1
CHAPTER 3
Taxes in Your Financial Plan
“In this world, nothing is certain but death and taxes.”
– Benjamin Franklin, Statesman, Inventor, Author
“Taxes are the price we pay for a civilized society.”
– Oliver Wendell Holmes, Jr., Civil War veteran, Supreme Court Judge
“Only the little people pay taxes.”
– Leona Helmsley, Hotel Owner, Fashion Designer, Prison Inmate
President Bush’s tax cuts on investment income reduced
tax bills by an average of $500,000 on incomes of more
than $10 million. (The New York Times)
It was part of his “Leave No Billionaire Behind” program …
2
Taxes and Financial Planning

About one-third of each dollar you earn goes
to pay taxes



(May Day has become Tax Freedom Day)
Understanding tax rules and regulations can
help you reduce your tax liability
To help you cope with the many types of taxes
you should...
 Know current tax laws as they affect you
 Make purchase and investment decisions that
reduce your tax liability
 (But be careful: Not all tax-advantaged investments are good deals)
 Maintain complete tax records
3
Four Types of Taxes
 Taxes on purchases
 Sales tax & excise tax
 Taxes on property
 Property tax (on real estate)
 Personal property tax (DMV)
 Taxes on wealth
 Federal estate tax and gift tax
 State inheritance tax
 Taxes on earnings
 Income tax
4
Fifth Type of “Tax”

Social Security “Taxes”
 6.20% of Gross Salary

Medicare “Taxes”
 1.45% of Gross Salary

If self-unemployed, almost twice this
amount!
 The self-employed pay the employer’s portion
as well as their own (They are their own
employer)
Social Security and Medicare contributions are not technically
taxes but for personal financial planning, it makes sense for us to
think of them as taxes. They are often called “payroll taxes.”
Effect of Taxes
Or “How Much Does It
Really Cost?”
Price of Stereo
California State Sales Tax – 8.0%
Subtotal – “Out of Pocket”:
$299.00
23.92
$322.92
Federal Income Tax – 25%
California State Income Tax – 7%
Subtotal – Income Taxes:
$133.77
37.46
$172.23
Total – “Out of Pocket” & Taxes:
$494.15
And what if we add in Social Security?
$535.08
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6
Let’s calculate how much it really costs
“Out of Pocket” Expense
Actual Expense= ———————————
( 1 – Marginal Tax Rate)
$322.92
$535.08 = —————————————
( 1 – (25% + 7% + 7.65%) )
And you thought I was exaggerating, didn’t you?
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Filing Your Federal Income Tax Return

Who Must File?



Single $10,150; Married $20,300; etc.
But in reality, anyone who earned income and
paid taxes should file (If only to get a refund or
to claim the Earned Income Credit!)
There are five filing status categories





Single or legally separated
Married, filing jointly
Married, filing separately
Head of household
Qualifying widow or widower
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Which Tax Form Should You Use?
1040EZ
 Single or married filing jointly, under age 65
and with no dependents
 Income consisted of wages, salaries, and tips,
and no more than $1,500 of taxable interest
 Taxable income is less than $100,000
 No adjustments to income (retirement accts)
 No itemized deductions
Some folks were even eligible
 No income tax credits
to file using the telephone.
IRS got rid of this program.
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Decide Which Tax Form to Use(continued)
1040A
 Taxable income less than $100,000
 Some adjustments to income are allowed
 Some tax credits are allowed such as the
child care and dependent care credits
1040
 Required to use this form if income is over
$100,000 – Must use if you itemize
deductions
The 1040A form is just a tad bit easier than the 1040 form.
My advice is to always use the 1040 form.
What Tax Records to Keep
 Current tax forms and instruction booklets
 Social security numbers
 Copy of previous year’s returns
 W-2 form from employer
 1099 forms (interest, self employment)
 1098 (mortgage interest paid)
 Receipts, documentation
 Investment & business expense documents
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How Long Should You Keep Tax
Records?
11
 The IRS sez…
 “3 years from the date the return was due or filed,
or,
 2 years from the date the tax was paid, whichever
is longer”
 But then the IRS also sez…
 “You should keep some records longer”
 But they don’t say which records or how long
 Thanks a lot, guys!
 I sez…
 “Keep ‘em forever!”
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Let’s Start on the 1040 Form

Income (top half of page 1)


Adjustments to Income (bottom half of page 1)


