Personal Taxes in the U.S.
The personal tax code affects individuals’ financial decisions in a variety of ways. What follows is a selective overview of some of the more important features.
Background Information
- The U.S. tax code is moderately progressive, in that high-income people pay a larger percentage of income in taxes than lower income people (this applies in theory - in reality many high income people take advantage of tax shelters and tax breaks which greatly reduce the taxes they pay).
- Certain aspects of the tax code are regressive in that they place a larger tax burden on people making less income. For example, lower income people spend a larger portion of their income on food than wealthier people - a sales tax on food would thus be regressive. You pay social security tax on the first (approximately) $87,000 of income - this tax is thus regressive because high income individuals pay no tax on their incomes above the social security limit.
The tax form filed by most individuals is referred to as the 1040. The steps to completing your taxes are as follows:
1) Choose your filing status: single, married filing jointly, etc.
2) Indicate the number of exemptions or dependents - you can include yourself and anyone else for whom you are financially responsible. Each dependent reduces your taxable income by $3,200 (as of 2005).
3) Indicate all sources of income. This includes wages and salaries, investment income like interest, dividends, and capital gains, alimony received, business income (if you are a sole proprietor), money received from retirement accounts and pensions, etc. This also includes things like quiz show earnings, royalties from books or recordings, loans that are forgiven, etc.
4) Next, you are allowed to adjust your income downward based on certain allowable expenditures, including contributions to your retirement accounts (IRA deduction and Self-employed SEP, SIMPLE, or qualified plans), interest on your student loans (up to a certain limit that changes over time), tuition and fees for educational expenses or moving expenses required to keep your job, alimony paid, and if you are self-employed, a portion of your social security tax and health insurance premiums.
5) Line 38 - itemized deductions. You are allowed to deduct certain expenditures from your taxable income, including things like state and local income taxes, local property taxes, interest on your home mortgage, charitable contributions (especially those to Colby), medical and dental expenses that exceed a given percentage of your income, etc. If you are single and the total of your itemized deductions exceeds $4,850 (in 2004) you get to deduct the full amount (technically your deductions may be reduced if you are subject to the Alternative Minimum Tax (see line 43) but this is very complicated and left to CPAs). If your itemized deductions do not exceed $4,850, then you can claim $4,850 as the standard deduction.
6) You may also be entitled to tax credits for things like taxes paid to foreign governments, child care expenses, adoption expenses, education credits, credits for taking care of an elderly relative, etc.
7) Finally, subtract all of your allowable deductions, credits, etc. to obtain your taxable income - you then calculate the amount of tax you owe using the table below:
ScheduleX — Single
If taxable income isover-- / But not over-- / The tax is:$0 / $7,300 / 10% of the amount over $0
$7,300 / $29,700 / $730 plus 15% of the amount over 7,300
$29,700 / $71,950 / $4,090.00 plus 25% of the amount over 29,700
$71,950 / $150,150 / $14,652.50 plus 28% of the amount over 71,950
$150,150 / $326,450 / $36,548.50 plus 33% of the amount over 150,150
$326,450 / no limit / $94,727.50 plus 35% of the amount over 326,450
Schedule Y-1 — Married Filing Jointly or Qualifying Widow(er)
If taxable income isover-- / But not over-- / The tax is:$0 / $14,600 / 10% of the amount over $0
$14,600 / $59,400 / $1,460.00 plus 15% of the amount over 14,600
$59,400 / $119,950 / $8,180plus 25% of the amount over 59,400
$119,950 / $182,800 / $23,317.50plus 28% of the amount over 119,950
$182,800 / $326,450 / $40,915.50 plus 33% of the amount over 182,800
$326,450 / no limit / $88,320.00plus 35% of the amount over 326,450
Examples (assuming you're single):
1) if your taxable income was between 0-$7,000 (say $5,000):
Your tax = (.10) ($5,000) = $500
Your marginal tax rate, or the tax you would owe on the next dollar of income is 10%.
Your average tax rate, calculated as the total tax divided by your income is 500/5,000 = 10%.
2) Taxable income of say $20,000:
You owe 10% on the first $7,300 ($730), plus 15% of anything over $7,300, so the total bill is 730 + (.15)(20,000-7,300) = 730 + 1,905 = 2,635.
Your marginal tax rate is 15%, implying that you would owe 15% of the next dollar earned.
Your average tax rate is 2,635/20,000 = 13.18%, implying that on average you paid 13.18% out of each dollar in taxes. (Notice your average rate will always be less than or equal to your marginal rate).
3) Taxable income of say 40,000:
You owe 10% of the first $7,300, 15% of the money between 7,300 and 29,700, and 25% of anything over 28,700. Your bill is thus (.10)7,300 + (.15)(29,700 – 7,300) +
(.25)(40,000-29,700) = 730 + 3,360 = 4,090 + (.25)(10,300) = 3,910 + 2,575 = 6,485.
Your marginal rate is 25%, implying that you would owe 25% of the next dollar earned.
Your average rate is 6,485/40,000 = 16.21%, implying that you paid 16.21% out of each dollar in taxes.
