Chapter 4Chapter 4Lecture 1Lecture 1

Tax Planning and StrategiesTax Planning and Strategies

Why Understand Taxes?Why Understand Taxes?

Knowledge of the tax laws can help Knowledge of the tax laws can help you:you:

Conserve income.Conserve income. Maximize deductions.Maximize deductions. Enhance investments.Enhance investments. Protect transfer of wealth when you die.Protect transfer of wealth when you die.

Sources of Federal Tax Sources of Federal Tax LawLaw

US Constitution.US Constitution. Statutory (legislative branch).Statutory (legislative branch).

The Internal Revenue Code.The Internal Revenue Code. Administrative (executive branch).Administrative (executive branch).

The Treasury Dept. – the IRS is a The Treasury Dept. – the IRS is a division of the Treasury Dept.division of the Treasury Dept.

Court decisions (judicial branch).Court decisions (judicial branch).

Beginning of the Beginning of the Tax SystemTax System

In 1913, the 16th In 1913, the 16th Amendment gave Amendment gave Congress the right Congress the right to impose the first to impose the first income tax.income tax.

The IRC: Title 26 The IRC: Title 26 of USC (1939, of USC (1939, 1954, 1986).1954, 1986).

Federal Tax Legislative Federal Tax Legislative Process (statutory)Process (statutory)

House Ways and Means House Ways and Means Committee.Committee.

Voted by the House.Voted by the House. Senate Finance Senate Finance

Committee.Committee. Voted by the Senate. Voted by the Senate. Joint Conference Joint Conference

Committee reconciles.Committee reconciles. Revised bill voted by the Revised bill voted by the

House and Senate.House and Senate. Signed by the President. Signed by the President. Incorporated into the IRC.Incorporated into the IRC.

The Executive BranchThe Executive Branch

Treasury DepartmentTreasury Department – administers – administers the tax law.the tax law.

Internal Revenue Service (IRS)Internal Revenue Service (IRS) is a is a division of the Treasury Department.division of the Treasury Department. The IRS explains and enforces the tax The IRS explains and enforces the tax

law.law. The Internal Revenue Code gives the The Internal Revenue Code gives the

IRS general authority to issue binding IRS general authority to issue binding rules and regulations.rules and regulations.

The Judicial BranchThe Judicial Branch

Courts interpret the law.Courts interpret the law. Disputes between the IRS and Disputes between the IRS and

taxpayers may be settled in the taxpayers may be settled in the federal courts.federal courts.

A federal court will issue an opinion A federal court will issue an opinion about the proper interpretation or about the proper interpretation or application of a tax law.application of a tax law.

Federal Income Tax Federal Income Tax StructureStructure

Progressive (or graduated) tax.Progressive (or graduated) tax. Increased income is taxed at increasing Increased income is taxed at increasing

rates.rates. Tax brackets.Tax brackets.

Importance of Tax Importance of Tax PlanningPlanning

Taxes are your Taxes are your largest annual largest annual expense.expense.

The average The average American spends American spends over a quarter of over a quarter of each year earning each year earning money just to pay money just to pay taxes.taxes.

Make sure you don’t Make sure you don’t overpay taxes.overpay taxes.

Income Tax StructureIncome Tax Structure Income tax is progressive, meaning that Income tax is progressive, meaning that

the more you earn, the higher the tax the more you earn, the higher the tax rate.rate.

Tax brackets -- are income ranges for Tax brackets -- are income ranges for which the same marginal tax rate applieswhich the same marginal tax rate applies 2006 2006 SingleSingle JointJoint

10% $ 7,55010% $ 7,550 $ 15,100 $ 15,100 15% $ 30,65015% $ 30,650 $ 61,300 $ 61,300 25% $ 74,20025% $ 74,200 $123,700 $123,700 28% $154,80028% $154,800 $188,450 $188,450 33% $336,55033% $336,550 $336,550 $336,550 35% over35% over over over

Marginal vs. Average Marginal vs. Average RatesRates

Marginal tax rate – looks at the Marginal tax rate – looks at the percent of the next dollar you earn percent of the next dollar you earn that will go toward taxes.that will go toward taxes.

Average tax rate – relates taxes to Average tax rate – relates taxes to taxable income or overall income.taxable income or overall income. The average amount of your total The average amount of your total

income taken away in taxes.income taken away in taxes.

Effective Marginal Tax Effective Marginal Tax RateRate

Income-based taxes you pay:Income-based taxes you pay: Federal.Federal. State.State. City or local.City or local. Social Security.Social Security.

Effective marginal tax rate – the rate Effective marginal tax rate – the rate you pay when all income tax rates are you pay when all income tax rates are combined.combined.

Capital Gains and LossesCapital Gains and Losses

Capital gain – what you make if you Capital gain – what you make if you sell a capital asset for a profit.sell a capital asset for a profit.

Capital loss – what you lose when Capital loss – what you lose when you sell a capital asset for a loss.you sell a capital asset for a loss.

Capital asset – includes almost any Capital asset – includes almost any asset you own, except for certain asset you own, except for certain business assets.business assets.

Capital Gains TaxCapital Gains Tax

Short-term capital gain (assets held Short-term capital gain (assets held 12 months or less) – taxed based on 12 months or less) – taxed based on your marginal tax rate.your marginal tax rate.

Long-term capital gain (assets held Long-term capital gain (assets held for longer than 12 months) – 15% for longer than 12 months) – 15% maximum tax rate.maximum tax rate.

Capital Gains Income vs. Capital Gains Income vs. Ordinary IncomeOrdinary Income

Capital gains income is preferable to Capital gains income is preferable to ordinary income.ordinary income. The maximum tax rate on long-term The maximum tax rate on long-term

capital gains is lower than the ordinary capital gains is lower than the ordinary tax rate.tax rate.

You have the ability to postpone capital You have the ability to postpone capital gain tax liability (by not selling the gain tax liability (by not selling the asset).asset).

Other IncomeOther Income

Dividend income – paid on shares of Dividend income – paid on shares of stock or mutual funds.stock or mutual funds.

Interest income – earned from Interest income – earned from savings accounts, from debt savings accounts, from debt securities (e.g., bonds), and from securities (e.g., bonds), and from loans.loans.

Filing StatusFiling Status

Single.Single. Married filing jointly and surviving Married filing jointly and surviving

spouses.spouses. Married filing separately.Married filing separately. Head of household.Head of household.

Paying Your Income Paying Your Income TaxesTaxes

Taxes are collected on a pay-as-you-Taxes are collected on a pay-as-you-go basis.go basis.

Most taxes are collected through Most taxes are collected through withholding from wages.withholding from wages.

Form W-4.Form W-4.

FICAFICA

Social Security – a mandatory Social Security – a mandatory insurance program administered by insurance program administered by the governmentthe government Death, disability, health problems, or Death, disability, health problems, or

retirement.retirement. Medicare – a government health Medicare – a government health

care insurance program.care insurance program.

FICA Tax RatesFICA Tax Rates FICA tax rate -- 15.3%.FICA tax rate -- 15.3%.

12.4 % for Social Security.12.4 % for Social Security. 2.9 % for Medicare.2.9 % for Medicare.

FICA tax deducted from your salary – 7.65%.FICA tax deducted from your salary – 7.65%. 6.2% for Social Security.6.2% for Social Security. 1.45% for Medicare.1.45% for Medicare.

Self-employed – you pay the whole tax.Self-employed – you pay the whole tax. Social Security cap, adjusted annually for Social Security cap, adjusted annually for

inflation, is $94,200 in 2006.inflation, is $94,200 in 2006. No cap on Medicare (all earnings are No cap on Medicare (all earnings are

subject to the tax).subject to the tax).

State and Local Income State and Local Income TaxesTaxes

Most states impose Most states impose an income tax; an income tax; however, some, however, some, like TX, FL, and like TX, FL, and WY, do not.WY, do not.

Local income taxes Local income taxes are uncommon; but are uncommon; but some larger cities, some larger cities, for example, NYC, for example, NYC, impose such a tax.impose such a tax.