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Chapter 4

Tax Planning and Strategies

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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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Table 4.1 Tax Rates and Brackets

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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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Figure 4.1 Historical Top Marginal Income Tax Rate

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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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Figure 4.3Calculating Your Taxes

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Table 4.2 Comparison of Education Credits

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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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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 strategies.

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Look to Capital Gains and Dividend Income

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

• 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 $13,000 in total gifts per year.

• Gift some of your estate while still alive.

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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.