2011 Paycheck Changes

By now, most employees in the United States have received their first paycheck of 2011.  About the same time the first check is received, payroll departments across the country were deluged with questions about the changes on employee checks.  This edition of the blog should help to clear up some of the confusion regarding a couple of these changes.

The Making Work Pay Credit is gone!  The implementation of this tax cut was sloppy anyway.  Single folks received up to $400 of tax cuts per year factored into their withholding.  Married folks received twice this amount or up to $800.  There was an upper limit to allowable income.  The credit itself was described in detail in a blog post almost two years ago.  In the tax cut bill that Congress finally passed in mid December, the Making Work Pay credit was happily missing.  That means however, that employees of nearly every income level will see their Federal Income Tax withholding increase for 2011.  It’s quite a shock in the amount of increase.  However, there are no more funny games to play when preparing your tax return or figuring out your W-4 values.  In summary, most employees will see their Federal Income Tax Withholding line increase.

Part two of the changes to employee checks this year has to do with the Social Security component of FICA withholding.  Normally, Social Security withholding is 6.2% of taxable wages up to a base.  That base is $106,800 per year as it has been for 3 years now.  Employers must match the 6.2% value meaning total Social Security taxes are actually 12.4% of taxable wages up to the base or up to $13243.20 per year per employee.  Self employed individuals paid the entire 12.4%.  This is a lot of money!  The above referenced tax cut bill cut the employee portion of Social Security by 2 percentage points.  Now the total is 4.2% up to the base.  Employers still are required to pay their portion at 6.2%.  Self-employed individuals now pay only 10.4% as well.

PaycheckCity, a site run by Symmetry Software (my day job employer), had implemented these changes and placed them on the site in late December.  To my surprise, the help desk team at PaycheckCity reported that CPAs and payroll staff members were writing with questions on why the Social Security rate was different.  Some even adamantly (and ignorantly) proclaimed that we were wrong and they would never use the site again.  The details of the tax plan have been all over the media in the last month.  Social media has trumpeted the changes as well through the many different outlets.  How anyone can still be unaware of this change just baffles me.  Hopefully,  I have provided some knowledge to those who hadn’t heard yet, while clearing up the confusion for those who had and were surprised at the change on their check.

Holidays and Taxes – Part 2

It’s time for year end planning!  Most blogs at this time of year talk about financial moves you can make to minimize your taxes.  I don’t think that bears repeating.  If you are interested in that, here are a few other sites that can help.

http://www.accountingtoday.com/news/Tax-Saving-Year-End-Tax-Planning-Tips-56551-1.html
http://www.smartmoney.com/personal-finance/taxes/year-end-tax-planning-massive-uncertainty-edition/
http://taxes.about.com/b/2010/11/08/year-end-tax-planning-tips-if-you-think-tax-rates-might-go-up-in-2011.htm
http://businesswest.com/2010/11/year-end-tax-planning

I’m more interested in getting everyone organized for the upcoming tax season.  The better prepared you are for tax season, the happier your accountant/tax preparer will be.  After the holiday lull begins in late December or early January (depending on your love of football) take some time to look for your 2010 documentation.

1) Medical receipts.  In order to deduct medical expenses on Schedule A, you must first be able to itemize and second have expenses that are more than 7.5% of your Adjusted Gross Income (AGI).  The most important part though is that you have good documentation. Do you have receipts for any payments to physicians or hospitals or pharmacies?  Did you pay with check or credit card? Having a copy of the statement showing your payment whether from your checking account or credit card is essential. If you cannot find all of your receipts or statements, now is the time to begin calling those who treated you in 2010.  Most doctors can provide you with a printout of your account activity for the year.  Keep an eye on the different codes from that system though.  Any insurance payments on your behalf should not be considered your own payments.

2) Mileage logs. If you drive your vehicle for business, medical or charitable purposes, did you keep good logs of your mileage?  It’s more than just noting starting and ending mileage and date.  A good record of what you did and where you went is essential as well.  Because there are three categories of mileage reimbursement, it is best if you can provide documentation for your tax preparer by category.   By assembling and keeping good notes now, you will save yourself many headaches in case of a future audit.

