Federal Income Tax Basics

INCOME TAXES

Federal income taxes can have a significant effect on your financial planning for retirement. As you well know, taxation is a complex subject, and it's not easy to stay abreast of changes in laws and regulations.

FEDERAL INCOME TAX BASICS

Let's begin by reviewing some basic information on how our federal income tax system works.

TAX RATES AND EXEMPTIONS

There are now six different tax rates that apply to taxable income: 10%, 15%, 25%, 28%, 33%, and 35%. The Tax Relief Act of 2001 made several changes to the tax code that will affect the tax rates until 2010, including the addition of the 10% tax rate.

Your taxable income is calculated by first determining your adjusted gross income (AGI). Your AGI is your gross income minus certain deductions that you are permitted to take directly on the front page of your federal income tax return. Examples of these deductions are: deductible contributions to an individual retirement account (IRA); interest forfeited as a penalty for premature redemption of a certificate of deposit; alimony payments.

After determining your AGI, you then calculate your taxable income by subtracting your personal exemptions and either your standard deduction or the total of your itemized deductions.

The personal exemption for the 2005 tax year is $3,200. The exemption amount is adjusted for inflation each year and phases out at higher income levels; the Tax Relief Act will reduce the phase-out limits starting in 2006.

The standard deduction for the 2005 tax year is $10,000 for married couples filing jointly, $5,000 for single individuals, $7,300 for head of household, and $5,000 for married individuals filing separate returns. If you itemize your deductions, you cannot take the standard deduction.

For the tax year in which you attain age 65 and thereafter, you entitled to an additional standard deduction of $1,250 (indexed) if you are married. If both you and your spouse are 65 or older, the additional standard deduction is $2,000. If you are single or head of household, the amount is $1,200 (indexed). The additional standard deduction is not available if you itemize deductions.

After you calculate your taxable income, you then figure your federal income tax liability by using the appropriate tax rate schedule. The tax rates will decrease each year until 2010. The federal income tax rate schedules for 2005 appear on the following page.

Each year the individual tax bracket amounts in the tables, as well as the personal exemptions and standard deductions, are indexed to increases in the Consumer Price Index (CPI).

LAFP 13 Taxes

LAFP 17 Taxes

EFFECTIVE/MARGINAL TAX RATES

There is a difference between your effective tax rate and your marginal tax rate.

Your effective tax rate is the percentage of your taxable income you pay in federal income tax. Calculate it by dividing the income tax amount by your taxable income for the year.

Your marginal tax rate, often referred to as your "tax bracket," is the rate at which your last dollar of income is taxed.

Let's assume that a married couple has a 2005 taxable income of $70,000. They file a joint return and pay a total of $10,830 in federal income tax. Their effective tax rate is 15.5% ($10,830 ¸ $70,000).

According to the 2005 tax rate schedule for married couples filing joint returns, if taxable income is over $59,400, the federal income tax is $8,180 plus 25% of the excess over $59,400. The marginal tax rate is therefore 25%.

The marginal tax rate is often used to determine whether a particular tax-favored investment is appropriate for you. You can use your marginal tax rate to compare an investment that produces tax-exempt income with one that produces taxable income. The table below illustrates this.

When is taxable interest equivalent to tax-free interest?
Tax-Free / If Your Marginal Tax Bracket is:
Interest / 10% / 15% / 25% / 28% / 33% / 35%
Rate / The equivalent taxable interest rate is:
1% / 1.1% / 1.2% / 1.3% / 1.4% / 1.5% / 1.5%
2% / 2.2% / 2.4% / 2.7% / 2.8% / 3.0% / 3.1%
3% / 3.3% / 3.5% / 4.0% / 4.2% / 4.5% / 4.6%
4% / 4.4% / 4.7% / 5.3% / 5.6% / 6.0% / 6.2%
5% / 5.6% / 5.9% / 6.7% / 6.9% / 7.5% / 7.7%
6% / 6.7% / 7.1% / 8.0% / 8.3% / 9.0% / 9.2%
7% / 7.8% / 8.2% / 9.3% / 9.7% / 10.4% / 10.8%
8% / 8.9% / 9.4% / 10.7% / 11.1% / 11.9% / 12.3%
9% / 10.0% / 10.6% / 12.0% / 12.5% / 13.4% / 13.8%
10% / 11.1% / 11.8% / 13.3% / 13.9% / 14.9% / 15.4%

