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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.Many people remember only whether they received tax refunds or owed money on their tax returns. But you should care how much you pay in taxes and the total and the marginal taxes that you pay, so you can make financial decisions that lessen your tax load. Although some people feel happy when they get refunds, you shouldn’t. All a refund indicates is that you overpaid your taxes during the previous year. When you file your income tax return, all you do is balance your tax checkbook, so to speak, against the federal and state governments’ versions of your tax checkbook. You settle up with tax authorities regarding the amount of taxes you paid during the past year versus the total tax that you actually are required to pay, based on your income and deductions. Last year, the IRS issued more than $200 billion in individual income tax refunds. If you figure just a 5 percent interest rate from a money market fund, taxpayers threw away more than $10 billion in interest on money that they could’ve invested.
Total taxesThe only way to determine the total amount of income taxes you pay is to get out your federal and state tax returns. On each of those returns is a line that shows the total tax (line 63 on Form 1040 returns). Add the totals from your federal and state tax returns, and you probably have one of the largest expenses of your financial life (unless you have an expensive home or a huge gambling habit). You need to note that your taxable income is different from the amount of money you earned during the tax year from employment and investments. Taxable income is defined as the amount of income on which you actually pay income taxes. You don’t pay taxes on your total income for the following two reasons. First, not all income is taxable. For example, you pay federal income tax on the interest that you earn on a bank savings account but not on the interest from municipal bonds (loans that you, as a bond buyer, make to state and local governments). A second reason that you don’t pay taxes on all your income is that you get to subtract deductions from your income. Some deductions are available just for being a living, breathing human being. For tax year 2007, single people receive an automatic $5,350 standard deduction, and married couples filing jointly get $10,700. (People older than 65 and those who are blind get slightly higher deductions.) Other expenses, such as mortgage interest and property taxes, are deductible to the extent that your total itemized deductions exceed the standard deductions. A personal budget or spending plan that doesn’t address your income taxes may be doomed to failure. Throughout this book we highlight strategies for reducing your taxable income and income taxes right now and in the future. Doing so is vital to your ability to save and invest money to accomplish important financial and personal goals.
Your marginal income tax rateMarginal is a word that people often use when they mean small or barely acceptable. Sort of like getting a C– on a school report card (or “just” an A– if you’re from an overachieving family). But when we’re talking taxes, marginal has a different meaning. The government charges you different income tax rates for different portions of your annual income. So your marginal tax rate is the rate that you pay on the last dollars you earn. You generally pay less tax on your first, or lowest, dollars of earnings and more tax on your last, or highest, dollars of earnings. This system is known as a graduated income tax, a system noted in Greece as far back as 2400 B.C. Our advice is to keep an open mind, listen to all sides, and remember the big picture. Back in the 1950s (an economic boom time), for example, the highest federal income tax rate was a whopping 90 percent, more than double its current level. And whereas during most of the past century the highest income earners paid a marginal rate that was double to triple the rate paid by moderate income earners of the time, that gap was greatly reduced during the past generation. Still, the highest income earners continue to pay the lion’s share of taxes. In fact, the Tax Foundation recently found the top 1 percent of all income earners pay about 34 percent of all federal taxes (while earning 19 percent of all income). The top 10 percent pay about two-thirds of the total individual income taxes collected (while earning 44 percent of all income). The fact that not all income is treated equally under the current tax system isn’t evident to most people. When you work for an employer and have a reasonably constant salary during the course of a year, a stable amount of federal and state taxes is deducted from each of your paychecks. Therefore, you may have the false impression that all your earned income is being taxed equally. Remember that your marginal tax rate is the rate of tax that you pay on your last, or socalled highest, dollars of taxable income. So, if you’re single and your taxable income during 2007 totals $36,000, for example, you pay federal income tax at the rate of 10 percent on the first $7,825 of taxable income. You then pay 15 percent on the amount from $7,825 to $31,850 and 25 percent on income from $31,850 up to $36,000. In other words, you effectively pay a marginal federal tax rate of 25 percent on your last dollars of income — those dollars in excess of $31,850. After you understand the powerful concept of marginal tax rates, you can see the value of the many financial strategies that affect the amount of taxes you pay. Because you pay taxes on your employment income and on the earnings from your investments other than retirement accounts, many of your personal financial decisions need to be made with your marginal tax rate in mind. For example, when you have the opportunity to moonlight and earn some extra money, how much of that extra compensation you get to keep depends on your marginal tax rate. Your marginal income tax rate enables you to quickly calculate the additional taxes you’d pay on the additional income. Conversely, you quantify the amount of taxes that you save by reducing your taxable income, either by decreasing your income — for example, with pretax contributions to retirement accounts — or by increasing your deductions. Actually, you can make even more of your marginal taxes. In the next section, we detail the painful realities of income taxes levied by most states that add to your federal income burden. If you’re a middle-to-higher income earner, pay close attention to the section later in this chapter where we discuss the Alternative Minimum Tax. And as we discuss elsewhere in this book, some tax breaks are reduced when your income exceeds a particular level — here are some examples:
Itemized deductionsare reduced for tax year 2007 when your adjusted gross income (AGI — total income before subtracting deductions) exceeds $156,400 ($78,200 for married persons filing separately).