3) Update your mailing address. If you moved this year, there are a lot of tax documents that are going to take the long road to your home.  This of course slows down their delivery through our illustrious mail system.  Make sure you notify current and former employers (W-2), banks (1099-int and 1098), student loan providers and investment providers of your new mailing address.  Depending on the situation, this could drastically affect your withholding as well if you live in one of the states with local taxes.

4) Make a plan. What is your financial goal for 2011?  Do you want to continue extinguishing your debt?   Will you be saving up for a big purchase to avoid interest?  Will you be moving or changing your family structure (marriage, divorce, kids etc)?  Start thinking about your plan for next year now.  If you don’t make any plans to reach that goal you always talk about, you will never reach it.

Any of these can be done at any time during the year.  However, a little extra planning at year end before the tax documents start arriving can make tax season so much easier for you.

Holidays and Taxes – Part 1

Greetings readers.  The next three blog posts will discuss some things that will help you during – and right after- the holiday season.  This week, I’ll discuss employee holiday parties and gifts to employees.  Next week, I’ll discuss year end planning tips. The end of the month will be about making some new goals for the new year.  Perhaps there will be time for one more summarizing tax law changes that should have been passed by Congress by that time.

Gift Cards
According to some statistics software attached to this blog, my post a couple years ago on employee gift cards and taxability is consistently the most visited page on this site.  It seems there is a lot of confusion regarding employer responsibility and payments to employees for holiday bonuses and gifts.  Somehow, the notion has entered the minds of the taxpaying public that if you give money or gift cards to employees below $25 or $50 that the amount is not taxable.  That is absolutely false.  The key to withholding on an employee gift is whether or not the value can be tracked easily.  If you give turkeys to all your employees, they cannot exchange that for cash, and determining the value of each turkey as it is given to an employee is nearly impossible.  If you give $25 gift cards to all your employees, it is very easy to determine the value: $25.  This amount should be taxed appropriately.  Likely, you will need to “gross up” the value.  A $25 gift card using supplemental rates could cost the company nearly $50 once payroll, withholding and unemployment taxes are added into it.  There is a simple gross up calculator available at PaycheckCity.com.  It is free to use after  registration.  This tool will tell you the cost from the paycheck perspective.

Holiday Parties
According to the IRS, the cost of  holding an employee holiday party can be deducted 100% as business expense.  As an employer, this can give your employees a chance to relax and talk about non-work topics.  It also causes team building.  Holiday parties should not be overly extravagant.  Think of the old Tyco/Koslowski debacle.  Having a reasonable party that shows your appreciation for their hard work during the year is a great way to give back and avoid the cost of giving out trinkets or gift cards.  You can find many articles that can help you provide guidelines for your employees during one of these parties.  You want it to be the social event of the year, but not because you ended up with a sexual harassment or discrimination lawsuit on your hands.

What if you invited clients to attend the party as well?  This actually takes away part of the deductible nature of the party.  Now it is for advertising purposes which means only 50% of the cost of the party can be deducted.  So you say, “I’ll just send my customers a nice gift like a goodie box from Fairytale Brownies or Rocky Mountain Chocolate Factory.”  Keep in mind that there is a limit on these as well for tax purposes.  For marketing purposes, spend as much as you want on a customer.  For tax purposes, you can only deduct up to $25 of the cost of gifts to your clients/customers.

Arizona’s New Withholding

Arizona has done it again.  Currently, anyone who is being paid in Arizona must select from several percentages on the A-4.  Arizona withholding is based on a percentage of federal withholding.  The percentage you pick will be multiplied times the federal withholding number on your paycheck to arrive at Arizona withholding.  If you selected 24.5%, and your federal withholding was $112, then your Arizona withholding would be .245×112 or $27.44.

This created a problem with all the federal withholding changes that have happened over the last 10 years.  Each time there was a withholding decrease, Arizona’s revenue decreased as well.  The Making Work Pay Credit last year decreased checks for everyone and was the last straw in the problem.  Arizona’s legislature had to increase the percentages on this form each time the federal government decreased withholding  just to keep withholding even. Finally, last year, the legislature directed the AZ Department of Revenue to develop a new withholding system to be put into place by July 1, 2010.

