Chapter 3
Taxes in Your
Financial Plan
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Taxes in Your Financial Plan
Chapter Objectives
1. Identify the major taxes paid by people
in our society
2. Calculate taxable income and the
amount owed for federal income tax
3. Prepare a federal income tax return
4. Select appropriate tax strategies for
various life situations
3-2
Objective 1
Identify the Major Taxes Paid by
People in Our Society
Planning Your Tax Strategy
Start planning for taxes ….
 Know current tax laws as they affect you
 Maintain complete and appropriate tax
records
 Make purchase and investment decisions
that reduce your tax liability
Goal: Paying your fair share but still taking
advantage of tax benefits.
3-3
Types of Taxes
 Taxes
on Purchases
– Sales tax & excise tax
 Taxes on Property
– Real estate property tax
– Personal property tax
 Taxes on Wealth
– Federal estate tax
– State inheritance tax
 Taxes on Earnings
– Income tax and Social Security
3-4
What Tax Records to Keep
•
•
•
•
•
•
•
•
Current tax forms and instruction booklets
Social security numbers
Copy of previous year’s returns
W-2 forms from employers
1099 forms (interest, self employment)
1098 (mortgage interest paid)
Receipts and documentation for expenses
Investment & business expense documents
3-5
Objective 2
Calculate Taxable Income and the Amount
Owed for Federal Income Tax
Step 1: Determine AGI
AGI = Adjusted Gross Income
Taxable Income
Net income = income on which
tax is
computed
Gross income minus deductions
3-6
Objective 2
Calculate Taxable Income
Main Components of Gross Income
•
Earned income
•
•
Investment income
•
•
Money received in the form of dividends, interest or
rent from investments
Passive income
•
•
Usually includes wages, salary, commissions, fees,
tips or bonuses
Results from business activities in which you do
not directly participate such as a limited
partnership
Other income
•
Alimony, awards, lottery winnings and prizes
3-7
Objective 2
Calculate Taxable Income
• Total income is affected by:
– Exclusions
• Amounts excluded from gross income
• Also referred to as tax-exempt income;
income not subject to federal income tax
– Example = interest on most state and city bonds
– Tax-deferred income
• Income that will be taxed at a later date, such
as earnings from an traditional individual
retirement account (IRA)
3-8
Objective 2
Calculate Taxable Income
• Adjusted gross income (AGI)
– Gross income reduced by certain reductions
– The basis for computing various deductions
• Adjustments to income
– Reduce AGI
– Contributions to a traditional IRA or Keogh
– Alimony payments
3-9
Objective 2
Calculate Taxable Income
Step 2: Computing Taxable Income
Tax deduction = amount subtracted from
adjusted gross income (AGI) to arrive at
taxable income
• Standard deduction
• Itemized deductions
3-10
Calculate Taxable Income
Itemized Deductions
• Medical & dental expenses (>7.5% of AGI)
• Taxes
• Interest
• Contributions
• Casualty and theft loses
• Moving expenses
• Job-related and other miscellaneous
expenses
3-11
Calculate Taxable Income
Exemptions
• Exemptions  subtracted from AGI
– An exemption = a deduction for yourself,
your spouse and qualified dependents
– The amount of the exemption
for the 2008 tax year is
$3,500 per person
– After deducting exemptions you
have your taxable income
3-12
Objective 2
Calculate Taxes Owed
Step 3: Calculating taxes owed
– Tax table rates = marginal rates
• The tax rate paid on the last (or
next) dollar of taxable income.
– Example:
• After deductions and exemptions,
a person in the 35% tax bracket
pays 35 cents in taxes for every
dollar of taxable income in that
bracket.
