1. © 2013 Pearson Education, Inc. All rights reserved.4-1 Chapter 4 Tax Planning and Strategies

2. © 2013 Pearson Education, Inc. All rights reserved.4-2 Introduction Most financial decisions are affected by taxes. Need to understand how taxes are imposed. What strategies are used to reduce taxes and what role does tax planning have in personal financial planning?

3. © 2013 Pearson Education, Inc. All rights reserved.4-3 The Federal Income Tax Structure Progressive or graduate tax Tax rates and tax brackets Personal exemption Itemized or standard deductions Taxable income

4. © 2013 Pearson Education, Inc. All rights reserved.4-4 The Federal Income Tax Structure Taxable income is a function of adjusted gross income (AGI), deductions, and exemptions. AGI = taxable income from all sources minus specific adjustments but before deducting standard or itemized deductions

5. © 2013 Pearson Education, Inc. All rights reserved.4-5 Table 4.1 Tax Rates and Brackets

6. © 2013 Pearson Education, Inc. All rights reserved.4-6 The Federal Income Tax Structure Assume you are in the 15% tax bracket. Does that mean you pay 15% of your taxable income in taxes? The last dollar earned is taxed at 15%. Earlier income is taxed at the lower rate.

7. © 2013 Pearson Education, Inc. All rights reserved.4-7 Marginal Versus Average Taxes Average Tax Rate—the average amount of your total income taken away in taxes Marginal Tax Rate (or marginal tax bracket)—the percentage of the last dollar earned that goes to pay taxes Tax-deferred—income on which the payment of taxes is postponed

8. © 2013 Pearson Education, Inc. All rights reserved.4-8 Figure 4.1 Historical Top Marginal Income Tax Rate

9. © 2013 Pearson Education, Inc. All rights reserved.4-9 Effective Marginal Tax Rate The rate you pay when all income taxes are combined (federal, state, city, Social Security taxes, etc.). Is greater than the marginal tax rate on federal income taxes.

10. © 2013 Pearson Education, Inc. All rights reserved.4-10 Capital Gains and Dividend Income Capital asset—an asset your own 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 gains tax—tax you pay on your capital gains

11. © 2013 Pearson Education, Inc. All rights reserved.4-11 Capital Gains and Dividend Income Lower tax rate on both the long-term capital gains and on dividends. Long-term capital gains tax on profits from the sale of stocks and bonds, not gains from sale of collectibles. Capital gains are not claimed or taxed until the asset is sold.

12. © 2013 Pearson Education, Inc. All rights reserved.4-12 Long-Term Capital Gains on Homes Capital gains taxes for most homeowners on sale of their homes Exemption up to $500,000 for couples filing jointly ($250,000) filing single on sale of principal residence Must have been occupied for 2 of the 5 years prior sale

13. © 2013 Pearson Education, Inc. All rights reserved.4-13 Figure 4.3 Calculating Your Taxes

14. © 2013 Pearson Education, Inc. All rights reserved.4-14 Table 4.2 Comparison of Education Credits

15. © 2013 Pearson Education, Inc. All rights reserved.4-15 Being Audited Audit—an examination of tax return by IRS Randomly selected—higher odds if itemized deductions are 44% of income. Asked to send additional information in mail or IRS face-to-face interview. Reexamine areas in question, get all data and records, appeal audit outcome if necessary.

16. © 2013 Pearson Education, Inc. All rights reserved.4-16 Help in Preparing Taxes Handle taxes by yourself. Use IRS publications, IRS hotlines, & self- help publications and computer programs. Hire a tax specialist.

17. © 2013 Pearson Education, Inc. All rights reserved.4-17 Tax Strategies to Lower Your Taxes Tax planning must be done ahead of time to minimize unnecessary tax payments. Tax strategies should supplement a solid investment strategy. There are five general tax strategies.

18. © 2013 Pearson Education, Inc. All rights reserved.4-18 Look to Capital Gains and Dividend Income 15 percent is the maximum tax rate for long-term capital gains for taxpayers in tax brackets that exceed 15 percent. Don’t have to claim capital gains until asset is sold. Qualified dividends from corporations are taxed at same low rates as long-term capital gains.

19. © 2013 Pearson Education, Inc. All rights reserved.4-19 Shift Income to Family Members in Lower Tax Brackets Can be complex and involve lawyers and establishment of trusts. Simpler way is to make gifts—recipients do not pay taxes on gifts either. Allowed $13,000 in total gifts per year. Gift some of your estate while still alive.

20. © 2013 Pearson Education, Inc. All rights reserved.4-20 Defer Taxes to the Future Tax-deferred retirement plans allow your to defer tax payments to the future. Roth IRAs allows taxes to be paid on contributions and never again. Capital gains taxes are postponed until you sell the asset.