Personal Finance By The Book » Taxes

How a CPA Saved Me $4310 in Taxes

Joe Plemon — Wed, 11 Apr 2012 10:06:55 +0000

Am I ever glad I got some help!

I have been doing my own taxes for many years, dating back to the days when I had to drive to the Federal Building 25 miles away to pick up all of my forms, read the books of instructions, then run all of the math on an 8 ½” x 11” pad before transferring the numbers to the forms. Everything was long hand; e-filing, tax software, the internet and personal computers had not been invented. Being a bit of a math nerd, I felt like this process gave me a rudimentary understanding of how the IRS worked.

Today, of course, I take advantage of whatever software will streamline the process. I still prepare my own taxes, but, when things get a bit dicey, I will ask a CPA to review my return before I send it in. The last time I asked for this review (about five years ago) my CPA, after thoroughly interrogating me, concluded that all was well and recommended no changes. I confess that my head swelled a bit as I thought, “I don’t need to hire a professional. I can do this myself.” So I did. Year after year. However, after successfully completing our first house flip in 2011, I knew it was time for another review. I now had two businesses (Plemon Financial Coaching and Plemon Homes) in addition to my wife’s business – an online store featuring her amazing hand crafted creations. I completed my taxes (using tax software), printed out the return, and met with the CPA. Am I glad I did!

He scrutinized my work and asked numerous questions before scoring a bingo: “Do you pay for your own health insurance?” For those of you who are tax savvy, I confess to being red faced, but remember that I have already admitted to being overly prideful. Back to the question…my tax software interview question for my Schedule C was “Does your business purchase health insurance for you or for you and your spouse?” Because my business does NOT directly pay for any health insurance, I hit the “No” button and continued along my merry way. But when my CPA worded the question as he did, I unhesitatingly said “Yes”. The key, of course, is to attribute those health insurance payments to my business. The wording difference between my tax software and my CPA is subtle, but it is worth over $1000 on my Federal return and another $150 on my State return.

I then asked the follow up question, “I have been making that mistake for several years now. Can I go back and change it?” The answer was a good one, but it could have been better: the IRS allows amended returns up to three years old. Good news for 2008, 2009 and 2010; not so good for the two years before then.

Still, I am pretty pumped. On my 2011 federal and state returns, I saved $1,586 in taxes (I still need to write Uncle Sam a check—just not as big), and for the previous three years, I am going to be refunded $2,724 … a total of $4,310.

Amending a previous year’s return

In order to amend a previous return, I need to send in my original return, my amended return and a schedule 1040X. Because my 2008 eligibility expires on April 16 of this year, I was up against a time line, so I filled out the 1040X myself, saved it as a PDF file, then emailed my original 2008 return along with the 1040X to my accountant who prepared the packet to be mailed (one can’t e-file amended returns). I must get approval on the Federal return before submitting my state return, so, for additional assurance, I sent my Federal return by certified mail, return receipt requested. Once I catch my breath, I will go ahead and file my amended 2009 and 2010 returns.

What did I learn?

I learned that hiring a professional is well worth it. In the future, I will continue to prepare my own taxes, but, instead of having my CPA review my return sporadically, I am planning to have him do so annually.

I also learned that pride can be costly and that humble pie is not very tasty.

Readers: Do you prepare your own taxes, hire a professional or (like I do) have a professional review your taxes after you have prepared them? What costly tax mistakes have YOU made?

5 Plans for Your Tax Refund

Joe Plemon — Wed, 08 Feb 2012 11:00:57 +0000

According to USA Today, the average tax refund last year was over $3,000. If you are anywhere near average, you will soon have thousands of dollars in your pocket – money which will disappear if you do not have a plan for it. Not everyone should have the same plan, but all should create a strategy which will mesh with their overall financial well being. What is the best plan for you? Read on.

If you have consumer debt, jump-start a debt snowball. By using that $3,000 to get rid of your smallest debts, you will be able to make bigger payments on your remaining debts. Continue to knock them off one at a time, from smallest to largest, and watch your debt snowball grow. Note: I would not include my house payment in this snowball.

