CHAPTER II UNDERSTANDING TAX LIABILITIES

CHAPTER II

UNDERSTANDING TAX LIABILITIES

“If you want to thrive in today’s economy, you must challenge the status quo and get the financial education necessary to succeed.”

Robert Kiyosaki Author, Motivational Speaker: Rich Dad, Poor Dad

Keeping More of What You Earn

The harsh reality of essentially getting your tax liability to zero is nearly impossible. Especially, if you are a high-income earner with an employer sponsored pension. In the absence of achieving a zero-tax base, the next best thing is reducing your tax liability as low as feasibly possible. When planning for retirement the contributions deposited into investment accounts are either pre-tax, after-tax or both. Knowing the

difference between the two and leveraging that knowledge towards your investment strategies can allow you to retain more of your dollars and reduce your tax liability.

Pre-tax contributions are money that has not been taxed and can be invested by individuals and employers in the form of Traditional and Self-Directed IRAs, 401(k), 457 and 403(b) plans, pensions, and profit-sharing accounts. These contributions may be invested in certificates of deposits (CDs), annuities (fixed, variable, or immediate), mutual funds, stocks, and bonds. Pre-taxed contributions provide immediate tax benefit as its lower taxable income by the dollar amount contributed to one’s retirement account. Additionally, interest and dividend income or capital gains are also exempted from taxation until funds have been withdrawn. Upon withdrawal, funds are treated as ordinary income and taxed for the calendar year of the withdrawal.

Strict guidelines are established by the Internal Revenue Service that mandate a pre-tax retirement account must have a custodian, or financial institution, who is responsible for reporting total contributions and withdrawals for each tax year. Whenever a

withdrawal occurs from a pre-tax retirement account, the custodian/financial institution will send a 1099-R tax form to the account owner for reporting during the tax year of the withdrawal. Note: An early withdrawal from the pre-tax retirement account (typically, before age 59 ½), will trigger a penalty tax generally 10 percent plus the tax on the withdrawal amount.

There is an exception to this rule under Rule 72(t) section 2 of the IRS code. Rule 72(t) section 2 allow individuals to take substantial equal periodic payment (SEPP) on an annual basis prior to age 59 ½ as long as certain SEPP qualifications are met. Individuals considering this option must make at least five SEPPs based on the owner’s life expectancy as determined through IRS approved methods. Participants must adhere to the payment schedule for five years or until reaching age 59 ½, whichever comes later. Note: There are two exceptions to this rule, owners’ disability, or death.

After-Tax contributions are ordinary income that has been taxed and deposited in an interest-bearing account such as Roth IRAs, money-market accounts, savings accounts, CDs, annuities stock, bonds, etc. After-tax monies deposited in these accounts is only

tax on the investment gains above the original investment amount. An advantage of investing aftertax dollars is that the tax rate you pay today will more than likely be lower than the tax rate you pay in the future. Since only investment gains are taxed at the time of withdrawal, you pay a much smaller portion in taxes rather than on the whole amount withdrawn compared to pre-tax investments. Typically, qualified dividends and long-term capital gains generated from after-tax investments are taxed at a lower rate over time and in some instances, long term capital gains are not taxed at all.

Like pre-tax investments accounts, after-tax accounts require financial institutions to provide a report of interest income in the form of a 1099 tax form each year. The 1099 tax form will reflect any interest income, dividend income and capital gains that must be reported when you file your annual tax return.

Provisional Income Tax

The Internal Revenue Service defines provisional income as the sum of wages, taxable and nontaxable interest, dividends, pensions, self-employment, and

other taxable income plus 50 percent of your Social Security benefits. Most retirees do not pay federal income tax on their Social Security as many annual retirement earnings fall below IRS taxable threshold. Comparatively, nearly one third of retirees pay federal income tax on their Social Security benefits. This segment of retirees consists of those who receive substantial retirement incomes that exceed certain IRS income limits. Depending on the amount of retirement income received, the event can trigger a tax up to 85 percent of the Social Security benefit. Additionally, some states may tax Social Security income. Currently, 13 states (Colorado, Connecticut, Kansas, Minnesota, Missouri, Montana, Nebraska, New Mexico, North Dakota, Rhode Island, Utah, Vermont, and West Virginia) collect state income tax on Social Security benefits. Tax amount can vary among states by adjusted gross income and other factors. Check with your tax advisor or local state official to determine if the state you reside in taxes Social Security income.