Wages, interest, investments returns, business
profit, real estate profit, pension fund income, etc.
Student expenses, retirement contributions, etc.
Adjusted Gross Income (AGI) – (bottom of page 1)

Gross income (wages, etc.) minus adjustments to
income (retirement accts, alimony, etc.)
 Bottom line on front page of Form 1040 and top line on
back page of Form 1040
The AGI is an important number. Many tax items are tied to
AGI such as the ability to contribute to retirement accounts
or utilize certain deductions and personal exemptions.
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Computing Adjusted Gross Income
Income
(line 7 – W2)
Earned Income
+ Business Income
(line 22)
+ Investment Income, etc.
Total Income
(line 36)
Adjustments
Retirement contributions
to
+ Alimony paid
Income
+ Student loan expenses, etc.
Total Adjustments to Income
(lines 37 & 38)
AGI
Adjusted Gross Income
Total Income – Total Adjustments
Form 1040 – Page 1
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Income Tax Fundamentals

Tax Deductions – Amount subtracted from AGI to
arrive at Taxable Income
 Standard Deductions for 2014 – $6,200 single,
$12,400 married, $9,100 head of household or
 Itemized Deductions – Schedule A (medical
expenses, mortgage interest, gifts to charities,
property & state taxes) , and
 Personal Exemptions – Deductions for you, your
spouse & dependents – $3,950 per person for 2014
You get to claim the Standard Deduction or the Itemized
Deductions. But you can not claim both! This is a great
source of confusion for many people. Everyone gets to claim
the Personal Exemptions (unless your AGI is too much).
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Computing Taxable Income
Adj Gross Inc
- Std Deductions
- Pers Exemptions
Taxable Income

line 40
line 42
line 43
Adj Gross Income
- Itemized Deductions
- Personal Exemptions
Taxable Income
Standard Deduction (Tax year 2014)


or
$6,200 for singles, $12,400 for married couples, etc.
Itemized Deductions


Only used if greater than Standard Deduction
Deductions reported on Schedule A
Taxable Income is then used to compute Tax
Form 1040 – Top of Page 2
(line 44)
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Computing Tax Due

Taxable Income is used to compute Tax
Tax Tables (up to $100,000; for most people)
 Tax Rate Schedules
 One of the other methods (Schedule D, etc.)
 Marginal Tax Rate – The rate used to calculate
the tax due on the next dollar of Taxable Income
 The rates are 10%, 15%, 25%, 28%, 33%, 35%



The 39.6% rate was reintroduced starting in 2013
Average Tax Rate – Total Tax Due divided by
the Taxable Income (not really very important but good
to be aware of − if only to debunk the flat-tax advocates)
Form 1040 – Top of Page 2
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2014 Marginal Tax Rates
Single
Rate
Married
Rate
$0
$9,075
10%
$0
$18,150
10%
9,075
36,900
15%
18,150
73,800
15%
36,900
89,350
25%
73,800
148,850
25%
89,350
186,350
28%
148,850
226,850
28%
186,350
405,100
33%
226,850
405,100
33%
405,100
406,750
35%
405,100
457,600
35%
39.6%
457,600
406,750
39.6%
The 39.6% rate was reintroduced in 2013 after years of
fighting between the two parties. Since 2001, the rates
were temporary. After the “fiscal cliff” fight at the end of
2012, the rates became permanent … until the next clash.
Plus each year they are adjusted for inflation.
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2013 Marginal Tax Rates
Single
Rate
Married
Rate
$0
$8,925
10%
$0
$17,850
10%
8,925
36,250
15%
17,850
72,500
15%
36,250
87,850
25%
72,500
146,400
25%
87,850
183,250
28%
146,400
223,050
28%
183,250
398,350
33%
223,050
398,350
33%
398,350
400,000
35%
398,350
450,000
35%
39.6%
450,000
400,000
39.6%
The percentage rates do not change. The tax brackets are
simply adjusted upward according to the inflation rate.
The 2012 brackets were lower than the 2013, the 2011
lower than the 2012, etc.
Example: Computing Tax Due Using
2014 Marginal Tax Rates
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Example: You are single with $37,900 of taxable income
Single
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%
Computations
$9,075 * 10%
Tax
$907.50
($36,900-9,075) * 15% $4,173.75
($37,900-36,900) * 25%
$250.00
Total Tax: $5,331.25
The first $9,075 is taxed at the first marginal rate of 10%
Between $9,075 and $36,900 you are taxed at the second rate of 15%
Any amount over $36,900 (in this case, $37,900 – $36,900 = $1,000)
is taxed at the third marginal rate bracket of 25%
The next dollar you make is always taxed at your current marginal rate.
The Average Tax Rate
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Example: The single taxpayer from the previous
slide had $37,900 of taxable income and
$5,331.25 of taxes due
The Average Tax Rate is therefore:
$5,331.25 ÷ $37,900 = 0.14067 ≈ 14.1%
Discussion: Who would win and who
would lose with a “Flat Tax?”
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The “Marriage Penalty”
Single
Rate
Married
Rate
$0
$9,075
10%
$0
$18,150
10%
9,075
36,900
15%
18,150
73,800
15%
36,900
89,350
25%
73,800
148,850
25%
89,350
186,350
28%
148,850
226,850
28%
186,350
405,100
33%
226,850
405,100
33%
405,100
406,750
35%
405,100
457,600
35%
39.6%
457,600
406,750
39.6%
If the marginal rates are higher for single taxpayers, how come we sometimes
hear people complain about the so-called “marriage penalty?”
Because the second wage-earner in the family pays their taxes at the highest
marginal rate. They do not get to take advantage of the lower tax brackets.
Actually, married couples with only one wage-earner get rewarded, not punished.
But, of course, they need more money because they are two.
In 2003, Congress removed the marriage penalty for the first two brackets and
extended it several times, making it permanent during the “fiscal cliff” fight of
December 2012 … until the next Congressional tax confrontation.
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The Dreaded AMT!

