Chapter 4
Managing Income Taxes
Objectives
• Explain the nature of progressive income taxes
and the marginal tax rate.
• Differentiate among the eight steps involved in
calculating your federal income taxes
• Use appropriate strategies to avoid overpayment
of income taxes.
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Introduction
• Tax Planning: Seeking legal ways to reduce,
eliminate, or defer income taxes.
• Taxable Income: the income upon which
income taxes are levied.
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Taxes
• Progressive income taxes and the marginal tax
rate
– Taxes – amount owed as % income. Taxes are
compulsory charges imposed by government
on its citizens and their property.
– Internal Revenue Service (or IRS)
– Internal Revenue Code
• The progressive nature of the federal income tax
– Progressive tax – is one that requires a
higher tax rate as income increases.
– Regressive tax – is one that demands a
decreasing proportion of one’s income.
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Progressive Nature of the
Federal Income Tax
Taxable Income
First $8700
Over $8700 but not over $35,350
Over $35,350 but not over $85,650
Over $85,650 but not over $178,650
Over $178,650 but not over $388,350
Over $388,350
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Rate
10%
15%
25%
28%
33%
35%
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Marginal Tax Rate
and Financial Decisions
• Marginal tax rate is the rate at which your last
dollar of income is taxed.
• Your effective marginal tax rate can be 43%
and includes Medicare, Social Security, Federal,
State and City
• Your average tax rate is lower.
– Average tax rate: Proportion of total gross
income paid in income taxes.
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How Your Income Is Really Taxed
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8 Steps in Calculating
Your Income Taxes
1. Determine your total income.
2. Determine and report gross income after
subtracting exclusions such as gifts,
inheritance, tax refunds, etc.
3. Subtract adjustments to income such as moving
expenses, tuition and fees, student loan interest
expense, etc. to determine the adjusted gross
income (AGI).
4. Subtract either the IRS’s Standard Deduction
for your tax status or itemize your deductions.
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8 Steps in Calculating
Your Income Taxes
5. Subtract the value of your personal exemptions.
($3,800 Each Dependent)
6. Determine your preliminary tax liability based
upon your taxable income.
7. Subtract tax credits for which you qualify.
8. Calculate the balance due the IRS or the
amount of your refund.
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The Process
of Income Tax Calculation
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Total Income
• Income to include:
–
–
–
–
–
–
–
Wages and Salaries
Commissions
Bonuses
Tips Earned
Interest and Investment Income
Retirement Income
Unemployment benefits
– Gambling and Lottery Winnings
• Include capital gains and losses in Total Income. Long
term gains or losses are taxed at 10% - 15% and short
term gains or losses are taxed at your marginal tax rate.
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Gross Income
• Income to exclude from taxes:
– Gifts
– Inherited money or property
– Income from a carpool
– Federal income tax refunds
– Employee contributions to flexible spending
accounts
– Reimbursements from flexible spending
accounts
– Child support payments received
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W-2 Form
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Deductions
• Subtract either the IRS’s standard deduction
for your tax status or your itemized deductions.
• Standard deduction depends on filing status.
– $5,950 for single individuals – 2012 tax year
– $11,900 for married couples – 2012 tax year
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Deductions
• Itemized deductions:
Medical and dental
expenses
• Amount must exceed
7.5% of total adjusted
gross income for 2012.
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Deductions
• Itemized deductions: Taxes you paid
– Real Estate Property Taxes (home or land)
– Personal Property Taxes – vehicle
registration, license fees
– State, Local, and Foreign Income Taxes
– State and Local Sales Taxes (instead of state
and local income taxes)
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Deductions
• Itemized deductions: Taxes you paid
– Interest Paid on Home Mortgage Loans
– “Points”
– Interest Paid on Home-Equity Loans
– Interest paid on loans used for investments
– Mortgage insurance premiums on new loans
after January 1, 2007
– Gifts to charity
– Casualty and theft losses that is uninsured
and exceed 10% of your AGI
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Deductions
• Miscellaneous deductions in excess of 2% of
adjusted gross income
– Job search expenses
– Moving expenses
• Other miscellaneous deductions allowed at
100%:
– Gambling losses
– Business expenses for workers with
disabilities
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Exemptions
• Exemption (or Personal Exemption)
• Subtract the value of your personal exemptions.
