As most of you know -- and even more will realize, now that football season is over -- this is an election year. Most of the issues, at least partially, will be about taxes. How will a candidate pay for proposed programs? Does our ballooning budget deficit matter, or will tax revenue catch up with it? Should the tax cuts be repealed or made permanent?
Even the war in Iraq is partially a tax question: Were the tens of billions spent to fight the war the best way to make America safer, or could those resources have been spent on some other security measures, such as screening more of what gets placed on planes and shipped through our ports?
Furthermore, you hear a lot of claims about who benefited from the Bush administration's tax cuts, but you don't hear as many actual numbers (at least, I don't). So, since much of the election comes down to taxes -- and since the tax filing deadline is looming -- we thought we'd offer a brief lesson on how your tax bill is calculated, followed by a quick look at whose tax bills will be lower this year.
First of all, there's a big difference between how much money you made during the year, and how much is actually taxed. (For this explanation of how your "gross income" becomes your "taxable income," permit me to borrow from an excellent explanation in an earlier article by Fool Selena Maranjian.)
The money trail
It all begins with income -- which, for most of us, is automatically reported to the Internal Revenue Service. Your employer reports you were paid. Your bank reports interest you earned. Your brokerage reports dividends paid to you and stocks that you sold (for which you'll need to calculate your gains or losses).
You may need to report additional income sources, too -- such as tips, gambling winnings, business income, rental income, alimony income, or the $1 million you won on that DMV-Castaway show after being locked up in a Department of Motor Vehicles office for three months with a dozen strangers and a registration to renew. (Just remember, we thought of it first.)
- Total all your income for the year, and you'll be looking at what's called your "gross income." To this, you now make "adjustments."
- Subtract whatever amount you contributed to a qualifying IRA or other retirement accounts.
- Subtract any alimony payments you made and any moving expenses that qualify.
- If you're self-employed, subtract half of the self-employment tax you paid.
- Subtract any qualified student loan interest paid and any medical savings account deduction.
Once you've made all your adjustments, you'll be left with a very important sum: your "adjusted gross income," or AGI. The AGI is used throughout your tax return -- expect it to pop up all over the place, like the little critter in carnival "Whack-a-Mole" games. It's used to determine limitations on a number of tax issues, including exemptions, deductible IRA contributions, and itemized deductions.
From your AGI, you now claim your exemptions and make your deductions. You can take either an itemized deduction or a standard deduction -- whichever is greater. The standard deduction ranges from about $4,750 to $9,500, depending on your filing status.
You're entitled to one exemption for yourself, plus one each for your spouse and/or dependents, if you have them. The exemption is a set amount that you're permitted to deduct from your income, reducing the sum on which you're taxed. Exemption levels are tied to inflation and change from year to year, usually increasing.
Once you've taken your exemptions and deductions, you're left with your "taxable income." It's this number that determines your tax. You just flip to the tax tables, which may tell you that, for example, if you were married and had taxable income of $70,000, your tax bill is $11,126.
Breaking down the brackets
How did the IRS arrive at that number? Here's where tax brackets come into play, which for 2003 are 10%, 15%, 25%, 28%, 33%, and 35% -- down from 10%, 15%, 27%, 30%, 35% and 38.6% in 2002. The more you earn, the higher your tax bracket. However, this doesn't mean that every dollar is taxed at that rate. As a taxpayer climbs the income ladder, he benefits from each bracket.
Using the example above, the first $14,000 is taxed at 10%; everything from $14,001 to $56,800 is taxed at 15%; and the remaining income is taxed at 25% -- known as the "marginal rate." (If taxable income reached $114,650, this couple would have moved into the 28% bracket.) Add it all up, and you get the final tax bill of $11,126.
The politics of tax cuts
Now, let's wade into more political waters and address an election issue: Who benefited most from the recent tax cuts? Here are the 2002 and 2003 tax liabilities of various taxpayers:
Taxable 2002 2003
Income Taxes Taxes DifferenceSingle filers$20,000 2,704 2,654 50 (1.9%)$35,000 5,803 5,566 237 (4.1%)$50,000 9,839 9,316 523 (5.3%)$75,000 16,823 15,753 1,070 (6.4%) $100,000 24,308 22,739 1,569 (6.5%)$200,000 57,253 53,571 3,682 (6.4%)$1,000,000 362,199 331,332 30,867 (8.5%)Married filers$20,000 2,404 2,304 100 (4.2%)$35,000 4,654 4,554 100 (2.1%)$50,000 7,289 6,804 485 (6.7%)$75,000 14,053 12,376 1,677 (11.9%)$100,000 20,789 18,614 2,175 (10.5%)$200,000 51,813 47,446 4,368 (8.4%)$1,000,000 356,759 325,207 31,553 (8.8%)
So, looking at just the tax tables, married people benefited the most from the tax cuts, on a percentage basis -- especially those with taxable income of $75,000 or $100,000. On a dollar basis, the millionaires win, saving $30,000 in taxes, compared to a few hundred for lower-to-middle income taxpayers. Of course, the rich pay the majority of taxes -- could you imagine writing a check to Uncle Sam for $331,332?! -- so any broad tax cut would naturally affect them more. But it also helps that the highest tax bracket got the biggest cut this year -- down from 38.6% to 35% -- whereas the other brackets got a two percentage-point chop or none at all (though the income level for the 10% bracket was raised, benefiting everyone).
Lower brackets are just one way in which the Jobs & Growth Tax Relief Reconciliation Act of 2003 put more money in a lot of Americans' pockets. Plus, there are broader, more philosophical issues to consider. Why should the wealthy pay more in taxes than everyone else? What's better for the country: A millionaire with $30,000 more cash, or 300 average earners with an extra $100? We know you have an opinion, so visit the Fool's Current Events discussion board and tell us what you think.
In the meantime, get your taxes done -- visit our Tax Center if you need help -- and figure out how much of those programs, interest payments on the deficit, and security measures you'll be expected to pay for this year.