Chapter 3

Taxes in Your Financial Plan

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Taxes in Your Financial Plan

1. Identify the major taxes paid by people in our society

2. Calculate taxable income and the amount owed for federal income tax

3. Prepare a federal income tax return

4. Select appropriate tax strategies for various life situations

Chapter Objectives

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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 your fair share but still taking advantage of tax benefits.

Objective 1Identify the Major Taxes Paid by

People in Our Society

Planning Your Tax Strategy

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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

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What Tax Records to Keep

• Current tax forms and instruction booklets• Social security numbers• Copy of previous year’s returns• W-2 forms from employers• 1099 forms (interest, self employment)• 1098 (mortgage interest paid)• Receipts and documentation for expenses• Investment & business expense documents

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Objective 2Calculate Taxable Income and the

Amount Owed for Federal Income Tax

Step 1: Determine AGI

AGI = Adjusted Gross Income

Taxable Income

Net income = income on which tax is computed

Gross income minus deductions

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Objective 2Calculate Taxable Income

Main Components of Gross Income• Earned income

• Usually includes wages, salary, commissions, fees, tips or bonuses

• Investment income • Money received in the form of dividends, interest or

rent from investments• Passive income

• Results from business activities in which you do not directly participate such as a limited partnership

• Other income• Alimony, awards, lottery winnings and prizes

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Objective 2Calculate 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)

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Objective 2 Calculate Taxable Income

• Adjusted gross income (AGI)

– Gross income reduced by certain reductions

– The basis for computing various deductions

• Adjustments to income

– Reduce AGI

– Contributions to a traditional IRA or Keogh

– Alimony payments

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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

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Calculate Taxable Income Itemized Deductions

• Medical & dental expenses (>7.5% of AGI)

• Taxes• Interest• Contributions • Casualty and theft loses• Moving expenses• Job-related and other miscellaneous

expenses

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Calculate Taxable Income Exemptions

• Exemptions subtracted from AGI

– An exemption = a deduction for yourself, your spouse and qualified dependents

– The amount of the exemption for the 2008 tax year is $3,500 per person

– After deducting exemptions you have your taxable income

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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.

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2008 IRS Tax Brackets

Rate on Taxable Income

Single TaxpayersMarried Taxpayers

Filing JointlyHead of Households

10% up to $8.025 up to $16,050 up to $11,450

15% $8,025-$32,550 $16,050-$65,100 $11,450-$43,650

25% $32,550-$78,850 $65,100-$131,450 $43,650-$112,650

28% $78,850-$164,550 $131,450-$200,300 $112,650-$182,400

33% $164,550-$357,700 $200,300-$357,700 $182,400-$357,700

35% Over $357,700 Over $357,700 Over $357,700

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2008 IRS Tax ExampleTax on a single taxpayer’s income of $40,000

Rate on Taxable Income

Single TaxpayersTaxable Amount

Tax Due

10% up to $8.025 $8,025 $802.50

15% $8,025-$32,550 $24,525 $3,678.75

25% $32,550-$78,850 $7,450 $1,862.50

28% $78,850-$164,550 $40,000 $6,343.75

33% $164,550-$357,700

35% Over $357,700

Average Rate 15.86% = $6343.75 / $40,000Marginal Rate 25.00%

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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)

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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

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Objective 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• Hope Scholarship and Lifetime Learning

credits

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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

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Determining Your

Tax Liability

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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.

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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 can result in penalties of 50 to 75 percent

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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.

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Which Tax Form Should You Use?

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

1040EZ1040A1040

• Which form to use?– Type of income– Amount of income– Number of deductions– Complexity of tax situation

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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

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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

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How Do I File My Taxes Online?

• Tax preparation software– TurboTax and TaxCut 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

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How Do I File My Taxes Online?

• Free File Alliance– Online tax preparation and filing free to

many taxpayers– http://www.irs.gov - go to “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

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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

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Available Tax Assistance Sources

• Tax publications – e.g. Ernst and Young Tax Guide and J.K.

Lasser’s Your Income Tax

• The Internet – 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

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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

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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?

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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%

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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

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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 you tax preparer,

accountant or lawyer– Be on time for you’re 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

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Objective 4Select Appropriate Tax

StrategiesTax Planning Strategies

• Practice tax avoidance– Legitimate methods to reduce your tax

obligation to your fair share but no more– 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

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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

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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

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Tax-Planning StrategiesConsumer 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

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Tax-Planning StrategiesInvestment 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

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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

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Tax-Planning Strategies Investment Decisions

Children’s Investments

Children under 14 with investment income of more

than $1500 are taxed at parent’s top rate

Retirement Plans– Traditional IRA

– Roth IRA

– Education IRA

– Keogh Plan

– 401 (K) Plan

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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

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