MANAGING YOUR TAXES. After Studying This Chapter, You ll Be Able To

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1 3 MANAGING YOUR TAXES The Basics of the U.S. Tax System Starting Point Go to to assess your knowledge of managing your taxes. Determine where you need to concentrate your effort. What You ll Learn in This Chapter The major features of the U.S. federal income tax system Tax basics How taxes are calculated How to file tax returns Tax planning strategies After Studying This Chapter, You ll Be Able To File your taxes on time Calculate taxable income and determine your tax liability Select strategies to legally minimize the taxes you pay

2 136 MANAGING YOUR TAXES INTRODUCTION Taxes can take a big bite out of your budget, so your strategies for legally minimizing your taxes are crucial to your financial plan. It s important to consider the tax implications of your potential financial decisions and to be proactive in developing a plan to minimize tax payments. In this chapter, you ll first examine the main features of the federal income tax system and the requirements for filing, calculating, and paying taxes. Federal income taxes are the focus of this chapter because they take the biggest tax bite. Finally, this chapter discusses the most common tax planning strategies. 3.1 The Basics of Federal Income Tax There s no question the U.S. federal income tax system is complicated. The statutes and regulations that describe the tax laws fill literally thousands of pages, and it is estimated that the average taxpayer spends more than 10 hours per year filling out the required forms. It s a good idea to make one of your personal financial goals to learn more about the tax system so that you can keep adequate records and reduce what you owe. Your income tax is one of your household s largest cash outflows, and you work around four months out of the year just to pay your federal taxes The Progressive U.S. Tax System Although there have been many changes in the tax law throughout our country s history, the United States has always maintained a progressive tax, one that imposes higher tax rates on taxpayers with higher incomes, requiring them to pay proportionately more in taxes, through either higher tax rates or other rules. In its infancy, the United States had no income tax at all. It wasn t until the 16th amendment to the U.S. Constitution was passed in 1913 that Congress imposed a tax on income, which was necessary to pay national security expenses associated with World War I. Since that time, tax rates have increased or decreased based on economic and political circumstances. Today, federal income taxes are used to finance many worthwhile government activities, including the national defense, education, social programs, drug safety, transportation, and road maintenance. Because a progressive tax is based on each taxpayer s ability to pay, lowerincome families do not bear a large tax burden. In fact, some people in the United States pay no federal income tax at all. If you earned less than $8,450 in 2006 ($16,900 if married and filing jointly), you didn t even need to file a tax return. As a result, high-income taxpayers account for the lion s share of all income tax revenues collected, and the poorest don t pay any taxes at all.

3 3.1 THE BASICS OF FEDERAL INCOME TAX 137 In contrast to a progressive tax, a regressive tax places a disproportionate burden on taxpayers with lower incomes. Any time the same tax rate is levied on all taxpayers as in the case of payroll, consumption, and sales taxes the tax is regressive. This type of tax takes a bigger bite out of low-income families disposable incomes. Although rich people spend more on food, clothing, and other consumer purchases than poor people, the proportion of their income going to these categories is still lower, so the tax affects them less. The tax that finances Social Security and Medicare, the federal systems for retirement income and retiree health care, is a classic example of a regressive tax. If you look at your pay stub, you ll probably see an amount withheld for FICA (Federal Insurance Contributions Act), the tax that finances Social Security and Medicare. The FICA tax is regressive not only because everyone pays the same rate but also because there is a maximum income on which the Social Security portion of the tax (6.2 percent) is imposed; earnings over the maximum are subject only to the 1.45 percent Medicare portion of the tax. The U.S. income tax system maintains its progressive nature through increasing marginal tax rates, exemptions, credits, and deductions. (A marginal tax rate is the rate that applies to your next dollar of income.) These features of the tax system imply that not all your income is taxable and your taxable income is not all taxed at the same rate. The current tax rules assess taxes on taxable income the amount of income that is subject to taxes under the law according to a table of marginal tax rates. Marginal tax rates today are low by historical standards. Not only is the bottom bracket lower than it s been in decades, but the current top marginal tax rate, which applied to any income above $336,550 in 2006, is only 35 percent. In comparison, the top bracket at the end of World War II was 94 percent on income over $1 million The Internal Revenue Service The Internal Revenue Service (IRS) is the government agency responsible for collecting federal income taxes. Because there are sometimes ambiguities in the laws, the IRS also writes regulations and makes rulings that interpret laws, often giving specific taxpayer examples for clarification. When there are disputes about how to interpret and apply these laws and regulations fairly, the federal tax court sometimes hears cases and makes rulings. The Internal Revenue Code, a compilation of all tax laws passed by Congress, along with the IRS regulations and tax court judicial decisions, make up the totality of tax laws in the United States. Although the IRS is often seen in a negative light after all, nobody likes to pay taxes it performs a truly amazing function, processing 130 million individual income tax returns each year, collecting more than $1.7 trillion in taxes, and issuing more than $200 billion in refunds, most within a few short months.