How Is Provisional Tax Calculated?

Provisional income is calculated by adding gross retirement income minus Social Security income, any tax-free interest such as interest from municipal bonds

plus 50 percent of Social Security benefits. Table 2-1 illustrates how provisional income is taxed by filing status.

Table 2-1

Social Security Provisional Income by Filing Status

Tax Filing Status Provisional Income Social Security Taxation

Single or Head of Household

Joint Filers Less than $25,000 0% $25,000 - $34,000 Up to 50% More than $34,000 Up to 85% Less than $25,000 0% $32,000 - $44,000 Up to 50% More than $44,000 Up to 85%

Based on the information is Table 2-1, a single filer with a gross pension retirement income of $42,000, $1500 in municipal bond interest and $24,000 in Social Security income would be impacted as follows. Divide Social Security benefit by half totaling $12,000 and add to the total $43,500 retirement income totals, which produce a taxable provisional income amount of $55,500 before any tax deductions.

In retirement, many of the tax deductions and credits received during one’s working years are no longer available, e.g., mortgage interest (if home is

paid-off), childcare credit, retirement, and charity contributions, etc. Chances are the standard deduction is all that remains.

Types of Credits and Deductions

A good strategy to reduce taxable liabilities is to leverage the use of tax credits and deductions. Done properly, significant tax savings can be realized for long-term financial stability. The use of tax credits can reduce the amount of tax owed or increase overall tax refund, and some credits may be claimed even if you owe taxes, (consult a tax professional). Comparatively, deductions can also reduce income prior to tax calculations.

Credit Types

• Family and Dependent Credits

o Advance Child Tax Credit Payments o Child Tax Credit and Credit for Other

Dependents o Recovery Rebate Credit o Earned Income Tax Credit o Adoption Credit o Credit for the Elderly or Disabled

• Income and Saving Credits

o Saver’s Credit (Retirement Savings Contributions Credit) o Foreign Tax Credit o Excess Social Security and RRTA tax Withheld o Credit for Tax on Undistributed Capital Gains o Credit for Prior Year Minimum Tax • Homeowner Credits

o Residential Energy Efficient Property Credit o Plug-in Electric Drive Vehicle Credit • Health Care Credits

o Premium tax Credit o Health Coverage Tax Credit • Education Credits

o American Opportunity Credit and Lifetime

Learning Credit

Similarly, there are several types of deductions that can greatly reduce taxable liability owed. Specifically, pre-tax, standard, and itemized deductions. Although I will cover a wide range of deduction types, these three deduction types represent the most used deduction among tax filers.

Pre-Tax Deductions – Consist of money that is subtracted from an employee’s gross pay prior to taxes being withheld. The following is a list of the most common pre-tax deductions:

• Healthcare Insurance • Health Savings Accounts (HSAs) • Supplemental Insurance Coverages • Short-Term Disability • Long-Term Disability • Dental Insurance • Child Care Expenses • Medical Expenses and Flexible Spending

Accounts • Life Insurance • Commuter Benefits • Retirement Funds • Tax-Deferred Investments • Vision Benefits • Parking Permits

Standard and Itemized Deductions

Standard and Itemized Deductions are the two most used deductions after pre-taxed deductions and will often include other deduction types highlighted in this chapter. The total expense amounts claimed by filers will determine which type of deduction to best exercise. If deductions are less than the standard deduction table, use of this table is the best option.

Should filers expenses exceed the fixed amounts provided in the standard deduction table then using the itemized deduction is the recommended choice.

