March 15, 2012Welcome
Welcome to The Shaw Atlas, the monthly newsletter from Shaw & Associates, CPAs & Financial Advisors. We look forward to keeping you abreast of ever-changing tax codes, providing you with money saving accounting tips and illustrating proactive strategies to help you achieve the financial life you envision.
March 15, 2012
2011 Corporate Income Tax Returns
April 15, 2012
Business Personal Property Tax
April 17, 2012
- 2011 Personal Income Tax Returns
- 2011 LLC Income Tax Returns (unless filed as a S corp)
- 2012 1st Quarter Estimated Payments
Recently, income tax brackets have been a hot political news topic. Some say that people making $50,000 per year are in the 30% tax bracket while others are quoting that “millionaires and billionaires” are only paying 15% of their income in taxes. I read one statement that an individual does not reach the 30% tax bracket until they make at least $500,000. Most of these statements are shrouded in political spin. Since we will be hearing so much about tax brackets throughout the election season, I wanted to give you a better understanding of income taxes so you can not only cut through the spin, but use this information to evaluate your own tax situation.
There are several things to consider when listening to the political writers, or more aptly named, professional spin doctors.
MARGINAL TAXES VS. AVERAGE TAXES
The federal income tax code is considered “progressive” because people are taxed at higher rates when their income attains certain levels. It is important to note that as income grows and exceeds a level or “marginal tax bracket”, only the income that is above that level gets taxed at a higher rate. All of the income below the level gets taxed at the lower rates of the previous levels. Thus each time you go to the next level, your “marginal” tax bracket changes. Marginal means the tax rate on the next dollar of taxable income.
On the other hand, an “average” tax rate is calculated by dividing your actual taxes by your taxable income. Since the average includes income taxed at all levels, the average rate will generally be less than the marginal rate. For instance, a single person with $50,000 of taxable income (gross income less all allowed deductions) in 2011 would be in the 25% marginal income tax bracket. Their actual taxes would be $8,625 meaning the average tax rate would be 17.25% (8,625/50,000). There can be a significant difference between marginal and average taxes. We could skew this even more by changing the facts. If the person’s taxable income is $34,501 (one dollar above the level) the marginal tax bracket is still 25%, but the average is 13.77% because only $1 is taxed at the higher marginal rate.
STATE INCOME TAX RATES
If a writer includes state income taxes, both the marginal and average rates will change. In a state like Colorado, which has just one tax rate (4.63%), the rates would go to 29.63% and 21.88% in the above $50,000 taxable income example. However, in states that have progressive tax rates (such as California whose highest state tax rate is around 12%) the marginal and average rates will be much higher. Thus we need to know what the writer is including in his definition of tax rates before comparing to another writer.
DEFINITION OF INCOME
You may hear that a person who makes $50,000 of income pays no tax, while another writer states that a person making $50,000 of income pays a 30% tax. How can that be? Well, it depends on the definition of income. A person with $50,000 of gross income (income before any deduction) can, very easily, reduce that taxable income down so that they pay zero tax through itemized deductions, exemptions and tax credits. However, in the example above, the person with $50,000 of taxable income (after all deductions) is in a 30% marginal tax bracket when combining federal and state taxes. If you do not know what definition each writer uses for income, it is hard to compare.
FICA (EMPLOYMENT) TAXES
Some writers include FICA taxes when they do their calculations. The FICA taxes could add an additional 7.65% if using only the employee portion of the tax, or 15.3% if combining the employee and employer rates. This becomes even more important when you consider that the social security portion of the FICA taxes (6.2% and 12.4% respectively) is charged only on the first $106,800 of wages. Thus, for people earning less then $106,800, their marginal and average rates will be significantly affected by FICA taxes, whereas, those making much larger amounts will see as great an impact on the marginal rate, but very little impact on the average rate.
FLAT TAX RATES
Some income items, such as qualified dividends and long-term capital gains, are taxed at a flat rate (currently 15% federally) and not subject to the progressive tax system. “Millionaires and Billionaires” could have a very high “marginal” tax bracket because income from other services is still taxed at a higher rate, but their average rate would be significantly less when factoring in the flat rate on the dividends and capital gains. Another factor that comes into play here is that most income from non-dividend sources is taxed only once at the individual income tax level. However, dividends are taxed twice; first at the corporate rate (as high as 35%) and then again at the individual rate (flat 15%).
Is your head spinning? You can see how easy it is to spin income tax information to sway voters. However, no matter what side of the political aisle you lean towards, knowledge of our income tax system will not only help you make informed judgments on what is being discussed in today’s media, but will help when evaluating your own personal tax situation.
When the question “Are you diversified?” is asked, most people typically start thinking about different asset classes within an overall portfolio; large cap, small cap, domestic vs. international, or bond classes. We all know how important diversification can be, however, are you Tax Diversified?
There are three main tax vehicles for investments; Tax Now, Tax Later or Tax Never.
This would be any investment in a non-qualified account in which the interest or dividends from the investments are taxed in the year they are received. If this investment is sold in a particular year, it would also be subject to capital gains tax. Stocks, bonds, or mutual funds held directly in a brokerage account would typically fall into the “Tax Now” category as would checking and savings accounts, CDs, or real estate holdings. Investors keep “Tax Now” accounts to meet their short and medium term financial needs.
Qualified accounts such as 401(k)s, traditional IRAs, SEP IRAs and Simple IRAs fall into this category. Typically, contributions towards these investments are not taxed in the current year. Proceeds are then allowed to grow tax deferred. However, upon withdrawal, the proceeds will be treated as ordinary income and will be subject to your current ordinary income tax rate. “Tax Later” investments allow you to defer the taxes in your higher earning, working years to years when you are retired and possibly in a lower income tax bracket.
With “Tax Never” investments such as Roth IRAs, contributions are taxed in the current year. You do not receive an upfront deduction for retirement savings, however, the account will grow tax deferred, and you will not pay taxes upon withdrawal during retirement. In today’s climate, “Tax Never” investments have appeal. With large deficit spending, shortfalls in Social Security, and increased Medicare costs, there is a tremendous amount of economic uncertainty. If tax rates are higher in the future, a “Tax Never” investment provides a distinct advantage.
Having a mix of Tax Now, Tax Later, and Tax Never investments provides flexibility and control during retirement. What if during retirement you need to withdrawal significant funds in one year? If most of your retirement savings are in Tax Later investments and you withdraw additional money, it will be taxable as ordinary income. However, if you had a diversified mix, you could have additional options. With a Roth IRA, you could withdrawal additional funds when you want without creating additional taxable income. Tax diversification also allows you to manage your taxable income to take advantage of certain thresholds to minimize tax liability in any given year.
Everyone’s individual situation and retirement goals are different. It is important to meet with both your tax and financial advisor to develop the best tax diversification strategy for you. Have questions? Give us a call.
Dr. Mark Kollar and St. Renatus have been nominated for the 2012 Bravo! Entrepreneur Award for Emerging Entrepreneur. Congratulations!
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