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Why Are My Taxes So High – Part II


In my previous blog on this topic, I focused on the different types of savings that could reduce your tax bill so that you would have more money to spend on your personal wants and needs. In this blog I am going to focus on issues that have shown up when I am preparing a client’s tax return. None of the examples relate to a specific client to protect the innocent but they do reflect how client’s are not paying attention to how the tax law treats the income they are receiving.

Let’s start with the different tax rates for different kinds of income. As you know your wages are taxed at what are referred to as ordinary tax rates. If you have interest income from savings accounts or certain other investments this income is also taxed at ordinary income tax rates. On the other hand, if you have dividend income from stock investments or capital gains from selling a profitable stock or mutual fund, this income will be taxed at capital gain tax rates in 2012. That rate can be zero % or 15% depending on what the rest of the taxable income is that is being reported on your return.

The income you have for your tax return gets “stacked” for purposes of determining what the tax rate is that you will pay in any given year. For instance, if your income is all from wages for you and your spouse and you file a joint return with your spouse, the income of the spouse is stacked on top of your income to determine the adjusted gross income, then you subtract your standard or itemized deductions and your personal exemptions to arrive at what is called “taxable income”. The amount of your taxable income then determines what tax rates will be applied to your taxable income. In a simple example, your wage income is $70,000 and your spouse’s wages are $40,000. You are using the standard deduction (because you rent and do not have enough itemized deductions) of $11,900 for 2012 and your two personal exemptions total $7,600. This leaves you with $90,500 of taxable income. The first $17,400 will be taxed at 10%, the next $53,300 will be taxed at 15% and the remaining $19,800 will be taxed at 25%. Because you are in the 25% incremental tax bracket, any interest income will be taxed at 25%, any dividends and capital gains will be taxed at 15%.

Let’s make a few changes to our example. Your neighbor, who has the same income as you from wages, has the ability to itemize because he has a mortgage on his house and has real estate taxes, state income taxes and makes charitable contributions. The total of all those deductions are $22,000. He also has 3 children so he has $11,400 of additional personal exemptions. These additional amounts reduce his taxable income to $69,000. In this instance, the first $17,400 is taxed at 10% and the remaining $51,600 will be taxed at 15%. This also leaves him with $1,700 that he could have in interest income that would be taxed at 15%. In addition, any dividend income or capital gains income that he would have would be taxed at zero % because he is in the 15% incremental tax bracket.

In comparing these two examples, if both of you had $1,700 of interest income and $2,500 of dividend income you would have $570 more tax than what would be the taxes your neighbor would have with the same income. This is because you are now in the 25% incremental tax bracket while your neighbor is in the 15% incremental tax bracket.

Now let’s look at some decisions that people are making that influence their tax bill. Your neighbor was concerned with what was happening with the financial markets and decided to get out of the investments that were creating the dividends and put all his invested assets into things that created just interest income. He still had a total of $4,200 to include on his tax return. That put his total taxable income at $73,200 and resulted in $2,500 of the $4,200 being taxed at 25%, or $625 in taxes that he would have by changing the nature of his investments.

Because of the challenges being faced by many tax payers due to loss of jobs or income from lower hours worked or lower paying jobs, people have taken money out of their 401(k) or IRA accounts to pay for their living expenses. When this happens these withdrawals are then taxable income. In many instances these withdrawals have caused the taxpayer to go into the next incremental tax bracket resulting in more tax being paid then may have been necessary.

Let’s go back to the first example of you and your spouse both working. Your spouse loses the job paying $40,000 per year. There is $40,000 in the IRA that you decide to take out to replace that lost wage income. If you took it out all at once, that $40,000 would result in $19,800 being taxed at 25% because that is what the incremental tax bracket was in the example. Now suppose that you talked with your tax professional before you did the withdrawal and she suggested that you take out $20,000 this year and then take the other $20,000 out next year. This would result in the incremental tax rate being only 15% for this year and 15% for next year (assuming the tax rates stay the same for 2013). In addition, your spouse might find a new job in the interim and you may not have to take out that second $20,000. By spreading the withdrawal over 2 years and keeping the tax rate at 15%, you would be able to save $1,980 (10% more tax rate on the $19,800) in taxes which gives you greater purchasing power for your money.

It is always better to have someone else review the options you have to choose from to figure out which ones will work best for you. In the end you will get better control over your tax burden and then you will have the answer to why your taxes are what they are.

FrancisStOnge

Francis St. Onge, CFP®
President
Total Financial Planning, LLC
Brighton, MI

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