Tax Planning and Strategies. 4-2 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall Learning Objectives 1. Identify and understand the.

Tax Planning and Strategies

4-2Copyright © 2010 Pearson Education, Inc.  Publishing as Prentice Hall

Learning Objectives

1. Identify and understand the major federal income tax features that affect all taxpayers.

2. Describe other taxes that must pay.

3. Understand what is taxable income and how taxes are determined.

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Learning Objectives

4. Choose the tax form that’s right for you, file and survive an audit if necessary.

5. Calculate your income taxes.

6. Minimize your taxes.

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Introduction

Most financial decisions are affected by taxes.

Need to understand how taxes are imposed.

What strategies are used to reduce taxes and what role does tax planning have in personal financial planning?

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The Federal IncomeTax Structure

Progressive or graduate tax

Tax rates and tax brackets

Personal exemption

Itemized or standard deductions

Taxable income

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The Federal IncomeTax Structure

Taxable income is a function of adjusted gross income (AGI), deductions, and exemptions.

AGI = taxable income from all sources minus specific adjustments but before deducting standard or itemized deductions

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The Federal IncomeTax Structure

Assume you are in the 15% tax bracket. Does that mean you pay 15% of your taxable income in taxes?

The last dollar earned is taxed at 15%. Earlier income is taxed at the lower rate.

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Marginal Versus Average Taxes

Average Tax Rate—the average amount of your total income taken away in taxes.

Marginal Tax Rate (or marginal tax bracket)—the percentage of the last dollar earned that goes to pay taxes.

Tax-deferred—income on which the payment of taxes is postponed

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Effective Marginal Tax Rate

The rate you pay when all income taxes are combined (federal, state, city, Social Security taxes, etc)

Is greater than the marginal tax rate on federal income taxes.

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Capital Gains andDividend Income

Capital asset—an asset your own

Capital gain—what you make if you sell a capital asset for a profit

Capital loss—what you lose when you sell a capital asset for a loss.

Capital gains tax—tax you pay on your capital gains

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Capital Gains andDividend Income

Lower tax rate on both the long-term capital gains and on dividends.

Long-term capital gains tax on profits from the sale of stocks and bonds, not gains from sale of collectibles.

Capital gains are not claimed or taxed until the asset is sold.

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Long-Term CapitalGains on Homes

Capital gains taxes for most homeowners on sale of their homes

Exemption up to $500,000 for couples filing jointly ($250,000) filing single on sale of principal residence.

Must have been occupied for 2 of the 5 years prior sale

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Filing Status

Single

Married Filing Jointly and Surviving Spouses

Married Filing Separately

Head of Household

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Cost of Living Increases in Tax Brackets, Exemptions, and Deductions

Tax brackets change annually to reflect changes in the cost of living (inflation).

Standard deductions and personal exemptions are increased to reflect inflation.

Bracket Creep—tax increase caused by inflation increasing wages

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Paying Your Income TaxesPay-as-you-go basis.

Withholding from wages.

Quarterly estimated taxes sent to the IRS

Payments with tax return

Withholdings from stock dividends, retirement funds, and prize winnings.

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Paying Your Income Taxes

You have some control over how much is deducted for taxes from your wages.

Withholdings are determined by income level and information on W-4 form.

W-4 form (usually filled out with new employer)—marital status, number of exemptions claimed

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Other Taxes

Income-Based Taxes:Social Security or FICAState and local income taxes

Non-income-based taxesExcise taxesProperty taxesGift and estate taxes

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Calculating Your Taxes

Must you file a tax return?

Depends on income, filing status, age, whether you can be claimed as dependent.

Dependent—person you support financially.

Calculate taxes anyway to get any refund due to you.

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Step 1: Determining Gross or Total Income

Sum of all taxable income from all sources.

Active income—income from wages or a business

Portfolio or investment income--securities

Passive income—activities in which the taxpayer does not actively participate

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Step 2: Calculating Adjusted Gross Income (AGI)

Gross income less allowable adjustments

Adjustments include:Tax-deductible contributions Retirement contributions

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Step 3: Subtracting Deductions

Choose between standard deduction or itemizing deduction.

