*2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Chapter 4 Using Tax Concepts for Planning*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-2 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-3 Chapter Objectives (cont’d) Explain how to determine your taxable income, tax liability, and refund or additional taxes owed

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-4 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-5 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-6 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-7 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 was scheduled to expire

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-8 Background on Taxes (cont’d) –Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010: Legislation that extended many of the previous tax law provisions through the year 2012 Unless made permanent, will expire at the beginning of 2013 Revert to old, higher tax rates with the highest being 39.6%

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-9 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 Individual rates lowered 2-3% Child tax credit increased to $1,000 Standard deduction increased for married taxpayers Will also need an extension to go beyond 2012

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-10 Background on Taxes (cont’d) Social Security and Medicare Taxes –Earned Income: Earned income represents salary or wages –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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-11 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 $110,100 as of 2012 –Reduced to 4.2% for 2011 and 2012 Medicare taxes are 1.45 % of your earned income –Self-employed people must pay both parts of these taxes themselves—15.3%

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-12 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-13 Financial Planning Online Go to This Web site provides information about tax rates, guidelines, and deadlines

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-14 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-15 *2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Exhibit 4.1 Form 1040 (page 1)*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-16 *2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Exhibit 4.1 Form 1040 (page 2)*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-17 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-18 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-19 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-20 Gross Income (cont’d) 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-21 *2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Exhibit 4.2 Schedule B of Form 1040*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-22 *2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Exhibit 4.3 Schedule D of Form 1040 (Page 1)*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-23 *2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Exhibit 4.3 Schedule D of Form 1040 (Page 2)*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-24 Gross Income (cont’d) Determining gross income –Determined by adding your salary, net business income interest income, dividend income, and capital gains Adjusted gross income: adjusts gross income for contributions to IRAs, alimony payments, interest paid on student loans, and other special circumstances

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-25 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 –Adjusted by the IRS each year to keep pace with inflation

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-26 Deductions and Exemptions (cont’d)

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-27 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 –State income tax: an income tax imposed by some states on people who receive income from employers in that state Local income taxes also deductible when itemizing

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-28 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 in excess of 7.5% of adjusted gross income may also be itemized –Charitable gifts Gifts to qualified organizations –Cash or property Be sure to keep receipts and records of gifts

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-29 Deductions and Exemptions (cont’d) –Other expenses Theft losses, job expenses if substantial –Summary of deductible expenses Total deductible expenses to decide whether to itemize or use the standard deduction

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-30 *2011 IRS forms are displayed in this chapter because 2012 forms were not available at the time of main text publication IRS forms can be obtained online from irs.gov. Exhibit 4.5 Schedule A of Form 1040 (Page 1)*

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-31 Financial Planning Online Go to This Web site provides income tax rates and information on personal exemptions for each state.

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-32 Deductions and Exemptions (cont’d) Exemptions –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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-33 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-34

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-35 Exhibit 4.6 Tax Rate Schedules for 2012 (cont’d)

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-36 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)]

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-37 Taxable Income and Taxes (cont’d) Tax credits: specific amounts used to directly reduce tax liability –Child tax credit: a tax credit allowed for each child in a household Was increased to $1,000 in 2003; may revert to $500 in 2013 Available as a refund to low-income workers who owe no income tax

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-38 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-39 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

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-40 Financial Planning Online Go to turbotax.intuit.com/tax-tools/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.

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-41 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?

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-42 Exhibit 4.7

Copyright ©2014 Pearson Education, Inc. All rights reserved.4-43 Exhibit 4.7 (cont’d)