Chapter 4: Managing Income Taxes Garman/Forgue Personal Finance Tenth Edition PPT slide program...

Chapter 4:Managing Income Taxes

Garman/Forgue

Personal FinanceTenth Edition

PPT slide program prepared by Amy Forgue and Ray Forgue.

Copyright ©Cengage Learning. All rights reserved. 4 - 2

Introduction

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

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


Your Next Five Years

In the next five years :

1. Sign-up for tax-advantaged employee benefits at your workplace.


Your Next Five Years

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

3. Buy a home to reduce income taxes.

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

5. Maintain good tax records.


Learning Objective #1

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


Income Taxes

Taxes are compulsory charges imposed by government on its citizens.

Internal Revenue Service (or IRS)

Internal Revenue Code


Progressive Taxes

The progressive nature of the federal income tax.

A Progressive Tax is one that requires a higher tax rate as income increases.

A Regressive Tax is one that demands a decreasing proportion of one’s income.


The Marginal Tax Rate

Marginal tax bracket (or MTB)

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

Indexing

Table 4.1: Progressive Nature of the Federal Income Tax

Taxable Income Rate

First $8350 10%

Over $8350 but not over $33,950 15%

Over $33,950 but not over $82,250 25%

Over $82,250 but not over $171,550 28%

Over $171,550 but not over $372,950 33%

Over $372,950 35%



Marginal Tax Rate and Financial Decisions

Decreasing your taxable income saves you more in taxes as your marginal tax rate goes up.

Additional taxable income costs you more in taxes as your marginal tax rate goes up.

The amount saved or added is equal to your marginal tax rate times the amount the taxable income goes down or up.


Marginal Versus Average Tax Rates

Your effective marginal tax rate can be 43% when state income and Social Security taxes are included.

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

income paid in income taxes.

Figure 4.1: How Your Income Is Really Taxed


Concept Check 4.1

Distinguish between a progressive and a regressive tax.

What is a marginal tax bracket, and how does it affect taxpayers?

Explain why many taxpayers have a marginal tax rate as high as 43 percent.




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


8 Steps in Calculating Your Income Taxes

1. Determine your total income.

2. Determine and report gross income after subtracting exclusions.



3. Subtract adjustments to income to arrive at your adjusted gross income (AGI).



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

5. Subtract the value of your personal exemptions.

6. Determine your preliminary tax liability.



7. Subtract tax credits for which you qualify.

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

Figure 4.2: The Process of Income Tax Calculation



Total Income

Total Income: Compensation from all sources.


Total Income

Income you might receive: Wages and Salaries Commissions Tips Earned Interest and Investment Income Retirement Income Scholarships Bonuses


Total Income

Also include capital gains and losses in total Income. Long-term gains (or losses) are taxed

at 10 or 15%. Short-term gains (or losses) are taxed

at your marginal tax rate.

Figure 4.3: W-2 Form



Gross Income

Determine and report your gross income


Gross Income

Certain types of income such as gifts that do not have to be reported are called exclusions. : Gifts Inherited money or property Life insurance benefits Child support payments Scholarships


Subtract Adjustments to Income

Adjustments to Income are subtractions allowed for such things as IRA contributions, alimony paid, student loan interest paid.

Adjusted Gross Income (or AGI) is the result after subtracting adjustments from gross income.


Deductions

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

Standard deduction depends on filing status. $5,700 for single individuals (2009) $11,400 for married couples (2009)


Itemized Deductions

Medical and dental expenses

You may subtract amounts that exceed 7.5% of your AGI.


