Chapter 3 Taxes in Your Financial Plan McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Taxes in Your Financial Plan Chapter Objectives Identify the major taxes paid by people in our society Calculate taxable income and the amount owed for federal income tax Prepare a federal income tax return Select appropriate tax strategies for various life situations 3-2

Objective 1 Identify the Major Taxes Paid by People in Our Society Planning Your Tax Strategy Start planning for taxes …. Goal: 3-3

Types of Taxes Taxes on Purchases Taxes on Property Taxes on Wealth Taxes on Earnings 3-4

What Tax Records to Keep Current tax forms and instruction booklets Social security numbers Copy of previous year’s returns W-2 forms from employers 1099 forms (interest, self employment) 1098 (mortgage interest paid) Receipts and documentation for expenses Investment & business expense documents 3-5

Objective 2 Calculate Taxable Income and the Amount Owed for Federal Income Tax Step 1: Determine AGI AGI = Taxable Income Net income Gross income minus deductions 3-6

Objective 2 Calculate Taxable Income Main Components of Gross Income Earned income Investment income Passive income Other income 3-7

Objective 2 Calculate Taxable Income Total income is affected by: Exclusions Tax-deferred income 3-8

Objective 2 Calculate Taxable Income Adjusted gross income (AGI) Adjustments to income 3-9

Objective 2 Calculate Taxable Income Step 2: Computing Taxable Income Tax deduction = Standard deduction Itemized deductions 3-10

Calculate Taxable Income Itemized Deductions 3-11

Calculate Taxable Income Exemptions Exemptions  subtracted from AGI An exemption = The amount of the exemption for the 2008 tax year was $3,500 per person; for 2014 it is $3,900. After deducting exemptions you have your taxable income 3-12

Objective 2 Calculate Taxes Owed Step 3: Calculating taxes owed Tax table rates = marginal rates Example: After deductions and exemptions, a person in the 35% tax bracket pays 35 cents in taxes for every dollar of taxable income in that bracket. 3-13

2008 IRS Tax Brackets 2012 IRS Tax Table 3-14

Tax on a single taxpayer’s income of $40,000 2008 IRS Tax Example Tax on a single taxpayer’s income of $40,000 3-15

Objective 2 Calculate Taxes Owed The average tax rate = the total tax due divided by taxable income Average tax rate < marginal tax rate Example: Taxable income = $40,000 Total tax bill = $6,344 Average tax rate = 15.9% ($6,344 / $40,000) 3-16

Objective 2 Calculate Taxes Owed Alternative minimum tax (AMT) 3-17

Objective 2 Calculate Taxes Owed Tax credits Amount subtracted directly from the amount of taxes owed Examples: 3-18

Tax Credit versus Tax Deduction Reduces Your Taxes by $100 $100 Tax Deduction Amount Your Taxes are Reduced is Based on Your Tax Bracket 3-19

Determining Your Tax Liability 3-20

Objective 2 Calculate Taxes Owed Step 4: Making Tax Payments Payroll Withholding Estimated Quarterly Payments 3-21

Objective 2 Calculate Taxes Owed Step 5: Watching Deadlines-Avoiding Penalties Form 4868  automatic six-month extension Penalties & Interest 3-22

Objective 3 Prepare a Federal Income Tax Return Every citizen or resident of U.S. and every U.S. citizen who is a resident of Puerto Rico is required to file income tax. Five filing status categories: Single or legally separated Married, filing jointly Married, filing separately Head of household Qualifying widow or widower (2 years) 3-23

Which Tax Form Should You Use? ≈ 400 federal tax forms and schedules Basically the choice is between 3 forms 1040EZ 1040A 1040 Which form to use? 3-24

Completing the Federal Income Tax Return Filing status and exemptions Income Adjustments to income Tax computation Tax credits Other taxes (such as from self-employment) Payments (total withholding and other payments) Refund or amount you owe Refunds can be directly deposited to your bank account. Payments may be directly debited from your bank account. Your signature = Most common filing error 3-25

How do I File My State Tax Return? All but 7 states have a state income tax Most states tax rate ranges from 1 to 10 percent States usually require income tax returns to be filed when the federal income tax return is due 3-26

How Do I File My Taxes Online? Tax preparation software TurboTax and TaxCut are two of the most popular tax preparation software packages Tax software allows you to complete needed tax forms 3-27

How Do I File My Taxes Online? Free File Alliance Online tax preparation and filing free to many taxpayers http://www.irs.gov - go to “Free File” Various qualification criteria to file free; use “Guide Me to a Service” Connect to selected firm’s website Use form’s online software to prepare and file tax return 3-28

Available Tax Assistance Sources IRS Services Publications and forms 1-800-TAX-FORM www.irs.gov Recorded messages 1-800-829-4477 Phone hot line 1-800-829-1040 Walk-in service at an IRS office 3-29

Available Tax Assistance Sources Tax publications e.g. Ernst and Young Tax Guide and J.K. Lasser’s Your Income Tax The Internet Tax preparation software companies Tax Preparation Services Tax preparers charge between $40 and $2,000 depending on the complexity of the return Over 40 million U.S. taxpayers pay someone else to do their taxes 3-30

Types of Tax Preparation Services One-person, local offices to large firms such as H & R Block “Enrolled agents” = Government-approved tax experts CPA Tax Accountants Attorneys 3-31

Evaluating Tax Services Factors to consider: 3-32

Tax Service Warnings Ultimately you are responsible for providing complete and accurate information Hiring a tax preparer does not guarantee that you will pay the correct amount Beware of tax preparers that offer refunds in advance “Refund anticipation loans” can charge interest rates in excess of 300% 3-33

What if Your Return is Audited? ≈ 0.6% of all returns are audited If you claim large or unusual deductions you are more likely to be audited. Three types of audits: Correspondence audit Office audit Field audit 3-34

What if Your Return is Audited? Audit Rights When Audited: 3-35

Objective 4 Select Appropriate Tax Strategies Tax Planning Strategies Practice tax avoidance Tax Evasion 3-36

Tax Planning Strategies Minimizing Taxes If you expect Then you should Because The same or a lower tax rate next year Accelerate deductions into this year Greater benefit to higher rate The same tax rate next year Delay income into next year Delay paying taxes A higher tax rate next year Delay deductions Greater benefit Accelerate income Taxed at lower rate 3-37

Tax-Planning Strategies Consumer Purchasing Home ownership Use home equity line of credit to buy a car or consolidate debt 3-38

Tax-Planning Strategies Consumer Purchasing Job-related expenses may be allowed as itemized deductions Health care expenses like FSA’s (Flexible Spending Accounts) allow you to reduce your taxable income when paying for health related expenses 3-39

Tax-Planning Strategies Investment Decisions Tax Exempt Investments Tax Deferred Investments Tax A type of tax shelter 3-40

Tax-Planning Strategies Investment Decisions Capital Gains Self Employment Advantage: Disadvantage: 3-41

Tax-Planning Strategies Investment Decisions Children’s Investments Children under 14 with investment income of more than $1500 are taxed at parent’s top rate Retirement Plans 3-42

Changing Tax Strategies IRS Changes: Personal Changes: 3-43