1. Chapter 3 Taxes in Your Financial Plan Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2. 3-2 Taxes in Your Financial Plan Chapter Learning Objectives LO3.1 Identify the major tax types in our society LO3.2 Calculate taxable income and the amount owed for federal income tax LO3.3 Prepare a federal income tax return LO3.4 Select appropriate tax strategies for various life situations Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

3. 3-3 Planning Your Tax Strategy Start planning for taxes …. Know current tax laws as they affect you Maintain complete and appropriate tax records Make purchase and investment decisions that reduce your tax liability Goal: Paying your fair share but still taking advantage of tax benefits. Learning Objective LO3.1 Identify the Major Taxes Paid by People in Our Society Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4. 3-4 Types of Taxes 1. Taxes on Purchases ◦ Sales tax and excise tax 2. Taxes on Property ◦ Real estate property tax ◦ Personal property tax 3. Taxes on Wealth ◦ Federal estate tax ◦ State inheritance tax 4. Taxes on Earnings ◦ Income tax and Social Security Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

5. 3-5 Learning Objective LO3.2 Calculate Taxable Income and the Amount Owed for Federal Income Tax Step 1: Determine AGI AGI = Adjusted Gross Income Taxable Income Net income = income on which tax is computed Gross income minus allowable deductions Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6. 3-6 Main Components of Gross Income Earned income o Usually includes wages, salary, commissions, fees, tips, and bonuses Investment income o Money received in the form of dividends, interest, or rent from investments Passive income o Results from business activities in which you do not directly participate, such as a limited partnership Other income o Alimony, awards, lottery winnings, and prizes Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7. 3-7 Total Income Is Affected by… Exclusions ◦ Amounts excluded from gross income ◦ Also referred to as tax-exempt income; income not subject to federal income tax  Example = interest on most state and city bonds Tax-deferred income ◦ Income that will be taxed at a later date, such as earnings from an traditional individual retirement account (IRA) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8. 3-8 Adjusted Gross Income (AGI) Gross income reduced by certain adjustments, described below Adjustments to income ◦ Reduce AGI ◦ Contributions to a traditional IRA or Keogh ◦ Alimony payments A tax shelter is an investment that provides immediate tax benefits Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9. 3-9 Taxable Income Step 2: Computing Taxable Income Tax deduction = amount subtracted from adjusted gross income (AGI) to arrive at taxable income ◦ Standard deduction ◦ Itemized deductions Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10. 3-10 Calculate Taxable Income Itemized Deductions Medical & dental expenses (>10% of AGI) Taxes Interest Contributions Casualty and theft loses Moving expenses Job-related and other miscellaneous expenses (>2% of AGI) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

11. 3-11 Calculate Taxable Income Exemptions Exemptions  subtracted from AGI ◦ An exemption = a deduction for yourself, your spouse, or qualified dependents ◦ The amount of the exemption for the 2014 tax year is $3,950 per person ◦ After deducting exemptions, you have your taxable income Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

12. 3-12 Tax Record-Keeping System Exhibit 3-2 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

13. 3-13 Calculating Taxes Owed Step 3: Calculating taxes owed ◦ Tax table rates = marginal rates  The tax rate paid on the last (or next) dollar of taxable income ◦ Example:  After deductions and exemptions, a person in the 35% tax bracket pays 35 cents in taxes for every dollar of taxable income in that bracket. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

14. 3-14 2014 IRS Tax Brackets Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

15. 3-15 2014 IRS Tax Example Tax on a married taxpayer’s income of $90,025 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16. 3-16 Average and Marginal Tax Rates The average tax rate = the total tax due divided by taxable income  Average tax rate < marginal tax rate  Example: ◦ Taxable income = $90,025 ◦ Total tax bill = $14,219 ◦ Average tax rate = 15.8%  ($14,219 / $90,025) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

17. 3-17 Alternative Minimum Tax (AMT) Paid by taxpayers with high amounts of certain deductions and various types of income Designed to ensure that those who receive tax breaks also pay their fair share of taxes Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

18. 3-18 Tax Credits Amount subtracted directly from the amount of taxes owed Examples: ◦ Earned income credits ◦ Foreign tax credits ◦ Child and dependent care credits ◦ Savers credit (formerly retirement tax credits) ◦ Adoption tax credits ◦ Education credits to offset college education expenses Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

19. 3-19 Tax Credit versus Tax Deduction $100 Tax Credit Reduces Your Taxes by $100 $100 Tax Deduction Amount of Tax Reduction is Based on Your Tax Bracket Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

20. 3-20 Determining Your Tax Liability Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

21. 3-21 Making Tax Payments Step 4: Making Tax Payments Payroll Withholding Based on the number of exemptions and the expected deductions claimed Estimated Quarterly Payments Estimated tax payments made throughout the year based on income made during the year and reported on Form 1099 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

