Chapter 4 Tax Planning and Strategies Tax Planning and Strategies

Chapter 4Chapter 4 Tax Planning and Tax Planning and

StrategiesStrategies

IntroductionIntroduction

Most financial decisions are affected by Most financial decisions are affected by taxes.taxes.

Need to understand how taxes are Need to understand how taxes are imposed.imposed.

What strategies are used to reduce taxes What strategies are used to reduce taxes and what role does tax planning have in and what role does tax planning have in personal financial planning?personal financial planning?

How It All BeganHow It All Began

1616thth Amendment, 1913 Amendment, 1913Tax Rate: 1-6%Tax Rate: 1-6%Only about 1% of the population had to Only about 1% of the population had to

pay taxespay taxes

Taxes Impact Our Lives and Taxes Impact Our Lives and Financial PlanFinancial Plan

YearYear DayDay YearYear DayDay

19501950 March 29March 29 19951995 April 23April 23

19551955 April 1April 1 19961996 April 24April 24








The Federal IncomeThe Federal IncomeTax Structure Tax Structure

Progressive or graduate tax—tax rises as Progressive or graduate tax—tax rises as income risesincome rises

Tax rates and tax bracketsTax rates and tax brackets—Table 4.1 (page 90)—Table 4.1 (page 90)

Income ranges in which the same marginal tax Income ranges in which the same marginal tax rates applyrates apply

10%-35% of Earnings10%-35% of Earnings Personal exemptionPersonal exemption Itemized or standard deductionsItemized or standard deductions Taxable incomeTaxable income

Table 4.1Table 4.1

Paying Your Income TaxesPaying Your Income Taxes Pay-as-you-go basis. Pay-as-you-go basis.

Withholding from wages. Withholding from wages.

Quarterly estimated taxes sent to the IRSQuarterly estimated taxes sent to the IRS

Payments with tax returnPayments with tax return

Withholdings from stock dividends, retirement funds, Withholdings from stock dividends, retirement funds, and prize winnings.and prize winnings.

Paying Your Income TaxesPaying Your Income Taxes

You have some control over how much is You have some control over how much is deducted for taxes from your wages.deducted for taxes from your wages.

Withholdings are determined by income level Withholdings are determined by income level and information on W-4 form. and information on W-4 form.

W-4 form (usually filled out with new W-4 form (usually filled out with new employer)—marital status, number of employer)—marital status, number of exemptions claimedexemptions claimed

Tax Forms Used By EmployersTax Forms Used By Employers

W4W4

Calculating Your TaxesCalculating Your Taxes

Must you file a tax return?Must you file a tax return?

Depends on income, filing status, age, Depends on income, filing status, age, whether you can be claimed as dependent.whether you can be claimed as dependent.

Dependent—person you support financially.Dependent—person you support financially.

Calculate taxes anyway to get any refund Calculate taxes anyway to get any refund due to you.due to you.

Step 1: Determining Gross or Step 1: Determining Gross or Total IncomeTotal Income

Sum of all taxable income from all sources.Sum of all taxable income from all sources.

Active income—income from wages or a businessActive income—income from wages or a business

Portfolio or investment income--securitiesPortfolio or investment income--securities

Passive income—activities in which the taxpayer Passive income—activities in which the taxpayer does not actively participatedoes not actively participate

What Is Taxable?What Is Taxable?

WagesWagesSalariesSalariesTipsTipsAlimonyAlimonyCapital GainsCapital Gains InterestInterestDividendDividend

Step 2: Calculating Adjusted Step 2: Calculating Adjusted Gross Income (AGI) Gross Income (AGI)

Gross income less allowable adjustmentsGross income less allowable adjustments

Adjustments include:Adjustments include:Tax-deductible contributions Tax-deductible contributions Retirement contributionsRetirement contributions

Step 3: Subtracting Deductions Step 3: Subtracting Deductions

Choose between standard deduction or Choose between standard deduction or itemizing deduction. itemizing deduction.