4 138 MANAGING YOUR TAXES Figure 3-1 Schedule X: 2006 Tax Rate Schedule for Single Filers If your taxable income is: But not You will Taxable Over: more than: owe: income over: $0 $7,550 10% of $0 $7,550 $30,650 $755 15% of $7,550 $30,650 $74,200 $4,220 25% of $30,650 $74,200 $154,800 $15,108 28% of $74,200 $154,800 $336,550 $37,676 33% of $154,800 $336,550 $97,653 35% of $336,550 Schedule Y-1: 2006 Tax Rate Schedule for Married Filing Jointly If your taxable income is: But not You will Taxable Over: more than: owe: income over: $0 $15,100 10% of $0 $15,100 $61,300 $1,510 15% of $15,100 $61,300 $123,700 $8,440 25% of $61,300 $123,700 $188,450 $24,040 28% of $123,700 $188,450 $336,550 $42,170 33% of $188,450 $336,550 $91,043 35% of $336,550 Marginal tax rates in Congress has provided funding to further automate the process, a trend that causes some taxpayers concern as they envision a futuristic government with electronic access to their most intimate financial information. More likely, though, honest taxpayers will benefit from further automation, and dishonest ones will be more easily forced to pay their fair share. The IRS also offers many free services to taxpayers at its Web site, Publications on most tax topics are available for download or by mail. The comprehensive tax preparation reference IRS Publication 17, Your Federal Income Tax, is a must-have for individuals who prepare their own taxes Tax Rate Schedules Tax rate schedules show how much income tax must be paid for particular ranges of income. There are separate schedules for different household types. Figure 3-1 shows two of these schedules Schedule X, for single taxpayers, and Schedule Y-1, for married taxpayers filing jointly. Each schedule includes lists of income ranges and rates.

5 3.1 THE BASICS OF FEDERAL INCOME TAX 139 FOR EXAMPLE Tax Brackets Let s suppose that you re a single filer and your taxable income is $65,000 in Although this income puts you in the 25 percent tax bracket, the first $7,550 will be taxed at 10 percent, the income between $7,550 and $30,650 will be taxed at 15 percent, and the remainder will be taxed at 25 percent, for a total of $12,808 in taxes owed. Now what happens if you earn another $1,000? Because having taxable income of $66,000 wouldn t push you into a new tax bracket, the calculation of your taxes will be exactly the same except that you ll apply the 25 percent rate to an additional $1,000 resulting in an additional $250 in federal income taxes (25 percent of $1,000). A tax bracket is the range of taxable income to which a particular marginal tax rate applies. Taxpayers sometimes use this term to describe the highest bracket that applies to their income. Thus, a single filer who, in 2006, told you that she was in the 25 percent bracket, meant that her taxable income was between $30,650 and $74,200. As you can see, you pay lower tax rates on your first dollars of income and higher rates on later dollars of income. For example, Schedule X indicates that the tax rate on the first $7,550 of taxable income in 2006 is only 10 percent. Thus, if you were a single filer with taxable income of $7,550 or less, you would be in the lowest tax bracket and pay only 10 percent of your taxable income in taxes. Unless your taxable income falls in the lowest tax bracket, the same marginal tax rate does not apply to your entire taxable income. Because you can t do much about what tax bracket you fall in, much of tax planning is aimed at minimizing your average tax rate, or the proportion of total taxable income paid in taxes, for a given level of income. Your average tax rate is calculated as follows: Average tax rate Taxes paid/taxable income For some purposes, it may be useful to consider the proportion of your total income paid in taxes (as opposed to taxable income as in the definition just provided). You may also see this ratio referred to as your average tax rate. Because of the progressive, or increasing, tax rate schedule, your average tax rate will always be less than your marginal tax rate. Let s return to the previous scenario involving taxable income of $65,000 and taxes of $12,808. Although the marginal tax rate is 25 percent (your highest

6 140 MANAGING YOUR TAXES Figure 3-2 $160, % $140,000 $120,000 $100,000 $80, % $60,000 $40, % $20,000 $- 11.5% $ % $20 $40 $80 $160 Taxable Income ($000) After-tax income Taxes owed Taxes paid, after-tax income, and average tax rates for selected taxable income levels. bracket), the average tax rate is only 19.7 percent: Figure 3-2 shows the proportion of taxable income paid in taxes and average tax rates for taxpayers at various income levels Inflation Indexing of Tax Brackets The levels of income that trigger each successive increase in tax rate are automatically increased each year to account for inflation. This feature of the tax system has been in place since 1981 a year of double-digit inflation. This system banks on the fact that the income levels for each bracket will be higher next year than they are today. The fact that certain aspects of our tax law are indexed for inflation is an important protection for taxpayers in lower tax brackets. The government doesn t want households to have an extra tax burden unless they re actually experiencing a higher level of purchasing power.