There are other glaring problems with this method.  Arizona’s tax rates are based on a formula.  By requiring employees to pick a flat percentage, they are forced to determine a marginal (or average) tax rate for their tax situation.  This can change based on events in a person’s life like marriage, divorce, new children, home purchase, a second job or a spouse begins working that didn’t before.  Any of these events change the marginal rate.  Most people never adjust their A-4.  This obviously causes frequent confusion.

Another problem is that many people simply have no federal tax liability.  With no federal withholding, there was no way to have any Arizona withholding and inevitably, these individuals would end up paying extra every year at tax time.

Yet another problem is those that move into the state mid-year.  As a Tax Preparing CPA, I found it very difficult to advise my clients when they move in mid- year which percentage to pick.  The problem still exists in the second year (first full year of residence) since they have no history to draw from in selecting their percentage.

So…..Arizona’s new method was recently announced and here is the form.  All employees must complete a new one of these by July 1, 2010.  Guess what? They solved none of the above mentioned problems and even made some new problems.  Now, the percentage you select is percent of gross pay.  This decouples the state from federal withholding changes but still does not give employees who are new a clue to which rate to select.  Now instead of new employees only being confused, any person working in the state gets to be confused and not just for half a year, but for next year as well.  There is still no basis in the actual tax rates with these percentages.

Instead of providing some rates that anyone can pick, there are still three lines for employees to select based on income level.  This should have been removed.  If you have very low tax liability but a higher than $15,000 income, you cannot select the lowest rate.  On the back of the new form, there is a worksheet provided.  Notice in line 10 of the worksheet that there is no provision in the instructions for selecting anything other than line 1 (front side) percentages.  What if the calculation result is lower than the percentages on the form?

Employees are not able to determine their “target” withholding without digging into last year’s tax return or contacting their tax preparer.  Again, changes in taxable life events make last year’s number irrelevant.  What are you supposed to choose? This value is difficult for those without a tax background to understand.

Supposedly, payroll “experts” were used to help develop this form.  Unfortunately, they chose to tweak the existing system enough to only make things more confusing.   I hope that the state will make some wholesale changes to this form to more closely match what other states are doing and what the Arizona tax system actually looks like.  It’s not bad to use withholding allowances and marital status.  We are forced to use that on the tax form.   Let’s get this right next time.

Double The Tax Fun – 2 States!

Q.  I am having a difficult time trying to figure how much I owe in state tax.  I lived and worked in California from 1/1/2009 through 8/7/2009.  I began living in Colorado on 8/8/2009 through the end of the year and worked from home for the same company I worked for back in California.  State taxes were withheld for each state on the income made while living in each state (California withholding stopped when I moved to Colorado)  Do I owe California state income tax on the income I earned while living in Colorado?  If so can I get a credit as I was also taxed by Colorado on that income? Thanks!

A. Multi-state tax situations are always so much fun to decipher.  Over the last several years of my tax practice, I’ve prepared multi-state returns for Iowa, Missouri, Oklahoma and Montana in conjunction with Arizona.  Each state has different laws regarding what income must be counted.  However, residency is the most important.  In your case, if you have documentation showing that you physically relocated on the date you mentioned, then it becomes much easier to prove that your residency changed.  The company you work for is irrelevant to the solution.

California is one of those states with huge budget problems right now.  In an audit, they will try to prove that you did not change states completely.  Residency involves switching your drivers license, sale of the old home or cancellation of the lease, change of mailing address, car title address changes, voter registration changes etc.  If CA is able to prove that you only will be in CO temporarily, then they may determine that you owe CA tax on everything. I don’t know the tax law as well in CA, but they may provide a credit to you for tax paid to CO if it is determined that you actually owe CA tax on everything earned last year.  Check with your tax preparer.

Good documentation is key.  For this reason, I would visit a licensed tax preparer this year.  The complexities of dividing up income and maintaining adequate documentation as well as the right questions to ask to determine your true residency status is worth the price of the professionally prepared return.