If your consumer debt is paid off, build your emergency fund. Most financial planners recommend an emergency fund of at least six months expenses. Therefore, if your monthly spending budget is $4,000, you need an emergency fund of $24,000. If you are not there, your $3,000 refund will definitely help.

If you have no consumer debt and your emergency fund is in place, invest for retirement. A good rule of thumb is to invest 15% of your take home pay for your retirement, so if you are not quite there, put that $3,000 to work. In 20 years, at an 8% rate of return, $3,000 annually would grow to nearly $150,000.

If you have satisfied steps 1-3 above, save for your children’s college. Consider a Coverdale Educational Savings Account or a 529 plan. Each has its own advantages, but both will earn tax free growth (as long as the investment is used toward a college education). I like tax free, don’t you?

If you have already satisfied all of the above steps, take a cruise. Surprised? Don’t be. You are doing great with your finances, so loosen up and enjoy yourself. You deserve it!

Bonus plan: bring the money home each month. Many mistakenly think that they somehow “win” when they get a refund from the IRS. Not true. A refund simply means that the IRS is returning your money after hanging onto it for a year. You can keep your Uncle Sam’s hands off of your money by upping the number of exemptions you claim on your W-4 form. Doing so could give you as much as an additional $250 each month throughout the year instead of a $3,000 refund after the year is over.

Zig Zigler once said that those who aim at nothing will hit it every time. Don’t let your refund vaporize…have a plan and follow it. You will be glad you did.

Readers: Are you expecting a tax refund? What is YOUR plan?

Should you Itemize or take the Standard Deduction?

Joe Plemon — Wed, 01 Feb 2012 11:00:11 +0000

With income tax filing time upon us, you need to be asking yourself whether you should itemize or take a standard deduction. If talking taxes makes your head hurt, I beseech you to stick with me for two reasons: 1) this is simple stuff and 2) understanding these two types of deductions could save you hundreds of dollars on your return.

The basics:

If the total of your itemized deductions is greater than your standard deduction, you will choose to itemize. Why? Because every itemized dollar above that standard deduction will give you a bigger refund. Simple. Right?

What is a standard deduction?

Any deduction effectively lowers the income level you pay taxes on. A standard deduction is the default amount Uncle Sam gives everyone. The standard 2011 tax deductions are:

Single — $5,800
Head of household — $8,500
Married Filing Joint Return — $11,600
Married Filing Separately — $5,800
Qualifying widow/widower — $11,600
Dependent — $900 to $5,800

Most of you will have a standard deduction of either $5,800 (single) or $11,600 (married).

What is an itemized deduction?

As the name indicates, an itemized deduction is the total of allowable deductions which you spent in 2011. Think of itemized deductions as a treasure hunt – if you are single, you need to find more than $5,800; if you are married, you need more than $11,600.

Allowable itemized deductions are:

Medical and dental expenses which exceed 7.5% of your adjusted gross income
Taxes (state and local income taxes, property taxes and state sales tax)
Interest expenses, such as home mortgages
Charitable contributions
Casualty and theft losses which exceed 10% of your adjusted gross income

An Example:

Let’s say your year-end statement from your mortgage company says you paid $8,800 in mortgage interest in 2011. If you are filing married joint return, you have not reached the standard deduction of $11,600. However, if you gave $6,000 in charitable contributions, your total of itemized deductions is now $14,800 ($8,800 plus $6,000), meaning you should definitely itemize. It is time to continue your treasure hunt with the other allowable deductions, starting with the taxes you paid. Remember: every additional dollar you can claim will increase your refund.

If the total of your allowable expenses leaves you short of the standard deduction, go with the standard deduction.

That is all there is to it. I told you it was simple.

Readers: Did this explanation help you better understand itemized versus standard deductions? Which do you claim?