Note: The above do not include social security taxes or state or local taxes.
The combined social security and medicare tax rate is 7.65% each from the employee and the employer (ie., they both pay 7.65%). State income taxes range from 0% in Alaska, Florida, Nevada, New Hampshire, S. Dakota, Tennessee, Texas, Washington, and Wyoming to a maximum of 11% in Montana.
Taxation of Investment Income:
Interest income: Interest income from bank accounts, CDs, money market accounts, corporate bonds, etc. is taxed as ordinary income subject to both state and local taxes.
Interest from U.S. Treasury bonds is subject to federal income taxes, but not state income taxes.
Interest income from state or municipal bonds (referred to as munis) is exempt from Federal taxes, and usually from state income taxes if the bond was issued by the state or municipality in which you live.
Municipal bonds generally offer a lower interest rate than corporate bonds because they're tax exempt. To determine whether you're better off investing in a corporate bond or a municipal bond you need to compare them as follows:
Define
MTR = marginal tax rate
ATR = after-tax rate - what you would earn after taxes
PTR = pre-tax rate - what you earn before taxes
To determine what a corporate bond would pay after taxes you compute the following: ATR = (1 - MTR)PTR.
If a corporate bond paid 10% then it would be worth after taxes
Corporate Municipal
MTRATRMTRPTR
15%.10(1 - .15) = .08515%.08/(1 - .15) = .0842
25%.10(1 - .25) = .07525%.08/(1 - .25) = .1067
33%.10(1 - .33) = .06733%.08/(1 - .33) = .1194
If a municipal bond paid 8%, then it would be equivalent to a corporate bond that paid PTR = ATR/(1 - MTR), where ATR is the rate on the muni.
As you can see from the table above, municipal bonds are "worth more" to high income individuals because they are in higher tax rates.
Dividend Income: As of this year dividend income is taxed at a maximum rate of 15%; if you are in the 10-15% income tax bracket the maximum tax rate on dividend income is 5%. This tax rate also applies to dividends from preferred stock if the stock is classified by the IRS as equity - some preferred stock may be classified as a form of debt, in which case the dividends are taxed as ordinary income. Note: the cut in dividend tax rates is temporary - it expires in 2009 (this is an accounting gimmick that allowed Congress to pretend that the tax cut did not exceed $350 billion).
Capital Gains: The tax rates depends on how long you hold the asset and your marginal tax rate.
1) Capital gains on assets held for less than 1 year are taxed as ordinary income.
2) For assets held for longer than 1 year:
if you are in the 10-15% marginal bracket, the tax rate is 5%
for all other tax payers the tax rate is 15%
In 2008 the tax rate for payers in the 10-15% bracket goes to zero. In 2009 the tax rates go to 10% for people in the 10-15% bracket and 20% for all others.
The maximum rate for some capital gains, such as collectibles, remains at 28%.
Saving for retirement
The government wants to encourage people to save for their retirement. To promote this activity they have provided financial incentives in the form of tax deferrals to encourage you to save and invest for your “golden years”.
Tax deferrals work as follows:
1) You first must establish a qualified retirement plan or account.
For the self-employed this is often in the form of an IRA – Individual Retirement Account. You set up an account with a bank, stock broker or mutual fund, indicating that you will be using the account to save for retirement.
If you are not self-employed the firm you work for will probably have a 401-K program for its employees. There are 4 things you must know about your firm’s 401-K program:
1)How long do you have to work at the firm before you are eligible to participate?
2)What is the company’s match? In most firms you are encouraged to contribute a fixed percentage of your income to your retirement account – the firm will then contribute a matching amount. For example, the firm may contribute one-half of one percent of your salary for each one per cent you contribute up to a maximum of 6% - if you contribute 6% they will thus contribute 3%. The IRS sets a limit on the amount of money you are allowed to contribute to a retirement account in a given year ($14,000 in 2005 plus an additional $4,000 if you're over 50).
3)What are your investment options? Most firms contract with a bank, stock brokerage firm, or mutual fund company to manage their retirement accounts. The firm managing the plan will give you a variety of options – typically several mutual funds – into which you invest both your contribution and the company’s match.
4)How long must you work for the firm before you are fully vested? You own the money you have contributed to your 401-K. If you leave the firm to work for another company you are free to take the money with you – to “roll it over” into another retirement account without any penalty. You don’t own the employer’s contribution until you’re fully vested in the plan. For example, they may require 5 years of employment before you’re fully vested – if you leave after 1 year you get to keep 20% of their contribution, 40% after 2 years, etc.
You do not pay taxes on the money you contribute to an IRA or 401-K plan when you invest the money in your retirement account – you pay the tax when you withdraw the money after retirement. You are thus “deferring” the taxes on your contributions (and your employer’s match) while they are invested in your account. In addition, you do not pay taxes on the interest, dividends, and capital gains your account earns until you withdraw the money.
To understand why this is important, assume
a)you contribute $2,000/year into a retirement account
b)you are in the 28% tax bracket
c)you earn 10% on your investments
d)you start contributing at age 25 and retire at age 65
At age 65 your account will be worth $885,185.11 (in 3 weeks it will take you 30 seconds to do this calculation). If you withdrew all of the money at age 65 you would have to pay taxes on the full amount, so you would have (1 - .28)885,185.11 = $637,333.28.
