PFIN 4

Preparing Your Taxes

3

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GITMAN/ JOEHNK/ BILLINGSLEY

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1 Discuss basic principles of income taxes and determine your filing status

2 Describe the sources of gross income and adjustments to income, differentiate between standard and itemized deductions and exemptions, and calculate taxable income

3 Prepare a basic tax return using the appropriate tax forms and rate schedules

4 Explain who needs to pay estimated taxes, when to file or amend your return, and how to handle an audit

LEARNING OUTCOMES

PFIN4 | CH3

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5 Know where to get help with your taxes and how software can make tax return preparation easier

6 Implement an effective tax planning strategy

LEARNING OUTCOMES (continued)

PFIN4 | CH3

Taxes

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• Dues paid for membership in a society• Cost of living in a country

• Objective of tax planning • Maximize the amount of money that one can

keep by legally minimizing the amount one pays

PFIN4 | CH3

Income Taxes

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• Type of tax levied on taxable income by the federal, state, and local governments

• Progressive tax structure: Larger the amount of taxable income higher the rate at which it is taxed

• Marginal tax rate: Paid on the next dollar of taxable income

• Average tax rate: Rate at which each dollar of taxable income is taxed on average• Calculated by dividing the tax liability by

taxable incomePFIN4 | CH3

Categories of Filing Status

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• Single taxpayers• Married filing jointly• Married filing separately• Head of household• Qualifying widow or widower with

dependent child

PFIN4 | CH3

Take-Home Pay

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• Employer withholds a portion of income every pay period and sends it to the IRS to be credited to the tax account

• Employer withholds funds for federal income taxes and for FICA (Social Security) taxes

• Other payroll deductions• Life and health insurance, savings plans,

retirement programs, professional or union dues, and charitable contributions

PFIN4 | CH3

Taxable Income

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• Amount of income subject to taxes• Gross income: Total of taxpayer’s income

subject to federal taxes that includes:• Active income• Portfolio income• Passive income

PFIN4 | CH3

Exhibit 3.2

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Capital Gains Tax Categories as of 2013

PFIN4 | CH3

Adjustments to (Gross) Income

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• Allowable deductions from gross income• Educator expenses (limited), higher education

tuition costs (limited), IRA contributions (limited), self-employment taxes paid, self-employed health insurance payments

• Adjusted gross income (AGI)• Amount of income that remains after

subtracting all allowable adjustments to income from gross income

PFIN4 | CH3

Deductions

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Exemptions

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• Deductions from AGI based on the number of persons supported by the taxpayer’s income• Can be claimed for oneself, his/her spouse,

and dependents• Personal exemption can be claimed only once

PFIN4 | CH3

Considerations for Calculating Taxable Income

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Exhibit 3.4

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Taxable Income and the Amount of Taxes Due (2013)

PFIN4 | CH3

Filing Considerations

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• Estimated taxes: Payments required on income not subject to withholding that are paid in four instalments

• Usual filing deadline is April 15

PFIN4 | CH3

Filing Considerations

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• Time beyond the usual April 15 deadline during which taxpayers can file their returns without incurring penalties

File extension

• Filed to adjust for information received after the filing date of the taxpayer’s original return or to correct errors

Amended return

• Examination by the IRS to validate the accuracy of a given tax return

Tax audit

Tax Preparation Services

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• National and local tax services• Certified public accountants (CPAs)• Enrolled agents (EAs)• Tax attorneys• Computer-based tax returns

PFIN4 | CH3

Effective Tax Planning

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• Tax evasion: Illegal act of failing to accurately report income or deductions and failing to pay taxes

• Tax avoidance: Act of reducing taxes in ways that are legal and compatible with the intent of Congress

• Objectives of tax planning• To reduce taxes• To shift taxes• To defer taxes

PFIN4 | CH3

Tax Strategies

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• Maximizing deductions - Bunch deductions into one tax year if this allows you to itemize rather than take the standard deduction

• Income shifting: Taxpayer shifts a portion of income to relatives in lower tax brackets

• Tax-free and tax-deferred income• Some investments like municipal bonds

provide tax-free income• Tax deferred: income that is not subject to

taxes immediately but that will later be subject to taxes PFIN4 | CH3

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• Taxes • Income taxes• Progressive tax

structure• Marginal tax rate• Average tax rate• Federal withholding

taxes• Federal Insurance

Contributions Act (FICA) or social security tax

KEY TERMS

• Taxable income• Gross income• Adjustments to

(gross) income• Adjusted gross

income (AGI)• Standard deduction• Itemized deductions• Tax credits• Estimated taxes• Amended return

PFIN4 | CH5

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SUMMARY

• The objective of tax planning is to maximize the amount of money that you can keep by legally minimizing the amount of taxes you pay

• Calculating income tax involves several steps and many computations

• Tax income is calculated on the basis of tax rates, tax credits, tax forms and schedules, and the procedures for determining tax liability

PFIN4 | CH5