Dorothy in Taxland - Tax on Marriage (2007-09-17)

Dorothy in Taxland - Tax on Marriage

(2007-09-17) by David John Marotta

Few Americans look forward to the idea of filing taxes. At best we feel like Dorothy being dropped into the Land of Oz. At worst, we feel like the Wicked Witch of the East having the house dropped on us.

As Glinda advises us, "It's always best to start at the beginning," and at the beginning of the tax return is determining your filing status. You would think that this is an easy and straight forward question. But since this is the beginning of dangerous journey on the yellow brick road, it is worth understanding the inequities that this section of the code causes.

Two different people with the exact same income and the exact same deductions can end up with very different amounts of tax owed, simply because of their filing status. Married couples -rich and poor alike- often bear the brunt of the inequities created by our current tax system

Every tax system does a certain amount of harm. The more progressive the tax system, the more devastating the unintended consequences. No marriage-neutral tax system can exist given a progressive taxation system.

Most people wrongly assume that the marriage tax penalty was eliminated by some of the tax changes that were enacted and gradually implemented over the past several years. The marriage tax penalty was eliminated in the 10% and 15% brackets by increasing the number of married couples who get special tax breaks.

Let's look at some examples.

Michael and James work in the same business. Each makes the same salary and takes the same deductions. The only difference is that Michael's wife stays home, while James's wife works at the firm.

In this case, the tax code gives Michael and his wife a tax break. Michael gets the benefit of claiming two personal exemptions (one for himself and one for his wife). The tax code favors these provider/dependent marriages like Michael's. They are better off filing jointly since Michael's wife - who is not earning any income - can't put her personal exemption to good use. But by filing jointly, Michael and his wife can use both personal exemptions, thus lowering the taxes on Michael's earnings.

However, James and his wife find themselves paying significantly more tax simply because they are married filing jointly.

If James and his wife are both low-income their filing status will dramatically change their tax status. A low income couple who marries and combines their income can forfeit other programs designed to help the truly needed. The most important of these programs is the Earned Income Tax Credit (EITC).

For 2007, a couple's income must be under $39,783 in order to qualify for EITC, while filing single or head of household must be under $37,783. Imagine a couple where each makes about $20,000 a year and you can see their dilemma.

EITC isn't small change either. In fact it is a much better way of targeting poor working families than raises to the minimum wage. For 2007, the maximum EITC credit is $4,716 which can make a huge difference in a struggling family.

The marriage penalty remains even if James and his wife are well-off. They are taxed as though they represent one very high income taxpayer and must pay more than they would if they were unmarried and just living together.

Most likely, neither Michael nor James will let the tax code determine if they should get married. But you can bet that Michael's wife and James's wife will let the tax code determine how much they are willing to work.

Because James and his wife are taxed at a combined rate, there is very little incentive for James's wife to continue working. Another way to think of it is a tax on families with two earners. In other words, it is a tax on married women whose husband's work, especially on women with high incomes.

James and his wife, by combining their incomes, have pushed each other into the top marginal tax bracket. That means for every dollar that James's wife earns, she is probably taxed at over 50%, including federal, state, and local taxes.

Now compare James's situation with Michael's. If Michael's wife can save a dollar by bargain shopping and preparing homemade meals, they are a dollar richer. James and his wife would have to earn at least two times as much to fare as well. Because of their combined income pushing them into the highest tax brackets, the government will take over half of everything they earn.

They will also have additional expenses as a result of working, and few, if any, of these expenses will reduce their income. Their business clothes, gas, and child care expenses may all have to get paid with after tax dollars making these expenses two times more costly than the income they may generate.

If all of this public policy debate makes your head swim, you are not alone. The bottom line is: The flatter the tax system, the less it matters whether couples combine their incomes or not. If every dollar of income were taxed the same and there were no deductions or credits, it would not matter if James and his wife combined their incomes. The same flat percentage of a combined amount is still the same flat percentage.

