CHAPTER 3: MANAGING YOUR TAXES

Principles of Federal Income Taxes Chapter 3 Principles of Federal Income Taxes Typical American family pays about a third of its gross income in various types of taxes. Internal Revenue Service (IRS) is responsible for the administration and enforcement of federal tax laws.

Economics of Income Taxes: Chapter 3 Economics of Income Taxes: Federal income taxes are assessed according to a progressive tax structure; i.e., the larger the taxable income, the higher the tax rate. The next higher rate applies only to the additional income in that bracket, not to your entire income. Tax brackets, standard deductions, and personal exemptions are indexed to inflation.

2003 Tax Rate Schedule (single taxpayers) Taxable Income Tax Rate $1 – $7,000 10% $7,001 – $28,400 15% $28,401 – $68,800 25% $68,801 – $143,500 28% $143,501 – $311,950 33% Over $311,950 35%

Example: If you have $80,000 in taxable income, what will your federal income tax liability be?

Work through the tax brackets: + ($28,400 – $7,000) x 15% = $ 3,210 ($68,800 – $28,400) x 25% = $10,100 ($80,000 – $68,800) x 28% = $ 3,136 Tax Liability $17,146

Your marginal, or stated, tax rate is 28%, the rate of your highest bracket. Your average tax rate is 21.4%, which is calculated by dividing the amount of taxes paid by your taxable income: $17,146  $80,000 = 21.4%

More Principles of Taxation: Filing Status has to do with your marital status and family situation; factor in determining amount of income tax paid. Taxes are due on a pay-as-you-go basis; at time of filing you receive credit for amount already withheld and settle up for the past year. Your income is subject to federal, state and local income taxes and Social Security taxes.

It's Taxable Income that Matters! is the amount of our income on which we calculate taxes owed.

Determining Taxable Income & Tax Liability: Chapter 3 Determining Taxable Income & Tax Liability: Gross income [1] – Adjustments [2] = Adjusted Gross Income (AGI) [3] – Deductions [4] – Exemptions [5] = Taxable Income [6] Calculate taxes using tables or rates [7] – Tax Credits [8] + Other Taxes [9] = Tax Liability [10]

[1] Gross Income: All income that is subject to federal income taxes. 3 classifications of income which must be kept separate for deduction purposes: Earned or Active Income Wages & salaries Alimony received Business & farm income Prizes, awards, gambling winnings Unearned or Portfolio Income Interest Dividends Capital gains Most types of investment earnings Passive Income Income from real estate (unless real estate is your primary business) Limited partnerships & Tax shelters

Tax-Exempt Income: Either totally or partially excluded from gross income for income tax purposes: Child support received Insurance reimbursements Gifts (limits apply) Scholarships (some limits) Tax refunds Return of original investment capital

Capital gain (loss) occurs when an asset is sold for more (less) than its original cost. Short-term capital gain occurs when an item is held for 1 year or less; taxed at ordinary income tax rates. Long-term capital gain occurs when an item is held longer than 1 year; currently taxed at 15% or less. (See Exhibit 3.3) Generally, the sale of a home is now excluded from capital gains taxation (some limits and exceptions).

[2] Adjustments to Gross Income: Chapter 3 [2] Adjustments to Gross Income: Items which can be subtracted from gross income. Adjustments include: Traditional IRA contributions (some limits) Self-employment tax—50% of amount paid Alimony paid Penalty on early withdrawal of savings

[3] Adjusted Gross Income (AGI): Chapter 3 [3] Adjusted Gross Income (AGI): Subtotal obtained when adjustments are subtracted from gross income. Certain itemized deductions and other calculations are limited by this amount.

Chapter 3 [4] Deductions: The standard deduction is the blanket amount allotted for various deductible expenses taxpayers normally incur. If your deductible expenses are greater than the standard deduction, you may itemize your deductions instead. Choose the most advantageous method; itemized deductions must be documented. At higher income levels, limits are applied to both deductions and exemptions.

Itemized deductions are listed on Schedule A and include the following: Medical and dental expenses (only amount in excess of 7.5% of AGI) State and local income taxes and property taxes Home mortgage interest Charitable contributions Casualty and theft losses (very limited) Job and misc. expenses (only amount in excess of 2% of AGI)

[5] Exemptions: Amount subtracted based upon the number of people supported by the taxpayer’s income. You are an exemption on your own return unless you can be claimed by someone else. Children, spouses, elderly parents are other examples of exemptions. Each person can be claimed on only 1 tax return!

[6 & 7] Taxable Income & Tax Calculation: Chapter 3 [6 & 7] Taxable Income & Tax Calculation: Taxable income is the amount on which the tax calculation is done to determine taxes owed. If your taxable income is under $100,000, use the tax rate tables. If greater than $100,000, calculate amount using tax schedules. Alternative minimum tax is calculated differently; for higher-income taxpayers.

Chapter 3 [8] Tax Credits: Tax Credits are subtracted from the amount of taxes you owe. Credits include: Credit for child & dependent care expenses Education credits Child tax credit Adoption credit Earned income credit (EIC)

Tax Credits versus Tax Deductions: Chapter 3 Tax Credits versus Tax Deductions: Credits directly reduce the amount of taxes you owe. Deductions are subtracted from your AGI and reduce your taxable income. Which results in lower taxes?

Extra $1000 $1000 Deduction Tax Credit Gross Income $34,000 $34,000 Other deductions/ exemptions – 6,000 – 6,000 Extra $1000 Deduction – 1,000 – 0 Taxable Income $27,000 $28,000 Taxes Calculated $ 3,700 $ 3,850 $1000 Tax Credit – 0 – 1,000 Tax Liability $ 3,700 $ 2,850

Chapter 3 [9] Other Taxes: In addition to federal income taxes, taxpayers with certain situations may be required to pay other taxes at this time. Self-employed individuals must pay the self-employment tax.

[10] Tax Liability: This is the total amount of taxes that you owe. Chapter 3 [10] Tax Liability: This is the total amount of taxes that you owe. You subtract any payments already made or withheld from your pay. If you have overpaid, you may choose to get a refund. If you have underpaid, you must pay the difference plus any tax penalties.

Tax Forms and Schedules: Chapter 3 Tax Forms and Schedules: All taxpayers file their returns on some variation of Form 1040. If more detail is needed, taxpayers will also have to file other forms and schedules. Frequently used schedules include: Schedule A (itemized deductions) Schedule B (interest/dividend income) Schedule C (personal business income) Schedule D (capital gains/losses)

Other Filing Considerations Chapter 3 Other Filing Considerations Quarterly payment of estimated taxes April 15 filing deadline Filing extensions Amended returns (1040X) Audited returns

Preparing Your Tax Return Chapter 3 Preparing Your Tax Return Do it yourself! Get help from the IRS Use professional services Tax services Certified public accountants (CPAs) Enrolled agents (EAs) Tax attorneys Use tax software Taxpayer is responsible for accuracy!

Effective Tax Planning Chapter 3 Effective Tax Planning Tax avoidance is legal. Tax evasion is not! Reduce taxes Use all appropriate deductions or credits. Use techniques that receive preferential tax treatment, such as depreciation on real estate and tax-exempt income on municipal bonds.

Shift taxes Defer taxes Chapter 3 Shift taxes Use gifts or trusts to shift some of your income to others in lower tax brackets. Defer taxes Postpone taxes to the future when you may be in a lower tax bracket. Use retirement plans, IRAs, annuities, life insurance policies, and EE savings bonds.

THE END!