Why America Is Doomed to Debt

Joe Plemon — Mon, 22 Nov 2010 10:14:46 +0000

Fixing the national debt is not about politics or economics; it is about human nature.

Some Deficit Reduction Ideas

As President Obama’s bi-partisan deficit reduction commission is nearing their December 1 deadline for a united attack on our federal deficit, numerous ideas are being considered. This commission, along with a separate19-member group sponsored by the Bipartisan Policy Center, are suggesting such ideas as:

6.5 percent national sales tax (not the Fair Tax)

One year Social Security payroll tax holiday

Raising Social Security pension age

Raising the income cap on who pays into Social Security

Cutting military spending

Cutting health care while raising Medicare premiums

Revamp the income tax incremental tax structure

Dropping home mortgage interest and charitable contributions tax deductions in lieu of a refundable 15% tax credit

An Apt Description of the Debt Problem

Former Senator Pete V. Domenici of New Mexico, who was the senior Republican on the Senate Budget Committee for more than a quarter-century, correctly assesses the quandary, “This problem is so big, so obvious and yet so hard to solve. And it’s not going to be solved unless and until the leadership on both sides and the president decide that it is big enough to be considered a war.”

With current national debt of $13.7 Trillion (see Real Time National Debt Clock) and projected national debt of $19.6 trillion by 2015, I agree with Domenici. I am not a cynic or a pessimist, and I hope I am wrong, but, as I reiterate: this is about human nature.

What am I talking about? Human beings are basically self-centered.

This one attribute will kill efforts to put sanity into our federal deficit. Why? Three reasons:

1) We will transfer the problem.

Although no one knows how long we can corporately tread water, we will try to prolong the eventual collapse by tweaking the system instead of fixing it. Worded differently, “We are going to protect our own generation even it we have to build a time bomb for future generations” Self centered? You bet.

2) We won’t sacrifice.

We want our national problem fixed, but won’t give an inch when our own special interests are threatened. Some are already carping about the commission’s idea of raising Social Security age to 68 by 2050 and to 69 by 2075. What? This is a very minor adjustment for a broken system whose trust fund, according to our current administration, will be exhausted in 2037. My point is that we want someone to make sacrifices as long as that someone isn’t us. The unemployed don’t want unemployment compensation cut. College students don’t want their Pell grants cut. All entitlement recipients want to keep full funding flowing their way. Reality is this: our current national debt is about $45,000 per citizen, or $124,000 per tax payer. Does the word “unsustainable” fit? If our nation is going to ever take on this monster, all Americans must expect to make sacrifices. Being self centered won’t get the job done.

3) Career politicians

Our decision makers have their own careers on the line. I understand that making unpopular decisions – possibly career threatening decisions – is tough. I am glad I am not in their shoes. But then I remember: these are public servants. The vows of their respective offices should challenge every Congressman and Senator to have the backbone to make decisions on one simple standard: “Do what is best for our nation.” In a time of crisis, doing what is right means being willing to vote for sacrificial cuts even if their whiny constituents vote them out of office. Making tough decisions goes with the territory. Sadly, I am not confident our career politicians have that kind of character. Protecting their own hind sides is simply another form of being self centered.

The cure for our nation’s woes, as former Senator Domenici aptly stated, “… is so big, so obvious and yet so hard to solve.”

I agree. Either we sacrifice now, under our own terms, or Disaster will overtake us, under his terms. The choice is ours.

Like I said, this is about human nature.

Readers: Jump in with your thoughts. Do you think there is any hope America will actually attack its national debt? What would need to happen? Is human nature the real culprit? Am I over-reacting?

Guidelines and Tax Saving Tips Pertaining to Retirement Savings

Joe Plemon — Wed, 28 Jul 2010 09:36:34 +0000

Saving for retirement with specialized retirement plans is an excellent way to build wealth on a tax-free or tax-deferred basis. Considering that most people rely on their tax-deferred retirement accounts as income after they stop working, making a mistake can be extremely costly.

