Financial Planning - Tax Considerations
Tax considerations are a crucial part of any financial plan and fall into two categories, income taxes and estate taxes. The ability to reduce the amount of income tax paid each year means more money in your pocket to spend or save as you wish. Congress has provided numerous ways for all taxpayers to reduce their taxable income legally. Allowable deductions are based on a number of criteria, such as income earned, number of children, home ownership, etc., and a few of these are explored below. While some of us will qualify for more deductions than others, we all have the ability to pay the least amount of tax possible. Estate taxes are those that are imposed upon an inheritance, and therefore the beneficiaries, upon the death of the estate owner. Ensuring that the beneficiaries are able to keep the largest amount of the assets possible is the cornerstone of estate planning tax considerations. Even those who have small estates can save money with proper estate planning.
What are Marginal Tax Rates?
Much was made in late 2010 about the Bush-era tax cuts. The Bush tax cuts, which were signed into law by President George W. Bush in 2001 and 2003, effectively lowered the marginal tax rates for almost all American taxpayers. Marginal tax rates, otherwise known as tax brackets, are the maximum rate that a taxpayer pays on his or her last dollar earned. While it sounds complicated, it really isn't. Let's assume an unmarried worker has taxable income of $69,000 in 2011. The tax rate on this amount will be $1,700 plus 15% of the amount over $17,000 ($9,500). But, if this same worker has taxable income of $69,001 in 2011, the tax rate will be $9,500 plus 25% of the amount over $69,000 ($9,500.25).
While the real dollar amount owed is only $.25, the percentage difference of $1 in additional taxable income will cost that worker 25% of the extra income. That means that 25% of this worker's last dollar earned was used to pay taxes. And that's the vexing tax problem with marginal tax rates. When most people try to reduce their taxes, they aren't really trying to cheat. They're merely looking for legal loopholes to try to save at least a portion of their extra income.
The United States has what's called a "progressive" tax code. The percentage of income tax owed rises as taxable income increases. For married couples who file a joint return (and surviving spouses if one spouse dies during the year) the increases occur at $17,000, $69,000, $139,350, $212,300, $379,150, and $379,150. With each bracket, there is a flat amount due along with a percentage. For example, if taxable income is $145,000 the flat amount due is $27,087.50 plus 28% of the amount over $139,350. If taxable income is $425,000, the amount of tax due is $102,574 plus 35% of the amount over $379,150. It's clear that as income goes up, so do taxes. This is why opponents of a progressive tax believe that marginal tax rates punish people who are successful.
Small Business Owners
Small business owners who are set up as S corporations or LLCs pay income taxes at individual rates. The income from the business "passes through" the business and is taxed on the owner's individual return. But small business owners have a number of ways to legally reduce their tax liability each year. Two types of deductions, business expenses and capital expenses, can be taken to reduce the amount of taxable income on which income taxes are paid.
Business expenses are those associated with conducting business. For example, rent for an office or store, business travel, and salaries are deductible business expenses. Capital expenses are those associated with the purchasing of assets like computer equipment or a warehouse. Capital expenses typically have a life of one year or more and increase the company's ability to produce goods or services.
Even if they are not incorporated, sole proprietors can claim deductions, too. A person with a home-based business might be able to deduct a portion of the mortgage interest, repairs, insurance, and utilities if he or she meets the "regular and exclusive use and principal place of business" criteria. This means that a part of the home (a bedroom, the basement, etc.) is used regularly and exclusively for running the business. For example, if you run an online business that sells downloadable ebooks, and you work regularly and exclusively from a spare bedroom, you should be able to deduct a portion of your expenses.
If you're thinking of starting a business, it's always a good idea to meet with a qualified tax professional who specializes in helping small businesses. The tax structure of the business (S-Corp, LLC, sole proprietor, etc.) will determine how taxes are assessed and at what rate they are paid.
Setting Up Trusts
Often referred to as the "death tax", federal estate taxes (inheritance taxes) have always been a contentious political issue. Therefore, the laws surrounding federal estate taxes are constantly changing, and it is impossible to tell from one year to the next the amount of tax that would be owed on an estate. A famous example of the changes in federal estate tax laws is that of George Steinbrenner, owner of the New York Yankees. When Steinbrenner died in 2009, he left an estate estimated at over $1.15 billion. But there was no federal estate tax at the time, so his heirs may have saved over $500 million in federal estate taxes. Compare that to 2010, when the amount of the exemption was placed at $5,000,000. The amount in the estate that exceeded $5,000,000 was subject to a 35% tax.
Estate planning takes changing exemption limits and tax rates into consideration. Because none of us knows what the exemption or tax rate will be in the future, tax considerations are one of the single most critical issues for those with a sizeable estate, and setting up a living trust is one of the best ways to protect your assets for the beneficiaries you choose. When a living trust is set up, the ownership of the assets is transferred to the trust and a trustee is selected to administer the trust. A properly executed trust avoids probate because the deceased does not own the assets. They are owned by the trust. After the death of the person who established the trust, the assets are distributed according to his or her wishes.
If you are considering a living trust, make sure you seek the help and advice of a qualified attorney who specializes in living trust preparations. Assets must be transferred properly in order for the trust to be valid at death. A living trust is not a do-it-yourself project.
How to Reduce Income Tax Liability
The easiest way for most people to reduce current tax liability is to contribute to a tax-deductible retirement plan. Whether it's an employer-sponsored 401(k) or an individual retirement account, in most cases, the amount contributed comes right off the top of taxable earned income. For example, a single parent with taxable income of $65,000 can contribute $5,000 to an individual retirement account ($6,000 if he or she is 50 or older). This deduction reduces taxable income to $60,000 ($59,000 if 50 or older).
Take advantage of all of the deductions to which you're entitled. For example, if you've upgraded appliances to energy-efficient models, you may be able to deduct 30% of the cost. If you or a dependent requires medical care that you must drive to regularly, you can write-off a portion of the cost. If you've made donations of clothing, a car, or any other item of value, you may be able to deduct it if you can accurately assess its fair market value. Those supporting an aging parent may qualify for the medical-expense deduction.
Finally, if you have a hobby or craft from which you derive even a small amount of income, you may be able to write off subscriptions, newsletters, and association fees if you sell an item for profit. Nothing beats the deductions possible with a self-owned business. Even with self-employment tax, turning a hobby into a full-blown business can allow you to maximize your tax deductions.
While we've covered the basics of financial planning here, there is much more to implementing a financial plan. To make sure you're on the right track, contact a licensed financial advisor. It only takes a few minutes, Start Now.
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