep Financial Records (Bankrate)

– http://www.bankrate.com/finance/personal-finance/how-long-to-keep-financial-records.aspx

• Keep investment records to document capital gains

and the tax basis of the investments (length of investment ownership + at least 6 years)

Strategy: Keep Tax Records a Long Time

• Never discard records relating to

– Home purchases

– Contributions to retirement accounts

– Retirement account rollovers and conversions

• When in doubt about keeping a tax record, do NOT throw it out!

– Save paper copy or scan and store electronically

Common Tax Errors • Claiming wrong number of dependents

• Failing to itemize deductions

• Forgetting charitable gifts made via payroll deduction and phone texting

• Overlooking medical expenses

• Reporting an erroneous investment cost basis

• Not including previous year’s state tax refund

• Not signing the tax return (if paper filed)

Tax Deduction Timing • Donations and payments for deductible expenses

must be made by end of the tax year to claim a deduction

• If you put a check dated Dec. 31 in the mail by that day, you are OK

• Donations and payments charged by year's end to a credit card are also OK, even if you don't actually pay until the next year

• You can make a contribution to IRAs for the prior year by the tax filing deadline (typically April 15)

General Tax Planning Strategies to Minimize Taxes

If you expect Then you should Because The same or a

lower tax rate next year

Accelerate deductions into this

year

Greater benefit to higher rate

The same tax rate next year

Delay income into next year

Delay paying taxes

A higher tax rate

next year

Delay deductions Greater benefit

Accelerate income Taxed at lower rate

Comments? Questions?

Experiences?