Let's say, for example, that your federal marginal tax rate is 25%. That means that you get to keep only $0.75 of each dollar of taxable interest. The other $.25 goes for tax. According to the table, you need a taxable return of 10.7% to leave you with 8% after tax (.75 x 10.7% = 8%). If you are choosing between a tax-free investment that pays 8% and a taxable investment that pays 10%, then, all other things being equal (such as safety and liquidity), the 8% tax-free investment is better for you. If the taxable investment pays 10%, you would have only 7.5% left after tax.

Your tax bracket is important in this comparison. If you are in the 15% bracket, you get to keep 85% of the taxable return. In that case, you keep $.85 of every dollar of taxable interest. Of the 10% taxable return, 8.5% stays with you. That makes it a better investment than the 8% tax-free one. The table bears this out. It says that, in the 15% tax bracket, it takes taxable interest of only 9.4% to equal nontaxable interest of 8%.

Here's how to do the comparison without the table. Subtract your marginal tax rate from 100%. Multiply the result by the taxable rate of interest. This is your "keep rate" after federal tax. Compare this keep rate with the nontaxable interest rate. Whichever is higher represents the better net return.

Capital Gains

When you sell a personal or investment asset, the result is either a capital gain or a capital loss. The tax treatment of the sale depends on whether the asset sold was a short-term asset or a long-term asset.

A short-term asset is an asset you held for 12 months or less at the time of the sale. A long-term asset is an asset that you held for longer than 12 months.

To determine the amount and type of gain or loss to report on your tax return, first net the short-term gains and losses against each other. Now do the same with the long-term gains and losses.

Unless gains and losses in a category cancel each other exactly, you now have a net short-term gain or loss and a net long-term gain or loss. (If both are losses or both are gains, skip to the next paragraph.) If you now have a net short-term gain and a net long-term loss (or vice versa), the two must be netted against each other. The result will be one gain or loss and it will be short-term or long-term.

Capital losses are deductible from ordinary income, up to $3,000 a year. If losses exceed this amount, the remaining loss can be carried forward and applied in future years. Short-term losses are deducted first. Losses above the $3,000 limit keep their short- or long-term character and are used in the capital gain/loss calculation for the following year.

Net short-term gains are taxed as ordinary income.

Net long-term gains are taxed at a flat 20% (10% for taxpayers in the 15% marginal tax bracket).

For assets acquired after December 31, 2000 and held for at least five years, the gain is taxed at 18% (instead of 20%) or 8% (instead of 10%) for taxpayers in the 15% marginal tax bracket.

For any tax year beginning after December 31, 2000, you may elect to have assets you owned before 2001 deemed to have been sold and reacquired on January 1, 2001. If you choose this treatment, you must pay the tax on the deemed gain (but you cannot deduct any deemed loss).

WHAT KINDS OF RETIREMENT INCOME ARE TAXABLE?

PENSIONPLANPAYMENTS

Pension income is subject to federal income tax. However, a part of your pension may not be taxed based on after-tax contributions you made to the Pension Plan.

As a member of Tier 3 or 4, you contribute an amount equal to 8% of your salary to the Pension Plan until you have 33 years of service. You may have contributed both on an after-tax and a pre-tax basis. The amount of your after-tax contributions will be returned to you free of federal income taxes as you receive your pension.

Some of the pension payments that you receive will therefore be partially tax free. The Department of Fire and Police Pensions will inform you of the amount of your first pension payment that is tax free. The balance of each pension payment will be taxable as ordinary income in the year received.

