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

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

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

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

5. 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

6. 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

7. 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

8. Financial Planning Online: Internal Revenue Service
Go to:
This Web site provides information about tax rates, guidelines, and deadlines

9. 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 and 2011 when the law expires

10. 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

11. 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

12. 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%

13. 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

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

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

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

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

21. 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

22. 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

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
Marriage penalty: term used to describe the fact that many two-income married people pay more in taxes than if they were single

26. Deductions and Exemptions (cont’d)

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 and student loans
State income tax: an income tax imposed by some states on people who receive income from employers in that state

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
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

29. 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

31. Financial Planning Online: State Income Tax Rates
Go to:
This Web site provides income tax rates and information on personal exemptions for each state

32. 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

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

34. 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)]

39. 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

40. 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

41. 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

42. 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

43. Financial Planning Online: Estimating Your Taxes
Go to:
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

44. 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?