Understanding Income Taxes:Federal, State, and Local

Objectives

• Determine correct filing status• Differentiate between standard and itemized

deduction• Define personal exemption amount• Define Adjusted Gross Income, Taxable

Income, Deductions and Credits.

Purpose of Income Taxation

Local, State and Federal governments collect income taxes to help pay for various benefits and services to citizens – including yourself.

– Deducted from wages– Estimated payments

Paying taxes is the price we pay for living in a civilized society.

Oliver Wendell Holmes, Jr.

Income Tax Rates

• Local – 1 to 1.5% or earned income determined by your municipality

• Pennsylvania State – 3.07% most sources of income

• Federal – all income from whatever sources derived less deductions, adjustments and credits. Graduated system (different tax rates apply to different ranges of income) 0%, 10%, 15%, 25%, 28%, 33%, 35%

5 Steps to calculating Federal Income Taxes

1. Determine Gross Income2. Calculate AGI (Adjusted Gross Income)3. Calculate Taxable Income4. Determine Tax liability5. Subtract tax credits and pre-payments to

determine tax refund or balance due

1. Gross Income

• IRS definition: “All income from whatever source derived”– Wages, tips, bonuses– Interest, dividends, capital gains– Rent– Lease– Royalties

2. Determine AGI Adjusted Gross Income

Even if you don’t itemize you can still benefitfrom certain deductions e.g. :• Educator expenses• IRA contributions• Tuition and Fees• Alimony• Student Loan Interest• Business loss

3. Calculate Taxable Income

• Subtract from AGI the larger of the Standard Deduction or Itemized Deduction for your filing status

• You can itemize: mortgage interest, real estate taxes, income taxes paid, unreimbursed medical and dental expenses that exceed 7.5% of your AGI, work related expenses, charitable contributions, etc.

3. Calculate Taxable Income cont’d2008 Standard Deduction

Filing Status Deduction Amount

Single $5,450

Married Filing Jointly, Qualified Widow(er)

$10,900

Head of Household $8,000

Married Filing Separately $5,450

Higher Standard DeductionAge > 65

Add’l $1,050 each taxpayer and spouse

3. Calculate Taxable Income cont’d

Finally, subtract exemptions for household members at $3,500

• Example: Family of 4 MFJ using standard deduction with gross income of $80,000

$80,000-$10,900 Standard Deduction-$14,000 Exemptions$55,100 Taxable Income

3. Calculate Taxable Income cont’d

• Example: Single person using standard deduction with gross income of $80,000

$80,000-$5,450 Standard Deduction-$3,500 Exemptions$71,050 Taxable Income

4. Calculate Gross Tax Using Tax Tables10% 15% 25%

Single $8,025-$32,550

$32,551-$78,850

$78,851-$164,550

Married Filing Jointly – Qualifying Widow(er)

$16,050-$65,100

$65,101-$131,450

$131,451-$200,300

Head of Household

$11,450-$43,650

$43,610-112,650

$112,651$-182,400

Married Filing Separate

$8,025-$32,550

$32,551-$78,850

$78,851-$164,550

5. Subtract

• Tax prepayments – Paycheck withholding– Estimated tax payments

• Tax credits– Earned Income Tax Credit– Additional Child Tax Credit– Other credits

Impact of Income on Taxation of Social Security Benefits

• Total all sources of income:– 50% of Social Security– Taxable income– Tax-Exempt income

• Compare to Base Amount of filing status– S, MFS, HOH $25,000-$34,000 50% is taxed >

$34,000 – 85% of SS benefits taxable– MFJ $32,000-$44,000 50% is taxed > $44,000- 85%

of SS benefits taxable

End Result

• Positive number = tax refund• Negative number = tax balance due

• Penalties and interest may be charged for significant underpayment

Tax Avoidance vs. Tax Evasion

• Avoidance – using tax code to legally pay the least amount of taxes owed.– Ex. Traditional IRA or 401(k) contributions.

• Evasion – illegal underpayment of taxes due – willfully and deliberately not paying taxes owed the government.

Tax Avoidance Tools

• Retirement Plans• U.S. Savings Bonds• Municipal Bonds• Charitable Contributions• 529 College Savings Plans

Using Retirement Plans to shelter income from taxes

• Employer Tax-Deferred Savings Plan(401(k)s, 403(b)s, etc.

• Individual Retirement Account (IRA) if you qualify contributions are considered an adjustment to income (reducing your taxable income)

• Age limits• Income limits

U.S. Savings Bonds• Promissory notes issued by the federal

government. $20,000 limit per person/year.• Income earned is exempt from state and local

taxes– State doesn’t tax income from federal debt– Federal government doesn’t tax income from state debt

• Earnings are federally tax-deferred for life of bond – up to 30 years

• EE bonds and I bonds (inflation adjusted)

Municipal Bonds

• Municipal bonds -= long term debt issued by local government and agencies– Proceeds finance public projects such as schools,

parks, roads, bridges– Purchased individually or in mutual funds– Interest received is free from state and federal tax

if issued by Pennsylvania governments

Charitable Contributions

• Benefits charity and donor• Consult advisors – legal, financial and tax prior

to taking action

Charitable Contributions cont’d

• Tax deductibility:– IRS definition “qualifying charity”– Certain limitations apply– Type of donation

• Outright gift• Charitable lead trust• Charitable remainder trust• Charitable gift annuity

– Understand the benefits and consequences of each type of donation before making a decision.

529 College Savings Plans

• Contributions PA state tax deductible up to $______

• Earnings grow federal and state income tax deferred

• Tax-free if proceeds used to fund qualified education expenses

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