1. © 2008 Thomson South-Western CHAPTER 3 MANAGING YOUR TAXES

2. 3-2 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

3. 3-3 Economics of Income Taxes  Federal income taxes are assessed according to a progressive tax structure –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 the entire income.  Tax brackets, standard deductions, and personal exemptions are indexed to inflation.

4. 3-4 Economics of Income Taxes  Tax rate for each bracket is called the marginal tax rate  Relating the tax liability to the level of taxable income earned, tax rate is called the average tax rate –It is lower than the marginal rate

5. 3-5 2005 Tax Rate Schedule (single taxpayers)

6. 3-6 Examples: Jason and David Jason’s marginal tax rate = 25% Jason’s average tax rate = 16.7% David’s marginal tax rate = 28% David’s average tax rate = 21.1%

7. 3-7 More Principles of Taxation  Filing Status a factor in determining amount of income tax paid. –Single –Married filing jointly –Married filing separately –Head of household –Qualifying widow/widower with dependent child

8. 3-8 More Principles of Taxation  Taxes are due on a pay-as-you-go basis –Employer withholds taxes all year –Self-employed deduct and pay taxes  Taxes paid are: –Federal income taxes –State income taxes –Local income taxes –Social Security taxes Medicare component

9. 3-9 It's Taxable Income that Matters Taxable Income is the amount of our income on which we calculate taxes owed.

10. 3-10 All income subject to federal income taxes  3 classifications of income that must be kept separate for deduction purposes Active Income Wages & salaries Alimony received Business & farm income Prizes, awards, gambling winnings 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 Gross Income

11. 3-11 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

12. 3-12 Adjustments to Gross Income (AGI)  Items that can be subtracted from gross income.  Some items included: –Traditional IRA contributions (some limits) –Self-employment tax—50% of amount paid –Alimony paid –Penalty on early withdrawal of savings

13. 3-13  The subtotal obtained when adjustments are subtracted from gross income.  Used to limit certain itemized deductions and other calculations Adjusted Gross Income (AGI)

14. 3-14 Deductions  Standard deduction – the blanket amount allotted for various deductible expenses taxpayers normally incur  Itemized Deductions – if deductible expenses are greater than the standard deduction, deductions may be itemized instead.

15. 3-15 –Medical and dental expenses –State and local income taxes –Property taxes –Home mortgage interest –Charitable contributions –Casualty and theft losses Itemized Deductions

16. 3-16 Exemptions  Self and dependents 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

17. 3-17 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?

18. 3-18 Tax Credits versus Tax Deductions A $1000 tax credit reduces tax by much more than a deduction. * Tax liability is figured as follows: the first $7,300 of taxable income is taxed at 10 percent, the balance at 15 percent.

19. 3-19 Tax Forms and Schedules  Variations of Form 1040  If more detail required, taxpayers also must file other forms and schedules.

20. 3-20 Common Tax Forms and Schedules

21. 3-21

22. 3-22 Example: 2005 Tax Return of the Beckers

23. 3-23 Example: 2005 Tax Return of the Beckers

24. 3-24 Other Filing Considerations  Quarterly payment of estimated taxes  April 15 filing deadline  Filing extensions  Amended returns (1040X)  Audited returns

25. 3-25 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  Computer-based tax returns  Taxpayer is responsible for accuracy!

26. 3-26 Effective Tax Planning  Tax avoidance is legal. Tax evasion is not!  Reduce taxes –Maximize deductions and/or credits –Income shifting –Tax deferral –Tax-free income