Assume you chose not to invest the money in a tax-sheltered retirement account; instead, you invest the money in a plain old mutual fund. There are two major differences:
1)You must first pay taxes on the money before you can invest anything. You will pay (.28)(2,000) = $560 in taxes each year. This means you will invest 2,000 – 560 = $1,440 each year, not $2,000. By investing in a tax-sheltered account you get to earn a return on the $560 you would have paid in taxes.
2)You will be taxed each year on your investment returns. The after-tax returns each year will be (1 - .28)(.10) = 7.2%.
At age 65 you would have $302,716.68 in your account. All of the money would be yours because you have already paid taxes on it. If you had invested in a tax-sheltered account, you would have had an additional 637,333.28 – 302,716.68 = $334,616.60.
You are a total moron if you fail to participate in your employer’s 401-K account. You will be passing up free money (the employer’s match), and foregoing the opportunity to benefits from tax-sheltered investing.
Home ownership
The tax code is designed to subsidize the cost of home ownership. This is accomplished in three different ways:
1)If you sell a home that you have lived in for two out of the last five years you do not have to pay taxes on the first $500,000 of capital gains.
2)You may treat the property taxes on the home as a tax deduction.
3) You may treat the interest portion of your mortgage payment as a tax deduction.
Why is the interest deduction important? Assume you have taxable income of $50,000, which puts you in the 25% tax bracket. You are trying to decide whether to buy a house with a mortgage payment of $1,500/month or rent an apartment for $1,000/month.
Your mortgage payment may be broken into two components: (i) repayment of the principal or loan, and (ii) interest. For a 30 year mortgage the interest component is VERY large in the early years of the loan. For example, for a $160,000 mortgage at 10% interest, at least 90% of your monthly payment would go towards paying interest for the first 7 years, at least 80% for the first 14 years, at least 70% for the first 18 years, and at least 50% for the first 23 years.
If you are allowed to deduct the interest portion of your mortgage from your taxable income you can greatly reduce your total tax bill. The total tax bill for the renter with $50,000 in taxable income would be 3,910 + (.25)(50,000 – 28,400) = $9,310.
For the home owner you first compute the total mortgage payments of 12 x 1,500 = 18,000. If 85% of that is interest, your interest deduction is (.85)(18,000) = 15,300. This lowers your taxable income to 50,000 – 15,300 = 34,700. Your total tax bill would be 3,910 + (.25)(34,700 – 28,400) = $5,485.
Note the following: the homeowner pays $18,000/year for housing while the renter pays $12,000. The renter, however, pays 9,310/year in income taxes while the homeowner pays 5,485, or 3,815 less. In reality the extra cost of the house is 6,000 – 3,815 = $2,175/year, not $6,000/year. The government thus subsidizes the cost of home ownership by allowing you to write off the interest component of your mortgage payment.
Educational Expenses
1) You can deduct up to $2,500 in interest on your student loans from your taxable income if (1) your parents do not claim you as a deduction, and (2) your adjusted gross income is less than $65,000 (it starts to phase out with an AGI of $50,000).
2) Hope and Lifetime Learning Credit:
Note: these are credits - not deductions - each allowable dollar reduces your taxes by a full dollar.
Both the Hope and Lifetime learning Credit allow you to claim a tax credit for allowable educational expenses. You can't use both in the same year, and they are limited to taxpayers with adjustable gross incomes of $40,000-$50,000 (single) or $80,000-$100,000 (couple).
The Hope credit is limited to the first two years of college - you can claim 100% of the 1st $1,000 of qualified expenses and 50% of the next $1,000 for a total credit of $1,500.
You must be enrolled at least half-time to claim the credit. The credit is not available to students who have been convicted of a federal or state drug offense. The Hope credit is available for each student in a family, so there is no real limit on the amount a family can claim.
The Lifetime learning credit allows you to claim a credit for 20% of the first $10,000 in qualified expenses for a maximum of $2,000 per family. There is no limit on the number of years you can claim the credit, you can be less than a half-time student, and you can be a convicted drug felon.
3) 529 Savings Plans
A 529 savings plan is a tax-advantaged way to save for college expenses. The savings plans may be established by states or by educational institutions; each plan sets up its own rules that conform to the IRS regulations, so they vary from state to state and school to school. The plan typically hires a mutual fund company to manage the investments - you send your contributions to the plan and tell them which mutual fund you want them to invest the money in; the money grows until you take it out to pay for your child's education.
Advantages:
1) The interest, dividends, and capital gains earned by your contributions accumulate on a tax-deferred basis - you don't pay taxes on the earnings until you take the money out.
2) You don't pay any taxes on the withdrawals if they are used to pay for qualified educational expenses.
To understand the importance of this assume that on the day your child is born your parents tell you they will contribute enough money to a 529 plan to pay for your child's college expenses. How much must they contribute to accumulate $416,646.76 in 26 years?