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Effective and Marginal Tax: Know Yours!- Understanding the difference between these two tax rates

The tax code is filled with terms we rarely use in everyday conversation. Two of the more common are Marginal Tax Rates and Effective Tax Rates. Knowing what they mean can help you think differently about your potential tax obligation.

Definition

Marginal Tax Rate: This is the tax rate applied to the next dollar you earn. Since our income tax rates are progressive, the next dollar you earn could be taxed at as little as zero or as high as 37%!

Effective Tax Rate: This is the tax rate you actually pay. It is total taxes paid divided by your total taxable income. Said another way, after taking your income and then applying taxes, deductions, credits, exemptions, and other adjustments, you are left with your true tax obligation. This obligation is a percent of your income.

A Simple Example

Consider two single people; Joe Cool who earns $50,000 and Chuck Browne who earns $500,000. If we had a flat tax of 10%, Mr. Cool would pay $5,000 in tax and Mr. Browne would pay $50,000 in tax. Both of their Effective Tax Rates would be 10% AND their Marginal Tax Rates would also be 10% because each additional dollar they earn would be taxed at the same 10%. However it is a different picture when you apply our progressive tax rates:

If we use the 2022 U.S. tax table for a single filer, Joe Cool pays $6,617 and Chuck Browne pays $148,753 in federal tax. This is because tax rates applied to Joe Cool’s income are (10 – 22%) while Chuck’s income over $50,000 gets Marginal Tax Rates of (22 – 35%). Ignoring other tax factors, our two taxpayers’ tax rates are:

Why Care?

  • Calculating Returns. The true return you receive on any taxable investment will be determined by your Marginal Tax Rate. A $500 profit from a new investment could cost Joe Cool 15% in federal tax, but it could cost Chuck Browne 35% in federal tax.
  • Phaseouts can provide a dramatic impact on Effective Tax Rates. The simple examples above do not account for income limits applied to many tax benefits. Additional income could have a very dramatic impact on Joe Cool if it triggers losing things like an Earned Income Credit, or Child Tax Credit. This could increase Joe’s Effective Tax Rate while not touching his Marginal Tax Rate.
  • Extra work can help the taxman more than you. There have been cases where adding a second job can actually cost you money by not understanding the impact of the income on your Effective Tax Rate. This is especially true for retired workers receiving Social Security Retirement Benefits. That extra job may make your Social Security benefits taxable.
  • It’s not that simple. In addition to all the different income phase-outs for credits and deductions, your Effective Tax Rate could be impacted by the elimination of itemized deductions, the Alternative Minimum Tax, and the marriage penalty.

So look at last year’s tax return and calculate your Effective Tax Rate. Then look at your income and determine the Marginal Tax Rate to be applied on your next dollar of income. Finally, if you anticipate an increase in earnings, consider forecasting the impact on your Effective Tax Rate.



The New $7,500 Tax Credit That Isn't- What you need to know

A highly-touted tax credit in the recently-passed Inflation Reduction Act is meant to incentivize Americans to purchase clean and electric vehicles. The bottom line, however, is that practically speaking YOU CAN’T GET IT.

Why few credits will be seen

As the new legislation is currently written, nearly all the electric vehicles sold today do not qualify for the new credit that begins in 2023. This is because:

  • The vehicle must be manufactured in North America AND
  • Powered by batteries with materials sourced in either the U.S. or from free trade partners AND
  • If by some stroke of luck you find a new vehicle that qualifies, the price must be below $55,000 for a sedan and $80,000 for a van, truck or SUV.

Tax code as behavior modification

The new electric vehicle tax credit is a classic example of the continued shift from using income taxes to pay for federal spending to using the tax code to get us to do what the government wants. In this case:

  • The government is trying to get manufactures to shift sourcing away from countries like China.
  • The government wants to motivate the creation of manufacturing jobs in the U.S.
  • The government wants to incentivize the manufacturing of lower-priced electric vehicles.

