So today we're going to begin understanding a little bit more about how income taxes work in general. Taxes are kind of this funny phenomenon and I tell everybody we can debate what types of, what taxes should look like ad nauseam, but what I want to focus on is what taxes look like right now, so that we can understand how they affect our financial plan. So financial planning involves decisions that affect our income. So whether or not we take a second job, deciding to finance a home, investment choices we make, contributing to a retirement account, these decisions that we know are critical in financial planning all have tax implications associated with them, too. And there go, as a result, the taxes are going to impact the amount of money we actually have at any of these instances. So we're going to want to learn a little bit about how taxes work and then how we understand and utilize the tax system in such a way that is consistent with our financial planning goals and make sure that we're reaching our goals very efficiently. Remember this was all part of that cash and credit management component of it as well as understanding that we can't change what's happening in the economic environment, which taxes are clearly part of that picture. So I want to also note that there are taxes on wealth. We're not going to talk about those, but estate and gift taxes for example are taxes on the right to transfer wealth. But they're not for the recipient, they're for the person giving the wealth if you will. Capital gains taxes which we'll touch on a little bit too are taxing the appreciation on capital assets once they're sold. So in other words, we buy something like a stock or a home, it appreciates, goes up in value. We sell it for a gain. That gain can be subject to taxation as well. So again, different forms of income. Now we'll see, and then because of that, different forms of income, won't all face the same types of taxes too. And then of course there's property taxes. Another tax on wealth for homeowners. And again this is a tax on the value of property that someone has and anyone who owns a home knows you get that bill typically once a year, and it's loads of fun to pay. So let's begin by understanding that within the tax system we're categorized into different filing statuses. So we can be single, married filing a joint return, meaning that we're going to combine all of our income, all of our expenses, into one return as a couple. We can be married but filing a separate return where we're going to split our income up, take different sets of deductions for each other, and there's reasons, pros and cons, why people are going to do each of those. If I'm unmarried, and have legal dependents, I can qualify under something called, Head of Household. So the difference between Head of Household and Single, is the presence of dependents, of course. And there can also be a qualifying widower who could even have a dependent child. So someone who's lost their spouse with a dependent child would also be under a unique filing status as well. To do our taxes [COUGH] and if you've sat down and done them, you'll potentially want to get this whole laundry list of information in front of you. There's our W-2s, the wages, salaries, the amount of money that we've earned and the taxes that were withheld on that money on our behalf by our employers, by our banks and credit unions and such. Our 1099s represent other forms of income other than what we earn in the job. So 1099 INT interest that were paid, 1099 DIV, dividends that we were paid, so on and so forth. And then of course, we'll also get a 1098 if we have a house with a mortgage, then we're going to get certain statements just documenting that we've had those mortgage payments. So we'll need a lot of these things to start of with plus receipts for charitable contributions, receipts for childcare if you have that as well and receipts, even potentially related to employee-related expenses, or job expenses, that your employer did not reimburse you for. So, if you printed off form 1040, or if you've got a split screen, have it open next to you. You'll kind of see that we're just basically summarizing form 1040 on the next two slides. Number one is we get gross income, that's that first section of 1040 that really adds up all the different forms of income that a family has, and we'll go through and look at some of those examples. After that we're going to take some adjustments we get to make to gross income. These are often referred to as above the line deductions, right? So once we make that first adjustment, we come up with this magical number that I'll have you put an asterisk next to on your notes, called AGI, the Adjusted Gross Income. This number's going to be used as a benchmark a lot of times in different types of calculations throughout the tax process. From there we're going to make a choice between itemized or standard deductions. Standard deduction are fixed amounts that changes a little bit every year, itemized represent those various expenses that we're going to have. And we're going to explore all of these in more detail in a few moments. After that we will also get to subtract off personal exemptions; this is going to be representative of everyone person who's covered by this tax return. So if this was a married couple with two children, two dependent children I should add, then we would have four personal exemptions. So again, the number of tax filers plus the number of dependents times the amount will give us our personal exemptions. From there, we get to taxable income. The amount of money after all the adjustments that actually faces taxation. So then, we then compute the tax itself, and we'll give some examples of how we do that too, and what the tax tables look like. Once we've calculated the tax, we then can subtract off potential tax credits that we might be eligible for and we'll see that there's some for a little bit of everyone in life. And then we potentially we need to add in other taxes that could exist, most of the time this could be related to any foreign income that we've earned so on and so forth. Then we get to our total or net tax due. And really this represents our total tax. Any tax due would be based upon whether or not we had money withheld. And again we'll take a look and see how that shakes up a little bit more. So, gross income, what's included, what's not? Well if we take a look at what's included: job money, alimony received, scholarships Above what you've paid for in fees. So if you get a really big scholarship that's well beyond what the cost of your education was, that extra money could be taxable. Of course, pensions, rental income, if you gamble, right? If you've won some significant prizes, all of those things can be subject to taxes. And of course, if you got state and