Federal Income Taxes Part 1

     Even though I’m an accountant by degree I believe the tax laws should be so simple that the simplest American can comply with these laws on their own.  But that is a topic for another day. But keep this mind as we go through this exercise.  I will try to make this post simple, so that all can understand, but that will entail teaching you some terminology.  Please stay with me here, don’t tune out, it’s going to be long boring, but you need to understand it.  I will be using 2011 rates and rules, because as you know, things change every year and many items are adjusted for inflation.

      Today, I want to focus on federal Income Taxes.  Yes, as Americans we all pay other taxes as well, but it is because we all pay other taxes that I only want to talk about income taxes.  Income taxes are the only taxes we pay that have “exceptions to the rule”, just like in spelling, there are exceptions that we have to learn.  Everyone pays payroll taxes, Social Security Taxes, and Medicare Taxes, those are taken out of our wages at the same percentage for everyone.  No exceptions, no tax returns to file, the only way to avoid payroll taxes is to not have a job.  Even self employed people pay payroll taxes, in fact they pay more because there is an employee and employer portion, and they have to pay both.  I’m also not going to go into state income taxes, property taxes, and sales tax except as they relate to your federal income taxes.

        I want to start off by talking about Effective Tax Rates. The media will tell you that some rich guy is paying less than his stated rate because he has a large amount of deductions and “loopholes”.  The truth is that no one pays them and I will show you why.  First we have to understand the difference between how much you make in a year (Wages), Adjusted Gross Income, and Taxable Income. Taxable Income is what is left after Personal Exemptions and Standards or Itemized Deductions are taken out, and is a much smaller number than either of the other two. That is true for everyone, not just the rich people. We will go into more depth later as to how each of these numbers is derived.  After we get to the Taxable Income number, then we can apply it to the Tax Rate Schedules.  For example, if there were no deductions, exemptions, or loopholes of any kind, a couple (married filing jointly) making $50,000/year would pay tax of $8,625 for an Effective Tax Rate of 17.25% even though they are in the 25% tax bracket. I know, you are saying “What? How is that possible?” It’s because not all income is taxed at the top rate in your bracket. For this couple:

$  8,500 x 10% = $   850     Effective Tax Rate= Total Tax / Taxable Income

$26,000 x 15% = $3,900                      17.25% = $8,625 / $50,000

$15,500 x 25% = $3,875

 Total Tax             $8,625

2011 Tax Rate Schedules
Taxable Income  is Over:	But Not Over:	Tax Rate is:	Of the Amount  Over:
$0	$8,500	. . . . . . . . . .10%	$0
$8,500	$34,500	$       850 + 15%	$8,500
$34,500	$83,600	$    4,750 + 25%	$34,500
$83,600	$174,400	$  17,025 + 28%	$83,600
$174,400	$379,150	$  42,449 + 33%	$174,400
$379,150	. . . . . . . . .	$110,016.50 + 35%	$379,150

I feel I could end my discussion right here and I would have made my point, but I promised you a look at how the Effective Tax Rate changes through different income levels, so I will carry on.

     Before we get any further, let’s talk about Tax Shelters. Tax Shelters have a bad connotation in our society, bringing to mind illegal ways to shelter income from taxes. But there are legal tax shelters as well, and they exist because protecting income from taxes can be beneficial to the government in some circumstances. Popular tax shelters are 401(k) Accounts and IRA s for retirement, Flex Savings Accounts and Medical Savings Accounts for medical costs, and 529 plans for college. It benefits the government if people have these types of accounts because they will rely less on the government during retirement, for medical expenses, and college expenses. The government allows deductions from our taxable income for money we have contributed to charity because the more help charities can give to those in need, the fewer people apply for government assistance. We are allowed to deduct interest paid on a home mortgage and also property taxes paid on a home to promote home ownership because home ownership contributes to more stable families and neighborhoods.  There are also deductions or credits for college expenses because if taxpayers go to college and graduate, they are more likely to have a higher income throughout their life, be more self-sufficient and pay higher taxes throughout their lifetime.  More specifically, these shelters can be lumped into five categories:Tax Exemptions, Tax Exclusions, Tax Deferrals, and Tax Deductions.