3-13
2008 IRS Tax Brackets
Rate on Taxable
Income
Single Taxpayers
Married Taxpayers
Filing Jointly
Head of Households
10%
up to $8.025
up to $16,050
up to $11,450
15%
$8,025-$32,550
$16,050-$65,100
$11,450-$43,650
25%
$32,550-$78,850
$65,100-$131,450
$43,650-$112,650
28%
$78,850-$164,550
$131,450-$200,300
$112,650-$182,400
33%
$164,550-$357,700
$200,300-$357,700
$182,400-$357,700
35%
Over $357,700
Over $357,700
Over $357,700
3-14
2008 IRS Tax Example
Tax on a single taxpayer’s income of $40,000
Rate on Taxable
Income
Single Taxpayers
Taxable
Amount
Tax Due
10%
up to $8.025
$8,025
$802.50
15%
$8,025-$32,550
$24,525
$3,678.75
25%
$32,550-$78,850
$7,450
$1,862.50
28%
$78,850-$164,550
$40,000
$6,343.75
33%
$164,550-$357,700
35%
Over $357,700
Average Rate
Marginal Rate
15.86%
25.00%
= $6343.75 / $40,000
3-15
Objective 2
Calculate Taxes Owed
The average tax rate = the total tax
due divided by taxable income
• Average tax rate < marginal tax
rate
• Example:
– Taxable income = $40,000
– Total tax bill = $6,344
– Average tax rate = 15.9%
» ($6,344 / $40,000)
3-16
Objective 2
Calculate Taxes Owed
• Alternative minimum tax (AMT)
– Paid by taxpayers with high amounts of
certain deductions and various types of
income
– Designed to ensure that those who receive
tax breaks also pay their fair share of taxes
3-17
Objective 2
Calculate Taxes Owed
• Tax credits
– Amount subtracted directly from the
amount of taxes owed
– Examples:
•
•
•
•
•
•
Earned income credits
Foreign tax credits
Child and dependent care credits
Retirement tax credits
Adoption tax credits
Hope Scholarship and Lifetime Learning
credits
3-18
Tax Credit versus Tax Deduction
$100 Tax Credit
Reduces Your Taxes by $100
$100 Tax Deduction
Amount Your Taxes are Reduced
is Based on Your Tax Bracket
3-19
Determining
Your Tax
Liability
3-20
Objective 2
Calculate Taxes Owed
Step 4: Making Tax Payments
• Payroll Withholding
Based on the number of exemptions and the
expected deductions claimed
• Estimated Quarterly Payments
Estimated tax payments made throughout
the year based on income made during the
year and reported on Form 1099.
3-21
Objective 2
Calculate Taxes Owed
Step 5: Watching Deadlines-Avoiding Penalties
• Form 4868  automatic six-month extension
– Submit estimated tax due with Form 4868 by April 15
• Penalties & Interest
– Underpayment of quarterly estimated taxes may
require paying interest on the amount owed
– Underpayment due to negligence can result in
penalties of 50 to 75 percent
3-22
Objective 3
Prepare a Federal Income Tax Return
Every citizen or resident of U.S. and every U.S.
citizen who is a resident of Puerto Rico is required
to file income tax.
•
Five filing status categories:
– Single or legally separated
– Married, filing jointly
– Married, filing separately
– Head of household
• Unmarried individual or surviving spouse
who with a child or dependent relative
– Qualifying widow or widower (2 years)
3-23
Which Tax Form Should You Use?
•
•
≈ 400 federal tax forms and schedules
Basically the choice is between 3 forms
1040EZ
1040A
1040
•
Which form to use?
–
Type of income
– Amount of income
– Number of deductions
– Complexity of tax situation
3-24
Completing the Federal Income Tax
Return








Filing status and exemptions
Income
Adjustments to income
Tax computation
Tax credits
Other taxes (such as from self-employment)
Payments (total withholding and other payments)
Refund or amount you owe
•
•
Refunds can be directly deposited to your bank account.
Payments may be directly debited from your bank account.
 Your signature = Most common filing error
3-25
How do I File My State Tax Return?
• All but 7 states have a state income tax
• Most states tax rate ranges from 1 to 10
percent
• States usually require income tax returns to
be filed when the federal income tax return
is due
3-26
How Do I File My Taxes Online?
• Tax preparation software
–
TurboTax and TaxCut are two of the most
popular tax preparation software packages
•
Using software can save 10 or more hours
– Tax software allows you to complete
needed tax forms
• Print and mail the forms or file online
– e-filing refunds usually take 3 weeks
– Cost for e-filing = $5 - $40
3-27
How Do I File My Taxes Online?
• Free File Alliance
– Online tax preparation and filing free to
many taxpayers
– http://www.irs.gov - go to “Free File”
– Various qualification criteria to file free; use
“Guide Me to a Service”
– Connect to selected firm’s website
– Use form’s online software to prepare and
file tax return
3-28
Available Tax Assistance Sources
•
IRS Services
– Publications and forms
• 1-800-TAX-FORM
• www.irs.gov
– Recorded messages
• 1-800-829-4477
– Phone hot line
• 1-800-829-1040
– Walk-in service at an IRS office
3-29
Available Tax Assistance Sources
•
Tax publications
–
•
The Internet
–
•
e.g. Ernst and Young Tax Guide and J.K.