Practically speaking, many couples would be better off having either mom or dad stay at home. Having one family member who is working at reducing expenses and improving lifestyle can be the least expensive way to increase family wealth. Saving money by doing more things for yourself is worth two times the income earned by the spouse who winds up in the top brackets. And besides, "There's no place like home."

from http://www.emarotta.com/article.php?ID=249

Dorothy in Taxland: Above the Line Deductions (2007-09-10)

Dorothy in Taxland: Above the Line Deductions

(2007-09-10) by David John Marotta

Those with wealth look ahead and adjust their affairs according to the tax code. But, most Americans look backward and only hope that Uncle Sam will return some of what they have already paid. Living in the moment and only looking backward is a recipe for paying the most tax at the worst time.

If you are like most Americans, you filed your tax return in mid-April and did not look at any of it during the last four months. The tax preparation which seemed so valuable at the time has faded like Dorothy's memories of Oz when she wakes up back in Kansas.

Many people who use tax computation software don't even understand the changing structure of our country's tax code. You fill in the blanks, press compute, pay the tax, and then forget about the torture until next year.

Into this dark forest of the tax code we throw college students and recent graduates. It is almost a rite of passage, better likened to a fraternity hazing than a step into adulthood. We smile a little when the trees grab the apples out of their hands.

The obfuscation of the tax code helps hide the details. Its Byzantine rules and regulations are carefully crafted to cover up just how much we pay each year. In other words, tax laws are stupid by design. While you are busy trying to translate word problems written in 'Taxglish' you don't realize they are asking all the wrong questions. Like Dorothy in the field of poppies, you can't seem to stay awake long enough to realize the danger.

Still, as long as you are so close to the Emerald City, it would be nice to have Glenda send a rain to help you get inside the city's gates. Similarly, a basic understanding of the specific contours of the stupidity of the tax code can help you avoid meaningless extra payments to the government and keep more of your income.

A professional tax expert can help you get the right deductions, but likely won't motivate you to keep the right records unless you understand the benefit for yourself.

There are three basic ways to reduce your tax burden: above the line deductions, below the line deductions, and credits. Each of these deductions is used in one of the three general formulas on the 1040 tax form. The first formula is: Gross income minus above the line deductions equals your adjusted gross income (AGI).

All deductions are not created equal. Some deductions are more valuable than others. What matters is whether or not the deduction is "above the line" or "below the line". The line in this case is your adjusted grow income (AGI).

Above the line deductions are subtracted from your gross income in order to compute your AGI. Therefore, above the line deductions reduce your AGI which also reduces your taxable income. A lot of calculations and limits are computed from your AGI. So, reducing your AGI can lower many subsequent calculations to lower other taxes you may have to pay. As a result, above the line deductions are more advantageous than those taken "below the line."

Above the line deductions will always lower your taxes. Above the line deductions are rare unless you are self-employed because they are mostly business related expenses. If you are self employed, you should have a lot of above the line deductions you are taking advantage of.

Above the line deductions include everything on Schedule C or F business deductions. If you are not a small business owner, you should consider performing some or all of your work under the umbrella of your own small business. If you run a successful business you will be paid twice what you are currently being paid and find yourself on the yellow brick road of accumulating real wealth. Even if you don't get any more pay, you may find more of your expenses are tax deductible and therefore you will pay less tax.

If you are not a small business owner there are still above the line deductions you can take such as: stock losses up to $3,000, IRA contributions, student loan interest, moving expenses, alimony and several other items.

Payments to your Health Savings Account (HSA) can also be deducted above the line. In 2007 the limit is $5,650 in tax free contributions. One out of every ten patients consumes 69 percent of health care costs. The other nine would benefit from an HSA.

With the savings on your insurance premiums, you should be able to accumulate a sizeable nest egg. And, unlike your traditional health care plan, your HSA funds are not subject to a "use it or lose it" policy. Anything you don't spend one year carries over to the next year. After all, it's your money.

In addition to doctor's visits, hospitalizations, lab tests and the like, an HSA can also pay for prescriptions and some over the counter drugs like aspirin with pre tax dollars. HSA accounts can even pay for vision and dental expenses such as contact solution and teeth cleanings.

Another above the line deduction is specifically designed for teachers. If you are a qualified educator you can deduct $250 for books, supplies and computer equipment you purchase. This deduction has been extended through 2007 as well.