Personal exemptions are a freebie — they’re a write-off of $3,400 in tax year 2007 just because you’re a living, breathing, human being. However, personal exemptions are whittled away for single-income earners with AGIs of more than $156,400, married people filing jointly with AGIs of more than $234,600, and married persons filing separately with AGIs of more than $117,300.
If you own rental real estate, you may normally take up to a $25,000 annual loss when your expenses exceed your rental income. Your ability to deduct this loss begins to be limited when your AGI exceeds $100,000.
Your eligibility to fully contribute to Roth Individual Retirement Accounts (see Chapter 20) depends on your AGI being less than or equal to $99,000 if you’re a single taxpayer or $156,000 if you’re married. Beyond these amounts, allowable contributions are phased out. Your marginal income tax rate — the rate of tax you pay on your last dollars of income — should be higher than your average tax rate — the rate you pay, on average, on all your earnings. The reason your marginal tax rate is more important for you to know is that it tells you the value of legally reducing your taxable income. So, for example, if you’re in the federal 28 percent tax bracket, for every $1,000 that you can reduce your taxable income, you shave $280 off your federal income tax bill.
State income taxes
Note that your total marginal rate includes your federal and state income tax rates. As you may already be painfully aware, you don’t pay only federal income taxes. You also get hit with state income taxes — that is, unless you live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, or Wyoming. Those states have no state income taxes. As is true with federal income taxes, state income taxes have been around since the early 1900s. You can look up your state tax rate by getting out your most recent year’s state income tax preparation booklet. Alternatively, we’ve been crazy — but kind — enough to prepare a helpful little (okay, not so little) table that can give you a rough idea of your state tax rates.This table reflects state individual income taxes. Some states impose other taxes, such as local, county, or city taxes, special taxes for nonresidents, or capital gains taxes, which aren’t included in this table.
The second tax system: Alternative Minimum Tax
There’s actually a second federal income tax system (yes, we groan with you as we struggle to understand even the first complicated tax system). This second system may raise your income taxes higher than they’d otherwise be. In 1969, Congress created a second tax system — the Alternative Minimum Tax (AMT) — to ensure that higher income earners with relatively high amounts of itemized deductions pay at least a minimum amount of taxes on their incomes. If you have a bunch of deductions from state income taxes, real estate taxes, certain types of mortgage interest, or passive investments (such as limited partnerships or rental real estate), you may fall prey to the AMT. The AMT is a classic case of the increasing complexity of our tax code. As incentives were placed in the tax code, people took advantage of them. Then the government said, “Whoa, Nelly! We can’t have people taking that many write-offs.” Rather than doing the sensible thing and limiting some of those deductions, Congress created the AMT instead. The AMT restricts you from claiming certain deductions and requires you to increase your taxable income. So you must figure the tax you owe under the AMT system and under the other system and then pay whichever amount is higher (ouch!). Unfortunately, the only way to know for certain whether you’re ensnared by this second tax system is by completing — you guessed it — another tax form.
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For Dummies is a registered trademark of Wiley Publishing, Inc. in the United States and other countries. Used here by license.