7 3.2 CALCULATING TAXABLE INCOME AND TAXES OWED The Marginal Tax Effect The tax laws include many rules that can reduce your taxable income. For example, you can subtract contributions to certain employer-provided retirement plans from your gross income before you calculate your tax. When making decisions, you should always consider the marginal tax effect the reduction in taxes owed as a result of a financial decision. As discussed in Section 1.4, effective decision making requires that you evaluate your alternatives based on the effect on your finances. In estimating the marginal tax effect, you should apply a tax rate that includes all types of taxes that the income would otherwise be subject to usually federal income tax, state income tax, Social Security, and Medicare tax. Some people also pay state and local taxes on income. Suppose Jeremiah has a taxable income of $40,000 (25 percent federal tax bracket) and lives in a state with a 5 percent state income tax. His next dollar of taxable income will be subject to 25 percent 5 percent 7.65 percent Social Security and Medicare tax, for a total of percent paid in taxes. Suppose Jeremiah has the opportunity to work overtime for his employer and expects to earn an additional $2,000. How much better off will he be if he decides to do so? Because his additional earnings will be subject to the percent marginal tax rate, he will net only $2,000 ( ) $1,247 after taxes. Although this chapter covers only the basics, there are many situations in which tax rules make certain financial decisions more attractive than others. It is always important to focus on the marginal tax effects when evaluating options. SELF-CHECK 1. What is the purpose of the IRS? 2. Explain the difference between marginal tax rate and average tax rate. 3.2 Calculating Taxable Income and Taxes Owed Although many people whine about filling out their tax forms as April 15 approaches, individuals who have their finances in order generally find that completing tax forms is fairly painless. The steps involved in calculating how much tax you owe are illustrated in Figure 3-3. In this section, we review terminology and rules and then look at how tax forms are filled out.

8 142 MANAGING YOUR TAXES Figure Start with: Income from all sources less exclusions Equals: Total Income 2. Minus: Adjustments to total income Equals: Adjusted Gross Income 3. Minus: Standard deduction or itemized deductions 4. Minus: Exemptions Equals: Taxable Income 5. Look up: Your tax on Tax Table Equals: Tentative Tax 6. Minus: Credits Equals: Total Tax Owed 7. Minus: Taxes already paid (payroll withholding and estimated taxes) Equals: Balance Due or Amount or Refund Steps in calculating federal income taxes owed Reporting Income As indicated in Figure 3-3, the first step in doing your taxes is to calculate your income. The calculation of income for tax purposes requires that you report most types of income and then make certain allowed adjustments to that income: Gross income is your income from all sources. However, some categories of income are excluded to arrive at total income on your tax forms, an amount that can be thought of as gross taxable income. Gross taxable income is income from all sources, less allowed exclusions. Table 3-1 details what is included and what is excluded in reporting total income. For example, you don t have to report scholarships used for tuition and course-related expenses or child support payments received from an ex-spouse. You do, however, have to report scholarships and grants applied to room and board expenses.

9 3.2 CALCULATING TAXABLE INCOME AND TAXES OWED 143 Table 3-1: What Is and What Is Not Included in Gross Taxable Income Included Alimony Business or partnership income Commissions, fees (if deducted) Dividends Employer-paid disability income Gambling winnings and prizes Hobby income Interest Not Included Annuities* Child support Disability payments* Gifts Inheritance Insurance claim payments Jury awards Life insurance proceeds Long-term capital gain on sale of primary residence* Investment gains/losses Moving expense reimbursement Wages, salaries, tips, bonuses Pension income Property rental income/loss Royalties Unemployment compensation Long term care benefits Military cost-of-living allowance Qualified benefits paid by employer* Required travel expenses paid by employer* Scholarships and fellowships* State and local bond interest Workers compensation payments Welfare *Limitations apply to these categories. For most people, the largest source of total income is earned income from employment salaries, hourly wages, bonuses, tips, and commissions all of which is included in gross taxable income. Other sources of gross taxable income include business income, investment income, alimony, unemployment compensation, and retirement benefits. Unearned income may include interest and dividends from investments, net business income, rents, and royalties you received during the year, annuity and pension income, awards for scientific and charitable achievement, gambling and lottery winnings, and scholarships spent on room and board.

10 144 MANAGING YOUR TAXES Employers and financial institutions must report the amounts they pay to you each year, and you generally receive a copy of this report in January following the tax year (Form W-2 for employment income and Form 1099 for other types of income), but you are also required to report other income (e.g., cash tips received by a waiter), even if these amounts do not appear on your W-2. Your taxable income, as reported on your W-2, excludes any payments made on your behalf for tax-qualified health insurance and retirement plans in other words, those amounts get taken off the top of your income and are not taxed. In addition to reporting profits from businesses, you may sometimes be able to subtract losses by entering a negative number in the business income category. However, the tax laws limit the deduction of losses to situations in which you actively participate in the management of the business. Gross income also includes any capital gain, or increase in value, of taxable investments that you sold during the year. For example, if you sold a rental property during the year for $100,000 and you had only paid $80,000 for it, you owe tax on the $20,000 capital gain. Note that even though you may have received the whole $100,000 in cash flow that year, you report only the gain for tax purposes. If you hold an investment longer than a year, the gain is subject to a special lower tax rate 5 percent for taxpayers in the 10 and 15 percent tax brackets and 15 percent for those in higher tax brackets. These rates also apply to certain dividend income. A special capital gain rule applies to profits on the sale of your primary residence, defined as where you lived for two of the five years before the sale. You can exclude up to $250,000 of the gain on the sale of your home ($500,000 for married couples) from your total income Adjusted Gross Income Certain expenses are subtracted from total income to arrive at adjusted gross income (AGI). Although many of the allowed adjustments to total income are subject to income limitations, they can significantly reduce your taxes and may not require you to itemize deductions to qualify. Some of these adjustments include deduction for unreimbursed expenses up to $250 for teachers of kindergarten through grade 12. deductible individual retirement account contributions up to $4,000. interest paid on student loans during the year. tuition and fees for higher education up to $4,000. deduction for one-half of the Social Security taxes paid on business income. deduction for moving expenses, if required for a new job.