• Standard Deductions – Are deductions taken when filers do not have enough deductions that exceed the standard deduction table, see Table 2-4. These deductions represent a fixed dollar amount that reduces taxable income. Note:

Standard deductions increases if the filer is blind or age 65 or older. The amount increase by $1,650 when single or head of household and if married or a qualifying widow(er) the amount increases by $1,300. • Itemized Deductions – Are deductions that exceed the standard deduction table. Filers subtract applicable deductions from taxable income to reduce overall tax liability. Note: some states do not permit itemized deductions such as Michigan or Massachusetts. Below are some of the most frequently used itemized deductions among tax filers.

o Deductible Taxes o State and Local Taxes o Property Taxes

o Real Estate Tax o Sales Tax o Charitable Contributions o Gambling Loss o Miscellaneous Expenses o Interest Expense o Home Mortgage Interest o Moving Expenses

Other Types of Deductions

• Work Related Deductions

o Business Expenses o Business Use of Car o Business Use of Home • Education Deductions

o Student Loan Interest o Work-Related Education Expenses o Teacher Educational Expenses • Health Care Deduction

o Medical and Dental Expenses o Health Saving Accounts

Continuing with the example, Table 2-4 shows the standard deduction for a single filer is $12,950. This amount is subtracted from the provisional income calculation of $55,500 for a taxable income of $42,550. Since this amount is greater than $34,000 for a single

filer identified in table 2-1, the provisional income would trigger 85 percent of the Social Security benefits being taxed ($20,400). Using information from Table 22, (Income Tax Bracket for Single Filer), the provisional income tax on $20,400 represents the 12 percent taxable income bracket. The calculation for this example is as follows, add $1,027.50 or 10% of $10,275 and the remaining $10,125 is taxed at 12% ($1,215) for an overall tax amount of $2,242.50. The annual Social Security income is reduced from $24,000 to $21,757.5 or $1,813.13 per month in net Social Security income. This amount may be further reduced if you reside in a state that tax Social Security benefits. Taxation of retirement benefits is something that must be factored in consideration when determining how much you will need to live on in retirement.

Tax Diversification

Many of you may be familiar with the old term “never put all of your eggs in one basket” There are not many absolute terms I support, but I subscribe to this one! Preparing for the future is much easier than predicting for the future. When it comes to good financial management, taking an all-in approach or

simply doing nothing at all is a failed wealth building strategy.

Over time, you can anticipate changes in tax and income levels. Investing in both Traditional and Roth IRAs can assist with hedging against lifestyle changes and financial market shifts in the future. Traditional IRAs are excellent investment vehicles for pre-tax contributions that can lower your tax rate today, allowing you to keep more of your money now. Roth IRAs are great investment vehicles for future income through after-tax contributions. These contributions are taxed today conceivably at a lower tax rate than in the future and allow investors to avoid paying tax on capital gains when taking a retirement distribution. By incorporating both Traditional and Roth IRAs into your investment strategies you gain financial tax benefits today and in the future. How much benefit you experience will depend on where you are now with your financial plan. Remember, to refer to the most current IRS guidelines to determine your eligibility for these accounts.

Developing the Right Financial Mindset

Many financial guides provide best case scenarios where at the end of the scenario there is a huge sum of money accumulated along with the assumption of a long-life span that goes well into one’s 80s and 90s. Well, this is not that type of guide! I am going to meet you where you are! The reality is, most will not reach a million or multi-million-dollar investment account or live well into their 80s and 90s and that is okay!

My goal is to provide you with financial insights that help shape your financial mind-set which can translate to you enjoying the best possible retirement life you can achieve. Daily, I am surrounded by high income earners in their 50s and older who have not properly prepared for retirement. Unfortunately, many have not contributed enough funds toward retirement and are overleveraged with debt. Quite the troubling reality. I hear the frustrations, concerns, and fears of what the future hold in retirement-life and the desperate need for a better way.

