Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)
Part II. Ordinary Income
OK, I admit that a title like “Ordinary Income” is not exactly an attention-getter. I didn’t make up the term, so don’t blame me for being boring. However, I can guarantee that the extremely high taxes that you will pay on your “ordinary” income will get your attention and cause more than a little bit of excitement in your soul.
No income is taxed at a higher rate than ordinary income—especially the subcategory of ordinary income known as “earned” income. Worse yet, no other type of income is more common. Ordinary income is what all of us ordinary folks earn—but it’s not the kind of income that the elite use to fund their fortunes and their lifestyles.
Ordinary income is extraordinarily taxed, and it is only through unordinary means that you can avoid an excessive tax liability. That awareness and avoidance is what Part II is all about.
Chapter 6. Employment Income
The Most Highly Taxed Income of All
Employment income, known as earned income in the tax code, is taxed at a higher overall rate than any other income, except for sources of income that have penalties attached to them. It is unfortunate (though by design) that this is the case, since employment income (salaries, wages, and tips) is by far the most common type of income that exists. Individuals and families struggling to make ends meet and trying to get ahead are the ones hit the hardest by this part of the tax code.
Income that comes from employment is subject to the ordinary income tax tables. Employment income is also subject to payroll taxes, including the taxes for Medicare, Social Security, and Unemployment (in addition to state taxes in many places). I sometimes hear people state that they paid no taxes because their income was not high enough or their deductions were sufficient to create no taxable income. What they are usually forgetting, though, is that they did pay payroll taxes—they just weren’t conscious of them because the taxes are taken out of their paychecks before they ever see the money. In fact, the payroll taxes are regressive, meaning they have a greater effect on those with low incomes than on those with higher incomes. Most of the payroll taxes actually phase out at higher income levels.
The reality is, though, that most people must be employed in order to survive. You can do two things to improve your situation if you currently depend on employment income. First, do all that you can to begin shifting your income to other sources over time, so that eventually you will not need this kind of income, allowing you to retire on income that is taxed favorably or not taxed at all. Even if you are not ready to retire you will have shifted your sources of income to those which allow you to keep more of what you earn. In other words, save as much money as you can and invest it in the types of income-generating investments that receive favorable tax treatment. Second, while you are employed, be sure to take advantage of any opportunity that you have to reduce the taxability of that income and therefore your overall tax bill. There are three main strategies to accomplish this:
· Claim employee business expenses.
· Deduct insurance premiums pre-tax.
· Defer or postpone income.
As you reduce your taxes you will in turn be able to save more money and deliberately put it to work in ways that will increase your non-earned–income sources so that eventually you will not have to be employed to meet your needs.
Claim Employee Business Expenses
Luke phoned me one day after a referral from another client, hoping that I could help him reduce his taxes. As we talked, I realized that his only source of income was from his employment as a salesperson and that he had very few deductions. Generally, the combination of those facts means there is not a lot that I can do to help.
However, Luke did have one thing working for him. As part of his efforts as a salesperson he incurred lots of expenses traveling and entertaining clients, for which his employer did not provide reimbursement. Together we estimated what those expenses would add up to for an entire year, which we figured was around $8,000. At that point I knew we had a good chance of saving Luke up to $2,850 in taxes by employing one of the strategies below.
If you are required to spend personal money for work–related expenditures, there are three ways to reduce the burden of those expenses:
· Get a full reimbursement from your employer.
· Get a full reimbursement, but have your pay reduced by an equal amount.
· Claim the expenses as a Miscellaneous Itemized Deduction.
This may seem obvious, but the first and best choice is to have your employer reimburse you for those expenses. If you track the expenses properly and turn the receipts in to your employer, the business will be able to reimburse you for those expenses free of tax. If Luke’s company were willing to do this (it wasn’t), it would have saved him the full $8,000 and not affected his taxes.
If your employer will not reimburse the expenses, the next best thing is to ask the employer if the company would reimburse the expenses and reduce your income by the same amount. That way the employer is not out any additional money. In fact, doing so would actually reduce your taxes and the employer’s taxes. You would not pay income tax or payroll taxes on the reimbursed amount and the employer would pay fewer payroll taxes as well. It is a little more cumbersome for the employer to adjust your pay, but if it is done only once or twice a year it could be worthwhile for both parties.
Example Luke had $8,000 in expenses for his work, which his employer would not reimburse. Luke asked his employer if the company would reduce his commissions by the amount of the reimbursement, which it agreed to do. Because of this arrangement the employer saved $612 in payroll taxes (7.65% employer payroll tax × $8,000 = $612) and Luke saved $2,852 [(7.65% employee payroll tax + 28% marginal income tax rate = 35.65% total tax rate) × $8,000 = $2,852]. This is a win–win, saving money for both Luke and his employer.