11 3.2 CALCULATING TAXABLE INCOME AND TAXES OWED 145 Without itemizing, you can also make adjustments for one-half of the Social Security taxes paid on business income and for moving expenses, if required for a new job. To see if you qualify for these or other adjustments to total income, you should consult the applicable IRS publications Standard vs. Itemized Deductions You may deduct certain expenses from your AGI to arrive at the taxable amount: You can either claim a specified standard deduction, a dollar amount based on filing status that is subtracted from AGI in calculating taxable income, or itemize your deductions. With itemized deductions, you report and deduct actual expenses in certain allowed categories to arrive at taxable income. The amount of the standard deduction increases annually with inflation and depends on your filing status. For tax year 2006, the allowed standard deduction amounts were Single: $5,150. Married filing jointly: $10,300. Married filing separately: $5,150. Head of household: $7,550. Qualified widower: $10,300. If your deductible expenses are greater than the standard deduction, and provided that you ve kept careful records, you report itemized deductions on Schedule A. Although you don t have to provide supporting documentation when you file your return, you must be able to produce proof of the expense if the IRS requests it. For example, if you ve made charitable contributions during the year, you should have a statement or receipt that acknowledges your donation. But if you take the standard deduction, you don t have to keep this type of record. If you itemize, you must file the long form 1040 instead of the 1040A or 1040EZ. The categories for itemized deductions include medical and dental expenses, taxes, some types of interest, gifts to charity, casualty and theft losses, job expenses, and most other miscellaneous deductions. The percentage of people who itemize deductions increases with income. This makes sense because people with greater income are likely to have greater expenses, most notably for mortgage interest and taxes, so the amount of their actual expenses is more likely to exceed the standard deduction. We discuss each category of itemized deductions in more detail next. Medical and Dental Expenses You can deduct out-of-pocket medical and dental expenditures for health insurance premiums, services (e.g., doctors, dentists, optometrists, nurses, hospitals), prescriptions, eyeglasses, hearing aids, travel for medical purposes, special schooling for disabled children, nursing homes, alternative medicine (e.g., chiropractors,

12 146 MANAGING YOUR TAXES acupuncturists), and other medical expenses if their sum is above 7.5 percent of your AGI. IRS Publication 502 lists legally deductible expenses. If your expenses are paid by your health insurer or employer, you can t deduct them you can deduct only unreimbursed expenses. To determine your deduction, you total your medical and dental expenses and then subtract 7.5 percent of your AGI. The remainder is your deduction. Taxes You Paid You may deduct state and local income taxes you paid during the tax year, real estate property taxes paid on your primary residence, and personal property taxes (imposed in some states on cars and other personal property). If you take a deduction for state taxes, you may have to make an adjustment to your income in a later year for state tax refunds. Interest You Paid Perhaps the most beneficial of all deductions is the mortgage interest deduction. You can deduct interest paid on your mortgage and home equity loans as well as certain charges, such as points or loan origination fees. Sometimes, you can t deduct the full amount of points in the year paid but must spread them out over the life of the loan. Interest paid on credit cards, personal loans, and car loans is not deductible. Gifts to Charity The tax laws allow you to deduct contributions made to charitable organizations. There are separate lines on which to report cash donations and noncash donations. Noncash contributions include food donated to the local food bank or used clothing given to a local charity. You can deduct only the current market value of the items donated, however. If you re uncertain of an item s worth, you should consider what the item would sell for at a flea market, or, for a fee, you can get a list of fair market values for commonly donated items from People who are actively involved in volunteer organizations can also deduct expenses incurred in their volunteer work, including mileage expenses. Casualty and Theft Losses Suppose your car, which was worth $3,000, was stolen during the year, and you did not have theft insurance on it. For such an unreimbursed loss, the tax law allows you to deduct the amount of the loss that exceeds 10 percent of your AGI, less $100. Job Expenses and Miscellaneous Deductions Many people incur expenses required for their employment but are not reimbursed for them by their employer (e.g., union dues, licenses and fees, books

