2. A SUPER SIMPLE INTRODUCTION TO TAXES, Part 1 of 2

At its core, gift planning can accomplish two things.  It can trade a gift for income and it can reduce taxes.  Most of the complexity in charitable planning comes from the desire to reduce taxes.  Consequently, most of this text is focused on tax laws related to charitable giving.  Before jumping into a review of the various charitable tax strategies, it may be useful to begin with a quick review of the fundamentals of the U.S. tax system.

Since 1913, the federal government has levied an income tax.  For example, if a taxpayer earns a salary, he or she must pay a percentage of that earned income to the federal government in taxes.  Taxes are also charged when a taxpayer sells an item at a profit (called a capital gain).  Income from a capital gain is taxed at different rates than earned income, and so is calculated separately.

Not only does the federal government charge income and capital gains taxes, but most states do as well.  Taxpayers in these states pay both federal and state taxes.  In some of these states the state rules for charitable deductions are identical to the federal rules.  Other states reduce this deductibility or provide special incentives for particular types of charities.  Given the variety of these rules, this book will not review the various rules for charitable deductions from state income taxes, but will instead concentrate on the federal tax system.

Income and capital gains taxes are not the only form of federal taxation, of course.  The federal government charges taxes on the gratuitous transfer of money from one person to another, either at death (estate taxes) or during life (gift taxes).

A consistent feature of the federal tax systems is that the tax rates are not flat.  As income increases, the income tax rate increases and the capital gains tax rate increases.  As estate size increases, the estate tax rate increases.  As total (non-charitable) gift size increases, the gift tax rate increases.  These increasing tax rates mean that the tax effects from the same transaction may vary dramatically from person to person.  This text will most commonly calculate the effects for a taxpayer at the highest federal tax brackets and ignore state taxes, but the actual results will differ depending upon the actual tax circumstances of the individual donor.

The 2015 federal income tax brackets for a single person serve as an example of increasing (a.k.a. “progressive”) tax rates.  As a taxpayer earns more money, he or she will tend to pay a larger and larger share of this earned income in federal income taxes.  A “marginal” tax rate refers to the rate charged on the last dollar of earned income.  Calculating taxes owed is not as simple as finding the marginal tax rate and multiplying it by the taxpayer’s taxable income.  Instead, each separate level of income is taxed at the rate indicated in the tax table.

At the lowest level of taxable income, calculations only require using one rate.  For example, a single taxpayer with $5,000 of taxable income in 2015 would pay taxes at the 10% rate for all of his or her taxable income.  This taxpayer would owe $500 in taxes ($5,000 x 10%).  However, beyond this lowest bracket of taxable income, calculating taxes owed becomes a bit more complicated.

For example, if a single taxpayer had $10,225 of taxable income in 2015, then the first $9,225 would be taxed at 10%, and the remaining $1,000 would be taxed at 15%.  It is incorrect to simply use the 15% rate for all of the taxpayer’s taxable income.  (I.e., do not simply multiply the total $10,225 of taxable income by 15%.)  The 15% rate is the marginal tax rate, because it is the rate charged for the next dollar that the taxpayer earns.  But, the 15% rate does not apply to every dollar the taxpayer earns.

As a taxpayer earns more income and moves further up the tax brackets, calculating the income taxes owed requires more steps.  For example, a single taxpayer with $40,000 of taxable income would pay a 10% rate on the first $9,225 of income earned, a 15% rate on the next $28,225 earned ($28,225 is the difference between the top of the 15% tax bracket, $37,450, and the top of the 10% tax bracket, $9,225), and a 25% rate on the final $2,550 earned ($2,550 is the amount of the $40,000 taxable income above the top of the 15% tax bracket which ends at $37,450).

Charitable gifts may generate charitable income tax deductions.  Consequently, it is important to know how to calculate the effects of such deductions.  An income tax deduction reduces taxable income.  The value of a reduction in taxable income is the tax owed at the original taxable income less the tax owed at the reduced taxable income.  Thus, understanding the value of a tax deduction (such as a charitable tax deduction) requires the ability to calculate taxes owed at various levels of taxable income, and this requires understanding how tax brackets apply to taxable income.

Tax deductions reduce taxable income.  For example, a taxpayer with taxable income of $10,000 who then takes a $1,000 additional deduction will have $9,000 of taxable income.

A tax deduction has the same effect on taxable income regardless of the amount of taxable income earned by the taxpayer.  Whether the taxpayer’s taxable income is $10,000, $100,000 or $10,000,000, an additional $1,000 deduction will reduce the taxpayer’s taxable income by exactly $1,000.  However, the value of the $1,000 deduction may vary greatly depending upon the taxpayer’s taxable income.

A $1,000 deduction is not worth $1,000.  The deduction amount indicates the amount by which taxable income will be reduced, but its value depends upon the tax rate of the taxpayer.  Just because a $1,000 deduction reduces taxable income by $1,000 at all income levels does not mean it is worth the same at all income levels.  Often the value of the tax deduction is the amount of the tax deduction multiplied by the taxpayer’s highest tax bracket.  So, a $1,000 deduction is worth $100 to a taxpayer in the 10% tax bracket.  That same tax deduction is usually worth $396 to a taxpayer in the 39.6% bracket.  This difference in value helps to explain why charitable tax deductions may be more interesting to those with higher incomes.

Charitable income tax deductions are an itemized income tax deduction.  Other examples of itemized income tax deductions include the mortgage interest deduction, deductions for medical expenses greater than 10% of adjusted gross income, and deductions for state and local taxes.  In order to use itemized deductions, a taxpayer must give up the standard deduction.  So, a taxpayer who takes the standard deduction cannot use any charitable income tax deductions.