What this means for you

What this means for the average consumer is little to anything…right now. If you have your sights set on getting a clean or electric vehicle, make the decision without the influence of the credit. If maximizing the credit is important for you, you now need to pay attention to income limits and will need to wait for some time to see if the credit influences manufacturers to change their sourcing and assembly plans.



Understanding Tax Terms: Contemporaneous Records- Everyone needs to know what this means!

If you have problems getting to sleep at night and you turn to the IRS tax code for help, you might find some vocabulary that is very foreign to you. One of the more uncommon words used by the IRS is the term “contemporaneous.” So what does it mean and why should you care?

Contemporaneous defined

According to the IRS, it means that the records used to support a claim on your tax return are created and originated at the same time as your claimed deduction. In other words, if you realize that you forgot to get a receipt for something, you are out of luck if you try to get one at a later date.

Not fair!

Perhaps you know you had the expense, but you simply forgot to get a receipt. You can cry foul, but time and again the IRS has had tax courts uphold their elimination of a taxpayer’s deduction for lack of contemporaneous documentation. Here are some areas where the term contemporaneous is especially important:

  • Charitable contributions
  • Business deductions for expenses and capital purchases
  • Mileage logs
  • Tip records
  • Gambling losses
  • Business travel expenses

The donation of vehicles, boats and planes is often the most cited area where lack of contemporaneous documentation is a problem because these types of donations have a high estimated market value that changes from month to month. But timely, written acknowledgement from the charitable organization is also required for any donation of $250 or more.

What you need to know

  • Always get a receipt. Before you leave a donated item, always ask for a receipt. In the case of a vehicle, make sure the charitable organization gives you a 1098-C that is fully filled out. In addition, make sure the organization uses your vehicle or is a qualified charitable group that allows you to take the full market value of your donation.
  • If you forget, call right away. As soon as you realize a confirmation or receipt is missing, call to get one sent to you. Request that the receipt be dated as of the date of the service or activity.
  • Think tax year. Understanding the definition of contemporaneous is important, because it is not always precisely defined. If the documentation is received in the same year as the donation or transaction, you are usually in good shape.
  • Keep a log. Many transactions require the correct documentation at the time the activity occurs. This is true with deductible mileage, gambling loses and tip income. So keep a log of your activities as they occur.
  • Wait to file. To meet the IRS definition of contemporaneous, the receipt or acknowledgement must be received the earlier of either when you file your tax return OR the due date (including extensions) of your tax return. This is particularly true with charitable contributions. So if you want to play it safe, do not file until all documentation is in hand.


IRS Audit Rates- Don't get complacent…resurgence is underway

The IRS reported audit rates continue to be low…very low. But that is now changing with thousands of auditors being hired for a post-pandemic scale-up of their reviews.

So don’t get complacent. A closer look at the IRS data release reveals some audit pitfalls you should know about.

Audit Rate Statistics for Individuals

Source: IRS Data Books with 2019 audit figures updated through May 26, 2022

Observations

  • Fewer audit examinations obscure the reality that you may still have to deal with issues caught by the IRS’s automated computer systems. While not as daunting as a full audit, you’ll need to keep your records handy to address any problems.
  • Average rates are declining, but audit chances are still high on both ends of the income spectrum: no-income taxpayers and high-income taxpayers.
  • No-income taxpayers are targets for audits because the IRS is cracking down on fraud in refundable credits designed to help those with low income, such as the Earned Income Tax Credit (EITC). And while not on the charts, 87% of Earned Income tax returns that are audited had additional tax applied!
  • High-income taxpayers have long been a target for IRS audits. This group, however, saw a big decline in audit rates during the pandemic. Still, taxpayers with over $500,000 in income have more than double the chance of being audited than lower-income taxpayers. Not only do these taxpayers tend to have more complicated tax returns, but the vast majority of federal income tax revenue comes from them.
  • Complicated returns are more likely to be audited. Returns with large charitable deductions, withdrawals from retirement accounts or education savings plans, and small business expenses (using Schedule C) are more likely to be the target of an IRS audit.

Stay Prepared

Always retain your tax records and supporting documents for as long as you need them to substantiate claims on a return. The IRS normally has a window of three years from the filing date to audit a return, but this can be extended if the agency believes there’s any fraudulent activity.