13 3.2 CALCULATING TAXABLE INCOME AND TAXES OWED 147 and professional software, professional liability insurance, tools and supplies, job hunting costs, travel costs). Ordinary and necessary job-related expenses are deductible if they exceed 2 percent of your AGI. Several special rules apply to the miscellaneous deductions category. Gambling losses up to the amount of reported gambling income can be deducted without regard to the 2 percent limitation. Disabled workers are also allowed to deduct all their job-related expenses. Totaling Your Itemized Deductions After calculating your deductions, you total them and compare the amount to the standard deduction. Note that although it s a good idea to claim all deductions to which you are entitled, unusually large deductions might subject your return to increased scrutiny by the IRS Exemptions The last step in calculating your taxable income is to subtract the appropriate amount for your exemptions. An exemption is an amount of money that you re allowed to subtract for each qualifying person in your household. This usually means one exemption each for yourself, your spouse, and each of your dependents. A dependent is a member of a household who receives at least half of his or her support from the head of the household. The allowed exemption amount was $3,300 in 2006, and it increases annually with inflation and is phased out for high-income taxpayers. A person can be claimed as an exemption on only one tax form. So if your daughter is being claimed as a dependent on your tax form, she can t take an exemption on her own tax form. Note that the marginal benefit to a family is higher if the exemption is claimed by the taxpayer in the highest tax bracket Final Calculation of Taxes Owed Subtracting your deductions and exemptions from your AGI yields your taxable income. You use this amount to calculate your taxes. Figure 3-4 shows how each layer of income is taxed. In financial planning, you always consider the effects on the last layer of income. You can find the appropriate tax amount easily by using the tax table provided in the instruction booklet that comes with your tax forms. Although Section illustrates the increasing marginal tax rates by explaining how each layer of income is taxed, individual taxpayers are not expected to do that calculation themselves. Instead, the IRS has precalculated the tax. So all you have to know is your taxable income, and you can look up the tax amount that you must pay. When you ve determined your tentative tax, you re almost done.

14 148 MANAGING YOUR TAXES Figure % 90% 80% 70% 25% Bracket (taxable income from $28,400 to $52,200) Tax on layer $5,950 60% 50% 40 % 30 % Adjusted Gross Income Taxable Income 15% Bracket (taxable income from $7,000 to $28,400) $3,210 20% 10% 0% 10% Bracket (taxable income from $0 to $7,000) $ 700 Standard deduction = $4,750 $ 0 Personal exemption = $3,050 $ 0 Layers of total $9,860 income $60,000 The taxation of your income, by layer. Applying Available Credits Tax credits directly reduce the taxes you owe. The currently available credits include credits for foreign taxes paid, child and dependent care expenses, elderly and disabled status, education expenses, retirement contributions, dependent children, and adoption. Several of the available credits are particularly helpful for working parents and contribute to the progressive nature of the tax system. In addition to a flat credit per child under 17, you can take a credit for some of the costs of child care. For lower-income families in which both parents are employed, the Earned Income Credit can significantly reduce taxes paid. Some college students may also qualify for this tax credit. The Hope Scholarship Credit and the Lifetime Learning Credit are important for college students to be aware of. Contributions to retirement savings accounts may also qualify for credits.

15 3.2 CALCULATING TAXABLE INCOME AND TAXES OWED 149 Although many credits are fairly straightforward, some have specific income limitations or are phased out for higher-income families, so you may have to use an IRS worksheet to determine your eligibility for them. All credits except for the child tax credit require the filing of a special form (referenced on the appropriate line of Forms 1040 and 1040A). All the required forms and information on these credits are available on the IRS Web site, Alternative Minimum Tax Some taxpayers end up owing more in taxes than the calculation discussed so far would indicate because of the alternative minimum tax (AMT). This tax was originally designed to ensure that high-income people couldn t take advantage of too many special tax rules to avoid paying their fair share of taxes, but in recent years, it has also affected many middle-income taxpayers. The AMT works this way: You recalculate your taxes under a different set of rules in which many of the current deductions, exemptions, and special tax breaks do not apply. If the tax calculated in that way is larger than the one calculated in the normal way, you must pay the AMT, a higher tax amount. Whether you should take the time to do this depends on whether your tax situation includes many of the AMT triggers. Some of the triggers for AMT liability in a given year include a large number of exemptions claimed. exercise of incentive stock options. long-term capital gains. large itemized deductions, particularly for medical expenses or second home mortgage interest. If any of these apply to you, you should follow the directions for calculation of the AMT to see whether it applies. Don t be surprised if it does more than 2.7 million taxpayers were subject to it for tax year 2003, and the AMT is estimated to reach more than 35 million within the next decade. The IRS automatically calculates the AMT based on your submitted tax form, so if you neglect to do so and therefore underpay your taxes, you may end up paying additional interest and penalties. (Tax preparation software and tax professionals automatically calculate the AMT.) Paying Taxes Taxes are supposed to be paid on your income as you receive it. However, our tax system is complex enough that it isn t always easy to determine exactly how much you must pay until the year ends and you actually prepare your return. You must estimate this amount throughout the year to ensure that you pay enough.