local income tax refunds, assuming that you itemized in the previous year, then those would also be eligible or need to be included in gross income. Now what's not included: child support, federal income tax refunds, garage sale proceeds, acts of anything we get from insurance policies in general, welfare food stamps, income from municipal bonds, cash rebates, gifts and inheritances; remember there's transfer on wealth, but these are not income taxes, and of course, disability or worker's compensation. I want to point out too one of the reasons; when people say but those insurance, proceeds, what if someone got a million dollar payout? Well, the purpose of insurance, right, is to get someone restored back to, ideally, where they were before an, before an incident occurs. Taxes are more about where someone's had an economic gain. Insurance isn't about gain, right? That wouldn't make sense. It's about restoring someone to where they were before an incident. Doesn't represent a taxable gain, hence it's not really subject to taxes in most circumstances. Now, what about some of those adjustments to gross income we mentioned, what were those? Well, most common ones are going to be if you have student loan payments that you're making, then the interest portion of those student loan payments is going to be potentially something you can take as an above the line deduction. Qualified moving expenses and here this means you have move for a job, right, you have move far away for it for example, not just a convenience move or school district move. But you have move specifically, typically to relocate for a job. If that's not reimbursed by the employer then that's typically something you could take as an above the line deduction as well. Contributions you might make to a traditional IRA, for example, may be eligible for above the line deductions, and contributions you might make to something like a flexible spending plan, an employer benefit that let's us pay things like child care or health care expenses using pre-tax dollars. So, all of these may be above the line deductions. Now that's important, we're going to see, as a distinction from what we call itemized deductions and we will get to those in just a moment. If you recall the next thing we said was, the choice between the standard or itemized deductions. So just to take a look at where we are for standard deductions. Again for single, head of household, married filing jointly, married filing separately, these are all just driven by your filing statues. When it comes to this part of the calculation, what the decision is, is the standard deduction greater than the total of itemized deductions. In other words, we're going to take the one that's more, but we don't get both. So, once we take our standard deduction, we note what that is, and then we look and see what are itemizable expenses. Now the itemizable expenses are going to be found on schedule A, which is also something of course that you can see was on the course site of course. If your itemized deductions exceeded the standard deduction, you'll use those. The most common examples are if you paid state and local income taxes, then those would be itemizable expenses. If you had mortgage interest expense, that's an itemizable expense. Now, I want to refer to something called a floor here for a moment. Floors represent this percentage of AGI, below which the expenses don't count as an itemizable expense. So let me give you an example, medical expenses encounter a 7.5% floor. Let's assume for a moment that you had a $100,000 income, because the number's round, it's easy. This would mean that only the amount of out-of-pocket medical expenses you had above $7,500 would count. So if you had $8,000 of out-of-pocket medical expenses, you could itemize $500, okay? Charitable expenses are subject to a ceiling, right, of 50%; meaning you can't deduct more than 50% of your income, devoted to charity. So if you gave away 100% of your income, you couldn't actually deduct all of it. Un-reimbursed employee expenses, they have a 2% floor, and casualty and theft losses that weren't covered by insurance, have a 10% floor as well. So these are just some common examples of, of typical itemizable expenses that someone might have. Personal exemptions, again currently 3,950, and this is for each person that' covered on the tax return itself. So again, the filer, a spouse, independent children as well. So this is also going to be subtracted from income. So, right, we've taken a look now and seen, we get, we add up everything that's in income, we make some initial adjustments, then we decide standard or itemized, then we take a personal exemption or two, or three, or four, and we can subtract all of those. That brings us to that number of taxable income. And here, we, this is where we start identifying someone as being in a tax bracket. The tax brackets range from 10 up through 39.6% and they're of course listed here, for you. That's different than what we call the effective or average tax. Which is really what the tax liability is that you calculate divided by their income itself. So the tax, the effective tax rate is going to be lower than the marginal tax rate in most instances, of course. So let's just take a quick look here, from, this is from Form 1040's instruction manual and this just gives a sense of what it looks like, these tax brackets, if you will, for someone who's filing as single. So again, if your income was between $0 and $8,925, and remember here we're talking about taxable income, then you would pay 10% of that on, in taxes. If your income is below, is above $8,925 and below $36,250 then you're going to pay this $809, $892.50 plus 15% of the amount over $8,925. We'll give a brief example of how that calculation works, but we can then see how people will then be identified by, by their tax bracket based upon their level of taxable income. The brackets are different based upon filing status, so this one in particular is for someone who's filing as single, married filing jointly has much different amounts for the tax brackets and so does of course the others as well. So let's take a brief example here, we've got Jerome. He earned $65,000 last year. He's single with no dependents. He's currently a renter, made $1,000 in charitable contributions. He doesn't have an employer provided plan, but he did contribute $4,000 to a traditional IRA. So let's take a look $65,000 for his gross income. Less the adjustments that $4,000 from the traditional IRA. That gives him to an AGI of $61,000. Standard deduction, right, taken from form 1040 page two, Person exemption also taken from form 1040 page two, get us to taxable income. Now why didn't I subtract off the charitable contributions? If that's his only itemizable expense, it's simply not more than the standard deduction. He