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CHAPTER 3:
MANAGING
YOUR TAXES
Copyright  2002 by Harcourt, Inc. All rights reserved.
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Principles of
Federal Income Taxes
Typical American family pays
about a third of its gross income
in various types of taxes.
Internal Revenue Service (IRS)
is responsible for the
administration and enforcement
of federal tax laws.
Copyright  2002 by Harcourt, Inc. All rights reserved.
Economics of Income Taxes:
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 Federal income taxes are assessed
according to a progressive tax structure;
 i.e., the larger the taxable income, the
higher the tax rate.
 The next higher rate applies only to the
additional income in that bracket, not to
your entire income.
 Tax brackets, standard deductions, and
personal exemptions are indexed to
inflation to prevent bracket creep.
Copyright  2002 by Harcourt, Inc. All rights reserved.
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2000 Tax Rate Schedule
(single taxpayers)
Taxable Income
$0 – $26,250
$26,251 – $63,550
$63,551 – $132,600
$132,601 – $288,350
Over $288,350
Copyright  2002 by Harcourt, Inc. All rights reserved.
Tax Rate
15%
28%
31%
36%
39.6%
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Example:
If you have $80,000 in taxable
income, what will your federal
income tax liability be?
Copyright  2002 by Harcourt, Inc. All rights reserved.
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Work through the tax brackets:
$26,250 x 15% = $ 3,937.50
+
($63,550 – $26,250) x 28% = $10,444.00
+
($80,000 – $63,550) x 31% = $ 5,099.50
Tax Liability
$19,481.00
Copyright  2002 by Harcourt, Inc. All rights reserved.
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Your marginal, or stated, tax rate
is 31%, the rate of your highest
bracket.
Your average tax rate is 24.4%,
which is calculated by dividing
the amount of taxes paid by
your taxable income:
$19,481  $80,000 = 24.4%
Copyright  2002 by Harcourt, Inc. All rights reserved.
More Principles of Taxation:
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 Filing Status has to do with your marital
status and family situation; factor in
determining amount of income tax paid.
 Taxes are due on a pay-as-you-go
basis; at time of filing you receive credit
for amount already withheld and settle
up for the past year.
 Your income is subject to federal, state
and local income taxes and Social
Security taxes.
Copyright  2002 by Harcourt, Inc. All rights reserved.
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It's Taxable Income that Matters!
Taxable Income
is the amount of
our income on
which we actually
pay taxes.
Copyright  2002 by Harcourt, Inc. All rights reserved.
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Determining Taxable Income:
Gross income
– Adjustments
= Adjusted Gross Income (AGI)
– Deductions
– Exemptions
= Taxable Income
Copyright  2002 by Harcourt, Inc. All rights reserved.
[1]
[2]
[3]
[4]
[5]
[6]
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[1] Gross Income:
All income that is subject to federal income taxes.
3 classifications of income which must be kept
separate for deduction purposes:
Earned or Active
Income
Wages & Salaries
Alimony received
Business & farm
income
Unearned or
Passive Income
Portfolio Income
Income from real
Interest
estate (unless
real estate is
Dividends
your primary
Capital gains
business)
Most types of
Prizes, awards,
investment
gambling winnings earnings
Limited
partnerships &
Tax shelters
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Tax-Exempt Income:
Either totally or partially excluded from
gross income for income tax purposes:
Child support received
Insurance reimbursements
Gifts (limits apply)
Scholarships (some limits)
Tax refunds
Return of original investment capital
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 Capital gain (loss) occurs when an asset is
sold for more (less) than its original cost.
– Short-term capital gain occurs when an
item is held for 1 year or less; taxed at
ordinary income tax rates.
– Long-term capital gain occurs when an
item is held longer than 1 year; currently
taxed at 20% or less. (See Exhibit 3.5)
 Generally, the sale of a home is now
excluded from capital gains taxation (some
limits and exceptions).
Copyright  2002 by Harcourt, Inc. All rights reserved.
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[2] Adjustments to Gross Income:
 Items which can be subtracted from
gross income.