16 150 MANAGING YOUR TAXES For earned income from employment, the payment of estimated taxes is usually accomplished through payroll withholding, whereby the employer takes money out of your income for the government. The amount of tax withheld is based on expected income and your estimated number of exemptions, as indicated on a W-4 form, the Employee s Withholding Allowance Certificate. You complete a W-4 form whenever you begin a new job. The lower the number of exemptions claimed, the larger the amount withheld. Alternatively, if you don t expect to owe any taxes if you have fairly low income you can indicate that you are tax exempt so that no taxes will be withheld. Most taxpayers have more withheld than they will owe and receive a refund (without interest). Even if an appropriate number of exemptions is claimed on the W-4, you may still end up overpaying in withholding because the amount withheld assumes that you ll take the standard deduction. If you are self-employed or have investment income that hasn t been subject to withholding, you must still pay your taxes in advance of the April 15 due date. The law requires that you pay the tax in quarterly estimated tax installments during the tax year (on April 15, June 15, September 15, and January 15). If you underpay, you are subject to penalties. To avoid underpayment penalties, you should make sure that the total of your withholding plus estimated tax payments is at least as much as 100 percent of your prior year s tax owed. If you re self-employed, you are likely to owe additional taxes beyond the federal income tax. Self-employed individuals report total business revenues and certain deductible expenses on Schedule C. The difference between their revenues and expenses is taxable and therefore must be reported as business income (or loss) on their 1040 form. Individuals who report self-employment income are also required to file a Schedule SE (for self-employment) with their federal tax forms. This worksheet determines the Social Security and Medicare payroll taxes owed on business income. Whereas wage and salary workers split the 15.3 percent tax with their employer (each paying 7.65 percent), self-employed people are their own employers and thus must pay both portions. The combined effect of federal and state income taxes plus the Social Security and Medicare tax is a hefty bite out of business income, sometimes more than 50 percent for those in the highest marginal income tax bracket. If your total withholding and estimated taxes paid during the year are less than the amount of taxes you owe for the year, you must include a check for the remainder with your submitted form. If you ve paid too much in withholding, you re entitled to a refund. You may receive a refund even when you didn t have sufficient income to require any payment of taxes. This occurs because Congress has made certain tax credits refundable that is, you can get them even if you have no taxes owed to credit them against. The most important refundable tax credit is the additional child tax credit, which allows some households to receive the credit even if they owed no tax.

17 3.3 FILING YOUR FEDERAL TAX RETURN 151 You should try to minimize the amount of refund you ll receive because overpaying taxes is essentially like giving the government a zero-interest loan. Some taxpayers like to overpay their taxes, although this strategy doesn t make good financial sense. SELF-CHECK 1. Define alternative minimum tax, payroll withholding, and capital gain. 2. List some possible deductions a taxpayer may itemize. 3. What is the result when you subtract adjustments from total income? 3.3 Filing Your Federal Tax Return Filing a tax return involves reporting income to the IRS on official tax forms and paying any outstanding taxes owed. In this section, we explain the requirements for filing Filing Status Whether you must file a federal return depends primarily on your filing status, income, and age. Your filing status identifies your household type. Because your filing status may change, every year you must identify yourself as one of the following (based on your status as of the last day of the year): Single: Unmarried or legally separated from your spouse. Married filing jointly: Married couple filing a single tax return, even if only one spouse had income. Married filing separately: Married couple filing separate tax returns, each reporting his or her own income and allowed deductions from income. Head of household: Single person who lives with and pays more than half of the support for a dependent child or relative. Qualifying widow(er) with dependent child: Person whose spouse died within two years of the tax year and who lives with and pays more than half of the support for a dependent child Income Your taxable income is a major determinant of whether you must file a tax return and, of course, also determines the amount of taxes you pay. The IRS

18 152 MANAGING YOUR TAXES defines your AGI as the total of your earned income (e.g., salaries, wages, tips, bonuses, commissions) plus unearned income (e.g., interest, dividends, capital gains, rents, royalties, net business income) minus certain allowed adjustments. You are allowed to subtract certain amounts from your AGI to get your taxable income. The most important are called exemptions and deductions. You get a personal exemption of $3,300 (in 2006, indexed for inflation) for each qualifying person in your household, including yourself and each dependent, although this allowance is phased out for very high-income households. Also, you receive a standard deduction for certain qualifying expenses on which you are not taxed. The standard deduction for single taxpayers in 2006 was $5,150, whereas married couples filing jointly were allowed to deduct $10,300, and heads of household could deduct $7,550. Standard deductions are higher for people who are age 65 and older and for people who are blind. The allowed deductions are indexed for inflation so that the amount you can deduct increases annually. If your annual expenses in certain allowed categories exceed, in total, the standard deduction for your filing status, you should itemize instead of using the standard deduction. Itemizing deductions involves filing an additional form on which you detail all deductions. Whereas the standard deduction is available without proof of expenses, you must keep supporting documentation for all itemized deductions. If your earned income is no more than the total of your exemptions and standard or itemized deductions, your taxable income is zero, and you need not file a return. For a single taxpayer, this means that you could have earned up to $3,330 $5,150 $8,450 in 2006 without having to file. Married couples filing jointly had to file if they earned more than $6,600 $10,300 $16,900. Of course, if you made less than these amounts but had taxes withheld from your pay, you would need to file in order to get a refund. In addition to exemptions and deductions, you can also use a tax credit to reduce the taxes you owe. Tax credits, unlike exemptions and deductions, do not represent adjustments to your income. Rather, they are subtracted directly from the taxes you owe Age Age affects your obligation to file and pay taxes. For example, the larger standard deduction for individuals age 65 and older means that they can earn more income without being taxed. In certain circumstances, dependent children up to age 24 do not have to file. However, even if your parents claim you as a dependent, you still need to file a return if any of these apply: Your earned income was more than $5,150 (based on 2006 tax law).