Itemized Deductions

Taxes you paid: Real Estate Property Taxes (home or

land) Certain Personal Property Taxes State, Local, and Foreign Income Taxes State and Local Sales Taxes (instead of

state and local income taxes)


Itemized Deductions

Certain interest you paid

Interest Paid on Home Mortgage Loans

Mortgage Interest “Points”

Interest paid on loans used for investments


Itemized Deductions

Gifts to charity of cash or goods


Itemized Deductions

Uninsured casualty and theft losses that exceed 10% of your AGI


Miscellaneous deductions in excess of 2% of adjusted gross income

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

disabilities

Itemized Deductions


Exemptions

Exemptions (or Personal Exemptions) are based on the number of people supported by the taxpayer’s income.

Each exemption reduces taxable income by $3650 (2009).


Exemptions

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.


Your Preliminary 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.

Table 4.3: Tax Table Example

At Less

Least Than Single Married

23,550 23,600 3119 2701

23,600 23,650 3126 2709

26,050 26,100 3494 3076

26,100 26,150 3501 3084

26,300 26,350 3531 3114

26,350 26,400 3539 3121



Subtract Tax Credits

Subtract tax credits for which you qualify from your preliminary tax liability.

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


Tax Credits

American Opportunity Tax Credit

Lifetime Learning Credit

First-Time Home Buyer Credit

Earned Income Credit


Tax Credits

Child Tax Credit

Child and Dependent Care Credit

Retirement Savings Contribution Credit

Energy-Savings Tax Credits


Final 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.

Concept Check 4.2

Give five examples of income that must be included in income reported to the Internal Revenue Service.

How are long-term and short-term capital gains treated differently for income tax purposes?

Give five examples of income that is excluded from IRS reporting.


Concept Check 4.2

List three examples of adjustments to income.

Distinguish between a standard deduction and a personal exemption.

What advice on filing a Form 1040X can you offer someone who did not file a federal income tax return last year or in any one of the past three years?

List five examples of tax credits.




Use appropriate strategies to avoid overpayment of income taxes.


Avoid Taxes Through Proper Planning

Practice legal tax avoidance, not tax evasion.


Avoid Taxes Through Proper Planning

A dollar saved from taxes is really two dollars - or more. The opportunity cost of the use of the

dollar paid as taxes. Earning another dollar to replace one

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


Reduce Taxable Income Via Your Employer

Premium only plan

Transportation reimbursement plan

Flexible Spending Account (or FSA or Expense Reimbursement Account)


Reduce Taxable Income Via Your Employer

Defined Contribution Retirement Plan 401(k) Retirement Plan

Matching Contributions


Make Tax-Sheltered Investments

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



Investing with pretax income

Tax-deferred investment growth

IRA\Roth IRA



Coverdell Education Savings Account

Qualified Tuition (Section 529) programs

Govt. savings bonds



Municipal bonds

Capital Gains on Housing


Reducing Taxable Income: Other Strategies

Postpone income.

Bunch deductions.

Take all of your legal tax deductions.


Comparing Taxable and After-Tax Yields

After-tax yield taxable yield formula: After-tax yield equals The taxable yield times (1 - federal marginal tax rate) Example for someone with a 35% MTR:

5.7% taxable x (1.00 - 0.35) 5.7% x 0.65 The answer is a 3.71 after-tax yield

Concept Check 4.3

Distinguish between two types of tax-sheltered investment returns.

Explain how to reduce income taxes via your employer, and name three employer-sponsored plans that do so.


Concept Check 4.3

Summarize the differences between an IRA and a Roth IRA.

Identify three strategies to avoid overpayment of income taxes, and summarize each.



Top 3 Financial Missteps in Managing Income Taxes

People slip up in managing income taxes when they do the following:

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

2. Overwithhold income to receive a refund next year.

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

Do It NOW!

Managing your income taxes should not wait until you file in the spring. Start today by:

1. Projecting your taxable income and total withholding for this year.

2. Estimating your federal tax liability based on your income projection using this year’s tax tables or schedules.


Do It NOW!

3. Revising your W-4 form with your employer as necessary to withhold more if you estimate owing more in taxes or to withhold less to get an immediate raise in take-home pay if you expect a refund.


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