Which 1040 Do I Use?

Q. How do I know which 1040 I’m allowed to use? Does it really make a difference?

A. Yes! Each form has specific requirements that a taxpayer must meet in order to use it. IRS Tax Tip 2010-05 contains instructions on which form you should select.  Your options are:

1040EZ Requirements
Your taxable income must be below $100,000 and your earned interest below $1,500. You can only use the Single or Married Filing Jointly filing status. You must be under age 65 and not claim any dependents. You will not be claiming any of the special additional deductions for real estate taxes, motor vehicle purchase or disaster losses.

1040A Requirements
Your taxable income still must be below $100,000 to use this form. You want to claim the credits disallowed on the EZ form. You have capital gain distributions. You contributed to and IRA, paid student loan interest or higher ed tuition.

1040
Anyone can file with this form. However, if you have a simple tax situation, why go through the trouble of the long 2-page form if you don’t have to?

If you are confused about which form to file, you may wish to use the services of a professional tax preparer or CPA. Professionals are trained to help you understand your tax situation and can often make recommendations to help you improve your take home pay or lessen your tax bill in the upcoming year. Make sure you interview your tax preparer carefully. Not all of them are as prepared for any situation as you hope they will be.

Interesting Tax Quotes

We’ve all heard quotes from famous people about the U.S. tax system.  Here are a few more that may serve to lighten the mood on this Monday morning.

“No one understands the Income Tax Law except persons who have not sufficient intelligence to understand the questions that arise under it.”
New York State Senator Elihu Root in 1913

“No government can exist without taxation. This money must necessarily be levied on the people; and the grand art consists of levying so as not to oppress.”
Frederick the Great, 18th Century Prussian king

“Income tax has made more liars out of the American people than golf.”
Will Rogers

“Would it not be better to simplify the system of taxation rather than to spread it over such a variety of subjects and pass the money through so many new hands?” –Thomas Jefferson to James Madison, 1784. Papers 7:557

“Excessive taxation … will carry reason and reflection to every man’s door, and particularly in the hour of election.” –Thomas Jefferson to John Taylor, 1798. ME 10:64

I hope our elected officials remember as we creep ever closer to another tax filing season, that those who elect them do not have short memories when it comes to the use of their funds in government.  Large social engineering projects like tax credits for environmental issues or health care need to be well thought out and debated.  Rushing into something so big and path-altering will bring around yet another batch of unintended consequences and complexity.  Government at all levels should be focusing on simplification, transparency, increasing the tax base (not rates) and increasing efficiency.

I drive to work each morning past 3 sets of road warning signs.  These were installed as part of the national Amber Alert network. That is a great cause.  However, on both support posts of each set hangs an orange sign that says “Sign Not Active.”  I wonder how much was spent on purchasing and installing those signs to tell us something that is so obvious.  It’s not working!  That’s just one example of the thinking outside the private sector.

Perhaps one post per month in 2010 will be on something within government that shows how out of touch many elected officials truly are.  Maybe by banding together, we can create some extra focus on accountability in government in the coming election year.

Stealing the Tax Base

Pardon the baseball analogy.  The season is almost over and I just couldn’t help myself. There is statistical evidence that taxpayers in high tax states are leaving those states and setting up residence elsewhere at the rate of 1100 per day.  By increasing taxes to cover shortfall, states and the federal government to an extent are actually creating a situation of obtaining less tax revenue.

Today’s post comes from some statistics I read in a CNN.com article.  47% of U.S. households pay no income tax.  That is a staggering figure when you think about it.  I see four different classes of U.S. households when thinking about that statistic

1. Households that have no income tax liability and still get a refund
2. Households that truly have no tax liability
3. Households that pay income tax
4. Households that pay income tax and are targeted by current tax policy

Case number one contains individuals that have the lowest earnings.  Government policy provides refundable credits for many things including the Child Tax Credit and the Earned Income Credit.  They actually get money back from the system without paying anything in.

In case number two, taxpayers have income that is taxable but through a combination of itemized deductions, student loan interest, small business/passive losses and refundable credits, actually end up with no or little liability.  This year has likely seen an increase in the number of individuals who fall into this category.

The number of households who fall into the third category has likely decreased this year with the number of job losses the economy has produced.  These individuals have tax liability that goes beyond their eligible itemized deductions.  Some of the deductions allowed in lower income levels of this class and in the second class are actually phased out as income increases thus increasing the tax liability of this class.

Class four is the group that politicians and folks in class 1 and 2 love to hate.  These are the successful folks who either have a successful job or have started a successful company and are now reaping the benefits or even those who have received an inheritance from a friend or family member.  Many singers, actors and sports figures fall into this category as well.  It is very difficult to reach this category.  Therefore, I find it strange that tax policy targets this group.  We hear statistics such as “incomes over $250,000″ per year to describe the level at which this group sits.  If federal tax rates (and many states for that matter) continue to climb, those in this category could see total tax rates in the range of 75%!!  It is important to keep in mind though that this class of people also own the majority of the assets in this country.  Many of them actually create the jobs our economy so desperately needs.

Good tax and financial planning requires that pay attention to what is going on the the arena of tax.  The environment in today’s government is very desperate.  It is important that you get involved in the political process and let your representatives know how you feel regarding legislation that is before them.  If Americans voted based on how well their representatives actually represent them, I think there would be a large number of changes in those holding political office.  The tax and spend policies of both parties would suddenly come under such scrutiny that something would undoubtedly change.

I welcome your feedback.

What Tax Bracket Am I In?

Q. How do I know what tax bracket I’m in?  Where does that number come from?

A. This question probably ranks right up at the top of the list of most frequent questions.  First of all, you probably meant to ask what is your marginal tax rate.  Let me explain.  Federal income tax is calculated on a graduated scale. If you look at the image to the left of this post, you will see several numbers under the heading “Tax Rate.”  These are the percentages used in calculating your tax liability for a given amount of income.  You can see that your income is taxed at different rates as the amount of taxable income increases.  To say you are in the 25% bracket, only means that you make at least $67,900 of taxable income (for married people) and that a portion of your income is taxed at that rate.  Truly, your marginal or average rate is lower than your bracket in most cases until income gets significantly over $372,950.

To determine your marginal rate, you need to look at last year’s tax return.  Take your total tax liability number from line 61 of the 1040 and divide that by the number found in line 38 of the IRS Form 1040. This tells you the percentage of your income that is subject to federal tax.  For a total marginal tax rate, simply add up all the taxes you pay and divide by the value in line 38 of the 1040.

I think you will be surprised to see how high that number actually is.  Keep in mind that to get this exact, you should include property, sales, income and payroll taxes.  Higher income individuals in New York and California for instance, could see their marginal rate rise above 50%  Ouch!

Enough Withholding?

Q. I followed your advice and had my payroll department withhold based on W4 stuff instead of a flat percent.  How do I know if I’m on track?

A. That’s a rather amusing question actually.  Publication 15 and the W-4 both require that you use only marital status and number of allowances on the form.  If that is not the case, then the form is invalid and you revert to the status of Single-0 which is the highest regular withholding amount available.  You are not permitted to use a flat percent when calculating your federal withholding.  Your payroll department should already know this.

To answer your question, you have two options when deciding if your withholding needs to be adjusted.  I recommend to my clients that they do the annual check up in late August or early September.  That way, if there is gross over or under withholding, there is still time to fix it before the end of the year without breaking the budget.  Your CPA or tax planner of course is the first place you should check.  He/she will know your financial situation already and can quickly compare your withholding to your expected liability.

Secondly, you could visit the IRS website and download Publication 919.  This document is not for the faint of heart.  Basically, you will be completing a tax return using your last paystub and estimated information from your tax return.

Remember, the objective of withholding for federal and state purposes (not Social Security and Medicare) is to have your payments (withholding) match your liability (from your tax return) so that your refund or extra payment with the 1040 is as small as possible.

On a side note, if you look in the right margin of this blog, you will see my most recent Twitter posts.  Feel free to follow me on Twitter for daily financial thoughts.