The tax-free amount of your pension will continue until you have recovered all of the dollars that you contributed to the Pension Plan. Once your contributions have been recovered, the entire amount of all future pension payments will be taxable as ordinary income.

Withholding of taxes: The Department of Fire and Police Pensions will withhold income taxes from your pension checks. If you do not wish taxes to be withheld, you must notify the Department. By not having income taxes withheld, you may subject yourself to estimated tax requirements, which are described later.

DEFERREDCOMPENSATIONPLANPAYMENTS

OVERVIEW

If you participate in the City's Deferred Compensation Plan (also known as a Governmental 457(b) Plan under that section of the Internal Revenue Code), you are able to defer a portion of your current income on what is called a pre-tax basis. This means that federal and state income taxes are deferred on the amounts you contribute into this plan and on any investment earnings on the amounts you defer. The amounts you have deferred and their earnings will be taxable as ordinary income when you receive a distribution from the plan, usually at retirement

The benefit of tax deferral is that earnings on the amounts you defer can compound on a pre-tax basis. Another benefit is that, at the time you receive distributions from the plan, you may be in a lower income tax bracket.

The Deferred Compensation Plan is provided tax deferral advantages by the Internal Revenue Code because it is considered a long-term investment designed to help finance your retirement. The Internal Revenue Service therefore prohibits withdrawals of any money from the plan prior to your retirement or other termination of active service with the City, except in cases of death or strictly defined hardship.

DISTRIBUTION OPTIONS:

At retirement, you may have up to six choices as to how you wish to receive payments from the plan.

§  Lump sum: This is a single payment of your total account value. The entire amount you receive will be taxable as ordinary income in the year it is distributed. Lump-Sum distributions are not eligible for favorable tax treatment (forward averaging).

§  Partial Lump-Sum: This is a partial payment of your account value. You select an amount to receive less than your account value. The amount is taxable as ordinary income in the year that it is distributed.

§ Periodic Payments: This is a series of payments of a fixed amount (called a Amount Certain Periodic Payment) or over a period of time (called Period Certain Periodic Payment). Under an Amount Certain Periodic Payment, you can select a fixed amount to receive and these payments will continue until your account value is exhausted or you decide to change or stop the amount. Under the Period Certain Periodic Payment, you select to deplete your account value over a period of time, not to exceed your life expectancy, and the payments will fluctuate based on your account value and the number of remaining payments each time a payment is made to you. The payments may be received on a monthly, quarterly, semiannual or annual basis. These payments are taxable as ordinary income in the year received. You may elect to change your payments in either type at any time; however, there may be administrative charges from the record-keeper of the Plan for excessive changes.

§  Annuity Payments: Annuity payments are made by a third party insurance company. These are guaranteed payments based on your account value at the time you decide to annuitize your account and your life expectancy. Distributions are taxable as ordinary income in the year received. Annuity payments are irrevocable. There are several types of annuity payments:

§  Life Annuity: This is a series of payments made over your lifetime. If you die before receiving the full value of your account, the proceeds are forfeited.

§  Life Annuity with Period Certain Guaranteed: This is a series of payments made over your lifetime with a guarantee that a minimum number of payments will be made in the event of death prior to the period selected. The guaranteed period may be either ten, fifteen or twenty years. Refund Life Annuity: This is a series of payments made over your lifetime, with a guarantee that any proceeds from your account value are paid to your beneficiary, either in payments or lump-sum.

§  Jointsurvivorannuity with Period Certain Guaranteed: This is a series of payments made over your lifetime and over the lifetime of another individual should that individual survive you with a guarantee that a minimum number of payments will be made in the event of death to the beneficiary(ies). The guaranteed period may be either ten, fifteen or twenty years.

§  Designated Time Period: This is a series of payments over a designated time period you select. If you die prior to the end of the time period, your beneficiary(ies) will receive the remaining proceeds in payments or lump-sum.