3-3-11

McGraw-Hill/IrwinFocus on Personal Finance, 2e

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Taxes in Your Financial Plan3

3-3-33 Taxes in Your Financial Plan

1. Identify the major taxes paid by people in our society

2. Calculate taxable income and the amount owed for federal income tax

3. Prepare a federal income tax return4. Select appropriate tax strategies for various

life situation

Chapter Objectives

3-3-44 Objective 1: Identify the major taxes paid by people in our society

Planning your Tax strategy

In order to start planning for taxes, you should….

Know current tax laws as they affect you.Maintain complete and appropriate tax records. Make purchase and investment decisions that reduce your tax liability.

Your tax planning should be targeted toward paying your fair share but still taking advantage of tax benefits.

3-3-55 Types of Taxes

Taxes on Purchases.– Sales tax & excise tax.

Taxes on Property.– Real estate property tax.– Personal property tax.

Taxes on Wealth.– Federal estate tax.– State inheritance tax.

Taxes on Earnings.– Income tax.

3-3-66 What Tax Records to Keep

Current tax forms and instruction booklets. Social security numbers. Copy of previous year’s returns. W-2 forms from employers. 1099 forms (interest, self employment). 1098 (mortgage interest paid). Receipts and documentation for expenses. Investment & business expense documents.

3-3-77Objective 2: Calculate taxable income and the amount owed for federal income tax Step 1: Determining adjusted gross income.

First identify taxable income - the net income, after deductions, on which income tax is computed. Types of income subject to taxation include…

Earned income which usually include wages, salary, commissions, fees, tips or bonuses.

Investment income is money received in the form of dividends, interest or rent from investments.

Passive income results from business activities in which you do not directly participate such as a limited partnership.

Alimony, awards, lottery winnings and prizes.

3-3-88 Objective 2: Calculate taxable income

– Total income is affected by Exclusions. • Exclusions are amounts not included in gross

income.• Exclusions are also referred to as tax-exempt

income, which is income not subject to federal income tax. An example is interest on most state and city bonds.

– Total income is also affected by tax-deferred income. This is income that will be taxed at a later date, such as earnings from an traditional individual retirement account (IRA).

(continued)

3-3-99 Objective 2: Calculate taxable income

– Adjusted gross income is is gross income after certain reductions have been made. These reductions are called adjustments to income, and include the following.

• Contributions to a traditional IRA or Keogh.• Alimony payments.• Tax-deferred retirement plans, such as a 401(k)

or a 403(b)(7) are a type of tax shelter. Tax shelters are investments that provide

immediate tax benefits and a reasonable expectation of a future financial return.

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3-3-1010 Objective 2: Calculate taxable income

Step 2: Computing Taxable Income. – A tax deduction is an amount subtracted from

adjusted gross income (AGI) to arrive at taxable income.

– You can subtract the standard deduction from AGI or itemize your deductions;

– Itemized deductions can include items such as...

• Medical and dental expenses >7.5% of AGI.• Taxes, interest, contributions and theft loses.• Moving, job-related, and miscellaneous expenses.

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3-3-1111 Objective 2: Calculate taxable income

– Next subtract exemptions from AGI. • An exemption is a deduction for yourself, your

spouse and qualified dependents.• The amount of the exemption

for the 0000 tax year was 0000 per person but this amount increases slightly each year.

– After deducting exemptions you have your taxable income.

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3-3-1212 Objective 2: Calculate taxable income

Step 3: Calculating taxes owed. – The percent rates are the marginal tax rates on the

last dollars of taxable income. • For example, after deductions

and exemptions, a person in the 28% tax bracket pays 28 cents in taxes for every dollar of taxable income in that bracket.

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3-3-1313 Objective 2: Calculate taxable income

A person’s average tax rate is based on the total tax due divided by taxable income. This rate is less than a person’s marginal tax rate.

• For example, if a person with a taxable income of $40,000 has a total tax bill of $4,200, their average tax rate is 10.5%.($42,000/$4,200)

Alternative minimum tax is paid by taxpayers with high amounts of certain deductions and various types of income

Designed to make sure that those who receive tax breaks also pay their fair share of taxes

Subtract tax credits.A tax credit is an amount subtracted directly from the amount of taxes

owed, such as the earned income or child and dependent care credits.

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3-3-1414 Tax Credit versus Tax Deduction

$100 Tax CreditReduces Your Taxes by $100

$100 Tax DeductionAmount Your Taxes are Reduced

is Based on Your Tax Bracket

3-3-1515 Objective 2: Calculate taxable income

Step 4: Making Tax PaymentYou pay federal income taxes through either payroll withholding or estimated tax payments

WithholdingBased on the number of exemptions and the expected deductions claimed

Estimated PaymentsEstimated tax payments made throughout the year based on income made during the year and reported on Form 1099.

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3-3-1616

Determine tax withheld

W-2 Form

1 Control number 3 Employer's Identification number 4 Employer's State numberCopy B to be filed with

employee's FEDERAL tax return

This information is being furnished to theInternal Revenue Service

5 Statutory De- Legal 942 Sub- Void Employee ceased rep. emp. total

2 Employer's name, address, and ZIP code

8 Employee's social sec. number 9 Federal Income tax withheld 10 Wages, tips, other comp 11 Soc sec tax withheld

12 Employee's name, address, and ZIP code 13 Social security wages 14 Social security tips

16 16a Fr ben. incl in Box 10

17 State income tax 18 St wages, tips, etc 19 Name of State

20 Local income tax 21 Loc wgs, tips, etc 22 Name of localityDepartment of the Treasury Internal Revenue Service OMB No. 1545-000816-0331690

Information Data, Inc.9834 Collins Blvd.Benton, NJ 08734

123-45-6789 2,678.93

W-2 Wage andTax Statement

23,972.09 1,725.99

23,972.09Barbara Victor124 Harper LaneParmont, NJ 07819

Making Tax Payment Making Tax Payment 3-16

3-3-1717 Objective 2: Calculate taxable income

Step 5: Watching Deadlines and Avoiding Penalties Use Form 4868 to obtain an automatic four-month

extension Submit the estimated amount along with Form 4868

by April 15 Underpayment of quarterly estimated taxes may

require paying interest on the amount owed Underpayment due to negligence can result in

penalties of 50 to 75 percent

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3-3-1818Objective 3: Prepare a Federal Income Tax Return

There are five filing status categories.– Single or legally separated.– Married, filing jointly.– Married, filing separately.– Head of household.

• Unmarried individual or surviving spouse who maintains a household for a child or dependent relative.

– Qualifying widow or widower (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

3-3-1919 Which Tax Form Should You Use? There are about 400 federal tax forms and schedules. Basically the choice is between 3 forms

1040EZ1040A1040

Which form to use depends on– Type of income– The amount of income– The number of deductions– Complexity of tax situation

3-3-2020Process for Completing Federal Income Tax

Return

In summary the steps to completing your return include: Filing status and exemptions. Income. Adjustments to income. Tax computation. Tax credits. Other taxes (such as from self-employment) Payments (total withholding and other payments).

3-3-2121 Process for Completing Federal Income Tax Return cont’d…

Refund or amount you owe• Refunds can be sent directly to your bank account.

Your signature• Most common filing error

3-3-2222 How do I File my State Tax Return?

All but seven states have a state income tax

Most states tax rate ranges from 1 to 10 percent

States usually require income tax returns to be filed when the federal income tax return is due

3-3-2323 How do I file My Taxes Online?

Software packages like TaxCut and TurboTax allow you to complete the needed tax forms

You can print and mail the forms or file online With e-filing refunds usually take 3 weeks Over 60 million returns are filed electronically

last year Cost for the service is between $15-$40

3-3-2424 Available Tax Assistance Sources IRS Services.

– Publications and forms 1-800-TAX-FORM.– www.irs.gov– Recorded messages 1-800-829-4477.– Phone hot line 1-800-829-1040.– Walk-in service at an IRS office.– CD-ROM the IRS sells that has forms and pubs.

Tax publications e.g. Ernst and Young Tax Guide and J.K. Lasser’s Your Income Tax

The Internet. – Tax preparation software companies.

3-3-2525 Available Tax Assistance Sources

Tax Preparation Software. – TurboTax and TaxCut are two of the most

popular tax preparation software– Using software can save 10 or more hours

Tax Preparation Services– Tax preparers charge between $40 and $2000

depending on the complexity of the return– Over 40 million U.S. taxpayers pay someone

else to do their taxes

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3-3-2626 Available Tax Assistance Sources

Types of Tax Services – Range from a one-person office to large firms such

as H & R Block.– Government-approved tax experts are called

enrolled agents.– CPA Tax Accountants.– Attorneys.– If your professional tax preparer makes a mistake,

you are still responsible for paying the correct amount, plus any interest and penalties.

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3-3-2727 Evaluating Tax ServicesFactors to consider when evaluating tax services

Training and experience of the tax professional Fee for preparing taxes Questionable deductions 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

3-3-2828 Tax Service Warnings Ultimately you are responsible for providing

complete and accurate information 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%

3-3-2929 What if Your Return is Audited?

About 0.6% of all returns are audited.If you claim large or unusual deductions you

are more likely to be audited. There are 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.

Your Audit Rights You have audit rights, including time to prepare

for the audit, and clarification.

3-3-3030Objective 4: Select appropriate tax strategies for various life situations

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.

3-3-3131 Tax-Planning Strategies

To minimize taxes owed...– If you expect to have the same or a lower tax rate

next year, accelerate deductions into the current year.– If you expect to have a lower or the same tax rate

next year, delay the receipt of income until next year.– If you expect to have a higher tax rate next year,

delay deductions since they will have a greater benefit.

– If you expect to have a higher tax rate next year, accelerate the receipt of income to have it taxed at the current lower rate.

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3-3-3232 Tax-Planning Strategies

Consumer Purchasing Owning a home is one of the best tax shelters because

you can deduct mortgage loan interest and property taxes when you itemize. This reduces your taxable income.

Use your home equity line of credit to buy a car or consolidate debt, since the interest you pay can be deducted when you itemize.

Job-related expenses may be allowed as itemized deductions.

Health care expenses like FSA’s (Flex Spending Accounts) allow you to reduce your taxable income when paying for health related expenses

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3-3-3333 Tax-Planning Strategies contd….Investment Decisions

TAX EXEMPT INVESTMENTS Using tax-exempt investments, such as municipal bonds can help reduce your taxes .

TAX DEFERRED INVESTMENTS– Tax deferred annuities– Section 529 savings plans– Retirement Plans

Capital Gains Long-term capital gains taxed at a lower rate.

– Held more than one year.

3-3-3434 Tax-Planning Strategies contd….

Investment Decisions contd…SELF EMPLOYMENT

Owning your owning business can have tax advantagesBusiness owners have to pay additional taxes

CHILDREN’S INVESTMENTChildren under 14 with investment income of more than $1500 are taxed at parent’s top rate

Retirement PlansTRADITIONAL IRA

ROTH IRAEDUCATION IRAKEOGH PLAN401 (K) PLAN

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3-3-3535 Changing Tax Strategies

IRS modifies tax filing procedures, and Congress passes legislation to change the tax code each year.

You should take advantage of these changes for personal financial planning

Consider changes in your personal situation and income

Monitor your tax strategies to best serve your daily needs and long-term financial goals

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