At the beginning of every year, millions of taxpayers begin an annual ritual of financial reporting that we all know as filing income taxes. For most taxpayers, this annual activity is the only time they have looked at their financial picture since last year because of the anxiety and stress that filing causes. I thought about the angst around filings and considered three questions:
- How many people understand taxes?
- If people knew more about taxes would that alleviate some of the stress?
- The answer to "How can I avoid paying taxes?"
A Brief History of Taxes in the US
The 16th amendment of the United States Consitution established the right for Congress to levy taxes on US citizens. In 1913 the amendment was ratified and The Revenue Act of 1913 was passed to create a tax rate of 3% of the amount over $3,000. When the act was passed less than 5% of the population were subject to the tax.
Over the past 100 years, the tax code has exploded along with the rates and number of citizens who pay. As of this writing, the top rate is 37% and over 50% of the population pays income tax.
How Tax Laws are Created?
Tax laws start by being passed in the House of Representatives. Upon passing, the bill is sent to the Senate so changes can be negotiated with the house. When both sides agree, the bill is voted on in the Senate and upon passing the bill will be sent to the President for signature.
Role of the IRS
The Internal Revenue Service is an agency of the Treasury Department. The IRS Commissioner reports to the Treasury Secretary, who is appointed by the President. Many consider the IRS villains and blame them for all tax woes, but the agency exists because of laws passed by Congress and signed by the President.
The function of the IRS is to interpret and enforces tax laws. They take the statutory laws and create the forms and rules necessary to administrate the law.
How taxes are calculated?
Your personal taxes are calculated by taking your total income which consists of:
- Investment income
- Business income
- Social Security
Your total income is then reduced by adjustments like student loan interest, IRA contributions resulting in adjusted gross income.
The adjusted gross income is reduced by your deductions, you can take the standard deduction or itemize if the total exceeds the standard amount. The result is taxable income; which is multiplied by the applicable tax rate less any applicable tax credits to determine your tax liability.
The tax liability is subtracted from amounts paid in during the year from withholding and estimated payments. The result is either a refund or a balance due.
"How can I lower my taxes!"
The comment that I hear at least once a week, after telling someone I am a CPA. EVERYBODY wants to pay less and receive a huge refund and are willing to do anything to receive "their money back. I have witnessed taxpayers attempt to deduct everything from pet expenses to the renovation of their primary residence to increase their refunds.
When I first began practicing, I really believed there was a magic bullet to make a lot of money and pay little in taxes. I eventually learned that periodic tax planning is the best way to reduce your tax liability and possibly increase a refund.
The Fool-Proof Way!
Tax planning is truly the best way to reduce your tax burden in the long run, but some people don't want to pay the fees associated with planning. Those prospects of mine usually get what I call the fool-proof way of tax planning: