©2013, College for Financial Planning, all rights reserved. Module 10 Income Taxes & the Retiree Chartered Retirement Planning Counselor SM Professional Designation Program

Learning Objectives 10–1: Explain the essential concepts of U.S. income taxation. 10–2: Describe four basic strategies for minimizing total taxes. 10–3: Describe different issues involved in managing tax- deferred and taxable accounts, and the treatment of life insurance proceeds. 10–4: Describe how mutual fund distributions and share sales are taxed. 10–5: Describe the tax treatment that applies to stocks and fixed-income securities. 10–6: Explain the current rules on handling a gain on the sale of a principal residence. 10–7: Explain when and how Social Security benefits are taxed. 10-2

Questions to Get Us Warmed Up 10-3

Learning Objectives 10–1: Explain the essential concepts of U.S. income taxation. 10–2: Describe four basic strategies for minimizing total taxes. 10–3: Describe different issues involved in managing tax- deferred and taxable accounts, and the treatment of life insurance proceeds. 10–4: Describe how mutual fund distributions and share sales are taxed. 10–5: Describe the tax treatment that applies to stocks and fixed-income securities. 10–6: Explain the current rules on handling a gain on the sale of a principal residence. 10–7: Explain when and how Social Security benefits are taxed. 10-4

Basic Tax Formula 10-5 (1)Total income Minus:(2)Adjustments to income (deductions for adjusted gross income) Equals:(3)Adjusted gross income (AGI) Minus(4)Greater of: standard deduction or itemized deductions Minus(5)Personal exemptions

Basic Tax Formula 10-6 Equals: (6)Taxable income (7)Calculate tax Minus:(8)Credits Plus:(9)Other taxes (such as self-employment tax or AMT) Equals:(10)Net tax liability (amount of tax due for the year)

Calculating Federal Income Tax 10-7 Total (gross) incomeDeductible IRA —Adjustment to income *Alimony paid =Adjusted gross incomeInterest forfeitures 1/2 of self-employment tax HSA deduction Self-employed retirement plans —Standard deductionMedical expenses > 10 (7.5)% of AGI orReal & personal property taxes paid —Itemized deductions*Mortgage and investment interest —Personal exception amountCharitable contributions made =Taxable incomeCasualty loss > 10% of AGI * deductions for AGI Miscellaneous expenses > 2% of AGI, with certain exceptions

Calculating Federal Income Tax 10-8 Tax from table or scheduleChild/dependent care —CreditsChild tax credit Elderly/disabled Foreign tax General business Education Self-employment tax +Other taxes payableAlternative minimum tax (AMT) Tax on premature distributions =Net tax liability Medicare contribution tax

Income Tax Terms 10-9 Income from all sources, unless specially excluded by tax law; total income for tax purposes Gross (total) income Deductions that reduce total (gross) income to arrive at adjusted gross income (AGI) Adjustments to income Amount remaining after making allowable adjustments to total income Adjusted gross income (AGI) A dollar-for-dollar offset against tax liability Tax credit Income items received by a taxpayer that are exempt from taxation Exclusions Miscellaneous itemized deductions not subject to the 2% AGI floor Miscellaneous deductions One of four categories: (1) married filing jointly, (2) married filing separately, (3) single, or (4) head of household Filing status

Income Tax Terms The amount of taxes owed after subtracting all allowable credits Tax liability Percentage of tax payable on last dollar of taxable income Marginal income tax bracket Amount by which taxpayer offsets AGI, after taking standard deduction or using itemized deductions, to arrive at taxable income Personal exemption Amount on which tax is computed Taxable income Amount by which nonitemizers offset AGI before subtracting personal exemptions to arrive at taxable income Standard deduction Typically personal expenses allowed as a deduction from AGI. Amount by which itemizers reduce AGI before subtracting personal exemptions to arrive at taxable income Itemized deductions

Progressive Federal Tax System %up to$17,850 15%between$17,850 — $72,500 25%between$72,500 — $146,400 28%between$146,400 — $223,050 33%between$223,050 — $398,350 35%between$398,350 — $450, %over$450, Tax Year (MFJ)

Itemized Deductions Medical expenses (after 7.5% or 10% floor) State & local income taxes or sales tax Home mortgage interest including MIP Property taxes Investment interest expense Charitable contributions Casualty & theft losses Miscellaneous deductions Tier II miscellaneous itemized deductions 1-12

Capital Gains & Losses Net LTCG taxed at: o 0% if 10% or 15% marginal rate o 15%, if marginal rate 25%-35% o 20% if marginal rate of 39.6% Collectibles (maximum 28%) o coins, stamps, artwork, etc. Depreciation on realty (unrecaptured §1250 income—maximum 25%) Netted in most favorable manner Net STCG treated as ordinary income Net loss of $3,000 allowable per year 10-13

Learning Objectives 10–1: Explain the essential concepts of U.S. income taxation. 10–2: Describe four basic strategies for minimizing total taxes. 10–3: Describe different issues involved in managing tax- deferred and taxable accounts, and the treatment of life insurance proceeds. 10–4: Describe how mutual fund distributions and share sales are taxed. 10–5: Describe the tax treatment that applies to stocks and fixed-income securities. 10–6: Explain the current rules on handling a gain on the sale of a principal residence. 10–7: Explain when and how Social Security benefits are taxed