Itemize deductions—list of deductible expenses: medical expenses, tax expenses, mortgage interest payments, etc.

Standard deduction—government’s best estimate of what the average person would deduct if itemizing.

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Step 3: Subtracting Deductions

Take greater deduction between standard and itemized deduction.

Difficult to choose when they are close in value.

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Step 4: Claiming Your Exemptions

Exemption—deduction for each person supported by the income on a tax return.

An exemption includes yourself, spouse or dependents.

Dependent must qualify as child or dependent.

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Step 5: Calculating Your Taxable Income, and From That, Calculating

Your Base Income Tax Taxable income—subtract deductions and

exemptions from AGI

Base income tax—intersection of filing status and taxable income in the federal income tax tables.

Use tax rate schedules for taxable income greater than $100,000).

Alternative minimum tax (ATM) ensures that wealthy pay enough taxes.

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Step 6: Subtract Your Credits andDetermine Your Taxes Due

Tax credits reduce actual taxes paid.

Tax credits phase out as AGI increases.

Child CreditEducation CreditsChild and dependent care creditEarned income creditAdoption credit

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Other Filing Considerations

Choosing the right form between 1040EZ, 1040A, or 1040

Depends on dependents, income, itemizing.

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Other Filing Considerations

File by Mail or Electronic Filing (e-file)

Benefits of e-filing include:Faster refundsMore accurate returnsQuick electronic confirmationDelete the paperwork—nothing to mailFederal/state e-filing

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Filing Late and Amended Returns

File Late – Form 4868 - request an extension if unable to file by April 15th and include estimated tax payment.

Amended Return - Form 1040X – file within 3 years of original tax date.

Amend the state and local forms as well.

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Being Audited

Audit—an examination of tax return by IRS

Randomly selected—higher odds if itemized deductions are 44% of income.

Asked to send additional information in mail or IRS face-to-face interview.

Reexamine areas in question, get all data and records, appeal audit outcome if necessary.

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Help in Preparing Taxes

Handle taxes by yourself.

Use IRS publications, IRS hotlines, & self-help publications and computer programs.

Hire a tax specialist

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Model Taxpayers: The Taylors File Their 2007 Return

Chuck and Dianne Taylor

Using the various steps in calculating taxes for Form 1040

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Tax Strategies to Lower Your Taxes

Tax planning must be done ahead of time to minimize unnecessary tax payments.

Tax strategies should supplement a solid investment strategy.

There are five general tax stragies.

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Maximize Deductions—reduce taxable income to its minimum

1. Use tax-deferred retirement programs.

2. Use your home as a tax shelter.

3. Shift and bunch deductionss

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Look to Capital Gains and Dividend Income

15% is the maximum tax rate for long-term capital gains for taxpayers in tax brackets that exceed 15%.

Don’t have to claim capital gains until asset is sold.

Qualified dividends from corporations are taxed at same low rates as long-term capital gains.

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Shift Income to Family Members in Lower Tax Brackets

Can be complex and involve lawyers and establishment of trusts.

Simpler way is to make gifts—recipients do not pay taxes on gifts either.

Allowed $12,000 in total gifts per year.

Gift some of your estate while still alive.

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Receive Tax-Exempt Income

Interest from state and local government debt such as bonds is tax-exempt

The higher your marginal tax bracket, the more beneficial tax-free income is.

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Defer Taxes to the Future

Tax-deferred retirement plans allow your to defer tax payments to the future.

Roth IRAs allows taxes to be paid on contributions and never again.

Capital gains taxes are postponed until you sell the asset.

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Summary

Taxable income is a function of AGI, deductions and exemptions.

Apart from federal income tax, there are Social Security and Medicare taxes, state and local taxes, excise, sales, property, and gift and estate taxes.

To calculate taxes, determine total income, adjusted gross income, taxable income, then the taxes your owe.

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Summary

It is important to know if you must file a return, when to file, use the right form, and the information needed for the return.

Obtain the help you need for filing returns from the IRS, self-help tax books and computer programs and tax specialists.

There are five general strategies that can be used to reduce taxes to a minmum.

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