Personal Financial Planning: An "How-To" Guide (part 15)

Understanding Federal Income Tax Principals

by

Charles Lamson

A typical American family currently pays about one-third of its gross income in taxes: federal income and Social Security taxes on numerous state and local income, sales, and federal income and Social Security taxes and numerous state and local income, sales, and property taxes. Although you may think of tax planning as a year-round activity. You should always consider tax consequences when developing and revising your financial plans and making major financial decisions, such as purchasing a home and investing.

The overriding objective of tax planning is very simple: to maximize the amount of money you keep by minimizing the amount of taxes you pay. As long as it is done honestly and within the tax codes, there is nothing immoral, illegal, or unethical about trying to minimize your tax bill. Most tax planning centers on ways to minimize income and estate taxes. The next couple posts concentrate on income taxes paid by individuals, particularly, the federal income tax, the largest and most important tax for most taxpayers.

Federal, state, and local tax receipts fund government activities and a wide variety of public services, from national defense to local libraries. The administration and enforcement of Federal tax laws is the responsibility of the IRS, a part of the U.S. Department of Treasury.

Although the largest tax a person will normally pay is federal income tax, there are other forms of taxes to contend with. For example, additional federal taxes may be levied on income and on certain types of transactions. At the state and local levels, sales transactions, income, property ownership, and licenses may be taxed. Because most individuals have to pay many of these other types of taxes, you should evaluate their impact on your financial decisions. Thus, a person saving to purchase a new automobile costing $18,000 should realize that the state and local sales taxes as well as the cost of license plates and registration, may add another $1,500 or more to the total cost of the car.

Smart.sites How long does the average American have to work this year to pay federal, state, and local taxes? Get the answer at the Tax Foundation Web site, www.taxfoundation.org. You’ll also find information there about tax policy, tax rates, tax collections, and the economics of taxation.

Because tax laws are complicated and subject to frequent revision, I will present key concepts and show how they apply to common tax situations. The provisions of the tax code may change annually with regard to tax rates, amounts and types of deductions and personal exemptions, and similar items. Often these changes are not finalized until late in the year. Although tax rates and other provisions will change, the basic procedures will remain the same. Before preparing your tax returns, be sure to review the current regulations; IRS publications and other tax preparation guides should be helpful in this regard.

The Economics of Income Taxes

It should come as little surprise to learn that most people simply do not like to pay taxes. Some of this feeling undoubtedly stems from the widely held perception that a lot of government spending amounts to little more than bureaucratic waste. But a good deal of this feeling is probably also due to the fact that taxpayers get nothing tangible in return for their money. After all, paying taxes is not like spending $7,000 on furniture, a boat, or a European vacation. The fact is we too often tend to overlook or take for granted the many services that are provided by the taxes we pay---public schools and state colleges, roads and highways, and parks and recreational facilities, not to mention police and fire protection, retirement benefits, and many other health and social services.

Income taxes provide the major source of revenue for the federal government. Personal income taxes are scaled on progressive rates. A progressive tax takes a larger percentage of income from high-income groups than from low-income groups and is based on the concept of ability to pay. A progressive tax system might, for example, tax low-income taxpayers at 10 percent, middle-income taxpayers at 15 percent and high-income taxpayers at 30 percent.

As income moves from a lower to a higher bracket, the higher rate applies only to the additional income in that bracket and not to the entire income. For example, consider two single brothers Jason and David, with taxable incomes of $40,000 and $80,000.

Jason pays a 25 percent rate only on that portion of the $40,000 in income that exceeds $28,400. As a result of this kind of progressive scale, the more money you make, the progressively more you pay in taxes: Although David's taxable income is twice that of Jason's, his income tax is about 2.5 times higher than his brother's.

The tax rate for each bracket---10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent---is called the marginal tax rate, or the rate applied to an additional dollar of taxable income. When you relate the amount of taxes paid to the level of income earned, the tax rate, called the average tax rate, drops considerably. Jason's average tax rate, calculated by dividing the tax liability by taxable income, is 17 percent ($6,810/$40,000). David's average tax rate 21.4 percent ($17,146/$80,000). Clearly, taxes are still progressive, and the average size of the bite is not as bad as the stated tax rate might suggest.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 90-92* 

END

Smart.sites

How long does the average American have to work
this year to pay federal, state, and local taxes? Get
the answer at the Tax Foundation Web site,
www.taxfoundation.org. You’ll also find information
there about tax policy, tax rates, tax collections, and
the economics of taxation.