Soon you’ll be meeting with your tax advisor to discuss the meat and potatoes of your income tax return. Whether you are super organized and have everything in its proper place and a copy of all pertinent documents or you show up with a shoebox of W-2’s and 1099’s, you need to learn a bit of the lingo of your preparer.
I’ll be referencing the 2018 – 1040 Individual Income Tax return when citing line numbers. You can find it on www.irs.gov or we can send you a copy if you’d like to see the form.] Sometimes the IRS makes modest changes, so I will include a brief statement of some of the more relevant headings.
1. Wages: This is usually your W-2 income if you are employed by a company. If you participate in a tax-postponed plan, the number here reflects the adjustment for your before-tax participation (401-K plan). Had you chosen to skip or adjust your amount, the number on your W-2 would be reflected here. If you are a contractor or self-employed, your income shows up elsewhere.
3a. Qualified Dividends: Qualified dividends are those received on investments that you have held more than a year. These are taxed at your capital gains rates. Capital gains are currently taxed at a lower rate than your ordinary income tax rate. This is a preferred way to receive dividends. Sometimes it makes sense to trade out of an investment in less than a year. Just keep it in mind if you are rebalancing or an active trader.
3b. Ordinary Dividends: These are those that are held less than one year and are taxed at your highest taxable income rate. I recall an individual who ran an investment club. He was very active in trading. His biggest complaint to me was, “50% of my earned income is paid out in taxes.” Examining his return, I saw a large number on the line 3b. He was not taking money out of his investment club to pay taxes. Rather, to cover the tax due on this activity, he indirectly made another investment by covering the taxes from his W-2 earned wages. The result was that 50% of his W-2 income went to taxes.
Q:How do you pay the taxes on your realized investment earnings?
Taxes should be paid from the investment account that creates the tax bill where possible. Yet, most simply write a check from their earned income (see 3b above). Doing these is the same as making an additional investment in the account that created the tax. We refer to this as “compounding your taxes”!
4a. IRA, Pensions and Annuities: With the new SECURE Retirement Act, effective January 1, 2020, if you turn 70 ½ after that date, you can postpone your first mandatory withdrawal or required minimum distribution (RMD) until the year you turn 72. An example would be a person born on January 1, 1950. They turn 70 on New Year’s Day 2020. Under the new rule, if their circumstances fit, they have until 2022 (age 72) to start their RMD. If you have already started taking your RMDs, this does not apply to you.
Q: Will your current pre-tax participation, with any match, push you into a HIGHER tax bracket when RMDs are considered?
You might want to take a look at how your 401-k participation may be increasing your potential income tax in your later years, especially if you’ve been working for more than 20 years. We usually recommend sticking with the amount your employer is willing to match and save the rest in a taxable account.
5b. Taxable Amount for Social Security Benefits: For more than 50 years, Social Security benefits were income tax free. In the 1980s, Senator Dole worked with President Reagan to “save Social Security.” They started taxing 85% of your benefits if you hit a certain threshold.
Q: Ask your tax advisor: If you are receiving Social Security benefits, are you are reporting Social Security benefits as taxable because you hit that threshold?
If you are over 70 and not collecting Social Security, your benefits are frozen at age 70. Should you still be receiving wage or income from your business, you are required to participate in FICA (Social Security) without accruing additional benefits.
7. Adjusted Gross Income (AGI): This is the sum of your income from all sources adjusted for any deductions you may have. Although the Tax Cuts and JOBS act of 2017 reduced what you may deduct for home mortgage interest and property tax, there’s still an opportunity to make adjustments here unless you take the increased standard deduction. This AGI number impacts what you may pay for Medicare if you are over 65. If your total income is impacted by commissions or bonuses, you might think about deferring some into the next year. Some experts suggest bunching charitable contributions into one year. You can also choose whether to pay your property tax in December or push it into the following year in some areas. Just be careful to meet the deadline as late penalties can be high.
Q: Do you see a pattern here? Social Security benefits may be taxed and a big hit to what you pay for Medicare if your adjusted gross income is above a prescribed level.
Observation: Looking back to 1913, the first year of our present income tax strategy, this tax started as a temporary tax to pay for WWI. The average tax rate through 2020 has been just under 58%. Today, the highest tax rate is 37%. That is the fourth lowest rate in 107 years of taxing income.
Q: What do you think the odds are that you will be in a lower tax bracket in retirement – especially with the US Congress spending at record levels? (See my blog “5 Observations in Building a Portfolio.”)
8. Standard Deductions or Itemized Deductions: Here our friends in Congress continued the trend to reduce or eliminate deductions when they “reduce rates.” You are now capped on deduction for interest to only your primary residence with a cap of $750,000. Gone are the second home deductions. Continuing, the Congress limited SALT (state and local taxes) to $10,000. Many of our clients have homes that pay property taxes in excess of the limits.
Q: Ask your tax advisor how these limits impact your deductions. The standard deduction for 2020
is $12,400 for an individual, and $24,800 for a couple.
So, the IRS continues to clarify all your sources in income (your inflow). Figure your deductions (your write-offs) to determine your taxable income.
The IRS system is set up on a step up if the next $1.00 of earnings could push you into a higher bracket. For simplicity of these examples, I am using a married couple filing jointly. Your tax advisor can provide details relative to you. After allowable deductions, if their taxable income is $168,401, the IRS says they owe $28,765.
If they are paid a hypothetical $30,000 bonus, that money would be taxed at 24%, meaning $7,200 more in taxes on this additional “bonus” money.
Using 2020 standard deductions and no taxable dividends, here is some interesting math:
Standard Deduction $24,800
Taxable Income $168,491
Adjusted Gross Income $193,201
Taxes Paid: $28,765
Average Tax: 14.88%
Adding the $30,000 bonus at this bracket gives post-bonus adjusted gross income at $223,201. (That’s $193,201 + 30,000). Taxes paid would be $35,965, and the average tax would now be 16.33%. Do you see how the average rate increase because of a change in tax brackets? Will your present strategy set you up for a “bonus” beyond your control, like RMDs, and push you into higher tax brackets in retirement?
Q: What is your average tax bracket? How far away were you from the next highest tax bracket?
Ask your tax advisor. Many publish these average and marginal rates for you on comparative returns summaries.
Q: Would you like to have an idea what your total tax bill might be at today’s rates if you continue your present tax planning strategy?
Contact us at firstname.lastname@example.org.
Bonus Question: What does it take in 2020 for a married, filing jointly couple to hit the 37% rate (currently the highest PLUS 3.8% Obama tax on investment income)?
I wonder if Congress likes single people more. Two singles at $518,401 (taxable income) each as a “co-habitating” couple can go over $1,000,000 of taxable income before they hit the 37% tax bracket. I guess marriage has lost some of its charm with our Congressional representatives who legislate the tax laws.
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For educational purposes only. This information is from sources we believe to be reliable but is not guaranteed. Securities and investment advisory services offered through World Equity Group, Inc. Member FINRA, SIPC, a Registered Investment Adviser. SMART Group Houston is not owned or controlled by World Equity Group, Inc. Neither SMART Group Houston nor World Equity Group, Inc. provide tax or legal advice. For tax advice consult with a qualified tax professional.