Here are some retirement saving tax tips that should help you keep more of that money for yourself:

If You Plan on Converting to a Roth IRA, Do It This Year

If you are planning to convert any of your pre-tax investments to a Roth IRA, this is a great year for it. Why? Because taxes will likely increase on most income tax brackets next year, making that rollover more costly.

Don’t Take Early Distributions

The IRS conducted a study in 2003 which revealed that nearly 5 million taxpayers took money out of retirement accounts before they were 59 ½ years old. The retirement account penalties for withdrawing money early were about $3.4 billion! In addition to paying income taxes on your distribution, you are also smacked with a 10% penalty when withdrawing before the eligible distribution age.

If you use retirement savings plan specifies a minimum age to withdraw money, do not withdraw it before you are the appropriate age. If you feel there is a possibility of having to withdraw money prior to retirement, keep more than one retirement savings; one that allows withdrawals anytime, and another which does not.

When Changing Jobs, Take a Rollover Instead of a Distribution

When you change jobs, it’s in your best interest to roll your funds directly to the new employer’s retirement plan or your own IRA plan. If you choose a distribution instead of a 401k rollover, you’ll lose 20% because the of the 20% IRA Withholding tax law. This rule applies to a 401k or 403b plans and not to a SEP IRA. Sometimes, it is smart to roll a 401k to a SIMPLE IRA or traditional IRA because you will not only avoid paying taxes on the distribution, but will also have unlimited investment choices (compared the the few options most 401(k) plans offer).

You Can Designate Your Children as Your Beneficiaries

Many people commonly put their spouses on their retirement accounts as their beneficiary. If you have an IRA, you can designate children and/or grandchildren as beneficiaries, which allows the money to be stretched out over the child’s project life span. The child can take IRA pay outs over their lifetime if they choose. This means the money earns decades more tax-deferred or tax-free growth than it would have if the surviving spouse was named the beneficiary. Realize that naming your children as beneficiaries requires the corresponding spouse needs to sign a waiver; otherwise he or she is automatically the beneficiary.

You should consult a professional for setting up an IRA trust for minor children to make sure you avoid any money traps.

In Most Cases Don’t Take a Lump Sum When You Retire

In most cases, when you’ve finally said goodbye to the world of employment, do not take a lump sum on your pension or you’ll have an insanely high tax bill and the money will no longer grow tax free. Instead, you may consider moving your retirement funds from an employer-sponsored plan into an IRA to allow you to maintain tax-deferred status while taking distributions (that are subject to only ordinary income taxes at 59 1/2). There is a loophole in Section 72(t) where you can take equitable distributions from an IRA before 59 1/2 (but after 55) and avoid the 10% early withdrawal penalty (this loophole has other provisions to be aware of). It is highly recommended that you consult with a financial planner or tax professional who specializes in retirement plan distributions as the Internal Revenue Service’s code is complex and making the right decision depends upon your financial needs and situation. Be sure to also keep up the 2010 tax law changes by the IRS.

photo credit: Pug50

This is a guest post by TaxDebtHelp.com, a website that provides advice and guidance for taxpayers with tax debts and other major State and IRS tax problems.

Five Upcoming Tax Hikes and What They Mean to You

Joe Plemon — Mon, 19 Apr 2010 08:45:36 +0000

photo credit: alancleaver_2000

I know. Tax season just concluded and the last thing you want to hear about is taxes. I understand, but think of it this way – right now, while this stuff is fresh in your mind, is the best time to start considering what the future holds. So…are you ready? Take a deep breath and read on.

We heard it over and over again from candidate Obama during the 2008 Presidential campaign: “I will not raise taxes on any single person earning under $200,000 or family making less than $250,000 a year.” Of course the implication is, “If you make over those thresholds, watch out!”

The Obama administration has a great opportunity to keep both the promise and the implication as taxes will undoubtedly go up.