Alternative Minimum Tax – Line 45


Originally meant to make sure everyone who could
afford to pay would pay some taxes
Originally targeted to the very wealthy



The AMT will continue to affect more and more of
the middle class as wages climb with inflation


However, the AMT was and is still not indexed to
inflation
When it was created in the late 1960’s, $100,000
was a very unusual and substantial income
Especially two-income families
Always talk in Congress about eliminating it

But would add over $1.5 trillion to the budget deficit
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Tax Credits

(Are you still with us?)
Tax Credit – An amount subtracted directly
from the amount of taxes due





Foreign tax credits (48) & Education credits (50)
Child care credits (49) & Child tax credits (52)
Retirement savings contribution credit (51)
Energy & Other Credits (53 & 54)
Earned Income Credit (Not until line 66a)
Taxes After Deductions/Exemptions line 47
- Total Credits - line 55
Taxes Due after Credits line 56
Form 1040 – Upper middle portion of Page 2
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Tax Credit versus Tax Deduction

$100 Tax Credit
 Reduces your tax by $100 – “dollar for dollar”

$100 Tax Deduction
 Reduces your tax by the marginal tax bracket

Example – Tax Deduction





25% Tax Bracket
$100 * 25% = $25 reduction in Federal taxes
$100 * 7% = $7 reduction in California taxes
$32 total tax reduction
Never a reduction in Social Security taxes
A tax credit is worth more than a tax deduction.
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Other Taxes
(Wait! There might be more!)
Self-employment Taxes – Social Security &
Medicare taxes on the self-unemployed
 Social Security & Medicare taxes on tips
 Penalty Taxes on retirement and medical
savings account withdrawals
 Household employment taxes

Taxes After Credits
+
Other Taxes
Total Taxes Due
Form 1040 – Middle of Page 2
line 56
+ line 57-62
line 63
Making Tax Payments - Withholding
1 Control number
3 Employer's Identification number
W-2 Form 26
4 Employer's State number
Copy B to be filed with
employee's FEDERAL tax return
2 Employer's name, address, and ZIP code
Information Data, Inc.
9834 Collins Blvd.
Benton, NJ 08734
This information is being furnished to the
Internal Revenue Service
W-2 Wage and
Tax Statement
5 Statutory De- Legal 942 Sub- Void
Employee ceased rep. emp. total
Determine tax withheld
8 Employee's social sec. number
123-45-6789
9 Federal Income tax withheld 10 Wages, tips, other comp
2,678.93
12 Employee's name, address, and ZIP code
11 Soc sec tax withheld
23,972.09
1,725.99
13 Social security wages
14 Social security tips
23,972.09
Barbara Victor
124 Harper Lane
Parmont, NJ 07819
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17 State income tax
20 Local income tax
Department of the Treasury Internal Revenue Service OMB No. 1545-0008
16-0331690
16a Fr ben. incl in Box 10
18 St wages, tips, etc
19 Name of State
21 Loc wgs, tips, etc
22 Name of locality
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Payments

