Chapter 4 Lecture 1 Tax Planning and Strategies

Why Understand Taxes? Knowledge of the tax laws can help you: Knowledge of the tax laws can help you: Conserve income. Conserve income. Maximize deductions. Maximize deductions. Enhance investments. Enhance investments. Protect transfer of wealth when you die. Protect transfer of wealth when you die.

Sources of Federal Tax Law US Constitution. US Constitution. Statutory (legislative branch). Statutory (legislative branch). The Internal Revenue Code. The Internal Revenue Code. Administrative (executive branch). Administrative (executive branch). The Treasury Dept. – the IRS is a division of the Treasury Dept. The Treasury Dept. – the IRS is a division of the Treasury Dept. Court decisions (judicial branch). Court decisions (judicial branch).

Beginning of the Tax System In 1913, the 16th Amendment gave Congress the right to impose the first income tax. In 1913, the 16th Amendment gave Congress the right to impose the first income tax. The IRC: Title 26 of USC (1939, 1954, 1986). The IRC: Title 26 of USC (1939, 1954, 1986).

Federal Tax Legislative Process (statutory) House Ways and Means Committee. House Ways and Means Committee. Voted by the House. Voted by the House. Senate Finance Committee. Senate Finance Committee. Voted by the Senate. Voted by the Senate. Joint Conference Committee reconciles. Joint Conference Committee reconciles. Revised bill voted by the House and Senate. Revised bill voted by the House and Senate. Signed by the President. Signed by the President. Incorporated into the IRC. Incorporated into the IRC.

The Executive Branch Treasury Department – administers the tax law. Treasury Department – administers the tax law. Internal Revenue Service (IRS) is a division of the Treasury Department. Internal Revenue Service (IRS) is a division of the Treasury Department. The IRS explains and enforces the tax law. The IRS explains and enforces the tax law. The Internal Revenue Code gives the IRS general authority to issue binding rules and regulations. The Internal Revenue Code gives the IRS general authority to issue binding rules and regulations.

The Judicial Branch Courts interpret the law. Courts interpret the law. Disputes between the IRS and taxpayers may be settled in the federal courts. Disputes between the IRS and taxpayers may be settled in the federal courts. A federal court will issue an opinion about the proper interpretation or application of a tax law. A federal court will issue an opinion about the proper interpretation or application of a tax law.

Federal Income Tax Structure Progressive (or graduated) tax. Progressive (or graduated) tax. Increased income is taxed at increasing rates. Increased income is taxed at increasing rates. Tax brackets. Tax brackets.

Importance of Tax Planning Taxes are your largest annual expense. The average American spends over a quarter of each year earning money just to pay taxes. Make sure you don’t overpay taxes.

Income Tax Structure Income tax is progressive, meaning that the more you earn, the higher the tax rate. Income tax is progressive, meaning that the more you earn, the higher the tax rate. Tax brackets -- are income ranges for which the same marginal tax rate applies Tax brackets -- are income ranges for which the same marginal tax rate applies 2006 SingleJoint 2006 SingleJoint 10% $ 7,550 $ 15,100 10% $ 7,550 $ 15,100 15% $ 30,650 $ 61,300 15% $ 30,650 $ 61,300 25% $ 74,200 $123,700 25% $ 74,200 $123,700 28% $154,800 $188,450 28% $154,800 $188,450 33% $336,550 $336,550 33% $336,550 $336,550 35% over over 35% over over

Marginal vs. Average Rates Marginal tax rate – looks at the percent of the next dollar you earn that will go toward taxes. Marginal tax rate – looks at the percent of the next dollar you earn that will go toward taxes. Average tax rate – relates taxes to taxable income or overall income. Average tax rate – relates taxes to taxable income or overall income. The average amount of your total income taken away in taxes. The average amount of your total income taken away in taxes.

Effective Marginal Tax Rate Income-based taxes you pay: Income-based taxes you pay: Federal. Federal. State. State. City or local. City or local. Social Security. Social Security. Effective marginal tax rate – the rate you pay when all income tax rates are combined. Effective marginal tax rate – the rate you pay when all income tax rates are combined.

Capital Gains and Losses Capital gain – what you make if you sell a capital asset for a profit. Capital gain – what you make if you sell a capital asset for a profit. Capital loss – what you lose when you sell a capital asset for a loss. Capital loss – what you lose when you sell a capital asset for a loss. Capital asset – includes almost any asset you own, except for certain business assets. Capital asset – includes almost any asset you own, except for certain business assets.

Capital Gains Tax Short-term capital gain (assets held 12 months or less) – taxed based on your marginal tax rate. Short-term capital gain (assets held 12 months or less) – taxed based on your marginal tax rate. Long-term capital gain (assets held for longer than 12 months) – 15% maximum tax rate. Long-term capital gain (assets held for longer than 12 months) – 15% maximum tax rate.

Capital Gains Income vs. Ordinary Income Capital gains income is preferable to ordinary income. Capital gains income is preferable to ordinary income. The maximum tax rate on long-term capital gains is lower than the ordinary tax rate. The maximum tax rate on long-term capital gains is lower than the ordinary tax rate. You have the ability to postpone capital gain tax liability (by not selling the asset). You have the ability to postpone capital gain tax liability (by not selling the asset).

Other Income Dividend income – paid on shares of stock or mutual funds. Dividend income – paid on shares of stock or mutual funds. Interest income – earned from savings accounts, from debt securities (e.g., bonds), and from loans. Interest income – earned from savings accounts, from debt securities (e.g., bonds), and from loans.

Filing Status Single. Single. Married filing jointly and surviving spouses. Married filing jointly and surviving spouses. Married filing separately. Married filing separately. Head of household. Head of household.

Paying Your Income Taxes Taxes are collected on a pay-as-you-go basis. Taxes are collected on a pay-as-you-go basis. Most taxes are collected through withholding from wages. Most taxes are collected through withholding from wages. Form W-4. Form W-4.

FICA Social Security – a mandatory insurance program administered by the government Social Security – a mandatory insurance program administered by the government Death, disability, health problems, or retirement. Death, disability, health problems, or retirement. Medicare – a government health care insurance program. Medicare – a government health care insurance program.

FICA Tax Rates FICA tax rate %. FICA tax rate % % for Social Security % for Social Security. 2.9 % for Medicare. 2.9 % for Medicare. FICA tax deducted from your salary – 7.65%. FICA tax deducted from your salary – 7.65%. 6.2% for Social Security. 6.2% for Social Security. 1.45% for Medicare. 1.45% for Medicare. Self-employed – you pay the whole tax. Self-employed – you pay the whole tax. Social Security cap, adjusted annually for inflation, is $94,200 in Social Security cap, adjusted annually for inflation, is $94,200 in No cap on Medicare (all earnings are subject to the tax). No cap on Medicare (all earnings are subject to the tax).

State and Local Income Taxes Most states impose an income tax; however, some, like TX, FL, and WY, do not. Most states impose an income tax; however, some, like TX, FL, and WY, do not. Local income taxes are uncommon; but some larger cities, for example, NYC, impose such a tax. Local income taxes are uncommon; but some larger cities, for example, NYC, impose such a tax.