22. 3-22 Deadlines and Penalties Step 5: Deadlines and Penalties Form 4868  automatic six-month extension ◦ Submit estimated tax due with Form 4868 by April 15 Penalties & Interest ◦ Underpayment of quarterly estimated taxes may require paying interest on the amount owed ◦ Underpayment due to negligence or fraud can result in penalties of 50 to 75 percent Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

23. 3-23 Learning Objective LO3.3 Prepare a Federal Income Tax Return Five filing status categories: ◦ Single or legally separated ◦ Married, filing jointly ◦ Married, filing separately ◦ Head of household  Unmarried individual or surviving spouse who has a child or dependent relative ◦ Qualifying widow or widower with a dependent (2 years) Every citizen or resident of U.S. and every U.S. citizen who is a resident of Puerto Rico is required to file income tax. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

24. 3-24 Which Tax Form Should You Use? ≈ 800 federal tax forms and schedules Basically the choice is between 3 forms 1040EZ 1040A 1040 - Used by 60% Which form to use? ◦ Type of income ◦ Amount of income ◦ Number of deductions ◦ Complexity of tax situation Used by 20% of taxpayers Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

25. 3-25 Completing the Federal Income Tax Return 1. Filing status and exemptions 2. Income 3. Adjustments to income 4. Tax computation 5. Tax credits 6. Other taxes (such as from self-employment) Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

26. 3-26 Completing the Federal Income Tax Return 7. Payments (total withholding and other payments) 8. Refund or amount you owe o Refunds can be directly deposited to your bank account o Payments may be directly debited from your bank account 9. Your signature = Most common filing error Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

27. 3-27 How Do I File My State Tax Return? All but 7 states have a state income tax Most states’ tax rates range from 1 to 10 percent States usually require income tax returns to be filed when the federal income tax return is due Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

28. 3-28 How Do I File My Taxes Online? Tax preparation software ◦ H&R Block At Home and TurboTax are two of the most popular tax preparation software packages  Using software can save 10 or more hours ◦ Tax software allows you to complete needed tax forms ◦ Print and mail the forms or file online  e-filing refunds usually take 3 weeks  Cost for e-filing = $5 - $40 Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

29. 3-29 Selecting Tax Software Considerations: ◦ Personal situation ◦ Special tax situation ◦ Features in the software  “Audit check”  Future planning  State tax filing online ◦ Technical aspects  Hardware and operating system requirements  Online support Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

30. 3-30 How Do I File My Taxes Online? Free File Alliance ◦ Online tax preparation and filing free to many taxpayers (depends on income) ◦ Go to: http://www.irs.govhttp://www.irs.gov ◦ Select: “Free File” ◦ Various qualification criteria to file free; use “Guide Me to a Service” ◦ Connect to selected firm’s website ◦ Use form’s online software to prepare and file tax return Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

31. 3-31 Available Tax Assistance Sources IRS Services 1. Publications and forms  1-800-TAX-FORM  www.irs.gov www.irs.gov 2. Recorded messages  1-800-829-4477 3. Phone hot line  1-800-829-1040 4. Walk-in service at an IRS office 5. Interactive tax assistant 6. DVD 7. IRS2Go App Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

32. 3-32 Available Tax Assistance Sources Tax Publications ◦ e.g. Ernst and Young Tax Guide and J.K. Lasser’s Your Income Tax The Internet ◦ Tax preparation software companies Tax Preparation Services ◦ Tax preparers charge between $40 and $2,000, depending on the complexity of the return ◦ Over 40 million U.S. taxpayers pay someone else to do their taxes Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

33. 3-33 Types of Tax Preparation Services One-person, local offices to large firms such as H & R Block “Enrolled agents” = Government- approved tax experts CPA Tax Accountants Attorneys Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

34. 3-34 Evaluating Tax Services Factors to consider: Training and experience of the tax professional Fee for preparing taxes and how determined Questionable deductions suggested? If return is audited, will the preparer represent the client? Is tax preparation the main business activity, or is it a front for other financial products? Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

35. 3-35 Tax Service Warnings Ultimately you are responsible for providing complete and accurate information ◦ If your professional tax preparer makes a mistake, you are still responsible for paying the correct amount, plus any interest and penalties. Hiring a tax preparer does not guarantee that you will pay the correct amount Beware of tax preparers that offer refunds in advance “Refund anticipation loans” can charge interest rates in excess of 300% Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

36. 3-36 What if Your Return is Audited? ≈ 1.0% of all returns are audited If you claim large or unusual deductions you are more likely to be audited Three types of audits: ◦ Correspondence audit for minor questions ◦ Office audit takes place at an IRS office ◦ Field audit is the most complex, with an IRS agent visiting you at your home, your business or your accountant’s office Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

37. 3-37 What if Your Return is Audited? Audit Rights ◦ Request time to prepare ◦ Clarification of items being questioned ◦ Right to appeal audit results When Audited: ◦ Decide whether to bring your tax preparer, accountant or lawyer ◦ Be on time and bring only relevant documents ◦ Present evidence in a logical, calm, and confident manner; maintain a positive attitude ◦ Make sure your information is consistent with tax law ◦ Keep your answers aimed at the auditor’s questions Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