Withholding – “Pay As You Go” sez the IRS



(Relax. We are in the home stretch…)
“Forced savings” or “But I like a big tax refund”
means you are giving the Feds a free loan
Do your best to estimate tax bill (90%, 100%)
Estimated Payments – Quarterly


Self-employed
Other income not subject to withholding
Total Taxes Due
- Total Payments
Overpaid or Amount You Owe
line 63
- line 74
line 75 or 78
Form 1040 – Bottom of Page 2
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How to Avoid Common Filing Errors








Check your arithmetic, twice
Attach necessary documentation
Put your Social Security number, the tax year
and form number on the check
Make your check payable to the United States
Treasury
Keep a photocopy of your return
Put proper postage on your mailing envelope
Finally, check everything again
Form
If you need more time, file an extension! 4868
“Uh, Oh!”
If you find you have made a mistake,
should you…
Leave The Country?
B. Commit Suicide?
C. Pretend It Didn’t Happen?
D. File Form 1040X?
A.
The correct answer is (D). File Form 1040X.
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And Don’t Forget the State of CA



Once the Federal 1040 is finished, you get
to tackle the State of California’s Form 540
Fortunately, it is far less than ½ the work
Just Two Forms (usually)


Form 540
Schedule 540CA (California Adjustments)
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Tax Information Sources

The IRS has several methods of assistance
 Publications and forms 1-800-TAX-FORM
 Recorded messages 1-800-829-4477
 Phone hot line 1-800-829-1040 (much, much better)
 Walk-in service at an IRS office
 New e-mail service (I have been impressed with this!)


Tax publications - JK Lasser’s Your Income Tax
The Internet

www.irs.gov (Very useful – especially for downloading forms)

There are literally thousands of tax-related web sites
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Tax Information Sources

(continued)
Tax preparation software and electronic filing



Intuit’s TurboTax and other programs will print your
returns for mailing or send them electronically
Most companies will now let you file using your
browser on the Internet
Spreadsheets can be used to maintain tax data on
various income and expense categories
TurboTax has been the most popular program for many years.
Lately, other companies such as H&R Block At Home and TaxAct
have been gaining market share.
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Tax Information Sources

(continued)
Tax preparation services
 Tax Preparers, Enrolled Agents (government-
approved tax experts), Accountants (CPAs) or
Tax Attorneys
 If your professional tax preparer makes a
mistake, you are still responsible for paying the
correct amount, plus any interest and penalties
 For this reason, it is important to at least
understand the forms you are signing and check
that the numbers are reasonable
The IRS has created a registration and testing process for tax preparers.
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Tax Audits

Just under 1.0% of all returns are audited
 Relax! Many are just because of arithmetic errors
 If you claim large or unusual deductions, you are
more likely to be audited
 There are three types of audits
 Correspondence audit for minor questions
 Office audit takes place at an IRS office
 Field audit is the most complex, with an IRS agent
visiting your home, business or accountant’s office
(avoid this type at all costs!)

You have audit rights including time to prepare for
the audit
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Tax-Planning Strategies

Tax Evasion
 Illegally not paying all the taxes you owe,
such as not reporting all income

Tax Avoidance
 Legitimate methods to reduce your tax
obligation to your fair share but no more
Americans avoid about $50 billion in taxes annually by hiding
money in offshore accounts. As much as $1.6 trillion in North
American wealth is held offshore. (USA Today)
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Tax-Planning Strategies

(continued)
Put money in tax-deferred investments

Tax-deferred annuities (Only after retirement accounts
are funded to the maximum – very high fees)



Series EE U.S. Treasury bonds (Yawn)
Take advantage of tax-deferred retirement plans
(Now we’re talking!)
 401(k), 403(b) plans (Through your employer)
 Traditional or Roth IRA (Roth is better)
 Education IRA or 529 plan (Roth is better)
 Keogh, SEP or SIMPLE IRA if self-employed
Long-term capital gains (Lower rates than income)
37
Tax-Planning Strategies