19 3.3 FILING YOUR FEDERAL TAX RETURN 153 Your unearned income (such as earnings on investment accounts) was more than $750. Your gross income was more than the larger of $750 or your earned income (up to $5,150) plus $250. In addition, you should file if you want to get a refund of taxes withheld from your income or if you qualify for a tax credit When and Where to File Taxes There are very specific rules for when and where you file your taxes. Failure to meet these requirements is a violation of the tax law and may subject you to interest and penalties. It may also take longer to receive any refund. Tax returns must be postmarked by midnight on April 15 of the year following the tax year. So for income you earned in 2005, you had to file your return by April 15, If April 15 falls on a day that the post office is closed, the due date is extended by one day. You can extend the deadline by four months, to August 15, by filing Form 4868, Application for Automatic Extension, on or before the April 15 deadline. If four months is still not enough time, you can file another form to get an additional extension to October 15. About 9 million taxpayers request extensions each year. Although it might seem like a good way to avoid doing your taxes, extensions do not extend the deadline for paying the actual taxes, so you still have to include a check for any estimated amount you owe or be subject to penalties and interest. If you discover that you made a mistake on a prior year s taxes, you may file an amended return using Form 1040X for up to three years after the original tax year. The IRS receives about 4 million amended returns a year. The IRS operates several service centers where tax returns are processed. When you get your tax forms in the mail, they include a preprinted address label that directs your return to the appropriate service center. Even if you file your taxes electronically, the IRS still sends you the label. You can also find out where to mail it by checking your zip code at Many taxpayers choose to file their taxes electronically, either online, through their tax accountant, or by telephone. The IRS e-file uses online automation to replace many of the manual steps needed to process paper returns, resulting in faster processing with fewer errors (fewer than 1 percent of all electronic tax returns included errors in 2002). Most professional tax preparation services and software packages offer, and even encourage, electronic filing, but you can also do so on your own. Although using e-file supposedly does not increase your chances of being audited, it does allow the IRS to better track the information contained in your forms with paper forms, the IRS only inputs into its database certain

20 154 MANAGING YOUR TAXES data items from each return. If you have a very simple return, as is the case for college students, for example, you can even file electronically by telephone, entering the information by using your telephone keypad. A TeleFile package is automatically sent to any taxpayer who filed a Form 1040EZ in the previous tax year IRS Forms You have a choice of three primary tax forms: Form 1040, known as the long form. Form 1040EZ. Form 1040A. Which form to use depends on your filing status, your income (type and amount), and the deductions and credits you can claim. Even if you qualify to use either of the short forms (1040EZ or 1040A), you can use the standard 1040 long form instead. Depending on your income, deductions, and credits, you may need to include additional forms. Your tax forms may be filled out by hand, typed, or completed electronically. You can also pay a professional tax preparer to complete your tax return, although you still need to collect the necessary documentation and give it to the preparer. Software packages such as TurboTax and TaxCut can make completing your return and identifying the appropriate forms easier. These programs walk you through the entry of information by asking questions and then fill in the appropriate forms. After you use one of these programs, it remembers information from previous years, which makes it less likely that you ll forget potential deductions or credits. This can also help you avoid some common errors The Most Common Filing Errors No one has ever argued that filing taxes is easy. Even people with advanced degrees make mistakes on their tax returns. But these mistakes can cost you money. Your refund might be delayed. Or, worse yet, you might have to pay additional taxes, interest, and penalties. According to the IRS, the most common mistakes are 1 : math errors, both addition and subtraction. Math errors are the numberone mistake. Don t forget to clearly indicate negative numbers, preferably by using parentheses. incorrect or missing Social Security numbers for members of the household. incorrect tax entered from the tables. withholding and estimated tax payments entered on the wrong lines.

