Chapter 4

Chapter 4Managing Income Taxes

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• Explain the nature of progressive income taxes and the marginal tax rate.

• Differentiate among the eight steps involved in calculating your federal income taxes

• Use appropriate strategies to avoid overpayment of income taxes.

Objectives


Introduction

• Tax Planning: Seeking legal ways to reduce, eliminate, or defer income taxes.

• Taxable Income: the income upon which income taxes are levied.


Taxes• Progressive income taxes and the marginal tax

rate– Taxes – amount owed as % income. Taxes are

compulsory charges imposed by government on its citizens and their property.

– Internal Revenue Service (or IRS)– Internal Revenue Code

• The progressive nature of the federal income tax– Progressive tax – is one that requires a

higher tax rate as income increases. – Regressive tax – is one that demands a

decreasing proportion of one’s income.


Progressive Nature of the Federal Income Tax

Taxable Income RateFirst $8700 10%Over $8700 but not over $35,350

15%Over $35,350 but not over $85,650 25%Over $85,650 but not over $178,650 28%Over $178,650 but not over $388,350

33%Over $388,350

35%4 - 5


Marginal Tax Rateand Financial Decisions

• Marginal tax rate is the rate at which your last dollar of income is taxed.

• Your effective marginal tax rate can be 43% and includes Medicare, Social Security, Federal, State and City

• Your average tax rate is lower.– Average tax rate: Proportion of total gross

income paid in income taxes.


How Your Income Is Really Taxed

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8 Steps in CalculatingYour Income Taxes

1. Determine your total income.2. Determine and report gross income after

subtracting exclusions such as gifts, inheritance, tax refunds, etc.

3. Subtract adjustments to income such as moving expenses, tuition and fees, student loan interest expense, etc. to determine the adjusted gross income (AGI).

4. Subtract either the IRS’s Standard Deduction for your tax status or itemize your deductions.


8 Steps in CalculatingYour Income Taxes

5. Subtract the value of your personal exemptions. ($3,800 Each Dependent)

6. Determine your preliminary tax liability based upon your taxable income.

7. Subtract tax credits for which you qualify.8. Calculate the balance due the IRS or the

amount of your refund.


The Processof Income Tax Calculation


Total Income• Income to include:

– Wages and Salaries– Commissions– Bonuses– Tips Earned– Interest and Investment Income– Retirement Income– Unemployment benefits– Gambling and Lottery Winnings

• Include capital gains and losses in Total Income. Long term gains or losses are taxed at 10% - 15% and short term gains or losses are taxed at your marginal tax rate.


Gross Income• Income to exclude from taxes:

– Gifts– Inherited money or property– Income from a carpool– Federal income tax refunds– Employee contributions to flexible spending

accounts– Reimbursements from flexible spending

accounts– Child support payments received


W-2 Form


Deductions

• Subtract either the IRS’s standard deduction for your tax status or your itemized deductions.

• Standard deduction depends on filing status.– $5,950 for single individuals – 2012 tax year– $11,900 for married couples – 2012 tax year


Deductions

• Itemized deductions: Medical and dental expenses• Amount must exceed 7.5% of total adjusted gross income for 2012.


Deductions

• Itemized deductions: Taxes you paid– Real Estate Property Taxes (home or land)– Personal Property Taxes – vehicle

registration, license fees– State, Local, and Foreign Income Taxes– State and Local Sales Taxes (instead of state

and local income taxes)


Deductions• Itemized deductions: Taxes you paid

– Interest Paid on Home Mortgage Loans– “Points”– Interest Paid on Home-Equity Loans– Interest paid on loans used for investments– Mortgage insurance premiums on new loans

after January 1, 2007 – Gifts to charity– Casualty and theft losses that is uninsured

and exceed 10% of your AGI


• Miscellaneous deductions in excess of 2% of adjusted gross income– Job search expenses– Moving expenses

• Other miscellaneous deductions allowed at 100%:– Gambling losses– Business expenses for workers with

disabilities

Deductions


Exemptions• Exemption (or Personal Exemption)• Subtract the value of your personal exemptions.• Each exemption reduces taxable income by

$3,800 for 2012• Claiming another person as an exemption

requires that you provide more than one-half of their support.

• What if you are claimed as an exemption?– If someone else claims you, you cannot claim

yourself.– The opposite is also true.


Tax Liability• Determine your preliminary tax liability based on your

taxable income using the tax-rate schedule or tax table.• Taxable income is the amount remaining after subtracting

adjustments, deductions and exemptions from your gross income.

• Subtract tax credits for which you qualify.– Tax Credit: Dollar-for-dollar decrease in tax liability.

• American Opportunity Credit – up to $2,500 tax credit per student

• Lifetime Learning Credit – up to $2,000 tax credit per return

• Earned Income Credit – Eligible if income less than $13,980 single or $19,190 married (no child)

• Child Tax Credit - $1,000 per child


Tax Credits

• American Opportunity Credit• Lifetime Learning Credit• Earned Income Credit• Child Tax Credit• Child and Dependent Care Credit• Retirement Savings Contribution Credit• Adoption Credit• Energy Saving Vehicle Credit


Tax Liability

• After subtracting your credits from your preliminary tax liability you arrive at your final tax liability.

• Add up all prior payments from tax withholding or estimated tax payments.

• Calculate the balance due the IRS or the amount of your refund.


Avoid Taxes ThroughProper Planning

• Practice legal tax avoidance, not tax evasion.• A dollar saved from taxes is really two dollars -

or more. Remember the time value of money ?• Opportunity cost• Earning another dollar to replace one given to

the IRS• Earnings on a dollar not given to the IRS


Reduce Taxable IncomeVia Your Employer

• Premium only plan (health care)• Flexible Spending Account - $2,500 Max.

after December 31, 2012(or FSA or Expense Reimbursement Account)

• Defined Contribution Retirement Plan:– Tax Sheltered Investments– Matching Contributions– 401(k) - $17,000 Max Limit– IRA - $5,000 Max Limit– Roth IRA - $5,000 Max


Reducing Taxable Income: Other Strategies

• Coverdell Education Savings Account• Qualified Tuition (Section 529) programs• Govt. savings bonds – Interest income deferred• Municipal bonds – Interest earned tax exempt• Postpone income such as bonus payments• Bunch deductions into one year• Take all of your legal tax deductions.


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Comparing Taxable and After-Tax Yields• After-tax yield using taxable yield formula:

– After-tax yield equals the taxable yield times (1 - federal marginal tax rate)

• Lets compare the yield of a 5.7% corporate bond vs. 4% tax-exempt municipal bond

• If someone has a 35% Marginal Tax Rate:– 5.7% taxable interest x (1.00 - 0.35)– 5.7% x 0.65– The answer is a 3.71 after-tax yield corporate

bond– A municipal bond with 4% is preferred since

interest is tax exempt


Top 3 Financial Missteps in Managing Income Taxes

People risk incurring more tax liability when they do the following:

1. Turn all you income tax planning over to someone else.

2. Over-withhold too much income to receive a refund next year.

3. Ignore the impact of income taxes in you personal financial planning.


Good Money Habits inManaging Income Taxes

• Reduce you income taxes by signing up for tax-advantaged employee benefits at your workplace.

• Contribute to you employer-sponsored 401(k) retirement plan at least up to the amount of the employer’s matching contribution.

• When practical, consider purchasing a home to reduce income taxes.

• Do your own tax return so you can learn how to reduce your income tax liability.

• Maintain good tax records.


Questions ?

Chapter 4

Documents

Transcript of Chapter 4