General Tax Strategies Tax avoidance Tax reduction Tax deferral Conversion 10-15

Mutual Fund Investments Distributions Distributions: include short-term capital gains, interest, and dividends Dividends may be subject to preferential treatment (LTCG rates) Nontaxable: tax-exempt interest Capital gain distributions: result in long-term treatment 10-16

Mutual Fund Investments Cost basis of mutual fund shares Single-category average cost Specific Identification: most advantageous FIFO: assumed if no other method chosen 10-17

Basis in Mutual Fund Shares Average Cost Method Divides total cost of all shares by number of shares owned, resulting in all shares having same cost basis Gain or loss computed from proceeds of shares sold, less average cost, times shares sold First-In, First-Out (FIFO) Presumably lower-cost shares purchased first are used in computing gain or loss from sale Generally least advantageous method to investor 10-18

Basis in Mutual Fund Shares Specific Identification Investor identifies the particular shares that are being sold Identifying highest cost basis shares results in lowest gain on sale Identifying lowest cost basis shares results in lowest loss on sale 10-19

Learning Objectives 10–1: Explain the essential concepts of U.S. income taxation. 10–2: Describe four basic strategies for minimizing total taxes. 10–3: Describe different issues involved in managing tax- deferred and taxable accounts, and the treatment of life insurance proceeds. 10–4: Describe how mutual fund distributions and share sales are taxed. 10–5: Describe the tax treatment that applies to stocks and fixed-income securities. 10–6: Explain the current rules on handling a gain on the sale of a principal residence. 10–7: Explain when and how Social Security benefits are taxed

Considerations for Stock Dividends Cash (most subject to preferential rates) Return of capital Stock Dividend Reinvestment Plan (DRIP) Wash sales charitable contribution—FMV if held long term 10-21

Municipal Bonds Typically tax-exempt at federal level Double (or triple) tax exemption if from same municipality Private activity muni bond interest part of AMT (unless bonds issued in 2009 or 2010) Muni bond interest may increase the taxation of Social Security benefits 10-22

Bonds at Discount Market discount bonds Election to treat market discount as income, ratably over life of the bond Newly issued at discount Original Issue Discount (OID) treated as income over life of the bond 10-23

Bonds at Premium Taxable bond election to amortize premium as an adjustment to interest income downward adjustment to basis Tax-exempt bond premium must be amortized nondeductible adjustment to basis 10-24

U.S. Securities T-bills short term sold at discount taxable at maturity no state or local tax Treasury notes & bonds interest taxable no state or local tax 10-25

U.S. Securities Treasury inflation-indexed securities interest payments taxed when received inflation adjustments taxed in year of adjustment, although not paid until maturity phantom income causes most to be in tax-deferred accounts no state or local taxation Mortgage-backed securities GNMA, FNMA part interest, part principal interest is subject to federal, state & local taxes 10-26

Learning Objectives 10–1: Explain the essential concepts of U.S. income taxation. 10–2: Describe four basic strategies for minimizing total taxes. 10–3: Describe different issues involved in managing tax- deferred and taxable accounts, and the treatment of life insurance proceeds. 10–4: Describe how mutual fund distributions and share sales are taxed. 10–5: Describe the tax treatment that applies to stocks and fixed-income securities. 10–6: Explain the current rules on handling a gain on the sale of a principal residence. 10–7: Explain when and how Social Security benefits are taxed

Section 121 $250,000/$500,000 Exclusion Two of five years of ownership Principal residence for two of prior five years Once-every-two-years rule Partial exclusion available Nonqualified use—partial exclusion 10-28

Taxation of Social Security Benefits If income plus ½ Social Security benefits exceeds the thresholds given, then benefits are subject to taxation at the percentage shown 10-29

Question 1 Which one of the following is not includible in taxable income? a. unemployment compensation b. IRA withdrawals c. alimony received d. life insurance death benefits 10-30

Question 2 Which one of the following is not considered to be a capital asset? a. inventory b. stocks c. land held for investment d. management 10-31

Question 3 Which one of the following is the next step after calculating the tax based on taxable income for an individual taxpayer? a. subtract the personal exemption b. add the nondeductible itemized deductions c. subtract the allowable credits d. remit this amount to the IRS or request a refund 10-32

Question 4 Which one of the following techniques will result in tax deferral? a. reinvesting mutual fund dividends into more shares of the fund b. investing in high-growth stocks c. exchanging stocks on a regular basis by selling and reinvesting the proceeds d. taking a lump sum distribution from a qualified retirement plan 10-33

Question 5 Dividend reinvestment plans are popular because a. dividends are not currently taxable, thereby achieving tax deferral. b. dividends can be used for discounted stock purchases. c. basis calculations are simplified. d. they offer an efficient means of tax evasion

©2013, College for Financial Planning, all rights reserved. Module 10 End of Slides Chartered Retirement Planning Counselor SM Professional Designation Program