Chapter I served as a jump start towards building wealth and gaining your financial freedom. Possessing the right mindset is critical and only you can put this

piece into practice. Your thought process influences your actions, and your actions dictate your outcomes. The scenarios shared in this book are designed to help reshape your point-of-view (mindset) and inspire you to act.

Earned income for many of you is represented by your paycheck and if you are like most individuals, the goal is to bring home as much of your paycheck as possible. Taxes, insurances, savings, and investments can absorb most of your earnings leaving most with approximately 50 percent or less in bring-home pay from what is earned. Now, this may be a shocker to some, but if you review your pay statements some of you may be surprised. Hey! All is not lost by retaining approximately 50 percent of your earnings if you maximize your retirement contributions. The following scenario will highlight my point-of-view and more importantly, show you how to leverage current and future income with deductions using the provided link at the end of this chapter to determine how much taxes you should have deducted from your paycheck.

The following scenario provides assumptions for maximizing retirement contributions, $20,500 for those under 50 years of age and $27,000 for those 50

years and older, (this amount includes $6,500 in catchup contributions). If you are not fully funding your retirement accounts, you are doing yourself a huge disservice! Pay yourself first! The more income you contribute towards retirement the less taxes are taken from your income. Unfortunately, many do the opposite. Remember, the goal is to retain as much of your income as possible. Think of it as paying yourself prior to paying the IRS.

Maximizing Your Earned Income

Earned income triggers a taxable event that most experience. Fully funding one’s retirement savings both traditional and catch-up is the quickest method to reduce federal tax liability. For example, let’s look at Sam Smith. Sam is over the age of 50, single and lives in a state without state income tax. Sam has an annual salary of $100,000. By maximizing both retirement savings and catch-up contributions of $20,500 and $6,500 respectively for a combined total of $27,000, taxable wage is reduced to $73,000. This amount is further decreased by pre-tax deductions such as healthcare, vision and dental, long-term care and disability insurances totaling approximately $5,500 per year. Sam’s taxable wage is now $67,500 before

subtracting his standard deduction. Remember, it is not about how much money you make, it is about how much money you can retain from the money you make. For a better example, see Tables 2-2 and 2-3 (Income Tax Bracket for Single Filer and Married Couples Filing Jointly).

Table 2-2 Income Tax Bracket for Single Filer

2022 TAXABLE INCOME INCOME TAX DUE

Under $10,275 $10,276 - $41,775

10% $1,027.50 + 12% of the amount over $10,275 $41,776 - $89,075 $4,807.50 + 22% of the amount over $41,775 $89,076 - $170,050 $15,213.50 + 24% of the amount over $89,075 $170,051 - $215,950 $34,647.50 + 32% of the amount over $170,050 $215,951 - $539,900 $49,335.50 + 35% of the amount over $215,950 Over 539,901 $162,718 + 37% of the amount over $539,900

Table 2-3 Income Tax Bracket for Married Couple Filing Jointly

2022 TAXABLE INCOME INCOME TAX DUE

Under $20,500

10% $20,550 - $83,550 $2,055 + 12% of the amount over $20,550 $83,551 - $178,150 $9,615 + 22% of the amount over $83,550 $178,151 - $340,100 $30,427 + 24% of the amount over $178,150 $340,101 - $431,900 $69,295 + 32% of the amount over $340,100 $431,901 - $647,850 $98,671 + 35% of the amount over $431,900 Over 647,851 $174,253.50 + 37% of the amount over $647,850

Note, if Sam elected to invest only minimally three percent ($3,000) in retirement savings and forego contributing to catch-up, he would add an additional $24,000 of taxable income resulting in $91,500 of taxable income instead of $67,500. Additionally, he would not receive his company’s five percent matching ($5,000). As a result, Sam’s higher taxable income is taxed at a rate of 24 percent. Note: Many employers will contribute to employee’s retirement investment accounts usually five percent in company matched funds. So minimally, it is recommended to contribute up to the amount your employer is willing to match. Failure to do so results in losing out on free money! Another absolute, “Never leave free money on the table”! Comparatively, the following scenario assumes Sam fully funds both retirement savings and catch-up investment accounts, reducing his overall taxable rate to 22 percent.