If your employer is stubborn and will not reimburse you, even though it would save the company money, then your third option is to claim the expenses as a Miscellaneous Itemized Deduction. This strategy is the least effective, but can still be worthwhile. Although you are not able to reduce your payroll taxes by claiming this type of deduction, you may be able to reduce the taxable income on which your income taxes are calculated.
Unreimbursed employee expenses are claimed as part of itemized deductions on Schedule A. They fall into a category of itemized deductions that are known as Miscellaneous Itemized Deductions, which are limited (or phased out) by your overall income. Only the portion of miscellaneous deductions that is greater than 2% of Adjusted Gross Income (AGI) can be used toward the total itemized deductions that you can claim. In addition, all of your itemized deductions must add up to more than the standard deduction in order to be of benefit.
Example Luke has an AGI of $125,000. Only the portion of miscellaneous deductions greater than $2,500 (2% limitation × $125,000 AGI = $2,500) can be used as an itemized deduction. If the only miscellaneous deductions that Luke had were his unreimbursed expenses, he could claim $5,500 of those expenses ($8,000 expenses – $2,500 limitation – $5,500) as an itemized deduction.
If Luke is eligible for a standard deduction of $6,000 he would need an additional $500 of itemized deductions before there would be any advantage to itemizing deductions. As an example, if Luke had given $1,500 to charity he would have a total benefit of $1,000 in deductions greater than the standard deduction [($1,500 charity + $5,500 miscellaneous = $7,000 itemized) – $6,000 standard deduction = $1,000 overall additional benefit from itemized deductions].
Luke is in the 28% marginal tax bracket, so his tax savings generated from itemizing his deductions is $280 ($1,000 more deductions than the standard deduction × 28% = $280).
When compared to the previous example, in which his tax savings were $2,850 from being reimbursed in lieu of commissions, you can see that itemizing unreimbursed expenses may not be as favorable. In reality, the benefit of itemizing unreimbursed expenses can vary, anywhere from $0 in benefit up to an amount that is equal to that from the reimbursement method. The level of benefit will depend upon how many other itemized deductions and miscellaneous deductions you already have.
Example If Luke had $2,500 in miscellaneous deductions other than his unreimbursed expenses and $6,000 in other itemized deductions (such as charitable contributions), then every dollar claimed as an unreimbursed expense would benefit him. He would have already surpassed the 2% limitation on miscellaneous deductions, as well as the $6,000 standard deduction with his total itemized deduction. Since both of those limitations have been passed, every additional dollar claimed as an unreimbursed employee expense would reduce his taxes at his marginal tax rate.
If you are required to spend personal money for things that you do in your role as an employee, it could definitely be worth tracking those expenses and utilizing one of the three previously mentioned methods to reduce the expenses or reduce your taxes. If you plan to do this, it is also important to understand which expenses are OK to claim and what stipulations are placed upon those claims.
Note The IRS is currently scrutinizing this strategy. Their initial stance is that if an employee’s income is substantially the same, whether or not the expenses are claimed, then the reimbursements should be counted as wages. If they hold strong to this position and it stands up in the courts then a variation of this strategy will need to be used in order for it to continue to be viable.
Expenses That Can Be Claimed and How to Claim Them
In general, you can claim any expense that you personally pay for (and for which you are not reimbursed) that would be considered ordinary and necessary for your job. That would be any expense that is common and accepted in your trade or profession and is helpful and appropriate for your business. The expense does not have to be required to be considered “necessary.” While a list of possible expenses would be very large, these are several very common ones:
· Business meals
· Business entertainment
· Safety equipment
· Small tools
· Uniforms (required by the employer, but not suitable for ordinary wear)
· Protective clothing (e.g., hard hats, safety shoes, glasses)
· Physical exams (required by the employer)
· Subscriptions to professional journals
· The expenses incurred in seeking employment (in your present occupation)
· Business use of your home
· Certain Education Expenses
It is also worth noting that there are several expenses that you are not allowed to claim. Some of the more common ones are:
· Personal meals (no business purpose)
· Personal entertainment (no business purpose)
· Commuting (to and from home and work)
· Club membership dues (even if there is a business purpose)
· Travel (personal time on a trip, or business travel for employment away from home lasting more than one year)
Claiming most of these expenses is straightforward. If you incurred the expense for a legitimate and ordinary business purpose and you were not reimbursed, you can count it as a miscellaneous deduction. A few of these expenses, however, have special rules attached to them. These rules determine whether an expense can be claimed, and how much of the expense is eligible.
