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How to Lower Your Taxes

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By some estimates, the average American household now pays 40% of its income in federal, state, and local taxes.  This means should you fit that description:

• If you’re granted a $1,000 raise, you’ll take home $600.
• A money-market mutual fund paying 3% nets you only 1.8%.
• A tax-exempt bond paying 6% earns you the equivalent of a taxable bond yielding 10%.
• You must earn $1.67 to recoup every $1.00 you spend.  Put another way, you would have to make $125 in order to earn enough money to pay a $75 restaurant tab.

Clearly, taxes make it tougher to reach your financial goals, although the 1997 tax law eased the pain a bit with reductions in the taxes owed on investments and home sales as well as new tax breaks to help you save for both retirement and college.  Nevertheless, coupled with inflation, taxes steadily eat away at your wages up your net worth.  That means getting a basic understanding of the tax rules and then putting together a well-thought-out, carefully implemented tax plan.  It’s easier than you might think.

Determining Your Tax Bracket

The key to shrewd tax planning is knowing your tax bracket. This number is essential because it tells you how much of any extra earnings –from investments or moonlighting –you actually get to keep.  Furthermore, only by knowing your tax bracket you pinpoint what your home mortgage interest or business driving costs you after taking tax savings into account.

Under the present graduated U.S. tax system, as income rises, so does the percentage of income that goes to the government.  In theory, the federal tax law has only seven rates: 15%, 28%, 31%, 36%, and 39.6% for employment earnings and interest earned; and the 1997 tax law’s new additional 10% and 20% rates for profits on your investments, known as capital gains.  (There will also be an 8% and 18% tax rate on capital gains in the future, but more about that in moment).  With exemption and itemized deduction phase outs, however, your federal tax bracket can rise even higher than 39.6%.The tax you pay is an average of the rates on your earned income.  For example, in 1997 married couples with a taxable income between $41,201 and $99,600 fell into the 28% federal income tax bracket.  (Your taxable income is the amount of income your taxes are based on, after subtracting so-called adjustments, deductions, and exemptions).  But this doesn’t mean that if you make $55,000, 28% of it (or $15,400) would go to the Internal Revenue Service.  In the first place, parts of your earnings aren’t taxed at all.  If you claim three exemptions on your return, that lops $7,950 off your taxable income, since exemptions are worth $2,650 apiece.  You could also reduce your taxable income by at least the standard deduction amount of $6,900 (for 1997 joint returns).  If you itemize deductions, even more of your income escapes taxation.  So, assuming you take the standard deduction, your $55,000 of earnings would be pared down to $40,150.  The government wouldn’t even get 28% -or $11,242 –of that amount.  On a joint return, the tax bill on $40,150 of taxable income is roughly $6,026.  That’s about 15% of $40,150 and a hair over 11% of $55,000.

The reason?  Some of that income is taxed at a 15% rate and some is taxed at a 28% rate.  Your top tax rate –not your average rate –is still the number to keep in mind for tax-planning purposes, though.  In the preceding example, 28% of any extra taxable earnings would go to the IRS because that’s the marginal rate. Conversely, extra deductions –such as for an IRA contribution or a charitable donation –would produce tax savings at a rate of 28%.  For example, a $2,000 deductible Individual Retirement Account contribution would knock $560 (28% of $2,000) off a tax bill for someone in the 28% bracket.

To determine your own federal tax bracket, you need the latest IRS tax rate schedules.  The current tax rates are shown in the table on page 85.  Find the taxable income range in column 1 of the tax rate schedule for your marital status that includes your taxable income (line 37, Form 1040).  Then move across to column 2; the percentage shown is the marginal tax rate for your income.  For example, if your taxable income on a joint return is $35,000, your tax bracket is 15%.

If you are a high-income taxpayer, the tax rate schedules may not tell the whole story, however.  Hidden federal income tax rate increases take away the benefit of exemptions and itemized deductions in the upper-income ranges.  The result:  “bubble brackets” that can hike your tax bracket.  The phase-out of exemptions that begins at adjusted gross incomes of roughly $182,000 for joint returns (or about $121,000 for singles) boosts your effective marginal rate by .79% for each exemption.  That means a jump of 3.16% for a family of four.  (Your adjusted gross income is your total income minus what are known as adjustments, such as IRA deductions and alimony that you paid).  The phase-out for itemized deductions begins at approximately $121,000 of adjusted gross income, whether married or single, and adds as much as 1.19% to your marginal rate.

Of course, federal income tax is merely the most notorious levy.  For complete picture of your tax bite, you’ll need to add in the percentage of state and local income taxes you pay as well.  For instance, if your federal tax rate is 31% and your state tax is 9%, your combined marginal tax rate is 40%.

The tax rates and rules for sales of your investments changed dramatically with the 1997 tax law, too.  So it’s now become essential to understand which investments are taxed at which rates.  It used to be that figuring out your capital gain tax rate was fairly simple.  Before the 1997 tax law, if you had owned the investment for more than 12 months, it was a long-term capital gain and was taxed at a lower rate than if you had owned it for a shorter time (when the asset would be treated as a short-term gain and taxed at your income tax bracket).  The 1997 law, however, complicated life for investors.  Now how much you’ll pay in tax depends on whether you sold the investment before July 29, 1997; whether you hung on to it for more than 12 months, between 12 and 18 months, or over 18 months; and what income tax bracket you were in when you unloaded it.  As if that wasn’t messy enough, there are additional rules for investments you sell after the year 2000.  Specially, here are the new rules:

CAPITAL GAINS TAX RATES
For assets sold after May 6, 1997, but before July 29, 1997
If held more than 12 months …………………………………….20%
For filers in the 15% bracket …………………………………10%
For assets sold on or after July 29, 1997
If held more than 18 months ……………………………………..20%
For filers in the 15% bracket ……………………………….…10%
If held more than 12 months but not more than 18 months ………28%
For filers in the 15% bracket ……………………………….…15%
For assets sold after Dec.31, 2000
If held for five-year gain …………………………………………18%
For filers in the 15% bracket ……………………………….….8%

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