•        Tax Exemptions reduce taxable income. For individual tax filing, this is usually the Personal Exemption for yourself, your spouse, and your dependents.
•          Tax Exclusions exclude certain amounts from taxable income.  An example of this is employer sponsored health insurance and also Flex Savings Accounts . While many taxpayers take advantage of Flex Accounts, many others find it too hard to estimate what costs will be and if you don’t use it, you lose it. Under the Affordable Healthcare Act, Flex Accounts will be limited to $2,500 per year, but they are considering dropping the use it or lost it rule, but exactly what that would look like in the end is still up in the air.
•          Tax Deferrals allow taxpayers to postpone paying taxes on income until a later date. 401(k) and Traditional IRA plans are good examples of this.
•          Tax Credits are a dollar for dollar reduction in tax owed. This is better than any other type of shelter, others only reduce the amount income that is taxed. Credits offset taxes owed. Examples are the Earned Income Credit, the Child and Dependent Care Credit, 1^st Time Home Buyer Credit, Retirement Savings Contributions Credit, Child Tax Credit, and the American Opportunity Credit.  Some credits are refundable (meaning if they are more than the tax you owe, you can still get a refund), while others are not.
•          Tax Deductions are available to everyone whether you itemize or not. There is the Standard Deduction of $11.600 for Married Filing Joint in 2011, and this applies whether you have spent that much in deductible amounts or not. You only itemize your deductions if you have spent more than $11,600 in qualified deductions.  The conventional wisdom is that most people don’t itemize their deductions. I don’t know if they are scared of being audited if they do, or they don’t have enough to. Generally, for most people, if you own a home with a mortgage and real estate taxes, you should itemize. Some deductions are limited to amounts over a percentage of your AGI (Adjusted Gross Income), Medical expenses are limited to amounts over 7.5% of AGI, and expenses that have not already been covered by a FSA. Miscellaneous deductions are limited to amounts over 2% of AGI.

     The topics I have covered so far are the ones that average taxpayers are going to see. There are many more topics that could have been covered, but because most people don’t ever see them, I won’t take the time. I’ll leave that to the tax lawyers and tax accountants. At this point, I think your eyes have glazed over. I know it has given me a headache! I’m going to end this post here, and Part 2 will show the actual income level examples I promised. I just know that no one will read it if I put it all together into one post, in fact, I’ve probably already lost you. Can you see why I favor one low tax rate for everyone, something that could be assessed like Social Security Taxes, not needing returns to deal with the exceptions? Richer people would still pay more because 10% of $1,000,000 is still a lot more than 10% of $10,000, or 10% of $100,000. I know that view is too extreme for everyone else.  Or another possibility is only allowing for Personal Exemptions, so that the size of each family is taken into consideration. I just think that complying with the tax laws should be within everyone’s grasp. We shouldn’t have to hire an accountant because the laws are so complex!

      Look for Part 2 coming soon!

Light Bulb Moments

  A couple of weeks ago, I was pondering why some people are so sure that they pay more in federal income taxes than rich people do. The whole idea was just mind-boggling to me. Then it hit me, that light bulb of understanding that made me realize that people are told that, therefore they believe it. Most people don't do their own taxes, so they don't have personal experience crunching the numbers for themselves. I decided to write an blog post about income taxes, to explain in layman's terms why the rich don't pay less than average people. I threw out the suggestion on Facebook, asked if there would be interest if I took the time to write it, and there was a lot of interest. So, I've spent the last week doing some research.

     In the process of doing research, I realized there are many other connected things that the average person doesn't understand, including me. The entitlement programs of our government have been much maligned, but what are they? What requirements must be met to qualify for them? I know if my neighbor lost their job, was in danger of losing their house, I would be looking for ways to help them. But in the aggregate, it's easy to assume that people are getting benefits they don't deserve. If I don't understand them, I'm betting the majority of Americans don't really understand them either.

     The other light bulb of understanding went off yesterday as I was reading an article about the federal budget. Of course I can't find the article again to cite the source, I thought I had bookmarked it, but my bookmarks are full. The gist of the article was that democrats use tax cuts as bargaining chips to get additional spending approved while republicans use spending approvals to get their tax cuts passed. It's called cooperation and compromise (which there hasn't been much of lately), to "get things done". The real effect of such cooperation has been to reduce federal revenues while increasing spending. Thus, our exploding federal debt. This has got to stop, but to really stop it, both sides of the isle will have to compromise. We need a new type of cooperation, throwing out all previous prejudices, looking for new solutions not just old ones tied up in new string.

    To really solve our debt problems it's going to hurt all of us, and it needs to. There needs to be shared sacrifices, not one group thinking the rich should bail everyone else out, or the other group thinking they shouldn't have to pay for someone's big screen TV and a dozen tattoos. The problem is people on both sides know of people who have cheated the system. Yes, some rich people hide income in tax shelters, but did you know that there are legal tax shelters and illegal ones? The legal ones are there for a reason, and we use them everyday. The government is continually cracking down on the illegal ones, but new ones keep popping up. It isn't always the rich taxpayer that's doing the cheating, they are relying on advice from tax lawyers and accountants, sometimes that advice is bad. On the other hand, some welfare recipients know how to milk the system, have figured out how to get by without looking for work, don't use their benefits for the things they should, etc. etc. To fix the country's debt problems, we need to go forward with an attitude somewhere in the middle.

    I'm going to make my blog post on taxes a series of posts starting with taxes first. Later posts will look in depth at Social Security, Medicare and Medicaid, Social Security Disability, Welfare, Food Stamps, Unemployment Benefits. After that, if I'm not tired of writing, we'll see what happens. First, and foremost, I will try to make the posts bipartisan and factual. I want people to read them, not just assume that everything will have a republican slant. I want all to understand.