Tax season has officially arrived. April 15 may still be more than two months away but it’s never too early to get your tax documents and financial statements in order.
Taxes are a sensitive topic for many Americans; they were a serious bone of contention during the presidential campaign. Mitt Romney, the Republican presidential nominee, was attacked for not releasing his tax returns over the past decade, usually a customary and voluntary move made by presidential hopefuls. Romney reluctantly released his 2010 return and an estimate for 2011 to quiet critics who said he had paid no federal income tax. In 2011 Romney paid an effective tax rate of 14.1% on an adjusted gross income of nearly $13.7 million. If Romney had claimed all the deductions he was entitled to that year, his effective tax rate would have been less than 10%.
The widely held belief that wealthy Americans get more tax breaks is simply false, says Barbara Weltman, contributing editor of the tax filing guide “J.K. Lasser’s Your Income Tax 2013.” A large percentage of rich people do pay a lower tax rate because their income is derived from capital gains and dividends, which will be taxed at 20% starting this year (the 15% rate still applies to 2012 investments).
The majority of Americans are taxed on their wages, with a top tax rate of 35% (the American Taxpayer Relief Act of 2012 raises the top rate to 39.6% on taxable income exceeding $400,000 for singles or $450,000 for married couples filing jointly). According to the nonpartisan Tax Policy Center, 46.4% of Americans did not pay any federal income tax in 2011 but nearly two-thirds of these individuals did pay payroll taxes. The Joint Committee on Taxation estimated that 51% of U.S. households paid no federal income tax in 2009. The tepid economic recovery and high unemployment rate have caused millions of Americans to accept low-paying jobs or part-time work, affecting the percentage of people who pay federal income taxes. In 2007, before the financial crisis hit and when the economy was considered to be at “full employment,” 40% of households did not owe federal income tax.
Weltman says there are other vehicles that rich Americans use to lower their taxes. One way is establishing a trust that sets money aside for children and other family members. It’s a tool that wealthy Americans employ as part of their estate planning because it reduces gift and estate taxes collected by the federal government. Weltman says any individual can open a trust but it’s not practical for average Americans. It costs money to create one and a net worth of at least $100,000 is required. Wealthy individuals are also heavily invested in low-interest municipal tax bonds because the interest earned on these bonds is tax-free. Average Americans usually do not invest in these bonds because of the low return.
Even though average Americans may not have the resources to pour tons of money into stocks, bonds and other asset classes, there are plenty of ways to reduce one’s tax burden, Weltman says. Some tax breaks were even designed exclusively for low- and middle-income earners. Individuals receive a tax deduction for putting money aside in retirement accounts such as IRAs (the maximum per year is $5,000 for individuals under 50, $6,000 for individuals 50 and older).
Weltman also points out that taxpayers who fall into the 10% or 15% tax bracket ($70,700 for joint filers and $35,350 for singles) pay no tax on qualified dividends and long-term capital gains.
The earned income credit also gets money back for taxpayers. The average savings was $2,200 last year. According to Weltman, the top credit is $475 for singles and a maximum credit of up to $5,891 for families with three or more qualifying children for 2012. Self-employed people with modest earnings may qualify, Weltman adds.
Most importantly, the standard deduction that 60% of filers claim will also help reduce one’s tax bill. The credit is indexed for inflation every year, Weltman says, so filers can deduct a larger amount on their return.
According to the IRS, the Child and Dependent Care Credit helps millions of families every year, along with common deductions such as home mortgage interest, state and local tax and charitable contributions. Many business expenses are deductible as well.
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