doesn't get to take it. I use a list to point it out because oftentimes this is something that people do get a little hung up on, but charitable contributions aren't an itemizable expense unless we itemized, we cannot deduct a charitable contribution. So here, right, just showing that basic calculation, if you take a look from the tax table we had, he's in the 25% tax bracket, so that's $4991.25, this number's right from that table on the previous slide. Plus 25% of the difference between the taxable income minus the lower limit of that tax bracket. So his tax due was $8,641.25. Now, does he owe money, that's really the, really good question. How do we know if he would owe money? I mean, that's how much his tax was on the income that he earned. Whether or not he gets a refund, or has to cut the IRS a check come April 15th, well that has a lot to do with how much was withheld. If the withhold in his paycheck was such that he had more than that withheld, then he's going to get a refund, right? If he had less than that withheld, then he's going to have to owe the difference and cut a check to the IRS as a result of it. Now let's say that you realize then that your withholding isn't where it should be. Maybe you've had some family changes and such. But that may be that you actually have to change your W-4 that's on file with your employer, because that is what dictates your withholding. So you can use the worksheets that are included from the IRS website to actually make any changes, and to make sure that that change makes sense. So you can change the number of exemptions that should be considered on your withholding, or you could just ask for a certain amount to be withheld in addition to what the formula dictates to make sure that you don't owe any money. It can certainly be frustrating to have to pay those checks, but it's something that if you don't want, that if you want to avoid, just make sure that your withholding is on track for it there, too. So there's lots of other ways that we'll learn about, then, for how we can then manage this tax process now that we have a good sense of how the tax calculation actually works. One of those is a credit. Now credits, right, reduce the tax liability. So up until this time, we've talked about deductions and exemptions, meaning that things that we got to subtract out of income. But now, I want to talk briefly about something we get to subtract from the tax itself. So we calculated that tax liability for Jerome. What if he had credits? Well, first of all people would say what's better, a deduction or a credit? Well, if it's the same dollar amount a credit is better. A deduction reduces your tax liability by, by whatever the amount of the deduction is times your marginal tax rate. A credit reduces your tax liability dollar for dollar. Now we don't really get to choose the form of these, right? There are credits. There are deductions. We try and make use of both of as many of each as we can. So, we want to kind of think about those. What are the common credits that exist? The earned income tax credit is certainly one, it provides a tax credit to lower income working families. It involves multiplying a maximum amount of earned income by a specific credit percentage. So there's a big long work sheet that a family would go through to estimate the earned income tax credit. Credit, or they can oftentimes families that would qualify for EITC, and many others too with income below $52,000 could go to a VITA site and get all of this done for free, I want to add as well. So, EITC is an important one, and it's also one of the only fully refundable tax credit, meaning that you're always entitled to the amount of the credit even if it exceeded your liability. There's the child tax credit. This one is just simply if you have a number of dependent children that are available that are in your family, you're going to get a little bit of money for those. Now, that amount changes over time, of course and so that's something also that anyone with young children would want to make sure their taking advantage of, or minor children. There's also child and dependent care expenses. So for children that are under the age of 13, especially, where we might have day care expenses, after care expenses, even summer camp related expenses at times. If we need to have them going to those things so that we can work, then we're going to get that subsidized through the child and dependent care expenses. And again, this'll be a percentage of the expenses related to working or seeking work. Again what we have to pay someone to watch our children. And this usually needs to be a qualifying organization, as well. And you'll find that they're going to always provide these receipts for you. Upon request because they certainly know that families do rely upon this to subsidize the cost of child care. And, I also want to add too that this is called the Child and Dependent Care Expenses. Because for example, should we have a dependent or spouse who's physically or mentally incapacitated that also needs additional care so that we can go to work, that expense would also be eligible under this particular tax credits. So for children, or potentially a dependent spouse who as some special needs associated with them. A few others too, the retirement account contributions credit is kind of a nice one, you have to be over 18 for this one,. And of course if you're a dependent or a full-time student, you cannot qualify for this. But this is kind of an exciting one, though, depending upon where your level of income is, if you're right at less than $50,000 for a married couple filing jointly, or less than $37,500 for head of household and so on and so forth. You may be eligible for a credit on your retirement contribution and that's kind of exciting if you were, if you were able to sort of get a double benefit on your taxes for saving for retirement. And of course for some of you who might be investing in your education you should consider credits such as the American Opportunity Credit, the Lifetime Learning credit that people may be eligible for. It's important to note that for the same student in any given year, you can't claim both credits, right? You need to choose the one that makes the most sense and gives you the most bang for your buck on your taxes if you will. You could claim, you can, however, if you have multiple children, for example, in college or that have qualifying education, you can claim one credit for one, and another credit for the other. You could alternate which child gets which credit, for example, from year to year. So the idea's not to say you can't have both credits on your return, but you can't use both credits for the same child. In other words, you can't double dip on the same expense, which is a common theme a lot of times in taxes.
