March 2009

What you need to know about...Taxes

Author: Lew Wessel | Photographer: photography by anne

“Complex” does not even begin to describe our tax laws. My copy of the January, 2008 Internal Revenue Code, a compilation of just the basic tax laws, is 9,559 pages, and that’s with really, really small print. My five volumes of tax regulations weigh 16 pounds! Clarifying these are volumes of Internal Revenue rulings, Internal Revenue procedures, Private Letter rulings and, of course, libraries full of court cases.

Clearly, becoming a tax expert in your spare time is not a reasonable goal. What is reasonable, and advisable, is to learn the things you need to know about taxes in order to manage your financial affairs in a way that takes advantage of incentives built into the tax system and, just as importantly, avoids costly mistakes. Here are some basics:

FILE AND PAY YOUR TAXES. Seriously! Pay your taxes and don’t cheat! Millions of Americans file annual tax returns that belong in the fiction category at Barnes and Noble and then count on winning a never-ending game of tax-audit bingo. The current estimate of the annual loss to the U.S. Treasury as a result of this “game” is $350 billion dollars. Three words: Don’t do it! The penalties are too severe and, besides, do you really need more stress in your life? Learn some tax rules instead, and you’ll make out a lot better.

EVERYONE IS SUBJECT TO INCOME TAX. No, students are not exempt. Neither are toddlers, ministers, soldiers, resident aliens nor any U.S. citizen living anywhere in the world.

EVERYTHING IS SUBJECT TO INCOME TAX. “Income” is defined in the Internal Revenue Code as “all income from whatever source derived” unless specifically exempted. Payment in cash, swapped items, money earned illegally (think Al Capone), gambling winnings, etc. are all taxable and legally must be reported. Remember, substance trumps form in the tax code.

WHO HAS TO FILE. As you may have guessed, pretty much everyone has to file Form 1040 unless you make less than the combination of the standard deduction and your personal exemption— a total of $8,950 for a single person in 2008. That said, go to, a great site for all kinds of tax information and query “who has to file” for more information.

WHEN TO FILE. April 15, of course. But, what you need to know is that you can get an extension ’til October 15 by just filing a simple form (Form 4868). You don’t even need a lame excuse—it’s automatic. You do, however, still need to pay your taxes by April 15. If you underestimate, you’ll just need to make up the difference with interest and perhaps some penalties when you actually file your return, but in the meantime you keep the IRS off your back.

THE BASIC TAX RATE STRUCTURE: I’ve talked to many people who think that all their income is taxed at one percentage and that if they earn more money ALL of their income is taxed at a higher percentage level. Not true! Income is taxed at six levels, ranging progressively from 10% to 35% (see Tax Table). The part of everyone’s taxable income that falls within a particular level or “bracket” is taxed at that bracket’s percentage rate. As an example, Tiger Woods pays the same 10 percent tax on his first $16,050 as you do; he pays the same 15 percent on the next $50,000 as you do; etc. Once he gets to a taxable income of $357,700 (by about January 3rd, in his case), he will be in the 35 percent bracket. However, he still gets to pay the lower rates before getting there.

KNOW YOUR MARGINALTAX BRACKET. Your marginal or top tax rate has a key impact on many decisions including: whether to invest in a Roth vs. a regular IRA, or whether to convert a regular IRA to a Roth IRA and, if so, how much to convert; whether to buy municipal vs. taxable bonds; and more. Most importantly, your marginal rate determines the value of your deductions (see below). Find your marginal rate on the Tax Table and remember it!

TAX DEDUCTIONS vs. TAXCREDIT. Tax deductions reduce taxable income while tax credits reduce taxes owed. Bottom line, a tax deduction saves you the amount of the deduction times your tax bracket; a tax credit saves you the full amount of the credit.

TAX GOODIES: You don’t have to resort to cheating to save a bundle on taxes. The tax code is chockfull of goodies Congress enacted to encourage certain behavior. Some are more complicated than others (e.g. oil and gas percentage depletion allowance), but there’s plenty of low-hanging fruit to pick. Here are a few examples:

HSA Accounts: My personal favorite because it allows an upfront deduction for contributions, BUT, there’s no tax on distributions as long as they are made for legitimate medical expenses. Earnings in the account are tax free until distributed. This is a tax no-brainer!

529 Plans: Same deal as an HSA, in that contributions are deductible in full on the South Carolina tax return, and distributions are not taxed as long as they are made for qualified higher education expenses. These plans are also fantastic for estate tax planning.

Dividends and Long-Term Capital Gains: These are special income items that are taxed at a max rate of 15 percent and not at all if you are in the 10 or 15 percent tax brackets. See how handy knowing your bracket is?!

Exclusion of gain on sale of personal residence: This one is so good it actually feels like you’re cheating—well, at least it did before housing values tanked. Fully $500,000 dollars of gain on the sale of your residence is excludable and not even REPORTABLE as long as you live in and own it for two out of the last five years.

Charitable deductions: This is the ultimate in the concept of benevolent self-interest. Giving the charity something other than cash, such as appreciated stock and just plain “stuff” is even more of a win-win. Make sure you keep very good records and get a receipt.

IRA’s and Roth IRA’s: The basic difference between the two is that you get a deduction up front with the regular IRA but ALL distributions are includable in income. With the Roth, you get no deduction up front, but ALL distributions are non-taxable. Both are great tools for saving for retirement. In general, the lower your tax bracket and the further you are from retiring, the better a Roth is going to look; but to be absolutely sure of your choice, run the numbers or ask a professional.

Business deductions: If you own or are partners in a business, the potential tax goodies grow exponentially—as do the opportunities for cheating, which is why the IRS keys in hard on small business returns. Retirement plans, such as Solo K’s or 401K Profit-Sharing plans can turbo-charge your savings; Section 105 medical reimbursement plans can turn ALL of your medical expenses into deductions; depreciation rules on business assets can result in a first-year deduction of up to $25,0000, etc. This is where a tax pro can really pay for him or herself. Hire one!

Some other basic advice:
KEEP GOOD RECORDS. You should keep all tax records for a minimum of three years and probably for seven just to be sure. Be particularly careful to keep very good records on all business expenses and charitable deductions.

FILE ELECTRONICALLY. Paper filing is not only bad for the environment, it’s bad for you. Paper returns arrive at the IRS and then have to be keyed in manually by temps hired for the tax season. Input error rates on these returns are about 10 percent compared to near zero for electronic returns. In addition, you have proof-positive of timely filing with e-file, and you’ll get your refund a lot quicker.

DO-IT-YOURSELF OR PAID PREPARER. You can try to file your own return, but if you do, for heaven’s sake, use a software package such as Turbo Tax. Still, if you want to get it right, hire a pro. Tax software will produce a mathematically accurate return, but not necessary a correct return. Just ask our new Treasury Secretary, Timothy Geitner.

Next month: Planning for retirement.

Tax Table

Marginal Tax Rates for Single Filer
10% on income between $0 and $8,025
15% on the income between $8,025 and $32,550; plus $802.50
25% on the income between $32,550 and $78,850; plus $4,481.25
28% on the income between $78,850 and $164,550; plus $16,056.25
33% on the income between $164,550 and $357,700; plus $40,052.25
35% on the income over $357,700; plus $103,791.75

Marginal Tax Rates for Joint Filers
10% on the income between $0 and $16,050
15% on the income between $16,050 and $65,100; plus $1,605.00
25% on the income between $65,100 and $131,450; plus $8,962.50
28% on the income between $131,450 and $200,300; plus $25,550.00
33% on the income between $200,300 and $357,700; plus $44,828.00
35% on the income over $357,700; plus $96,770.00

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