The example provided stresses the importance of paying yourself first. If your federal tax deduction is greater than your retirement savings contribution, chances are you need to revisit your retirement contribution strategy to reduce your overall tax

liability. Work closely with your CPA or financial professional for additional guidance.

Table 2-4 Standard Deductions

2022 FILING STATUS STANDARD DEDUCTION

Single

Married Filing Jointly

Married Filing Separately

Head of Household $12,400

$24,800

$12,400

$18,650

Continuing with the scenario federal taxes are also being deducted from Sam’s payroll of $500 per 26 weeks’ pay period at an annual deduction amount of $13,000. As a single filer Sam’s standard deduction is $12,400, these totals are subtracted from $67,500 totaling Sam would realize an adjusted income of $42,100. The adjusted income falls within the 22 percent tax bracket as indicated in Table 2-2. Based on Table 2-2 (Income Tax Bracket for a Single Filer), Sam end-of-year tax filing would be calculated as follows: Subtract the adjusted income of $42,100 from the 22% tax owe amount $41,775 = $325 x .22 = $71.50 +

$4,807.50 (12%-Tax) + $1,027.50 (10%-Tax) = $5,906.50 in taxes owed for tax year 2022.

Table 2-5 Taxable Income before Adjustments

Deductions $100,000 Income

Retirement Savings -$27,000 Pre-Tax Deductions -$5,500

Taxable Income $67,500 Table 2-6 Adjusted Incomes

Deductions $67,500 Taxable Income

Federal Income Tax -$13,000 Standard Deduction -$12,400

Adjusted Income $42,100

Table 2-7 Bring Home Pay

Deductions $100,000 Income

Retirement Savings -$27,000 Pre-Tax Deductions -$5,500 Federal Income Tax -$13,000

Bring Home Pay $54,500

Since Sam has already paid $13,000 in federal taxes, he would receive a federal tax refund in the amount of $7,093.50. This scenario assumes Sam is claiming zero on his federal tax withholdings. Based on the refund amount of $7,093.50, Sam’s federal tax withholding status should be increased to capture the near $7,100 he loaned the federal government throughout the year. When you are owed a federal or state income tax refund, you are essentially allowing your money to be borrowed at a zero percent interest rate. The monies Sam loaned the federal government could have fully funded a Roth IRA earning compounded interest. This scenario illustrates the importance of knowing where and how monies flow from your paycheck. Ultimately, the goal is too breakeven with your tax withholdings

and income by ensuring any additional monies are working hard for you.

Now let us examine how Sam faired in this scenario. His bring home pay was $54,500, see Table 2-7 plus he received a federal income tax refund of $7,093.50 for a total of $61,593.50 in realized net income. He contributed $27,000 in combined retirement and catch-up contributions while earning compounded interest at an annual rate of return of 10 percent, or $29,700. By year’s end, Sam retained $91,293.50 or 91 percent of his total earnings paying an effective federal income tax rate of 5.90 percent of his $100,000 salary. Sam could reduce his overall federal tax rate further if he elected to use itemized deductions if applicable. I recommend visiting the IRS website Tax Withholding Estimator https://apps.irs.gov/app/tax-withholdingestimator/about-you. The tax estimator tool can aid you with completing or updating your W-4 to determine how much federal income tax to withhold.

The provided scenario illustrates the importance of understanding payroll deductions and the impact it has on federal and state (where applicable) income tax liabilities. Executed correctly, you can expect to retain between 75 and 90 plus percent of your earned

income. Perfecting these strategies will allow you to maximize retention of your earned income and be strategically positioned to take advantage of other investments and asset protection opportunities towards achieving increased financial literacy and legacy wealth building.