38. 3-38 Learning Objective LO3.4 Select Appropriate Tax Strategies Tax Planning Strategies Practice tax avoidance ◦ Legitimate methods to reduce your tax obligation to your fair share but no more ◦ Financial decisions related to purchasing, investing, and retirement planning are the most heavily affected by tax laws Tax Evasion ◦ Illegally not paying all the taxes you owe, such as not reporting all income Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

39. 3-39 Tax Planning Strategies Minimizing Taxes If you expectThen you shouldBecause The same or a lower tax rate next year Accelerate deductions into this year Greater benefit to higher rate The same tax rate next year Delay income into next year Delay paying taxes A higher tax rate next year Delay deductionsGreater benefit Accelerate income Taxed at lower rate Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

40. 3-40 Tax-Planning Strategies Consumer Purchasing Home ownership ◦ One of the best tax shelters ◦ Deduct mortgage loan interest and property taxes ◦ Reduces your taxable income Use home equity line of credit to buy a car or consolidate debt ◦ Interest deductible Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

41. 3-41 Tax-Planning Strategies Consumer Purchasing Job-related expenses may be allowed as itemized deductions ◦ Union dues ◦ Business tools ◦ Job search costs Health care expenses like FSA’s (Flexible Spending Accounts) allow you to reduce your taxable income when paying for health related expenses Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

42. 3-42 Tax-Planning Strategies Investment Decisions Tax Exempt Investments ◦ Interest income from municipal bonds are exempt from federal and some state taxes Tax Deferred Investments ◦ Tax deferred annuities ◦ Section 529 education savings plans ◦ Retirement Plans - IRA, Keogh or 401(k)  A type of tax shelter Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

43. 3-43 Tax-Planning Strategies Investment Decisions Capital Gains ◦ Profits from the sale of stocks, bonds or real estate ◦ Long-term capital gains (held more than one year) taxed at a lower rate Self Employment Advantage: Owning your own business can have tax advantages Disadvantage: Business owners have to pay additional taxes Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

44. 3-44 Children’s Investments ◦ Children under 18 or a full-time student under 24 with investment income of more than $2,000 is taxed at parents’ top rate ◦ Under $2,000 qualifies for a $1,000 deduction, with remainder taxed at child’s rate Retirement and Education Plans ◦ Traditional IRA - Roth IRA - Education IRA ◦ Keogh Plan - 401(K) Plan Tax-Planning Strategies Investment Decisions Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

45. Retirement Plans Traditional IRA ◦ Available to people who are not participating in an employer sponsored program. ◦ Amounts withdrawn are included in gross income. Roth IRA ◦ Contributions not tax deductible. ◦ Amounts withdrawn are not included in gross income. 3-45

46. Education Plans & Retirement Plans Coverdell Education Savings Account ◦ Educational uses for kindergarten through college-age. 529 Plan ◦ Qualified educational expenses. Keogh Plan ◦ Self-employed retirement plan 401(K) Plan ◦ Tax-deferred retirement plan 3-46

47. 3-47 Changing Tax Strategies IRS Changes: ◦ IRS modifies tax filing procedures each year ◦ Congress passes legislation to change the tax code each year ◦ Take advantage of these changes for personal financial planning Personal Changes: ◦ Consider changes in your personal situation and income ◦ Monitor your tax strategies to best serve your daily needs and long-term financial goals Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

48. 3-48 Flat or VAT Tax? Flat tax ◦ All taxpayers pay the same rate ◦ Would increase taxes for many VAT = Value-Added Tax ◦ Taxes a product at each stage in the manufacturing process ◦ Tends to start small and rise over time Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

49. 3-49 Chapter Summary Learning Objective LO3.1 Tax planning can influence spending, saving, borrowing, and investing decisions. An awareness of income taxes, sales taxes, excise taxes, property taxes, estate taxes, inheritance taxes, gift taxes, and Social Security taxes is vital for successful financial planning. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

50. 3-50 Chapter Summary Learning Objective LO3.2 Taxable income is determined by subtracting adjustments to income, deductions, and allowances for exemptions from gross income. Your total tax liability is based on the published tax tables or tax schedules, less any tax credits. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

51. 3-51 Chapter Summary Learning Objective LO3.3 The major sections of Form 1040 provide the basic framework for filing your federal income tax return. Main sources of tax assistance: ◦ IRS services and publications ◦ Other publications ◦ The Internet ◦ Computer software ◦ Professional tax preparers such as commercial tax services, enrolled agents, accountants, and attorneys Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

52. 3-52 Chapter Summary Learning Objective LO3.4 Reduce your tax burden through careful planning and making financial decisions related to consumer purchasing, and the use of debt, investments, and retirement planning. Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.