Frank C. Kilcoyne, CSSC
Volume 21/April 2009

PAYING INCOME TAXES?

This being tax season, I could not resist wading into the morass. Actually, my ultimate point will be simple and straightforward – unlike the tax code itself. You all know that the federal government imposes a tax on income “…from whatever source derived.” In plain language, that means all money you receive is taxable unless Congress says it isn’t. Income that doesn’t count as taxable income is generally referred to as being an “exclusion” (getting technical already). And, fortunately for all of us in the claims resolution community, the most powerful exclusion for an individual in the entire tax code must surely be the Section 104 exclusion for structured settlements.

Of course, we don’t all pay the same taxes. How much we each owe is set according to how much money we earn with the percentage rates broken down into six tax “brackets”. They currently range from 10% to 35%. Although the top tax bracket has been as high as 94% in 1944, over the past 20 years it has ranged between 28% and 39%.

But wait - beyond these federal taxes, the states also lie in wait. Seven states don’t tax income (New Hampshire being the closest to my home), but the rest all do and the average tax rate in the Northeast is currently 4.83%.

Although the breakpoints for each tax bracket have varied from year to year, the current political climate indicates that triggers for the upper brackets will move down, meaning that the more you earn, the higher a tax you will pay. How does this work exactly? Let’s take a look:

Say you are a married person filing separately with a taxable income of $65,000 per year. Your income tax for year 2009 might look something like this:

�$65,000.00 Taxable Income Tax Rate Amount
          �  $0 - $8,350 x  10%   = $   835.00
          �  $ 8,351 - $33,950 x  15%   = $ 3,345.00
          �  $33,951 - $65,000 x  25%   = $ 7,762.25
�  Total Federal Income Tax Due   = $11,942.25
�  Average State Income Tax Due   = $  3,204.50
�  Total Income Tax Due   = $15,146.75  (23% Effective Tax Rate)

Now, let’s assume you are the same married person who had the misfortune to become injured due to someone else’s negligence. Due to your injuries, you will receive a settlement of $500,000 after paying liens, attorney fees, and expenses. As you have – literally - bled for this money (risk is real) you might invest your settlement proceeds in a 20-year U.S. Treasury bond currently yielding 3.63%. That would provide you with an annual return of $18,150 per year. Now add this to your taxable income and recalculate your taxes for 2009:

�

� $83,150 Taxable Income Tax Rate Amount
          �  $0 - $8,350 x  10%   = $   835.00
          �  $ 8,351 - $33,950 x  15%   = $ 3,345.00
          �  $33,951 - $68,525 x  25%   = $ 8,643.50
        ° $68,525 - $83,150 x  28%   = $ 4,095.00
�  Total Federal Income Tax Due   = $16,918.50
�  Average State Income Tax Due   = $  4,099.30
�  Total Income Tax Due   = $21,017.80 (25% Effective Tax Rate)
·  Income After Taxes   =$62,132.20

But wait a minute…had you placed your settlement proceeds into a tax-free structured settlement with the same exact payment schedule (20 years of payments and a return of principle at the end, just like a treasury bond), your annual tax-free return would be $23,588 per year. Hmm…$5,438 more in income than with the treasury bond? Yes. And let’s look at the taxes again under this scenario:

� $65,000 Taxable Income Tax Rate Amount
          �  $0 - $8,350 x  10%   = $   835.00
          �  $ 8,351 - $33,950 x  15%   = $ 3,345.00
          �  $33,951 - $65,000 x  25%   = $ 7,762.25
�  Total Federal Income Tax Due   = $11,942.25
�  Average State Income Tax Due   = $  3,204.50
�  Total Income Tax Due   = $15,146.75  (23% Effective Tax Rate)
·  Plus Tax Free Income   =$23,588.00
·  Income After Taxes   =$73,441.25

By simply saying “yes” to an income tax exclusion that Congress specifically meant you to have, you have not only reduced your total effective tax rate, but increased your final net income by $11,300 per year.

Why would anyone pay taxes when didn’t have to? Moving non-taxable money into the taxable column is not necessary and can seriously reduce income. Do you have a case where the claimant cares about maximizing income, financial security, and not over-paying taxes? Call Frank C. Kilcoyne, CSSC at 800-544-5533. I am here to help.

 

1 Article XVI, United States Constitution, “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”