Lasser’s Your Income Tax
Tax preparation software companies
Tax Preparation Services
–
–
Tax preparers charge between $40 and $2,000
depending on the complexity of the return
Over 40 million U.S. taxpayers pay someone
else to do their taxes
3-30
Types of Tax Preparation Services
• One-person, local offices to large
firms such as H & R Block
• “Enrolled agents” = Government-
approved tax experts
• CPA Tax Accountants
• Attorneys
3-31
Evaluating Tax Services
Factors to consider:
• Training and experience of the tax
professional?
• Fee for preparing taxes and how determined?
• Questionable deductions suggested?
• If return is audited will the preparer represent
the client?
• Is tax preparation the main business activity or
is it a front for other financial products?
3-32
Tax Service Warnings
• Ultimately you are responsible for providing
complete and accurate information
– If your professional tax preparer makes a mistake,
you are still responsible for paying the correct
amount, plus any interest and penalties.
• Hiring a tax preparer does not guarantee that
you will pay the correct amount
• Beware of tax preparers that offer refunds in
advance
• “Refund anticipation loans” can charge interest
rates in excess of 300%
3-33
What if Your Return is Audited?
≈ 0.6% of all returns are audited
•
If you claim large or unusual deductions you
are more likely to be audited.
• Three types of audits:
– Correspondence audit for minor questions
– Office audit takes place at an IRS office
– Field audit is the most complex, with an
IRS agent visiting you at your home, your
business or your accountant’s office
3-34
What if Your Return is Audited?
• Audit Rights
– Request time to prepare
– Clarification of items being questioned
– Right to appeal audit results
• When Audited:
– Decide whether to bring you tax preparer,
accountant or lawyer
– Be on time for you’re appointment; bring only
relevant documents
– Present evidence in a logical, calm and confident
manner; maintain a positive attitude
– Make sure your information is consistent with tax
law
– Keep your answers aimed at the auditor’s questions
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Objective 4
Select Appropriate Tax Strategies
Tax Planning Strategies
• Practice tax avoidance
– Legitimate methods to reduce your tax
obligation to your fair share but no more
– Financial decisions related to purchasing,
investing, and retirement planning are the
most heavily affected by tax laws
•
Tax Evasion
– Illegally not paying all the taxes you owe,
such as not reporting all income
3-36
Tax Planning Strategies
Minimizing Taxes
If you expect
Then you should
Because
The same or a
Accelerate
Greater benefit to
lower tax rate
deductions into
higher rate
next year
this year
The same tax rate Delay income into Delay paying taxes
next year
next year
Delay deductions
Greater benefit
A higher tax rate
Accelerate income Taxed at lower rate
next year
3-37
Tax-Planning Strategies
Consumer Purchasing
•
•
Home ownership
–
One of the best tax shelters
–
Deduct mortgage loan interest
and property taxes
–
Reduces your taxable income
Use home equity line of credit to buy a
car or consolidate debt
–
Interest deductible
3-38
Tax-Planning Strategies
Consumer Purchasing
•
Job-related expenses may be allowed as
itemized deductions
– Union dues
– Business tools
– Job search costs
• Health care expenses like FSA’s (Flexible
Spending Accounts) allow you to reduce your
taxable income when paying for health
related expenses
3-39
Tax-Planning Strategies
Investment Decisions
Tax Exempt Investments
– Interest income from municipal bonds are
exempt from federal and some state taxes
Tax Deferred Investments
– Tax deferred annuities
– Section 529 education savings plans
– Retirement Plans -IRA, Keogh or 401(k)
• A type of tax shelter
3-40
Tax-Planning Strategies
Investment Decisions
Capital Gains
– Profits from the sale of stocks, bonds or real
estate
– Long-term capital gains (held more than one
year) taxed at a lower rate
Self Employment
Advantage: Owning your own business can
have tax advantages
Disadvantage: Business owners have to pay
additional taxes
3-41
Tax-Planning Strategies
Investment Decisions
Children’s Investments
Children under 14 with investment income of more
than $1500 are taxed at parent’s top rate
Retirement Plans
–
Traditional IRA
–
Roth IRA
–
Education IRA
–
Keogh Plan
–
401 (K) Plan
3-42
Changing Tax Strategies
• IRS Changes:
– IRS modifies tax filing procedures each year
– Congress passes legislation to change the tax
code each year.
– Take advantage of these changes for personal
financial planning
• Personal Changes:
– Consider changes in your personal situation and
income
– Monitor your tax strategies to best serve your
daily needs and long-term financial goals
3-43