If you receive an audit letter from the IRS, it’s best to reach out for assistance as soon as possible.



You Can't Deduct that Loss- How to ensure your business is not deemed a hobby

You’ve loved dogs all your life so you decide to breed them and start a dog training business. Is this a business in the eyes of the IRS or a hobby? Knowing what the IRS is looking for and properly positioning your small business can save taxes and headaches if you are ever questioned by the IRS.

Why you should care

If your activity is a business, your income can be reduced by all your qualified business expenses even if it results in a loss. If your activity is deemed a hobby, no losses are allowed on your tax return, and even worse, after 2018 you cannot deduct expenses against this revenue. So you’re telling me if I knit three sweaters and sell them for $1,000 I cannot deduct the cost of the wool if it is a hobby? Technically, yes! Which is why you need to change how you think about these kinds of activities.

Tips to make it a clear business

Here are some tips to ensure full deductibility of your expenses against your business income.

  1. Profit motive. You must show that you intend to make a profit with your activity. The old rule of thumb was to show a profit at least three out of the past five consecutive years to safely qualify your activity as a small business. But this is no longer the case. Although more difficult to substantiate, you can show profit motive without ever showing a profit by your ongoing activities around the business.
  2. Active participation. You need to be actively involved in your pursuit for success. If you simply invest money in the dog business, but are never there to care for them or give lessons, you will have a hard time justifying the business nature of the activity.
  3. Be professional. Businesses have separate checkbooks, business cards and stationery. They have financial statements and show the same disciplines one would find in a “for profit” venture of the same type of activity you are pursuing. And they are organized as a business, ideally through a simple business structure like a single member LLC.
  4. Pleasure factor management. If your business has a large enjoyment factor, you will need to be even more cautious about having proper records. If you claim to be a golf pro giving lessons, but then spend all your time playing golf, you will have a hard time justifying the activity as a true business.
  5. Have multiple customers. If you only have one or two customers, who also happen to be relatives, your activity may be deemed a hobby. Having a number of customers, even without profits, can make all the difference in allowing for expense deductions.
  6. Showing profit motive without profits – Part II. How else can you show profit motive when no profit is to be found? Advertising is one way to do this. Keep copies of all ads trying to drum up business. Keep a daily diary of business activities, noting who you meet and for what purpose. Create and keep sample product, even if it is not yet sold.
  7. Understand your risk. There are certain business types that are under the IRS microscope when it comes to hobbies. Key among these are multi-level marketing businesses like Amway, Tupperware and Avon. It also includes the thousands of part-time sellers of goods on internet sites like e-bay. If you are in one of these business activities you will need to prove the business nature of your involvement and be prepared to be challenged.

Quick Checklist

Wondering if your business activity may be considered a hobby? Review this checklist. The more yes answers, the better your chances of defending your position.

  • Conducted activity in business-like manner?
  • Created a business entity?
  • Have expertise in your activity?
  • Put time and effort into the activity?
  • History of income/profits?
  • Have had prior success in a similar activity?
  • Is there a low element of pleasure/recreation involved?
  • Are there appreciating assets or an expectation that there will be?

Remember, having a business activity reclassified as a hobby can mean a big tax bite at tax time. But by keeping proper records and pro-actively knowing the pitfalls, you can avoid most problems.



Hidden Back to School Tax Deductions

Summer is coming to a close and the back-to-school advertising blitz is underway. Hidden in some of those school expenses are tax deductions you can take advantage of. Here are some ways you can save:

  1. Watch for tax deductions on the supply list. Schools often send a list of requested supplies for the school year. Some of the items on the list are clearly for personal use (such as an eraser or a ruler) while other items on the list are often for school use and classroom use (such as 24 pencils or paper towels). Keep track of these non-cash classroom/school donations for possible charitable deductions. Or even better, donate cash.
  2. Donate funds versus taking the raffle ticket. Raffles, subscription drives and silent auctions are fun ways schools raise money. To maximize your ability to deduct your donations, forgo the possible prize. Then the entire donation is clearly deductible. Remember to ask for a receipt when making the donation.
  3. Don’t forget your out-of-pocket expenses for your volunteer activities. Perhaps you donate your time at school functions, donate books to the school library, or help assist the teaching staff. Your out-of-pocket expenses and mileage should be tracked for charitable deduction purposes.
  4. Teachers, save your out-of-pocket expenses. A recent survey found that 94 percent of teachers spend their own money on classroom supplies — some as much as $1,000 per school year. On your 2022 tax return, teachers are allowed to deduct $300 on their tax return even if they claim the standard deduction. If you’re married, you can deduct up to $600 of classroom supplies.
  5. Use checks, not cash. If you usually provide donations to the school in the form of cash (like providing additional money to help other kids go on field trips) make those donations in the form of a check. The check will serve to help prove your donation.

Finally, don’t forget to review state rules for educational expenses. There are often credits available for out-of-pocket school and other educational expenses.

Correction: Please note the above-the-line deduction for charitable contributions is currently NOT available for the 2022 tax year. This provision expired at the end of 2021. Last week’s Tax Tip dated 7/29 did not reflect this change. Sorry for any confusion or inconvenience.



Great Tax Reduction Ideas

The tax code is about 75,000 pages long, so it’s not surprising there are many overlooked money-saving deductions hidden within it. And with the much higher standard deduction amounts, those who do not itemize think there are no longer ways to reduce your taxes. Since mid-year is a good time to review great tax reduction ideas, here are some to consider:

1. Charitable contributions if you don’t itemize

Even if you do not itemize deductions you can still take a deduction of $300 for your charitable contributions ($600 if married). Just ensure you get receipts to prove you made the donation. Too many make donations, but lack proof.

2. Maximizing HSA contributions

If you have qualified high deductible health insurance you can reduce your taxable income by contributing to a Health Savings Account (HSA). That way you not only reduce your taxable income, but you pay out-of-pocket qualified medical, dental and vision care with pre-tax dollars! And remember to contribute up to the annual limit ($3,650 for single or $7,300 for married in 2022 PLUS and additional $1,000 if you are age 55 or older).

3. Student loan interest

You can deduct up to $2,500 in interest paid on student loans from your tax return. This is true even if someone else helps you pay your loans. Parents who have co-signed student loans (creating legal obligation for the debt) often forget that they are also now eligible for the deduction on payments made by them.

4. Leveraging your itemized deductions

While many taxpayers do not have enough deductions to itemize, if you can bundle two or three years of deductions into one tax year you can maximize your deductions in all tax years. Here’s an example: You budget and make deductions to your favorite charities and church every year. Don’t change that practice, but prior to the end of the year, prepay all of next year’s donations prior to December 31 if it helps exceed the itemized deduction threshold. The following year use the full standard deduction with lower-to-no charitable donations.

5. Donating appreciated assets (stocks, mutual funds and other investments)

If you itemize deductions, instead of donating cash, consider donating appreciated assets you have owned for more than one year. Your charity gets the same financial value, but you not only get a great charitable donation, you also avoid paying capital gains tax on the investment. This could be a great idea if you feel stuck in a down market, but don’t want the tax exposure by selling a long-held investment.

6. Over-reporting state refunds

Remember if you use the standard deduction, your state refund does not add to your taxable income and should not be added to income. Even if you do itemize, your state refund may only apply if it provides a tax break. So couple a large state tax refund with your itemized versus standard deduction plan and save even more in taxes.

7. Taking full advantage of state tax deductions

Remember when you itemize, you can claim up to $10,000 in total taxes as an itemized deduction. But even if you do not have much in the way of state income taxes or property taxes, you can still deduct state sales tax. Even better, if you have a small business, many states now allow you to pay their tax at the entity level and avoid the $10,000 limit all together!

8. Leveraging retirement accounts to their fullest

There are numerous retirement tax plans that are great tools to help reduce your taxable income. They include 401(k), 403(b) and SIMPLE IRA plans offered through employers and numerous other versions of IRAs. The key is each has an annual contribution limit, and if you don’t use that limit for the year, it is gone. So review your options and try to take full advantage of the tax benefits within each plan.

