Taxes in Your Financial Plan

CHAPTER3 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, Convicted Tax Felon 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…

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

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

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?”

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?

Filing Your Federal Income Tax Return • Who Must File? • Single $10,400; Married $20,800; 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

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 • No income tax credits Some folks were even eligible to file using the telephone. IRS got rid of this program.

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 • Required to use this form if income is over $100,000 – Must use if you itemize deductions 1040 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

How Long Should You Keep Tax Records? • 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!”

Republican Tax Cuts of 2017 • Introduced many changes to the tax code • Many of which we will highlight as we slog through the Form 1040 for tax year 2017 starting on the next slide • Some changes are politically divisive and hurt states that are primarily Democratic • The tax cuts go overwhelmingly to the rich • Estimates range from 62% to 83% of the cuts go to those in the top 1% • Will increase the Federal deficit • Estimates range from $500 billion to $1.7 trillion • Corporate tax cuts are permanent but individual tax cuts will phase out after 8 years meaning that … • By 2027, approximately 53% of individuals will pay more

Let’s Start on the 1040 Form • Income (top half of page 1) • Wages, interest, investments returns, business profit, real estate profit, pension fund income, etc. • Adjustments to Income (bottom half of page 1) • 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.

Computing Adjusted Gross Income (line 7 – W2) Income Earned Income + Business Income + Investment Income, etc. Total Income Adjustments Retirement contributions to + Alimony paid Income + Student loan interest, etc. Total Adjustments to Income AGI = Total Income – Total Adjustments (line 22) (line 36) (lines 37 & 38) Adjusted Gross Income Form 1040 – Page 1

Income Tax Fundamentals • Tax Deductions –Amount subtracted from AGI to arrive at Taxable Income • Standard Deductions for 2017– $6,350 single, $12,700 married, $9,350 head of householdor • Itemized Deductions–Schedule A (medical expenses, mortgage interest, gifts to charities, property & state taxes) ,and • Personal Exemptions–Deductions for you, your spouse & dependents – $4,050 per person for 2017 You get to claim the StandardDeduction 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). The Personal Exemptions were removed in the 2017 tax cut bill starting in 2018.

Computing Taxable Income Adj Gross Inc or Adj Gross Income - Std Deductions - Itemized Deductions - Pers Exemptions- Personal Exemptions Taxable Income Taxable Income • Standard Deduction (Tax year 2017) • $6,350 for singles, $12,700 for married couples, etc. • The Standard Deductions double in 2018 • Itemized Deductions • Only used if greater than Standard Deduction • Deductions reported on Schedule A • Personal Exemptions ($4,050 per person 2017) Taxable Income is then used to compute Tax Due line 40 line 42 line 43 (line 44) Form 1040 – Top of Page 2

Computing Tax Due • Taxable Income is used to compute Tax Due • 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 • 10%, 15%, 25%, 28%, 33%, 35%, 39.6% • The rates have changed for 2018 to 2025 (more later) • 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

2017 Marginal Tax Rates From 2001 until the end of 2012, the tax rates were temporary and adjusted every couple of years. After the “fiscal cliff” fight at the end of 2012, the rates became permanent … until the end of 2017. The tax rates are temporary again after the tax cut bill but Republicans have vowed to make them permanent by 2025.

2016 Marginal Tax Rates The percentage rates normally do not change. The tax brackets are simply adjusted upward according to the inflation rate. The 2015 brackets were lower than the 2016, the 2014 lower than the 2015, etc. Note: The tax rates were changed substantially in December 2017. The new tax rates for 2018 are on the next slide.

2018 Marginal Tax Rates The December 2017 tax cuts will give the average poor family a tax cut of $60. The middle class will see an average tax cut of $930. Folks in the 95th to 99th income brackets will get about $13,480 back. The top 0.1% will see an average tax cut of $193,380. However, once the plan is fully phased in, taxes go up for the bottom 40%, will be unchanged for the middle 40%, go down slightly for the 80% to 99% range, and fall sharply for the top 1%.

Example: Computing Tax Due Using 2017 Marginal Tax Rates Example: You are single with $38,950 of taxable income The first $9,325 is taxed at the first marginal rate of 10% Between $9,325 and $37,950 you are taxed at the second rate of 15% Any amount over $37,950 (in this case, $38,950 – $37,950 = $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 Example: The single taxpayer from the previous slide had $38,950 of taxable income and $5,476.25 of taxes due The Average Tax Rate is therefore: $5,476.25 ÷ $38,950 = 0.1406 ≈ 14.1% Discussion: Who would win and who would lose with a “Flat Tax?”

The “Marriage Penalty” 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 people. 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.

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 • However, the AMT was never indexed to inflation • When it was created in the late 1960’s, $100,000 was a very unusual and substantial income • The AMT will continue to affect more and more of the middle class as wages climb with inflation • Especially two-income families • Was eliminated for businesses in the 2017 tax bill • But not for individuals

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 - Total Credits Taxes Due after Credits line 47 - line 55 line 56 Form 1040 – Upper middle portion of Page 2

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.

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 line 56 + line 57-62 line 63 Form 1040 – Middle of Page 2

Determine tax withheld Making Tax Payments - Withholding W-2 Form

Payments (Relax. We are in the home stretch…) • Withholding – “Pay As You Go” sez the IRS • “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

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 • If you need more time, file an extension! Form 4868

“Uh, Oh!” If you find you have made a mistake, should you… • Leave The Country? • Commit Suicide? • Pretend It Didn’t Happen? • File Form 1040X? The correct answer is (D). File Form 1040X.

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)

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’sYour Income Tax • The Internet • www.irs.gov (Very useful – especially for downloading forms) • There are literally thousands of tax-related web sites

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 prefer 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, TaxAct, and TaxSlayer have been gaining market share.

Tax Information Sources (continued) • Tax preparation services • Tax Preparers, Enrolled Agents (government-approved tax experts), Accountants (CPAs) or Tax Attorneys • VITA here at Southwestern! (Free for those who qualify) • 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.

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 (You want to avoid this type at all costs!) • You have audit rights including time to prepare for the audit

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)

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)

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 (Ooops! Eliminated by new tax bill!) • 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…

Home Ownership Example 1 2017 Taxes With No Home Deduction

Home Ownership Example 1(continued) Itemized Deductions from Home Ownership

Home Ownership Example 1(continued) 2017 Taxes With Home Deduction

Home Ownership Example 1(continued) Tax Savings for $50,000 Incomes For married couples buying at the lower end of the housing market, the tax savings are not as large as the real estate agents make them out to be.

Home Ownership Example 2 2017 Taxes With No Home Deduction

Home Ownership Example 2(continued) Itemized Deductions from Home Ownership *The new tax cuts limit the amount of state and local taxes deductions to $10,000 and the amount of mortgage interest from the first $750,000 of your mortgage.

Home Ownership Example 2(continued) 2017 Taxes With Home Deduction

Home Ownership Example 2(continued) Tax Savings for $80,000 Incomes Once your income reaches the middle to upper-middle class level, a home is normally a very good tax shelter. However, be mindful of the limits imposed by the new Republican tax cuts. Some states are binding together and suing the Federal government to overturn the new limits. Stay tuned!

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?

“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 • Of course, you might only get $50 in cash if you asked the recycling yard to come and get it • Not a bad deal, eh? • 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

The Bottom Line • “Death & Taxes” Benjamin Franklin • Pay 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 … instead become a CPA or tax preparer and you will be guaranteed lifetime employment)

Taxes in Your Financial Plan