Chapter 3

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 tax liability

Goal: Paying your fair share but still taking advantage of available tax benefits

3 Taxes in Your Financial Plan

Planning Your Tax Strategy

3-1

Objective 1Identify the Major Taxes Paid by

People in Our Society Taxes on Purchases

– Sales tax and excise tax (e.g., gas, cigarettes)

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 tax

3-2

The Progressive Nature of the Federal Income Tax

• Progressive tax – takes a larger percentage of income from high-income taxpayers than low-income taxpayers.

– Federal income tax

• Regressive tax – as income rises, the tax demands a decreasing proportion of a person’s income as income increases.

– State sales tax

Objective 2Calculate Taxable Income and the

Amount Owed for Federal Income Tax

Step 1: Determine AGI

Gross income:Earned income (wages, salary, tips, bonuses)

Investment income (dividends, interest)

Passive Income (business limited partnerships)

AGI = Adjusted Gross Income

Gross income minus adjustments

3-4

Objective 2Calculate 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

3-5

Calculate Taxable Income Exemptions

Exemptions also subtracted from AGI

– An exemption = a deduction for yourself, your spouse, and qualified dependents (increases annually for inflation)

– After deducting deductions and exemptions from AGI, you have taxable income

3-6

Objective 2Calculate 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.

3-7

Objective 2Calculate 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)

3-8

Objective 2Calculate 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

3-9

Objective 2 Calculate Taxes Owed

Tax Credits– Amount subtracted directly from the

amount of taxes owed

– Examples:• Earned income credit

• Foreign tax credits

• Child and dependent care credits

• Retirement tax credits (for savings plans)

• Adoption tax credits

• Hope Scholarship and Lifetime Learning credits

3-10

Tax Credit Versus Tax Deduction

$100 Tax CreditReduces Your Taxes by $100

$100 Tax DeductionAmount Your Taxes are Reduced

is Based on Your Tax Bracket

3-11Example: $5,000 x .25 mtb = $1,250 of tax savings

Determining Your

Tax Liability

3-12

Objective 2Calculate 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.

Who has to send the IRS estimated tax payments?

3-13

Objective 2Calculate 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

3-14

Objective 3 Prepare a Federal Income Tax

Return

• 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)

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.

3-15

Which Tax Form Should You Use?

• ≈ 400 federal tax forms and schedules• Basically the choice is between 3 forms

1040-EZ- (under $100k income, no itemizing/credits, no > $1,500 interest)

1040A- (IRA and child care credit, <$100k income, no itemizing)

1040- (“long form;” all income, credits, itemized deductions)

• Which form to use? It depends…– Type of income

– Amount of income

– Number of deductions

– Complexity of tax situation

3-16

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

3-17

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

3-18

Also tax preparation software, Free File Alliance (online filing), IRS services and VITA volunteers

Evaluating Tax Services

Factors to consider:

• Training and experience of 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?

3-19

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%

3-20

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

3-21

Objective 4Select Appropriate Tax

StrategiesTax Planning Strategies

• Practice Tax Avoidance– Legitimate methods to reduce your tax

obligation to your fair share but no more (e.g., deductions & credits, HSAs, tax-deferred/tax-free investing)

– Financial decisions related to purchasing, investing, and retirement planning are the most heavily affected by tax laws (e.g., home, IRAs)

– Keep good tax records (W-2s, 1099s, receipts, copies)

• Tax Evasion– Illegally not paying all the taxes you owe, such

as not reporting all income

3-22

Tax Planning StrategiesMinimizing Taxes

If you expect Then you should Because

The same or a lower tax rate

next year

Accelerate deductions into

this year

Greater benefit to higher rate

The same tax rate next year

Delay income into next year

Delay paying taxes

A higher tax rate next year

Delay deductions Greater benefit

Accelerate income Taxed at lower rate

3-23

Wrap Up

• Chapter Quiz

• Concept Check 3-1: Which Type of Tax?

• Is it Taxable? Is it Deductible?

• Concept Check 3-2- Tax Deduction or Tax Credit?

• Concept Check 3-3- Which Tax Form?

• Concept Check 3-4- Tax-Exempt or Tax-Deferred?