Taxes. Just hearing the word makes most people cringe. How a couple of easy steps can go a long way in making the process more bearable.
The first thing you need to know is that you don’t need to know how to prepare a tax return. You just need to know a couple of things that will make the amount of tax you pay as little as possible.
The second thing is that you don’t need to become an obsessive-compulsive record keeper. You can continue being a regular person, just one with a few more envelopes. You can live with that.
This discussion is not meant to replace your tax advisor, if you have one. Rather, it’s meant to give you the tools to reduce the fee she charges by keeping track of key expenses, and make sure you can manage the process – not do it yourself.
How Federal Taxes Work
The Internal Revenue Code (“IRC”) contains the rules for paying Federal taxes. It’s long, boring and has been patched together over many years and is now nearly unreadable, because it constantly refers you to lots of other places while you’re trying to read it. What’s important to know is that it contains Congress’ encouragement for you to do certain things, by reducing the taxes you pay if you do them.
Some tax incentives are called “above the line” adjustments. Above-the-line adjustments are more valuable than tax deductions because they come right off the top by reducing your income. Examples of above-the-line adjustments are contributions to retirement plans or health care savings accounts. People in Congress really want you to fund your retirement plan, and have given you every financial reason in the world to do so. So, if you go no further than to learn that there is yet ANOTHER reason to invest for your future, do that. It will very likely make a difference in the amount of tax you pay, too.
If you lend money to municipalities by buying municipal bonds, you usually don’t have to pay tax on the interest you receive for that loan. If you lend money to the Federal government by buying Treasury bills, bonds or notes, you generally won’t pay state tax on the interest you receive for those loans.
You’ve heard of tax deductions. Deductions are subtracted from your adjusted income. To see what the current standard deduction is, go to http://www.irs.gov/publications/p501/index.html Under “Publication 501 Contents,” go to “Standard Deduction,” and click “Standard Deduction Amount.” Scroll down to Table 7 to determine the amount of your standard deduction. You may have more deductions than that standard deduction amount. If you do, you will itemize their deductions, or provide a list that adds up to more than that standard deduction.
How do you know if you should itemize deductions?
Congress, through the tax code, encourages home ownership because it is seen as a stabilizing force in building communities, so both mortgage interest and property taxes are deductible. If you own a home, you will probably itemize deductions. You need to keep your property tax receipt, if these taxes aren’t part of your monthly mortgage payment . Otherwise, you’ll get a year-end statement with that amount from the bank that will also give you the total mortgage interest you paid, both of which are generally deductible.
Congress also encourages supporting charitable causes. So, if you contribute a significant amount to charity, it may make sense to itemize deductions.
And, with medical cost rising at an alarming rate, deductions are available for those, too - if they are more than a certain amount of your income .
So, if you have a lot of contributions to charities and/or medical expenses, it is a good idea to make envelopes called “Charity” and “Medical” and save all those receipts.
Like property tax, your state taxes are also deductible if you itemize your deductions.
If you work for someone else, and have lots of employee job expenses that were not reimbursed, you may be able deduct these, as well as education expenses that were directly related to your current job. Save those receipts in an envelope called “Employee Expenses.”
If you own your own or are starting your own business, you will probably file a “Schedule C.” This is the form that allows you to deduct business related expenses from your income. You are someone who definitely needs the help of a tax preparer – the sooner the better – particularly if yours is a home based business. While Schedule C itself does not appear to be a particularly complicated form, that is deceiving. Don’t do this yourself, but do save all business expenses.
Are there more? Yes, there are others. Lots of them. But, these are the big ones, and will give you a good start.
By organizing your deductions and knowing approximately how much you can deduct in each category you will have relatively organized information to give – and discuss with – your tax preparer.
These are also subtracted from your income. If you are single person, you are entitled to one exemption. A married couple filing a joint return receives two exemptions, and one more for each minor dependent child.
The amount of current Federal tax exemptions can be found at http://www.irs.gov/pub/irs-pdf/p501.pdf
In a nutshell, then the way taxes are figured is:
• Income minus
• Adjustments (like retirement contributions) equals
• Adjusted Gross Income minus
• Tax Deductions minus
• Total Exemptions equals
• Taxable Income which is multiplied by your tax rate.
Your tax rate is determined by whether you are married. Single people pay a higher rate of taxes on their income than married people.
Your tax rate is also “graduated.” That means that your money is lumped into groups, and each group is taxed at a progressively higher rate. Then, they’re all added together, and that is the amount of tax you owe.
The lower the income, the lower your tax rate.
Tax brackets are useful for thinking about the rate you’ll pay on taxable investments, like dividends and interest.
Your average tax rate is different than your tax bracket. Here’s how to figure your average tax rate.
Amount of Tax Paid divided by Total Income
8,922.50 / 50,000 = 17.8%
Your goal in tax planning is to try to reduce your income as much as you can with above-the-line adjustments like retirement plan contributions, then reduce the tax you pay as much as you can by taking all the deductions that are available to you.
If you have a simple tax situation - a W-2 form, and interest from savings - you may prepare your own taxes. If you have a lot of any of the categories mentioned under “Deductions,” you may review whether it would benefit you to itemize.
At any point that you feel that preparing your taxes is overwhelming, get help. The kinds of people available to prepare your taxes are
Tax Preparer Attended tax preparation courses, usually sponsored by their employer firm, such as H&R Block, Jackson Hewitt, etc.
Enrolled Agents Extensive training in personal tax preparation
Accountant A person who has a Bachelors degree in Accounting
CPA Certified Public Accountant, a professional designation requiring experience, education and passing an examination.
Generally, an Enrolled Agent has more than adequate training for any tax preparation or tax planning question the majority of people will have. Some employees of national tax preparations firms are enrolled agents, but you’ll need to ask their qualifications. Questions you will want to pose to potential tax preparers are:
• What credentials do you have?
Again, an Enrolled Agent will have extensive personal tax preparation training.
• How long have you been preparing tax returns professionally?
You want at least five years of experience
• Describe your typical client.
You want a tax preparer who has experience with the tax issues that you have; e.g., similar income, profession, investments, etc.
• Does your fee include representing me if I’m audited?
You want representation if audited included, or for a small additional fee
If you keep your receipts organized and have a relatively simple tax situation, you may want to try preparing your taxes on your own. If so, software such as “TurboTax,” “TaxACT,” and others are helpful, but obviously will not include answering questions or representation in case of an audit.
There are a few simple things that people who itemize deductions can do to decrease their taxes. These should be reviewed each year in mid-November.
• If you make State “estimated tax payments,” your last payment is due January 15 of the following calendar year. By making that payment before year end, it will be deductible.
• If you are considering any charitable contributions, make them prior to year end.
• If you own your home, consider making your January mortgage payment before year end, in order to deduct the interest from that payment.
• Schedule any doctor or dentist appointments before year end, especially in any year when you have high medical bills.
• If you’re planning to get married anyway, it’s better to do it in December than January to qualify for lower Married Filing Jointly tax rates.
Even if your spouse prepares your return (or oversees its preparation with a tax professiona, you are responsible for the tax return that you sign. Don’t sign it if you don’t understand it. Don’t be shy about asking questions.
There is yet another reason that you should put as much money as you can into your retirement account and health care savings account.
There is yet another reason that you might consider buying a home (deductible mortgage interest and property taxes), if you don’t already have one.
If you just put all receipts for deductible expenses in separate envelopes - medical, contributions business and employee expenses every year - you’ll be way ahead of the game.
You know the basic concept for how taxes are calculated.
You know how to interview a tax preparer.
You won’t sign a tax return that you don’t understand, and won’t be shy about asking questions