Chapter 4: Using Tax Concepts for Planning Personal Finance, Fourth Edition Jeff Madura © 2011 Pearson Education, Inc. All Rights Reserved

Chapter Objectives Explain how to determine your tax filing status Demonstrate how to calculate your gross income Show how deductions and exemptions can be used

Chapter Objectives (cont’d) Explain how to determine your taxable income, tax liability, and refund or additional taxes owed

Background on Taxes Taxes are an integral part of our economy They are paid on earned income, consumer purchases, wealth transfers and capital assets Special taxes are levied on things like alcohol, cigarettes and gasoline

Background on Taxes (cont’d) Taxes are paid at the federal, state, and local levels The purpose of taxes is to fund government activities The federal tax system is administered by the Internal Revenue Service This chapter focuses on the federal income tax process

Background on Taxes (cont’d) Corporations pay income tax on profits Homeowners pay property taxes Taxes are used to pay for government services and programs Most individuals pay taxes at federal, state and local levels

Background on Taxes (cont’d) Federal tax system is administered by the Internal Revenue Service (IRS) Taxes are paid in several ways At the time of a transaction Through payroll withholding By making estimated quarterly payments Tax year for federal income tax ends on Dec. 31 with taxes filed by April 15

Financial Planning Online: Internal Revenue Service Go to: http://www.irs.gov This Web site provides information about tax rates, guidelines, and deadlines

Background on Taxes (cont’d) Tax Law Changes Economic Growth and Tax Relief Reconciliation Act of 2001: tax cut package designed to provide short-term economic stimulus through tax relief for taxpayers Provisions scheduled to phased in between 2001 and 2011 when the law expires

Background on Taxes (cont’d) Jobs and Growth Tax Relief Act of 2003: an act that accelerated much of the tax relief resulting from the 2001 Tax Relief Act Lowered individual tax rates Increased child care tax credit Increased standard deduction for married taxpayers Lower long-term capital gains and dividend tax rates for investors

Background on Taxes (cont’d) Social Security and Medicare Taxes Wages are subject to FICA FICA (Federal Insurance Contribution Act): Taxes paid to fund the Social Security System and Medicare Medicare: a government health insurance program that covers people over age 65 and provides payments to health care providers in the case of illness

Background on Taxes (cont’d) Social Security and Medicare Taxes Your employer matches the amount that is withheld from your wages Social Security taxes equal 6.2% of your salary up to a maximum level of $84,900 Medicare taxes are 1.45 % of your entire salary Self-employed people must pay both parts of these taxes themselves—15.3%

Background on Taxes (cont’d) Personal income taxes: taxes imposed on income earned If you earn income you must file a Form 1040, 1040A or 1040EZ to determine your tax liability Filing deadline is April 15 of each year

Filing Status Taxpayers must specify a filing status for their tax return because different rates are associated with each status. Single Married filing jointly Married filing separately Head of household Qualifying widow(er) with dependent child

Gross Income Gross income: all reportable income from any source, including salary, interest income, dividend income, and capital gains received during the tax year Wages and Salaries—including bonuses, but excluding contributions to an employee sponsored retirement account Interest income: interest earned from investments or loans to other individuals

Gross Income (cont’d) Dividend income: income received in the form of dividends paid on stocks or mutual funds Capital gain: income earned when an asset is sold at a higher price than was paid for it Short-term capital gain: a gain on assets that were held less than 12 months Long-term capital gain: a gain on assets that were held for 12 months or longer

Gross Income (cont’d) Capital gains tax: the tax that is paid on a gain earned as a result of selling an asset for more than the purchase price

Gross Income Determining gross income Gross income: all reportable income from any source, including salary, interest income, dividend income, and capital gains received during the tax year

Gross Income (cont’d) Adjusted gross income: the amount calculated by adjusting gross income for contributions to individual retirement accounts, alimony payments, interest paid on student loans, and other special circumstances

Deductions and Exemptions Standard deduction: a fixed amount that can be deducted from adjusted gross income to determine taxable income Not affected by income Affected by filing status and age Marriage penalty: term used to describe the fact that many two-income married people pay more in taxes than if they were single

Deductions and Exemptions (cont’d)

Deductions and Exemptions (cont’d) Itemized deductions: specific expenses that can be deducted to reduce taxable income Interest expense: interest paid on borrowed money—primarily interest on mortgages and student loans State income tax: an income tax imposed by some states on people who receive income from employers in that state

Deductions and Exemptions (cont’d) Real estate tax: a tax imposed on a home or other real estate in the county where the property is located Medical expenses Amounts paid for prevention, diagnosis or alleviation of physical or mental defects or illness Amounts paid to affect any structure or function of the body Expenses for transportation to and from care Accident and health insurance premiums

Deductions and Exemptions (cont’d) Charitable gifts Other expenses Casualties or thefts Job-related expenses Compare the total allowable itemized deductions to the standard deduction and use the larger

Financial Planning Online: State Income Tax Rates Go to: http://www.taxadmin.org/fta/rate/ind_inc.html This Web site provides income tax rates and information on personal exemptions for each state

Deductions and Exemptions (cont’d) Personal exemption: an amount that can be deducted for each person who is supported by the income reported on a tax return Usually one exemption each for the filer, the spouse and each dependent child Deducted from gross income to determine taxable income

Taxable Income and Taxes Taxable income: adjusted gross income less deductions and exemptions Calculating Taxes Dependent upon taxable income and filing status Progressive tax—a tax system where a positive relationship exists between an individual’s income level and tax rate

Taxable Income and Taxes (cont’d) Determining your tax liability Determine filing status and follow the instructions on the tax schedule Tax Liability = Tax on Base + [Percentage on Excess over the Base x (Taxable Income – Base)]

Taxable Income and Taxes (cont’d) Tax credits: amounts that offset taxes; the full amount of the tax credit is subtracted from taxes owed Child tax credit: a tax credit allowed for each child in a household Was increased from $600 in 2001 to $1,000 in 2003 Available as a refund to low-income workers who owe no income tax

Taxable Income and Taxes (cont’d) College expense credit: a tax credit allowed to those who contribute toward their dependents’ college expenses Coverdell Savings Accounts: tax-free accounts that can be used for a variety of school expenses Section 529 College Savings Plan Allows tax benefits for parents who set aside money for their children’s future college expenses Available to all parents, regardless of income

Taxable Income and Taxes (cont’d) Earned income credit: a credit used to reduce tax liability for low-income taxpayers Other tax credits are also available, for example for child care and adoptions

Focus on Ethics: Reducing Your Taxes Resist the temptation to under report income The IRS usually uncovers such behavior There are many legal ways to reduce taxes File on time

Financial Planning Online: Estimating Your Taxes Go to: http://turbotax.intuit.com/tax-tools/ This Web site provides an estimate of your tax liability for the year and the tax refund that you may receive, based on your income, filing status, exemptions and deductions

How Tax Planning Fits within Your Financial Plan The key tax planning decisions for building your financial plan are: What tax savings are currently available to you? How can you increase your tax savings in the future? Should you increase/decrease the amount of your withholding What records should you keep?