Garman/Forgue

Personal FinanceNinth Edition

Chapter 4

Managing

Income Taxes

4 | 2

Learning Objectives

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

2. Learn the eight steps involved in calculating your federal income taxes.

3. Use appropriate strategies to avoid overpayment of income taxes.

4 | 3

4 | 4

1. Progressive Taxes AND THE Marginal Rate• Income tax is a progressive tax

• Progressive vs. Regressive taxes

• Marginal Tax Bracket– Our income is taxed at six different rates

– Our MTB is the rate that is applied to our last dollar of earnings

• Average tax rate: the proportion of our total income that we pay in income taxes

4 | 5

• There are five filing status categories.– Single – Married, filing jointly– Married, filing separately– Head of household

• Unmarried individual or surviving spouse who maintains a household for a child or dependent relative

– Qualifying widow or widower (2 years)

WHO MUST FILE?You must file if your gross income exceeds the allowed

amount:S = $9750 or if a dependent $5950

M/J = $19,500

4 | 6

1. Determine Your Total Income

• Total Income: Compensation from all sources.

– Wages and Salaries

– Commissions

– Tips Earned

– Gambling and Lottery Winnings

– Gifts

– Federal income tax refunds

– Capital gains and losses

– … and more (see pg 110)

4 | 7

W-2 Form

4 | 8

2. Subtract Adjustments to Income to Find Your AGI

Examples of items to be subtracted:

– Educator expenses

– Alimony paid

– Interest on student loans

– Moving expenses for new job

– …and more (page 112)

= Adjusted Gross Income (or AGI)

4 | 9

3. Subtract Deductions• Use 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

– $11,900 for married couples

• Itemized deductions can include:

– A % of Medical and dental expenses

– Taxes you paid (Real Estate / Property Taxes, State & Local Income Tax, etc.or State Sales Tax)

– Interest Paid on Home Mortgage Loans

– Gifts to charity

– Casualty and theft losses

– A % of Job Expenses and Miscellaneous deductions

– And more! (see page 114-117)

CHOOSE THE HIGHER

AMOUNT IN ORDER TO

ARRIVE AT THE LOWEST

POSSIBLE TAXABLE INCOME

4 | 10

4. Subtract Exemptions to find Your Preliminary Taxable Income

• Exemption: a specific amount ($3800) deducted from AGI – based on # of people supported by your income

• Each exemption reduces taxable income by $3800

• Yourself, spouse, and qualified dependents

– Certain criteria for “dependent” status

• Important: If someone else claims you, you cannot claim yourself

= Your Taxable Income

4 | 11

5. Determine Your Preliminary Tax Liability

• Look up your taxable income in the Tax Tables to find your preliminary tax liability for the year

• Be sure to look at the correct filing status

You’re almost done!

FULL SCENARIO OF THIS ON PG 118!!

4 | 12

• Tax Credit: Dollar-for-dollar decrease in tax liability

• You may take tax credits even if you don’t itemize

• Credits are subject to income limits

• Nonrefundable vs. Refundable tax credits Hope Scholarship Credit Lifetime Learning Credit Earned Income Credit Child Tax Credit Child and Dependent Care Credit Retirement Savings Contribution Credithttp://www.walletpop.com/blog/2010/01/22/common-tax-credits-explained/

= Total Tax Liability

6. Subtract Tax Credits for Which You Qualify

PG. 119-120

4 | 13

• Credits compared to Deductions?– One is directly subtracted from your tax liability

– The other is subtracted from your taxable income, so it reduces your overall tax liability by a certain percentage

Your AGI is $60,000 and your itemized deductions total $10,000.

What is worth more (and by how much)?…

a) an additional $1,000 deduction or

b) a $1,000 tax credit?

AGI = $60,000 - $10,000 (Itemized deductions)

$50,000Tax Liability for $50,000 => $8850

AGI = $60,000 - $11,000 (Additional $1000 deduction)

$49,000Tax Liability for $49,000 => $8600

a) Additional $1000 deduction reduces tax liability to: $8600 (Reduces it by $250)

b) A $1000 tax credit reduces tax liability to: $7850 (Reduces it by $1000)

4 | 14

Tax Liability

• Compare your Total Tax Liability to the amount you actually paid (refer to your W-2)

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

4 | 15

“Overwithholding” creates a Tax Refund

4 out of 5 taxpayers purposely do this

Average refund last year = $3000

Should it be viewed as a “windfall”?

What about the opportunity cost?

Should it be viewed as a form of “forced savings”?

Why not save on your own… and earn interest?

GOAL: to BREAK-EVEN

Decrease the amount withheld by adjusting your W-4

4 | 16

Avoid Taxes Through Proper Planning

• Practice legal tax avoidance, not tax evasion

– Which one is legal?

• Many strategies for reducing taxes

• Reduce taxable income via your employer

– Flexible Spending Account (use-it-or-lose-it!)

– Defined Contribution (401K) retirement plans

4 | 17

Use Tax-Sheltered Investments to Reduce Tax Liability

• Tax-Sheltered Investments: Investments that yield returns that are tax advantaged

• Investments using pretax dollars

• Investments that offer tax-deferred growth

• IRA investments

• Roth IRA investments

• Qualified Tuition (529) programs

• Govt. savings bonds

• Municipal bonds

4 | 18

Other Strategies to Reduce Tax Liability

• Postpone Income

• Accelerate Deductions

• Shift income to a child

• Bunch deductions / prepay some items

4 | 19

Top 3 Mistakes in Managing Income Taxes

1. Turning all your income tax planning over to someone else

2. Overwithholding too much income to receive a refund next year

3. Ignoring the impact of income taxes in your personal financial planning

4 | 20

Rules for Dependents:http://www.irs.gov/publications/p929/ar02.html#en_US_2012_publink1000203740

2012 1040 tax form: http://www.irs.gov/pub/irs-pdf/f1040.pdf

2012 Schedule A:http://www.irs.gov/pub/irs-pdf/f1040sa.pdf

2012 1040 EZ:http://www.irs.gov/pub/irs-pdf/f1040ez.pdf