 Adjustments include:
– Traditional IRA contributions (some
limits)
– Self-employment tax—50% of amount
paid
– Alimony paid
– Penalty on early withdrawal of savings
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[3] Adjusted Gross Income (AGI):
 Subtotal obtained when adjustments
are subtracted from gross income.
 Certain itemized deductions and other
calculations are limited by this amount.
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[4] Deductions:
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 The standard deduction is the blanket
amount allotted for various deductible
expenses taxpayers normally incur.
 If your deductible expenses are greater
than the standard deduction, you may
choose to itemize your deductions.
 You should choose the most
advantageous method; itemized
deductions must be documented.
Copyright  2002 by Harcourt, Inc. All rights reserved.
 Itemized deductions are listed on
Schedule A and include the following:
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– Medical and dental expenses (only
amount in excess of 7.5% of AGI)
– State and local income taxes and
property taxes
– Home mortgage interest
– Charitable contributions
– Casualty and theft losses (very limited)
– Job and misc. expenses (only amount in
excess of 2% of AGI)
Copyright  2002 by Harcourt, Inc. All rights reserved.
[5] Exemptions:
 Amount subtracted based upon
the number of people
supported by the taxpayer’s
income.
 You are an exemption on your own
return unless you can be claimed by
someone else.
 Children, spouses, elderly parents are
other examples of exemptions.
 Each person can be claimed on only 1
tax return!
Copyright  2002 by Harcourt, Inc. All rights reserved.
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Calculating and Filing Your Taxes
 Your federal income tax liability is
calculated on your taxable income [6].
 Taxes owed are found in the tax rate
tables or calculated using schedules.
 Alternative Minimum Tax is calculated
differently; for higher-income taxpayers.
 Exemption & deduction amounts are
limited at higher income levels.
Copyright  2002 by Harcourt, Inc. All rights reserved.
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Tax Credits versus Tax Deductions:
Credits are subtracted from the
amount of taxes you owe.
Deductions are subtracted from
your AGI and reduce your
taxable income.
Which results in lower taxes?
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Extra $1000
$1000
Deduction Tax Credit
Gross Income
$38,000
$38,000
Other deductions/
exemptions
– 6,000
– 6,000
Extra $1000 Deduction
– 1,000
–
Taxable Income
$31,000
$32,000
Tax Liability
$ 5,268
$ 5,548
$1000 Tax Credit
–
0
– 1,000
Taxes Due
$ 5,268
$ 4,548
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Tax Forms and Schedules:
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 All taxpayers file their returns on some
variation of Form 1040.
 If more detail is needed, taxpayers will
also have to file other forms and
schedules.
 Frequently used schedules include:
– Schedule A (itemized deductions)
– Schedule B (interest/dividend income)
– Schedule C (personal business income)
– Schedule D (capital gains/losses)
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Other Filing Considerations
 Quarterly payment of estimated taxes
 April 15 filing deadline
 Filing extensions
 Amended returns (1040X)
 Audited returns
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Preparing Your Tax Return
 Do it yourself!
 Get help from the IRS
 Use professional services
– Tax services
– Enrolled agents
– Certified public accountants
– Tax attorneys
 Use tax software
 Taxpayer is responsible for accuracy!
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Effective Tax Planning
 Tax avoidance is legal. Tax evasion is not!
 Reduce taxes
– Use all appropriate deductions or credits.
– Use techniques that receive preferential
tax treatment, such as depreciation on real
estate and tax-exempt income on
municipal bonds.
 Shift taxes
– Use gifts or trusts to shift some of your
income to others in lower tax bracket.
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 Defer taxes
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– Postpone taxes to the future when you may
be in a lower tax bracket.
– Use retirement plans, IRAs, annuities, life
insurance policies, and EE savings bonds.
 Use tax shelters (not many are left!)
– Some real estate and natural resource
investments provide tax write-offs.
– Generally considered passive investments,
and amount of write-off is limited.
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Still More Taxes!
 Federal taxes
– Social Security
– Excise (ex: gasoline)
– Gift and Estate
– Others, such as duties on imports
 State and local taxes
– Sales
– Income
– Property taxes, licensing fees, etc.
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THE END!
Copyright  2002 by Harcourt, Inc. All rights reserved.