These deductions are like Dorothy's ruby slippers, they are adjustments to your income and once adjusted nothing else in the tax code can touch them. Fund your retirement account, start a health savings account and go into business for yourself to take advantage of these incentives in the tax code.

from http://www.emarotta.com/article.php?ID=248

University Students: Getting Sucked Dry by Credit Cards (2007-09-03)

University Students: Getting Sucked Dry by Credit Cards

(2007-09-03) by David John Marotta

Last week we listed the ways university student are enticed into using credit cards. This week we will examine the economical impact of those initially small and convenient monthly payments.

If your credit card minimum payment was $10 and you repaid it every month for 15 1/2 years with an accruing interest of 15.9%, a $1,000 purchase would end up costing $2,250. Every time you use your credit card to pay for something you risk it being marked up two and a half times the normal sales price. Over time, that $10 T-shirt cost you $22.50!

Whenever you use your credit card, imagine that two and a half times the price of what you are buying will be deducted from your account over the next decade.

Students assume that they can run up a credit card bill because it will be easy to pay it off after they graduate when they get a high paying job. But the larger your debt the longer it takes to pay off that debt using minimum payments. The average student graduates with about $7,000 in credit card debt. They assume that $7,000 will be easily wiped away with their first high paying job.

Being burdened with $7,000 in credit card debt after graduation costs nearly $20,000 and can stretch nearly forty years to erase with minimum payments. Just when you should be saving and investing that $20,000, growing rich or buying your own home you are stuck with unfinished and unneeded college debt.

Whenever you casually reach for your credit card during college, visualize the choice between having the down payment on owning your own home or making that purchase.

Studies have linked accumulating credit card debt to psychological stress that increases the likelihood of dropping out of school and suicide. Students find themselves ill-equipped to handle the anxiety of mounting collection agencies alongside their course of studies.

Studies have also shown that a college degree is worth over a million dollars in increased lifetime earnings. Don't sacrifice the million dollar benefits of an education on the frivolous purchases of a credit card.

Every time you reach for a credit card image that credit card hanging on your wall instead of your diploma. It could cost you a million dollars to frame it.

The years after college and before children are the best time in your life to save. But you lose time and squander your resources if you enter the marketplace with credit card debt.

Your high school and college years are the prime years for funding your Roth IRA. If you use a credit card but don't fully fund your Roth IRA each year you have a credit card problem. Unlike a traditional IRA, you contribute to a Roth IRA after taxes, it grows tax free, and then in retirement you can make tax free withdrawals. Because the money is contributed after taxes, it is best to fund an IRA while you are a poor college student working summers and part time and still in a low tax bracket.

Contributing $2,000 a year to your Roth IRA during high school and college is better than starting to contribute during your first year after college and continuing for the remainder of your life.

Every seven years you wait to fund your Roth IRA you cut in half the standard of living you will have in your retirement. With normal market returns, after seven years of $2,000 a year contributions your Roth IRA will be appreciating at a rate of more than $2,000 a year, without any additional contributions. At normal market rates of return, that $14,000 contribution during high school and college will ultimately grow to more than $2 million dollars by age 67 and more than $4 million dollars by age 73.

Whenever you look at prices in a store or restaurant, imagine taking the decimal out in front of the cents. That is how much tax free income you are losing in retirement by not contributing to your Roth IRA. And by age 85 you could add another zero. The $8.50 lunch costs you $850 at age 63 and $8,500 by age 85.

If you don't think you have any problems with your use of credit cards, but you haven't been saving and fully funding your Roth IRA, you have a problem with your use of credit cards.

Every time you go to use your credit card ask yourself if you've fully funded your Roth IRA for the year. If you haven't, put the credit card right back in your wallet.

All debt is not equal. Credit card debt is bad debt. Student loans are good debt. Good debt is anything that last longer than it does to pay the loan back. Good debt is investing in things that will pay you more money than the debt costs. An education is good debt because it will increase your income, satisfaction in life, and longevity.

Credit card debt is bad debt. Bad debt is anything that you can wear, eat or drink. Always pay cash for these items. If you do, what you wear, eat and drink will be healthier and less expensive. The next time you pull out your credit card for any of these items imagine wearing, eating or drinking $20 dollar bills.

Use these visualization techniques to stem your excessive use of credit. Alternately, just leave your credit card locked in your dorm room. Life's too short to let it get sucked dry by credit cards.

from http://www.emarotta.com/article.php?ID=247