The Tax Code Demystified - The Foundation - Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part I. The Foundation

The tax code is extremely complex. It is notoriously long and downright unpleasant to read. Most people would rather pretend it doesn’t exist. Completely ignoring it or thwarting it, however, can lead to financial ruin. Even casual ignorance of it can lead to significantly fewer dollars in your bank account. It doesn’t have to be that way.

The full focus and purpose of this book is to help you pull your head out of the sand and face the reality that taxes have a major impact on your life. More importantly, the goal of this book is to help you realize that you can have a significant impact on your taxes.

Part I is the essential foundation for achieving that goal. If you do nothing more with this book than read and understand the chapters of Part I, you will be so much further ahead in your efforts to minimize your taxes than the majority of the population.

I have made these foundational principles simple, straightforward, and easy to understand. If you study the five chapters of this first part you will never regret it. Then, as you move on to the rest of the book, you will be fully equipped to seize the valuable strategies it has to offer.

Chapter 1. The Tax Code Demystified

Knowledge Is Power

I often remember a conversation I had with an acquaintance. He was telling me about the “smart” things he had done to reduce his taxes. His business had been successful that year, so in December he purchased several pieces of equipment that he didn’t really need in order to offset his income. With a mischievous grin, he said, “It’s a deduction, right?”

Right—it is a deduction (although that too is questionable). But as I spoke with him, it became clear that he thought a deduction of $3,000 meant he would pay $3,000 less in taxes. He thought he had just stiffed the government and gotten that equipment for free (because he spent $3,000 but saved $3,000 in taxes by doing so). He didn’t understand how a deduction actually works. In reality, he saved about $900 in taxes. But because he spent $3,000 on equipment he didn’t need, he ended up wasting $2,100. Most people dislike paying taxes, but you have to reallyhate giving the government money in order to waste $2,100 just to keep them from getting $900!

In reality, this man did not intend to waste the $2,100; he just misunderstood the meaning of the word “deduction.” I see this type of misunderstanding far too often; when people fail to grasp the true effects of a particular tax strategy on their return, they often end up making costly mistakes. This chapter will help solidify your understanding of the main components of your own tax return and the key terminology that is involved. That understanding will then help you recognize to what extent different strategies will (or won’t) help you reduce your taxes—helping you avoid similarly costly mistakes.

The Tax Code—Boiled Down

In actuality, the tax code is nothing more than one gigantic algebraic formula. While that image may scare you, it is meant to give you comfort in knowing that there is really no mystery or secret involved in determining your taxes. Once you understand the formula and where each number in the formula comes from, determining the amount of taxes that you owe is simply a matter of putting those numbers into the formula and voilà, out comes the answer! It is as simple as that.

The real secret within the tax code (and the great news) is that you control the numbers that go into the formula. Even better, there are many opportunities for you to decide where you want to place the numbers into the formula. Taking control of the numbers in your tax return and consciously placing them in the most advantageous places within the formula give you genuine power over your taxes and are the key ingredients of great tax planning.

image Example In an algebraic formula, the placement of numbers can have a dramatic effect on the outcome of the formula. For example: (2 + 3 + 8) x 12 = 156, whereas (2 + 3) x 12 + 8 = 68. The placement of the + 8 in the first formula resulted in a solution more than two times greater than in the second one. There are many opportunities in the tax code to move the “eights” around in order to affect the final outcome of the taxes that you owe.

Tax Insight is devoted to unraveling the mystery in the tax code, teaching you the formula, and helping you understand where your opportunities for controlling that formula lie. Learning and understanding these opportunities is where you gain control of your tax destiny. To gain that control you must first understand the key pieces of the formula. In its simplest form the tax formula looks something like this:

image The Tax Formula {[Income – (Adjustments + Deductions + Exemptions)] x Tax Rates} – Credits + Additional Taxes – Payments = Taxes Due or Refund.

In this master formula, each of the terms is a category (for example, “Credits”) made up of many subcategories (child care credit, foreign tax credit, earned income credit, and so on). The value for each category term in the master formula is calculated from a separate formula that combines the contributions of the subcategories. And each subcategory number is in turn derived from its own set of formulas and rules.

The plan of this book is to drill down from the level of the simple master formula to the deeper levels of the subcategory formulas. In the subsequent chapters of this section we explore each of the components of the master tax formula as it relates to your tax return. In subsequent sections, we dive into the nitty-gritty of each subcategory, again in relation to the appropriate parts of your tax return. Every part of this book aims to help you reap a more plentiful harvest from your tax planning efforts.

The Key Components of the Tax Formula

You have surely heard the lingo of the tax aficionado: AGI, deductions, credits, exemptions, brackets, marginal rates, effective rates, above-the-line, below-the-line, itemized, phase-outs, etc. You probably recognize these words and phrases, but do you understand what they mean? Do you know which of these are affecting you, how they are affecting you, or which can help you? Do you know how one component affects another? Is it possible to claim a deduction or credit and have it make no difference—or, worse, actually increase your taxes? These are important questions, and understanding the answers to them, can be critical in your tax planning efforts.

For tax planning purposes, the tax formula given above as a simple equation gets re-expressed as a sequence of arithmetic operations done on the key components of the formula (which include key subtotals such as AGI and AMT):

+ Income

– Deductions (Adjustments to Income)

= Adjusted Gross Income (AGI)

– Deductions (Standard or Itemized)

– Exemptions

= Taxable Income

x Tax Rates

= Income Tax (or AMT)

– Credits (non-refundable)

= Cannot equal less than $0 at this point

+ Other Taxes

– Credits (refundable)

– Payments

= Taxes Due or Refund

The first two pages of the federal tax return, called Form 1040, are an expanded version of this tax formula. All the other schedules and forms in a tax return are used to create the numbers that you plug into the first two pages of the return, which in turn are entered into the formula that determines your tax. In fact, when you look at Form 1040 (Figure 1-1), you will notice that the IRS has organized the lines of the return into successive sections that are divided and labeled in a way that resembles the formula above.

image

Figure 1-1a. Form 1040 (first page)

image

Figure 1-1b. Form 1040 (second page)

Next, we delve into a deeper understanding of the makeup of these key components. In doing so, you will begin to understand how each piece of the formula flows together and how the pieces affect one another. Once you have a solid understanding of each component and its effect on the formula, you will be better prepared to apply the strategies found in the other sections of this book.