Paying Taxes © 2010 Pearson Education, Inc. All rights reserved Chapter 6.

Paying Taxes

© 2010 Pearson Education, Inc.All rights reserved

Chapter 6

Learning Objectives

• Describe the basic principles of taxation and the major categories of taxes.

• Explain payroll taxes

• Describe the purpose and process of filing tax returns

• Explain how taxes affect your financial plan

© 2010 Pearson Education, Inc. All rights reserved 0-2

Tax Basics

• Tax is money collected by a government from its citizens for the purpose of operating the government

• Gross pay is the total amount of money you earn• Take-home pay is the amount of money you get to

keep and use• Net Pay is the amount of money you take home


Tax Basics

• Everyone pays taxes • Taxes pay the cost of government• The government levies taxes on different things• States can have different taxes too• There are all different types of taxes, such as:

– Sales Taxes

– Real Estate Taxes

– Payroll Taxes


Math for Personal Finance

• Ryan’s take-home or net pay was $147.76 and his gross pay was $160.00. Assume the FICA withholdings are 7.65. How much did Ryan pay in FICA from this check?



• Solution: Solution: Ryan paid 7.65 percent of the $60 or $12.24 in FICA from this check.


Sales Tax

• Sales tax is tax on purchases at a store

• Some of the price we pay for an item is a tax

• The merchant collects this money and sends it to the government

• The federal government does not impose a sales tax

• Many state governments do impose a sales tax


Real Estate Tax

• Governments calculate real estate taxes based on the value of the property

• The government sends the property owner a bill for this tax

• These taxes are primarily used to fund local schools

• They also vary significantly from state to state and county to county.


Payroll Taxes

• Payroll Taxes are taxes on your paycheck

• Many people pay taxes every time they get paid

• These taxes can include federal and state income taxes and social security (or FICA) withholdings.

• People who are self employed do not have taxes withheld from their earnings.

• See figure 6.1 for an example of a pay stub


Figure 6.1


The Internal Revenue Service

• Internal revenue service (IRS) is the government body that carries out the federal tax system

• The IRS is a branch of the United States Treasury Department

• They enforce the tax laws and collect taxes

• Each year in which you earn an income over a certain amount, you need to file a federal tax return with the IRS



• Tax returns report to the IRS all the information relative to your income taxes

• A tax return consists of a form called 1040 or 1040EZ (see Figure 6.2 a &b)

• On this form you need to include how much income you earned and how much you paid to the IRS

• You will either receive a refund or pay the difference to the government if you owe money


Figure 6.2a


Figure 6.2b



• Taxes are figured based on your earnings from January to December

• When the year is over, you have until April 15th to file your return

• Many careers involve helping people take advantage of tax laws to pay the lowest possible tax

• Attorneys and accountants make good incomes by helping people with tax issues


Check Your Financial IQ

• What is the major purpose of taxes?



• Taxes pay the cost of government


Understanding Payroll Taxes

• Personal Income Taxes are federal income taxes and state income taxes (the states that have them)

• Social Security provides payments to eligible retirees and disabled people

• Medicare provides health care coverage to mostly older Americans and some younger disabled people

• Payroll taxes include:

– Social Security and Medicare taxes

– Personal income taxes (state and federal)


Social Security and Medicare

• For most Americans, earned income is subject to FICA taxes

• FICA taxes are withheld from your paychecks and sent to the government

• These withholdings fund Social Security and Medicare

• For both Social Security and Medicare, your employer matches your contributions and sends the total amount to the government


Social Security and Medicare

• Your portion of the Social security tax is equal to 6.20 percent of your salary—up to a specific income level

• This amount is linked to inflation and increases slightly every year

• There is no cap on the amount of earnings subject to the Medicare tax



• Brogan’s grandfather made $112,000 in 2007, and the Social Security cap in 2007 was $97,5000.

• How much Social Security was withheld from his pay and how much Medicare was withheld from his pay?



• Solution: Brogran’s grandfather had 6.2% withheld from his pay for the first $97,500 he made during 2007 for a total of $6,045 or (.062 x $97,500). However, Medicare was withheld on the entire amount so Medicare withholdings were $112,000 x .0145 = $1,624.


Personal Income Taxes

• Personal income taxes is the income reported on your tax return

• Many people use a tax professional or tax preparation software for returns.

