Tax PreparationFinancial Literacy

Federal Income Tax Structure

The Federal income tax is a progressive tax The higher your income, the more you

pay, both as a dollar amount and as a percentage.

Tax Freedom Day (see Facts of Life, page 102) Almost four months of your yearly income goes to

pay various taxes (30%)

Tax Vocabulary

Tax Brackets: Income ranges in which the same tax rates

apply For example: 15%, 25%, 35%, etc.

Personal Exemptions: An allowed reduction in your income before

taxes are computed You get one for yourself, one for your spouse,

and one for each dependent

Tax Vocabulary, continued

Deductions are: Expenses that reduce taxable income, such

as: Some medical expenses Mortgage interest paid State and local income taxes Charitable contributions

Itemized Deductions (expenses): Deductions are calculated using Schedule A

Tax Vocabulary, continued

Standard Deduction: A set deduction allowed by the IRS regardless

of your actual expenses You can itemize deductions or take the

standard deduction, but not both

Taxable Income: Income subject to taxes after deductions and

exemptions are subtracted from gross income

Tax Example

Gross income – exemptions – deductions = Taxable Income

Assuming you are married filing jointly with gross income of $70,000 and taxable income of $49,423, your taxes would be $6,564 (see Figure 4.4 on page 109)

Marginal Tax Rate This chart shows the

highest tax rates charged for the highest incomes over the last 100 years.

The Fiscal Cliff agreement raised the highest tax rate to 39.6% on the highest earners

Average vs Marginal Tax Rates

Marginal tax rates are the percentage paid on your highest level of income Marginal tax rate in the example is 25%

Average tax rates are your actual taxes divided by your taxable income (will be lower than the marginal rate): $6,564/$49,423 = 13.28%

Or by your gross income: $6,564/$70,000 = 9.38%

Filing Status

Single: You are single at the end of the year with no

dependents Married filing jointly:

You and your spouse combine incomes Married filing separately:

You and your spouse file separate returns Head of Household:

You are unmarried but have at least one dependent child living with you

Other Taxes You Pay

Social Security (FICA) 6.2% for Social Security 1.45% for Medicare

State and local income taxes Excise taxes:

Sales taxes, gas taxes, property taxes, taxes on liquor, cigarettes, jewelry, air travel, etc.

Gift and estate taxes

Who Has To File A Return?

If your income is greater than $20,900

If it is less than that, you might not need to file, depending on your circumstances (check with your tax advisor)

However, if your income is less than that and if you had taxes withheld, you will not get a refund unless you file a return.

Itemizing Deductions

The most common deductions are: Medical and dental expenses exceed 7.5% of

adjusted gross income Tax expenses (state and local can be deducted, but

not Federal, Social Security, or sales taxes) Home mortgage interest Charitable contributions Casualty and theft losses

A deduction will lower your tax bill, but not dollar for dollar

Standard Deduction

The standard deduction is the government’s best estimate on what the average person would be able to deduct by itemizing

Remember that you can take the standard deduction or you can itemize, but not both

See Figure 4.2 for standard deduction amounts (page 106)

Exemptions

Personal Take one for yourself and one for your spouse

Dependents: Must have a qualifying relationship (child, grandchild,

parents, stepparents, uncles, nieces, etc.)• The dependent can’t earn more than the exemption

amountdoes not apply to children under 19 or to

children under 24 if full-time students Must provide more than half of dependent’s financial

support

Tax FormulaGross Income: Sum of Income from all sources

Less

Adjustments to gross income: tax-deductible expenses and retirement contributions (IRA, 401K), moving expenses, etc.

Equals

Adjusted Gross Income

Less

Exemptions and deductions

Equals

Taxable income

Calculating Your Base Income Tax

For most taxpayers, this is calculated using tax tables (see page 109)

Tax tables have tax brackets built in

Once taxes have been calculated, credits can be deducted

Common Income Tax Credits

Tax credits will lower your tax bill, dollar for dollar. Examples: Child Tax Credit (this can become a refund for parents

who don’t pay taxes) up to $1000 per child American Opportunity Credit

Credit for tuition, up to $2500 of the first $4,000 of educational expenses

Child and dependent care credit Credit for money paid for child or other dependent care

Earned income credit For low-income families, may result in negative taxes paid

Income Tax Due

Base Income Tax

Less

Tax Credits

Equals

Total Income Tax Due

Picking a Tax Form

Options: 1040EZ, 1040A, or 1040 1040EZ:

No dependents, taxable income less than $50,000, no itemizing deductions

1040A: No itemizing, alimony, capital gains, pension

or Social Security benefits; income less than $50,000

1040: everyone else