According to MoneyWatch.com, we can expect the following tax changes:

1. Hike from Health Care Legislation

Starting in 2013, if your income is above the $200,000/$250,000 level you will pay an additional 0.9 percent on your federal payroll taxes, and your investment income and gains will be bumped up by 3.8 percent levy.

2. Higher Income Taxes for High Earners

This is an easy one. All Congress needs to do is nothing in order to raise taxes on high earners. “How can this be?” you ask. Unless the Bush tax cuts of 2001 and 2003 are extended, they expire this year, pushing the top incremental brackets back to the 2000 levels. Specifically, the top levels of 33% and 35% will revert to 36% and 39.6% respectively. The 36% increment will include singles with taxable incomes of $192,000 and married couples filing jointly with incomes above $232,950. The 39.6% bracket includes everyone (singles or married) earning above $375,000. If no action is taken, these higher rates start in 2011. All other brackets will become permanent.

Strategy

Mark Juscombe, senior tax analyst at CCH publications, says, “You might want to reverse the usual tactic of deferring income into the next year.” Also, higher earners who are converting a traditional IRA to a Roth IRA may want to pay the conversion tax at the 2010 level instead of spreading the tax bill out to 2012. Recommendation: meet with your tax advisor!

3. Investment Gains

This is another “do nothing” tax hike. Long term capital gains and qualifying dividends, which have been at a 15% maximum rate for several years, will automatically go up without Congressional action; the capital gains to 20% and the dividends to be treated as ordinary income. According to MoneyWatch.com, the most likely fix will be to lock in the dividends at 20 percent, which is certainly better for those in brackets above that level. Also, keep in mind that if you are in the $200,00/$250,000 income levels, you will be adding another 3.8% of taxes to those gains starting in 2013 (see 1. above).

Strategy

Home owners of high value real estate who are considering down sizing would save considerably by doing so in 2010 instead of waiting. The first $500,000 capital gains for a married couple who has lived in the house for more than 24 months is not taxed, but what if the gain is $1 million? The capital gain tax difference between 15% (2010) and 20% (2011) is $25,000.

4. Return of Estate Tax

There is no federal estate tax this year (2010), but, without Congressional action, it will automatically revert to 2000 levels starting in 2011. What will this mean? Estates between $1 million and $10 million would be hit with a top rate of 55 percent while those above $10 million would pay 60%. However, Congressional leaders have promised to reinstate the 2009 rules – no tax on estates up to $3.5 million ($7 million for married couples) and a maximum rate of 45 percent on assets above that level, retroactive to January 1, 2010.

Strategy

Money Watch says, “Hope Congress gets its act together pronto – and talk to your attorney while you wait.” The current status is muddied by the fact that there is currently no 2010 federal estate tax but Congress is considering passing a bill that would make it retroactive to the beginning of 2010.

5. Fewer Write-Offs for High-Income Earners

The Obama 2011 budget calls for reinstating the phase-out of personal exemptions and itemized deductions for taxpayers in the two highest brackets. One proposal would cap the deduction rate for these brackets (36 percent and 39.6 percent) at 28 percent, which will certainly raise the ire of organizations who depend on charitable contributions.

For a great post and ensuing discussion on this topic, see Financial Samurai’s Why Are President Obama And The Democrats Against Charity?

Strategy

Hopefully, not getting a deduction in 2011 will not deter you from giving to charitable organizations, but reality is that the less taxes you pay, the more money you have to give. Tax wise, for those in the top two brackets, you might want to give an extra amount this year to offset the reduced deduction next year.

Summary

Has Obama kept his promise to not tax singles earning below $200,000 and married couples under $250,000 range?

Not exactly. The legislation he signed raising the tobacco tax nearly 62 cents on a pack of cigarettes will most certainly hit the average working class the hardest. However, the likely hikes discussed in this post will affect high earners the most.

As we said, the promise NOT to raise taxes on those earning under the given thresholds were implied promises TO raise taxes on higher earners. To that degree, President Obama is keeping his promises.

This post was included in Yakezie Carnival hosted by Foreigner’s Finance

The Fair Tax: Is It Too Good To Be True?