• These programs guide you through preparing your tax returns and include all the necessary forms

• Refer to Figure 6.3 for the IRS table of individual tax rates


Figure 6.3


Other Income Taxes

• Many people pay a state income tax, depending on where they live

• Some cities also collect income taxes

• Take a look at figure 6.4 for a listing of states with the highest and lowest tax rates


Figure 6.4



• What are the payroll taxes?



• Federal and state income taxes, Social Security, and Medicare are payroll taxes


Filing Taxes

• A tax return form allows you to record several different categories of information, including:– Filing Status– Exemptions– Gross Income– Adjusted gross income– Tax and credits


Filing Status

• Taxpayers need to specify a filing status when they submit their income tax return

• They must choose one of the following options: – Single– Married filing jointly– Married filing separately– Head of household– Qualifying widow(er) with dependent child


Filing Status

• Tax rules and rates differ depending on which status you choose

• Until the age of 18, most of you will be considered dependents by the IRS


Gross Income or Total Income

• Gross income is the total income consisting of the total amount of a person’s income from (almost) any source

• The first step in calculating the federal tax you owe is to determine your gross income

• Your employer will send you a W-2 form that details how much money you made

• See Figure 6.5 for a sample W-2 form


Figure 6.5


Gross Income or Total Income

• Capital gains occur when you sell an asset for more than what you paid for it

• Other forms of income include interest income, dividend income, and capital gains

• Gross income also includes income from tips, rental properties, and business income.

• Some types of income are not included in gross income and therefore are not taxes, such as: – Insurance reimbursements– Child support payments– Veteran’s welfare benefits


Adjusted Gross Income

• Adjusted gross income is figured by taking the total income and subtracting certain allowable amounts

• The next step in filing a tax return is to figure your adjusted gross income, or AGI.

• The allowable amounts include :– contributions to certain retirement

accounts

– alimony payments

– interest paid on student loans



• Last year Colt’s salary was $32,000 but he also received $1,200 in dividend income and lost $400 on the sale of one stock and gained $650 on the sale of another stock.

• What was Colt’s gross income?



• Solution: Colt’s gross income was $32,000 + $1,200 - $400 +$650 = $33,450


Deductions and Exemptions

• Standard deduction is a fixed amount all people are allowed to deduct from their AGI to reduce their tax liability

• Itemized deductions are specific expenses that, under tax law, can be deducted from income to reduce the amount of income subject to income tax

• You may be able to claim various deductions and exemptions that will reduce the amount of your AGI that is subject to your income taxes.

• These deductions include:– Standard deduction– Itemized deduction


Deductions and Exemptions

• Congress has approved certain items as tax deductible in order to encourage certain behaviors

• For example, Congress encourages home ownership

• Homeowners can deduct the interest paid on a mortgage loan and the real estate taxes they pay


Refund or Payment

• Accurate completion of your tax return will show you if you need to pay additional income taxes or if you will receive a refund

• In most cases, you will not receive a refund unless you pay taxes during the year



• When does a person file his or her taxes?



• A person fills out a tax return by April 15 of each year


Taxes and Your Financial Plan

• People want to lower their tax liability to the lowest possible level for their income

• They will keep more of their own money rather than paying it to the government in taxes

• Tax planning influences both your short-term and long-term future

• Consider the tax implications of your financial life at all stages



• Why are taxes an important part of your financial plan?



• You must consider the tax consequences of all your financial decisions because the tax impact may make one course of action better than another


Summary

• Taxes are monies the government collects from citizens for the purpose of operation the government

• The government collects taxes in a variety of ways and forms:– Sales taxes– Real estate taxes– Payroll taxes

• The IRS is the governmental body that carries out the federal tax system


Summary

• Payroll taxes include personal income taxes (state and federal) and Social Security and Medicare taxes

• Social Security and Medicare taxes are also known as FICA

• Filing taxes involves reporting your earnings for the year on a tax return.

• This is sent to the IRS and to any appropriate state or local tax collection agency


Summary

• Tax planning is another important step in your financial plan

• Taking full advantage of the ways to reduce your taxable income takes planning


Key Terms and Vocabulary

• Adjusted gross income

• Capital gain

• Gross income

• Gross pay

• Internal Revenue Service (IRS)

• Itemized deduction

• Medicare

• Net pay

• Payroll tax

• Personal income tax

• Sales tax

• Social security

• Standard deduction

• Take-home pay

• Tax

• Tax return


Websites

• www.irs.gov

• www.taxadmin.org/fta/rate/ind_inc.html


Paying Taxes © 2010 Pearson Education, Inc. All rights reserved Chapter 6.

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