(continued)
Owning a home is one of the best tax shelters
because you can deduct mortgage loan interest and
property taxes when you itemize – This reduces
your taxable income (Paid Advertisement from your
Friendly Local Real Estate Agent)
Use your home equity line of credit to buy a car or
consolidate debt (Careful! More later in Chapter 5)
Use tax-exempt investments, such as municipal
bonds (Only after retirement accounts are funded to the
maximum unless you are very wealthy)
Start a Business (Not a Hobby)
Let’s look at some home and business tax-planning examples…
38
Home Ownership Example 1
2014 Taxes With No Home Deduction
Single
Married
$50,000
$50,000
6,200
12,400
43,800
37,600
3,950
7,900
Taxable Income:
39,850
29,700
Taxes with no Home
Deduction:
$5,825
$3,551
Adjusted Gross Income
Standard Deduction
Subtotal:
Personal Exemptions
39
Home Ownership Example 1 (continued)
Itemized Deductions from Home Ownership
Deduction
State Income Tax
Real Estate Property Tax
DMV Property Tax
Mortgage Interest ($360,000*4%)
Gifts to Charity
Total Itemized Deductions:
$1,000
2,900
200
14,400
500
$19,000
40
Home Ownership Example 1 (continued)
2014 Taxes With Home Deduction
Single
Married
$50,000
$50,000
19,000
19,000
31,000
31,000
3,950
7,900
Taxable Income:
27,050
23,100
Taxes with Home
Deduction:
$3,608
$2,561
Adjusted Gross Income
Itemized Deductions
Subtotal:
Personal Exemptions
41
Home Ownership Example 1 (continued)
Tax Savings for $50,000 Incomes
Single
Without Home Deduction
With Home Deduction
Tax Savings:
Married
$5,825
$3,551
3,608
2,561
$2,217
$990
For married couples buying at the low end of the housing
market, the tax savings are not as large as the real estate
agents make them out to be.
42
Home Ownership Example 2
2014 Taxes With No Home Deduction
Single
Married
$80,000
$80,000
6,200
12,400
73,800
67,600
3,950
7,900
Taxable Income:
69,850
59,700
Tax with no Home
Deduction:
$13,325
$8,051
Adjusted Gross Income
Standard Deduction
Subtotal:
Personal Exemptions
43
Home Ownership Example 2 (continued)
Itemized Deductions from Home Ownership
Deduction
State Income Tax
Real Estate Property Tax
DMV Property Tax
Mortgage Interest ($720,000*4%)
Gifts to Charity
Total Itemized Deductions:
$2,000
5,000
400
28,800
800
$37,000
44
Home Ownership Example 2 (continued)
2014 Taxes With Home Deduction
Single
Married
$80,000
$80,000
37,000
37,000
43,000
43,000
3,950
7,900
Taxable Income:
39,050
35,100
Taxes with Home
Deduction:
$5,625
$4,361
Adjusted Gross Income
Itemized Deductions
Subtotal:
Personal Exemptions
45
Home Ownership Example 2 (continued)
Tax Savings for $80,000 Incomes
Single
Without Home Deduction
With Home Deduction
Tax Savings:
Married
$13,325
$8,051
5,625
4,361
$7,700
$3,690
Once your income reaches the middle to upper-middle class
level, a home is normally a very good tax shelter.
46
Home Business Example
 Remember
that $299 stereo that cost us
$535? Well, if it is a legitimate business
expense, then that same $299 stereo
costs us just $319!

You still have to pay state sales tax unless
you plan to resell it as retail. But you also
get to deduct the state sales tax as a
business expense.
When could a stereo be a legitimate business expense?
47
“Donate Your Car! Get A Tax Break!”

An all too familiar spiel we hear from charities
these days is that you can donate your car and
get a $2,500 tax break

In the 25% bracket, a $2,500 deduction is worth $625


Not a bad deal, eh?


Of course, you might only get $50 in cash if you asked
the junk man to come and get it
Well, no more. The charity must now sell the car and tell
you the actual amount they received for the car
However, if you don’t itemize deductions using
Schedule A and instead take the standard deduction,
then you can not take the deduction anyway!

Many people have been burnt by this tactic
48
The Bottom Line
 “Death
 Pay
& Taxes”
Benjamin Franklin
Your Taxes & Quit Complainin’!
 “Death,
Taxes & Tax Law Changes”
 And
if we want real tax reform, all we
really have to do is require the Senators
and Representatives in Congress to do
their own tax returns!

(But don’t hold your breath …)