21 3.4 TAX PLANNING STRATEGIES 155 computation errors in figuring the child and dependent care credits and the Earned Income Credit. Also, missing or incorrect identification numbers for child-care providers. Although somewhat less common than the preceding errors, the IRS also sees people make mistakes such as: not signing and dating the return. No signature, no refund! forgetting to report interest and dividend income. The IRS gets independent verification of this from your financial institution. not including all the required forms, especially those indicating taxes withheld (e.g., W-2, 1099). making out the check incorrectly (wrong amount, failure to sign). If your tax payment doesn t get to the IRS by the filing deadline because there is no signature, you are subject to penalties and interest. putting insufficient postage on the envelope. The post office then returns the envelope to you, and you could miss your filing deadline. giving the incorrect address for refunds. The IRS has refund checks totaling $80 million that came back as undeliverable. checking more than one filing status. For example, you can t be married and single at the same time. SELF-CHECK 1. What are the three primary tax forms? 2. What are filing status options for married people? 3. List five of the most common filing errors. 3.4 Tax Planning Strategies Understanding income taxation is important because it helps you anticipate the tax consequences of your financial decisions. The tax laws may often make one strategy clearly preferable to another for example, one investment alternative may offer tax benefits, while another doesn t. Also, your tax knowledge will help you evaluate whether you need to consult a tax professional and to prepare the necessary information for your financial planner. If your taxes are simple, you should be able to handle them yourself. If your situation is more complex, you might benefit from a tax specialist s more detailed legal knowledge.

22 156 MANAGING YOUR TAXES Tax planning strategies are those intended to: reduce taxable income. defer taxable income. receive income that is subject to lower tax rates. increase deductions and exemptions from income. maximize tax credits Tax Evasion vs. Tax Avoidance Effective personal financial management requires minimizing unnecessary cash outflows including any unnecessary taxes. Of course, you must pay taxes that you legally owe. Tax evasion is the deliberate failure to pay taxes that are legally owed, and it is against the law. Examples of tax evasion include failure to report tip income or earnings received under the table. Because waiters and waitresses usually earn more in tips than they earn in wages, the IRS regularly audits these jobs to estimate average tips and requires that employers withhold sufficient taxes from the employees wage income, sometimes leaving them with very little in their paychecks. However, restaurant workers usually receive more in tips than what is reported by their employers in these audits, thus resulting in under-withholding. Working under the table means working for someone who pays you in cash and doesn t withhold taxes. This is illegal. It is suspected that many farm and agricultural workers and their employers, particularly in areas near the U.S. borders, evade taxes in this way. Because these workers are often transient, it is difficult to catch them. Although tax evasion is illegal and can have serious consequences, there is nothing illegal about tax avoidance. When you use your knowledge of the tax rules to make financial decisions that reduce the taxes you owe, you are ensuring that you do not pay more taxes than you legally owe. The money you save in taxes can be applied to achieving your financial goals. Consider the example of tax-deductible versus nondeductible investment contributions. A tax-deductible investment allows you to invest without paying taxes on the money first. So, $1,000 of income results in $1,000 invested. If you invest instead in something without that tax benefit, then you pay taxes on the $1,000 in income first, leaving substantially less to actually invest. If your marginal federal income tax rate is 25 percent and your state tax is 5 percent, you will have only $700 left to invest after taxes. Tax avoidance requires thoughtful planning. In general, tax planning is the ongoing process of using the provisions of the tax law to reduce your taxes or defer them to later years. As you begin to work toward long-term financial goals, you should consider not just the current year s taxes but the taxes in future years, too. Because tax laws frequently change, you should try to stay informed about new rules.

23 3.4 TAX PLANNING STRATEGIES 157 Tax evasion is a crime and can, sometimes, result in imprisonment. When a crime boss is successful in avoiding prosecution for murder and other mayhem, federal officials sometimes choose to prosecute for tax evasion instead because it s easier to prove. In 1930, for example, gangster Al Capone was sentenced to 11 years in prison for his failure to pay taxes for 4 years Reducing Taxable Income You can reduce taxable income without reducing gross income. Many employers offer the opportunity to make pretax contributions to employee benefit and retirement plans, and they often match a portion or all of your contribution. This is a great benefit you should take advantage of if it is offered because the law allows you to use your pretax income to buy your benefits. Federal, state, and local income taxes as well as Social Security payroll taxes are calculated based on the income left after these expenditures have been made. You save whatever tax you would have paid on that income, and your employer saves its portion of the Social Security tax. Many large employers also allow employees to take advantage of flexible spending accounts, reimbursement accounts for qualified medical and childcare expenses. Each pay period, the employer subtracts a certain amount from your paycheck and deposits it in your flexible spending account. The amount deposited is not part of your taxable income. However, these accounts may have restrictions on when you can spend the money, so you need to make sure you know how your plan works. You can obtain reimbursement from the account as you incur qualified expenses, such as child-care expenses. This allows you to pay FOR EXAMPLE Saving on Health Care Suppose you work for an employer that offers you the opportunity to purchase your health insurance with pretax dollars at a cost of $300 per month. Your friend Jonah, who earns the same salary, has no health insurance through his employer and pays out of pocket, again for $300 monthly. How much better off are you than your friend if you are both subject to a marginal tax rate of 30 percent? Your taxable income will now be lower by the $300 amount, so you ll be able to avoid paying $90 per month in taxes ($ ), or $1,080 per year. Jonah must pay taxes on his full earnings. In effect, the tax deductibility allows you to get a $1,080 discount on the cost of the health insurance (equal to your tax savings), money that you can apply to one of your financial goals.