Chapter 3
Taxes in Your
Financial Plan
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Taxes in Your Financial Plan
Chapter Learning Objectives
LO3.1
LO3.2
LO3.3
LO3.4
Identify the major taxes paid
by people in our society
Calculate taxable income and
the amount owed for federal
income tax
Prepare a federal income tax
return
Select appropriate tax
strategies for various life
situations
3-2
Learning Objective LO3.1
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 the minimum required tax.
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
Learning Objective LO3.2
Calculate Taxable Income and the Amount
Owed for Federal Income Tax
Step 1: Determine AGI
AGI = Adjusted Gross Income
Gross income minus allowable
reductions (example: alimony,
contributions to IRA or Keogh, penalties
for early withdrawal)
3-5
Learning Objective LO3.2
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, and 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
3-6
Learning Objective LO3.2
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)
3-7
Learning Objective LO3.2
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
3-8
Calculate Taxable Income
Itemized Deductions
• Medical & dental expenses (>7.5% of AGI)
• Taxes
• Interest - Limitations
• Contributions - Limitations
• Casualty and theft loses
• Moving expenses - Limitations
• Job-related and other miscellaneous
expenses - Limitations
3-9
Calculate Taxable Income
Exemptions
• Exemptions  subtracted from AGI
– An exemption = a deduction for yourself,
your spouse, or qualified dependents
– The amount of the exemption
for the 2012 tax year is
$3,800 per person
– After deducting exemptions, you
have your taxable income
3-10
Tax Record-Keeping System
3-11
Learning Objective LO3.2
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.
3-12
2012 IRS Tax Brackets
Tax Bracket
10% Bracket
15% Bracket
25% Bracket
28% Bracket
33% Bracket
35% Bracket
Married Filing Jointly
$0 – $17,400
$17,400 – $70,700
$70,700 – $142,700
$142,700 – $217,450
$217,450 – $388,350
Over $388,350
Single
$0 – $8,700
$8,700 – $35,350
$35,350 – $85,650
$85,650 – $178,650
$178,650 – $388,350
Over $388,350
3-13
Learning Objective LO3.2
Calculate Taxes Owed
The average tax rate = the total tax
due divided by taxable income
• Average tax rate < marginal tax rate
• Example:
– Taxable income = $90,025
– Total tax bill = $14,566
– Average tax rate = 16.2%
» ($14,566 / $90,025)
3-14
Learning Objective LO3.2
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
3-15
Learning Objective LO3.2
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
Education credits to offset college education
expenses
3-16
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
3-17
Learning Objective LO3.2
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.
3-18
Learning Objective LO3.2
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 or fraud can result
in penalties of 50 to 75 percent
3-19
Learning Objective LO3.3
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 has a child or dependent relative
– Qualifying widow or widower with a
dependent (2 years)
3-20
Which Tax Form Should You Use?
•
•
≈ 800 federal tax forms and schedules
Basically the choice is between 3 forms
1040EZ
1040A
1040 -
•
Used by
20% of
taxpayers
Used by 60%
Which form to use?
–
Type of income
– Amount of income
– Number of deductions
– Complexity of tax situation
3-21
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
3-22
Federal Income Tax Form 1040
3-23
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
3-24
How Do I File My Taxes Online?
• Tax preparation software
–
H&R Block At Home (formerly Tax Cut) and
TurboTax 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
3-25
Selecting Tax Software
• Considerations:
– Personal situation
– Special tax situation
– Features in the software
• “Audit check”
• Future planning
• State tax filing online
– Technical aspects
• Hardware and operating system requirements
• Online support
3-26
How Do I File My Taxes Online?
• Free File Alliance
– Online tax preparation and filing free to
many taxpayers (depends on income)
– Go to: http://www.irs.gov
– Select: “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
3-27
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
3-28
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
3-29
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
3-30
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?
3-31
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%
3-32
What if Your Return is Audited?
≈ 1.0% 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
3-33
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 your tax preparer,
accountant or lawyer
– Be on time for your 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
3-34
Learning Objective LO3.4
Select Appropriate Tax Strategies
Tax Planning Strategies
• Practice tax avoidance
– Legitimate methods to reduce your tax
obligation to a minimum
– 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
3-35
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
3-36
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
3-37
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
3-38
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
3-39
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
3-40
Tax-Planning Strategies
Investment Decisions
Children’s Investments
•
Children under 19 or a full-time student under 24 with
investment income of more than $1,900 is taxed at
parents’ top rate
•
Under $1,900 qualifies for a $950 deduction, with
remainder taxed at child’s rate
Retirement Plans
- Traditional IRA
- Roth IRA
- Keogh Plan
- 401 (K) Plan
- Education IRA
3-41
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
3-42
Flat or VAT Tax?
• Flat tax
– All taxpayers pay the same rate
– Would increase taxes for many (pay their
fair share?)
• VAT = Value-Added Tax
– Taxes a product at each stage in the
manufacturing process
– Tends to start small and rise over time
3-43
Chapter Summary
Learning Objective LO3.1
• Tax planning can influence spending,
saving, borrowing, and investing
decisions.
• An awareness of income taxes, sales
taxes, excise taxes, property taxes,
estate taxes, inheritance taxes, gift taxes,
and Social Security taxes is vital for
successful financial planning.
3-44
Chapter Summary
Learning Objective LO3.2
• Taxable income is determined by
subtracting adjustments to income,
deductions, and allowances for
exemptions from gross income.
• Your total tax liability is based on the
published tax tables or tax schedules,
less any tax credits.
3-45
Chapter Summary
Learning Objective LO3.3
• The major sections of Form 1040 provide the
basic framework for filing your federal income
tax return.
• Main sources of tax assistance:
–
–
–
–
–
IRS services and publications
Other publications
The Internet
Computer software
Professional tax preparers such as commercial tax
services, enrolled agents, accountants, and
attorneys.
3-46
Chapter Summary
Learning Objective LO3.4
• Reduce your tax burden through careful
planning and making financial decisions
related to consumer purchasing, and the
use of debt, investments, and retirement
planning.
3-47