As with any part of the tax code, certain qualifications must be met and limits apply. Please feel free to ask for help if you think any of these ideas apply to you.



2023 Health Savings Account Limits- New contribution limits are on the horizon

Contribution limits for the ever-popular health savings account (HSA) are set for 2023. The new limits are outlined here with current year amounts noted for comparison. So plan now for your 2023 contributions.

What is an HSA?

An HSA is a tax-advantaged savings account whose funds can be used to pay qualified health care costs for you, your spouse and your dependents. The account is a great way to pay for qualified health care costs with pre-tax dollars. In fact, any investment gains on your funds are also tax-free as long as they are used to pay for qualified medical, dental or vision expenses. Unused funds may be carried over from one year to the next. You must be enrolled in a high-deductible health plan (HDHP) to use an HSA.

The limits

Note: An HDHP plan has minimum deductible requirements that are typically higher than traditional health insurance plans. To qualify for an HSA, your health coverage must have out-of-pocket payment limits in line with the maximums noted above.

The key is to maximize funds to pay for your medical, dental, and vision care expenses with pre-tax money. By building your account now, you could have a next egg for unforeseen future expenses.



IRS Announces NEW 2022 Mileage Rates- New rates begin in July

In a recent announcement, the IRS raised the standard mileage rates for travel beginning in July, 2022. Use the previously announced mileage rates for qualified travel in the first half of the year. Use the revised rates for travel in the second half of 2022.

NEW Mileage rates for JULY through DECEMBER 2022

2022 Mileage Rates JANUARY through JUNE

Here are the 2021 mileage rates for your reference.

2021 Mileage Rates

Remember to properly document your mileage to receive full credit for your miles driven.



NON-Retiree Retirement Ideas- Want money when you retire? Here are some tips.

Here are five common retirement planning ideas and what you can do to take advantage of them. The key is retirement planning starts now, not decades from now when you are reaching retirement age.

1. Having a plan

Surprisingly, most do not know how much money is needed for retirement. This is being made much more difficult with inflation playing a major role in finding the right answer. A retirement plan should consider how long you expect to live, an estimate of the amount of money you will need, and a description of your desired lifestyle during retirement. Your plan should have measurable goals that you aim to achieve.

Action item: If you have a plan, review it for possible revisions. If you do not, consider getting one put together as soon as possible.

2. Start early enough

One of the most powerful tools for a well-funded retirement is to start saving for your retirement at an early age. The sooner you start saving, the better off you will be.

Action item: Open a retirement account and start saving now. Increase the percent of your pay that you place in tax-advantaged retirement saving accounts. This includes IRAs, 401(k)s, and other plans.

3. Maximize employer contributions

Many employers have plans available to help their employees save for retirement. If your company has a pension plan, understand how it works and how much you can expect to receive upon retirement. If your company has a retirement plan contribution-matching program, take full advantage of this free money by making minimum contributions required to receive this employer match.

Action item: Review your employer-provided retirement saving options. Maximize the benefits they are providing.

4. Consider working after retiring

Do you plan on working during retirement or avoiding work at all costs? Do you plan on having a pension or Social Security covering all your retirement needs or none of it? Too often retirees plan the extremes, but reality is something in between. For example, if you are someone who plans to have your pension plan fail and Social Security go broke, you may be taking too conservative an approach.

Action item: Create a range of retirement funding scenarios, not just the worst-case or best-case scenario. Consider no work or part-time work. Think about some contribution from Social Security and potential pension income if your employer has a program.

5. Understand the true nature of your retirement

Are you being realistic in your future retirement plans? Have you correctly estimated the cost of health insurance? Have you really thought about the impact of relocating to a warmer climate? How important is living close to family and friends? Will you really downsize your home after the kids leave?

Action item: If you have a retirement plan that includes relocating or traveling to far-off places, consider test-driving this idea before you implement it. You may be surprised at the result.

Retirement should be something to look forward to, especially with a little planning.