Joe Plemon — Wed, 07 Apr 2010 08:55:00 +0000

Close your eyes and dream for a moment. Ready? OK. The IRS was just dissolved. No more federal income taxes. No Social Security/Medicare taxes either. Or capital gains taxes or gift taxes or estate taxes or self-employment taxes or corporate taxes.

Could this ever become a dream come true? If the advocates for the Fair Tax have their way, yes. The concept has been around for several years, but has become more refined and has recently been gaining bi-partisan grassroots support. I wonder…”Is Fair Tax an oxymoron or could there really be such an animal?”

What is the Fair Tax?

The definition, according to FairTax.org , is “The FairTax Plan is a comprehensive proposal that replaces all federal income and payroll based taxes with an integrated approach including a progressive national retail sales tax, a prebate to ensure no American pays federal taxes on spending up to the poverty level, dollar-for-dollar federal revenue replacement, and, through companion legislation, the repeal of the 16th Amendment.”

I have to say that a national sales tax which replaces all current federal taxes and provides the same federal revenue piques my interest. I am thinking, “It seems way too simple…what are the catches?” Explore this with me. I will share some advantages of the Fair Tax plan (found at the FairTax.org site) and then dig into any “catches”.

What are some advantages of the Fair Tax?

Americans take home 100% of their paychecks.

The exception would be state income taxes, but there will be no federal payroll deductions of any kind.

Retail prices will no longer hide corporate taxes or their compliance costs.

According to Dr. Dale Jorgenson of Harvard University, hidden income taxes are currently passed on to the consumer in the form of higher prices for everything we buy, boosting those retail prices by 20%. Because the Fair Tax puts an end to corporate taxes, retailers can be totally transparent in their pricing, bringing about clean competition and lower prices.

No taxes on used goods.

With the Fair Tax, you are only taxed once on goods and services. Used goods (used car, used home, used appliances, etc.) will not be taxed.

The Fair Tax is transparent and simple.

It will be charged just as sales taxes are charged today: whatever you buy and however much you spend, you will see exactly how much of your purchase goes to support the federal government. In contrast to our current system, one might not even need to be concerned about how long to keep their tax information.

The Fair Tax brings jobs home.

Because the FairTax removes the cost of corporate taxes and compliance costs from the cost of U. S. exports, these exports will be on a level playing field with foreign competitors. Lower prices means more demand for U. S. exports which translates into more American jobs.

The Fair Tax will make honest taxpayers out of tax evaders.

Although the number could be higher, the IRS admits to 16% noncompliance with the code. However, this does not factor in the criminal, drug and porn economy which is estimated conservatively at one trillion dollars of untaxed activity…all of which will be taxed when paying retail for anything. Furthermore, illegal immigrants who duck income taxes will not be able to avoid the FairTax.

What are the “catches” to the Fair Tax?

Repealing the 16th Amendment.

As already mentioned, the 16th Amendment, which authorizes Congress to levy an income tax, would need to be repealed. This could be difficult.

It might be cost prohibitive, especially to lower income families.

A sales tax rate of 23 percent would need to be imposed in order to generate $2.586 trillion dollars ($358 billion more than it replaces). Is 23 percent prohibitive? Not according to FairTax.org. Because the Fair Tax is not applied to necessities (via the distribution of “prebates”), the actual percent paid is less than 23 percent for all income levels. The following chart shows the effective percent rate of taxes paid by a family of four with two children, and this is if they spend all of their income! Notice that this family would need to spend over $29,140 before paying one dollar of taxes.

Wouldn’t it penalize retailers who have to raise prices to cover the cost of the Fair Tax?

Not really. All retailers would be need to be making allowances for the Fair Tax, so the playing field would be level. And there would be some savings to offset the Fair Tax, such as no employer match for Social Security and no corporate taxes. Also, retailers will be paid for administering the tax.

Couldn’t Congress simply raise the Fair Tax rate once it goes into effect?