• Each exemption reduces taxable income by
$3,800 for 2012
• Claiming another person as an exemption
requires that you provide more than one-half of
their support.
• What if you are claimed as an exemption?
– If someone else claims you, you cannot claim
yourself.
– The opposite is also true.
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Tax Liability
• Determine your preliminary tax liability based on your
taxable income using the tax-rate schedule or tax table.
• Taxable income is the amount remaining after subtracting
adjustments, deductions and exemptions from your gross
income.
• Subtract tax credits for which you qualify.
– Tax Credit: Dollar-for-dollar decrease in tax liability.
•
American Opportunity Credit – up to $2,500 tax credit
per student
•
Lifetime Learning Credit – up to $2,000 tax credit per
return
•
Earned Income Credit – Eligible if income less than
$13,980 single or $19,190 married (no child)
•
Child Tax Credit - $1,000 per child
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Tax Credits
• American Opportunity Credit
• Lifetime Learning Credit
• Earned Income Credit
• Child Tax Credit
• Child and Dependent Care Credit
• Retirement Savings Contribution Credit
• Adoption Credit
• Energy Saving Vehicle Credit
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Tax Liability
• After subtracting your credits from your
preliminary tax liability you arrive at your final
tax liability.
• Add up all prior payments from tax withholding
or estimated tax payments.
• Calculate the balance due the IRS or the
amount of your refund.
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Avoid Taxes Through
Proper Planning
• Practice legal tax avoidance, not tax evasion.
• A dollar saved from taxes is really two dollars or more. Remember the time value of money ?
• Opportunity cost
• Earning another dollar to replace one given to
the IRS
• Earnings on a dollar not given
to the IRS
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Reduce Taxable Income
Via Your Employer
• Premium only plan (health care)
• Flexible Spending Account - $2,500 Max.
after December 31, 2012
(or FSA or Expense Reimbursement Account)
• Defined Contribution Retirement Plan:
– Tax Sheltered Investments
– Matching Contributions
– 401(k) - $17,000 Max Limit
– IRA - $5,000 Max Limit
– Roth IRA - $5,000 Max
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Reducing Taxable Income:
Other Strategies
• Coverdell Education Savings Account
• Qualified Tuition (Section 529) programs
• Govt. savings bonds – Interest income deferred
• Municipal bonds – Interest earned tax exempt
• Postpone income such as bonus payments
• Bunch deductions into one year
• Take all of your legal tax deductions.
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Comparing Taxable and After-Tax Yields
• After-tax yield using taxable yield formula:
– After-tax yield equals the taxable yield times (1
- federal marginal tax rate)
• Lets compare the yield of a 5.7% corporate
bond vs. 4% tax-exempt municipal bond
• If someone has a 35% Marginal Tax Rate:
– 5.7% taxable interest x (1.00 - 0.35)
– 5.7% x 0.65
– The answer is a 3.71 after-tax yield corporate
bond
– A municipal bond with 4% is preferred since
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interest is tax exempt
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Top 3 Financial Missteps in
Managing Income Taxes
People risk incurring more tax liability when they
do the following:
1. Turn all you income tax planning over to
someone else.
2. Over-withhold too much income to receive a
refund next year.
3. Ignore the impact of income taxes in you
personal financial planning.
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Good Money Habits in
Managing Income Taxes
• Reduce you income taxes by signing up for taxadvantaged employee benefits at your
workplace.
• Contribute to you employer-sponsored 401(k)
retirement plan at least up to the amount of the
employer’s matching contribution.
• When practical, consider purchasing a home to
reduce income taxes.
• Do your own tax return so you can learn how to
reduce your income tax liability.
• Maintain good tax records.
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Questions ?
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