For example, to claim a meal as a business expense there are rules about whom the meal is with, as well as what is done before, during, and after the meal. If those rules are met, there are other rules that apply to how expensive the meal can be and how much of it is deductible (usually 50%). The expenses with special rules also come with an additional form (or forms) that must be filled out (principally Form 2106). These special expenses include:
· Business meals
· Business entertainment
· Business use of the home
· Tools and equipment that are depreciated
Part 4 of this book, “Business Income and Deductions,” has a chapter devoted to explaining each of these expenses with special rules. If any of these expenses apply to you, be sure to study the applicable chapters to fully understand the rules and how to use these deductions to your greatest advantage.
Deduct Insurance Premiums Pre-Tax
Another way to reduce the taxation of employment income is by deducting health insurance premiums from pre-tax income. This is done by contacting the person in charge of payroll and asking for your portions of the premium to be treated that way. The employer has to establish a Section 125 plan for this to be possible, but it is very easy to do and almost all employers already have.
Deducting premiums from your paycheck saves you and the employer money. This is because the deduction counts for both payroll and income taxes.
Example Tina’s employer makes her pay $250 per month from her paycheck to cover a portion of her health insurance premiums. If Tina’s marginal tax rate is 25% and she elects to have those premiums taken out of her paycheck pre-tax, she will save $980 in taxes [(7.65% employee payroll tax + 25% marginal income tax rate = 32.65% total tax rate) × $3,000 = $980]. In addition to her savings, the employer will also save $230 because the company will not need to pay the employer portion of the payroll taxes on the $3,000 (7.65% employer payroll tax × $3,000 = $230).
If you deduct premiums from your paycheck pre-tax you cannot also claim the health insurance premiums as a part of your medical expenses when you itemize your deductions. Even so, taking the premiums out pre-tax will almost always be a better choice. This is true for a few reasons. First, the paycheck option reduces income and payroll taxes, whereas itemized deductions only reduce income taxes.
Second, the medical expense deduction is subject to a phase-out—you can deduct only those expenses that are greater than 10% of AGI. In 2013–2016 the phase-out is 7.5% of AGI for those who are 65 years old and older, unless they are subject to the Alternative Minimum Tax, which would bring the threshold up to 10% as well. Beginning in 2017 it is 10% for all taxpayers (due to the Affordable Care Act.) For this reason, part or all of the premium may not really be deductible. (The itemized deduction rules are discussed in greater detail in Part 6 of this book. This is just a quick overview to put the pre-tax deductions in context.)
The third reason that pre-tax deductions are better than itemized deductions is that your total itemized deductions might not be greater than the standard deduction, and thus the overall advantage of those deductions could be diminished or even nullified.
Defer or Postpone Income
One more way to reduce your taxable income is through deferral and postponement. The most common way to do this is through employer-sponsored retirement plans or through Individual Retirement Accounts (IRAs).
To defer means to put off to a later time. There are several ways that the government has allowed for the legal deferral of income, meaning that you don’t have to count income that you have earned in the current year until a future year when you actually access that income. As long as the income is kept in an approved way—and you don’t access it—you don’t have to include it in your taxable income for the year.
Example Luisa earns $30,000 per year as an administrative assistant. Her employer offers a 401(k) retirement plan, to which Luisa contributes (defers) $5,000 of her income per year. For income tax purposes, it is as if Luisa earned only $25,000 ($30,000 income – $5,000 deferred = $25,000).
There can be significant benefits from deferring income. First, the full amount of income is available for investment (not just the amount left over after tax). Second, deferring income has the potential of lowering your marginal tax rates, since you have a lower taxable income. Third, deferring income could also mean you will not be subject to certain phase-outs of deductions and credits, lowering your taxes even further. Finally, income deferral will reduce your AGI, which in turn reduces all of the Itemized Deduction thresholds (such as the 10% for medical deductions and 2% for miscellaneous discussions discussed earlier in this chapter).
Example By deferring $5,000 in income, Luisa increases her refund by $1,400, or 28% of the $5,000 deferred, even though her $30,000 income places her in the 15% tax bracket (15% of 5,000 is $750). This dramatic change in her tax happens because her marginal tax rate is reduced to 10% and she has less of a phase-out of the Earned Income Credit because of her reduced AGI. The compounding effect of a lower AGI (because of all of the factors that are governed by that number) resulted in nearly double the benefit from the deduction that the marginal tax rates would have had on their own.
As you can see, tax deferral can have substantial effects on the taxes an individual will have to pay. Numerous ways to defer income are available and are delineated throughout the remainder of the book. Many of them are found in Part 3 under the chapters devoted to retirement savings strategies. The important take-home message for you at this point is this: Understand how deferral works and the ways in which it will affect your taxes.