Certainly. But shame on tax payers who would allow them to do so. Because the Fair Tax is highly visible and at a single tax rate, Congress will not be able to raise it without the accompanying publicity and disclosure.

Summary

The Fair Tax, in my opinion, is a great way to simplify the federal tax system in an equitable and transparent way. Although I admittedly could have dug deeper into this concept, there seem to be no obvious downsides to it (my Google search for disadvantages of the Fair Tax found very few objections). I like the idea of being penalized for spending money instead of earning money. The more I think about it, the more sense it makes. In fact (excuse the cynicism), it just makes too much sense for me to believe there is a chance that Congress will pursue it.

My prediction is that our legislators, in their ever increasing search for funding, will keep the current behemoth IRS system in place and implement a VAT (Value Added Tax) in addition to it. I hope I am wrong.

Readers: Help me out here. What have I missed? Are there downsides to the Fair Tax that I overlooked? Do you think it has a chance of ever becoming reality?

Income Tax Basics: They Really Are Simple

Joe Plemon — Tue, 22 Sep 2009 13:50:36 +0000

photo credit: piermario

“Where,” you are thinking, “does Joe get the audacity to think he can explain taxes in a few sentences?”

Good question, but stick with me. The key word here is “basics”. I believe that if you can understand three concepts: Federal Tax Brackets, Standard Deductions and Personal Exemptions, you can understand the basics of our Federal Income Tax System.

Federal Tax Brackets

Almost everyone knows that there are such things as tax brackets, but few understand how they work. Most have this fuzzy notion that if more income moves us to a higher bracket, all of our income is taxed at a higher rate, thus costing us money. You may have heard someone bemoan, “I got a pay raise, but I will end up with less money because it bumped me into a higher bracket.” This thinking, besides being a disincentive to ambition and productivity, is simply wrong. Let me assure you that with our current tax system, it is impossible to lose money by making money. In fact, even the very wealthiest will pay no more than 35% of their earnings.

We have a progressively bracketed tax system which, in 2009, works thusly for married couples filing jointly: the first $16,700 of taxable income is taxed at 10%; the next $51,200 is taxed at 15%; the next $69,150 is taxed at 25%, the next $71,800 at 28%, the next $164,100 at 33% and everything above that is taxed at 35%. Whether a couple earns $5,000,000 or $5,000 these same brackets apply. It is that simple.

Standard Deduction

The standard deduction is the amount you are allowed to deduct from your adjusted gross income before the first bracket kicks in. For 2009, the standard deduction is $11,400 for married filing jointly or $5,700 for single or married filing separately.

Personal Exemption

You are also allowed to deduct a personal exemption of $3,650 for the taxpayer, spouse and each allowable dependent in the household. This deduction, like the standard deduction, is subtracted from the adjusted gross income before any taxes are applied.

Putting it Together

Our hypothetical family, consisting of a married couple with one child, earns $40,000 in 2009. The first $22,350 this couple earns is not taxed a single penny. Where did I get the $22,350? By adding the standard deduction of $11,400 to $10,950 (three personal exemptions at $3,650 each). Their taxable income, therefore, is everything earned over $22,350, or $17,650 ($40,000 less $22,350). Are you with me so far?

Now let’s figure the taxes this couple will pay on this $17,650. The first $16,700 is taxed at 10% (see Federal Tax Brackets above) for a tax of $1670. The remaining $950 ($17,650 – $16,700) is taxed at 15% for a tax of $142.50. Their taxes are therefore$1670 plus $142.50 for a total of $1812.50.

Now, before you bombard me with “what if” scenarios, I want to reiterate that the purpose of this post is to explain the basics of our Federal Income Tax system. These are the basics and you must admit they are pretty simple.

Footnote 1: You, like me, may be surprised to learn that, when comparing tax rates by country, many nations have higher rates than the United States

Footnote 2: My wife just read this post and said, “For the first time in my life, I ‘get it.’” Success!

Footnote 2: