Chapter 4

Copyright ©2004 Pearson Education, Inc. All rights reserved.

Chapter 4

Using Tax Concepts for Planning

Copyright ©2004 Pearson Education, Inc. All rights reserved. 4-2

Chapter Objectives

• Explain how to determine your tax filing status

• Explain how to calculate your gross income

• Demonstrate how deductions and exemptions can be used


Chapter Objectives

• Explain how to determine your taxable income, tax liability, and refund or additional taxes owed

• Demonstrate how to fill out a tax form and determine your tax liability


Background on Taxes

• Financial planning involves decisions that affect your income

– Whether or not to take a second job

– Deciding to finance a home

– Investment decisions

– Contributing to a retirement account

• These decisions affect the amount of taxes you pay and therefore affect your wealth


Background on Taxes

• 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


Financial Planning Online:Internal Revenue Service

• Go to: http://www.irs.gov

• This Web site provides information about tax rates, guidelines, and deadlines.

http://www.irs.gov/

http://www.irs.gov/

http://www.irs.gov/

http://www.irs.gov/


Background on Taxes

• 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


Background on Taxes

• 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%


Background on Taxes

• Personal income taxes: taxes imposed on income earned– If you earn income you must file a Form

1040 to determine your tax liability

– Filing deadline is April 15 of each year


Background on Taxes

• Tax Relief Act of 2001– Lower taxes rates phased in gradually until

2010

– Impact various adjustments made to determine personal income taxes

– Designed to provide both a short-term stimulus to the economy and long-term tax relief for individual taxpayers


Filing Status

• Taxpayers must specify a filing status for their tax return because different rates are associated with each status.– Single

– Married filing joint return

– Married filing separate return

– Head of household

– Qualifying widow(er) with dependent child


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


Gross Income

– 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


Gross Income

– Capital loss: a loss that results from selling an asset at a lower price than was paid for it

– 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


Gross Income

• Determining gross income– 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

• All of these items related to gross income are reported on Form 1040


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



Exhibit 4.4: Standard Deduction Amounts for the 2000 Tax Year



• 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


Financial Planning Online:State Income Tax Rates

• Go to: http://taxes.yahoo.com/statereport.html

• This Web site provides income tax rates and information on personal exemptions for each state.

http://taxes.yahoo.com/statereport.html





– 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

– Charitable gifts

– Other expenses

• Casualties or thefts

• Job-related expenses

• Compare the total allowable itemized deductions to the standard deduction and use the larger



• 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


Taxable Income and Taxes

• Taxable income: adjusted gross income less deductions and exemptions

• Taxes– Depends on taxable income and filing status

– Progressive: a term used to characterize a tax system where a positive relationship exists between an individual’s income level and tax rate



– 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)]



Exhibit 4.6: Individual Tax Rates for the Year 2000 (Panels A and B)



Exhibit 4.6: Individual Tax Rates for the Year 2000 (Panels C and D)



– Marginal tax bracket: the tax rate imposed on any additional (marginal) income earned

• 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 who is less than 17 years old (reduced or eliminated for households in high-income brackets)

• Gradually increasing from $600 in 2001 to $1,000 in 2010

• Available as a refund to low-income workers who owe no income tax



– College expense credits: tax credits for parents who incur college expenses, based on the amount of financial support they provide

• 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



– Earned income credit: a special credit for taxpayers who earn low incomes; can reduce the amount of taxes owed

– Other tax credits are also available, for example for child care and adoptions


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


Financial Planning Online:Tax Information Resource

• Go to: http://www.taxplanet.com

• This Web site provides useful information on the most recent tax rates, forms, laws, and issues. Search for a particular tax topic in which you are interested.

http://www.taxplanet.com/




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?


Integrating the Key Concepts


Integrating the Key Concepts

• Part 1: Financial Planning Tools– In Chapter 2 we learned about personal financial statements

– In Chapter 3 we learned about time value of money

– In Chapter 4 we learned about tax planning

• Part 2: Liquidity Management

• Part 3: Financing

• Part 4: Protecting Your Wealth

• Part 5: Investing

• Part 6: Retirement and Estate Planning

Documents

Chapter 4