Itemize deductions—list of deductible Itemize deductions—list of deductible expenses: medical expenses, tax expenses, expenses: medical expenses, tax expenses, mortgage interest payments, etc.mortgage interest payments, etc.

Standard deduction—government’s best Standard deduction—government’s best estimate of what the average person would estimate of what the average person would deduct if itemizing. deduct if itemizing.

Figure 4.3Figure 4.3

Step 4: Claiming Your Step 4: Claiming Your Exemptions Exemptions

Exemption—deduction for each person Exemption—deduction for each person supported by the income on a tax return. supported by the income on a tax return.

An exemption includes yourself, spouse or An exemption includes yourself, spouse or dependents. dependents.

Dependent must qualify as child or Dependent must qualify as child or dependent.dependent.

How To Reduce Taxes:How To Reduce Taxes:

ExemptionsExemptions PersonalPersonal Your DependentsYour Dependents

DeductionsDeductions StandardStandard ItemizedItemized

Mortgage interestMortgage interest Other taxesOther taxes Large medical & dental Large medical & dental

expensesexpenses CharitiesCharities

Step 5: Calculating Your Taxable Income, Step 5: Calculating Your Taxable Income, and From That, Calculating Your Base and From That, Calculating Your Base

Income Tax Income Tax Taxable income—subtract deductions and Taxable income—subtract deductions and

exemptions from AGIexemptions from AGI

Base income tax—intersection of filing status and Base income tax—intersection of filing status and taxable income in the federal income tax tables.taxable income in the federal income tax tables.

Figure 4.5Figure 4.5

Step 6: Subtract Your Credits andStep 6: Subtract Your Credits and

Determine Your Taxes DueDetermine Your Taxes Due Tax credits reduce actual taxes paid.Tax credits reduce actual taxes paid.

Tax credits phase out as AGI increases.Tax credits phase out as AGI increases.

Child CreditChild Credit Education CreditsEducation Credits Child and dependent care creditChild and dependent care credit Earned income creditEarned income credit Adoption creditAdoption credit

How Can I Reduce Tax Bill?How Can I Reduce Tax Bill?

Credits—offset your taxes, they don’t Credits—offset your taxes, they don’t merely reduce your taxable income, they merely reduce your taxable income, they offset taxes.offset taxes.Child CreditChild CreditThe Hope Scholarship Tax CreditThe Hope Scholarship Tax CreditLifetime Learning CreditLifetime Learning CreditChild and Dependent Care CreditChild and Dependent Care CreditEarned Income CreditEarned Income CreditAdoption CreditAdoption Credit

StatusStatus

Single—no dependentsSingle—no dependentsMarried JointlyMarried JointlyMarried SeparatelyMarried SeparatelyHead of Household—dependentsHead of Household—dependents

Other Filing ConsiderationsOther Filing Considerations

Choosing the right form between 1040EZ, Choosing the right form between 1040EZ, 1040A, or 1040 1040A, or 1040

Depends on dependents, income, Depends on dependents, income, itemizing.itemizing.

FormsForms

1040: Long form, itemized deductions, 1040: Long form, itemized deductions, complex incomecomplex income

1040A: Short form, standard deduction1040A: Short form, standard deduction1040EZ: simple form, standard deduction, 1040EZ: simple form, standard deduction,

<$50,000, no dependents<$50,000, no dependents

Fill in your name, your spouses name, and address

Fill in your SSN and your spouses SSN

If you wish to donate to the presidential election, check here

1.Fill in the wages amount fromW-2

2. Taxable interest

Add lines 1+2

Enter $

Subtract line 5 from 4

$7700

Tax Forms Used By EmployersTax Forms Used By Employers

W-2W-2

7. Income tax withheld

10. Use amount from line 6 to find your tax on a tax table and enterThe amount on line 10

9. . Add 7 and 8. These are your total payments. 9.

10. TAX. Use the amount on line 6 above to find your tax in the tax table on pages25-29 of the booklet. Then enter the tax from the table on this line 10.

11a. If line 9 is larger than line 10, subtract line 10 from line 9.11a

11a. Subtract line 10 from line 9

Add line 7 and 8

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Chapter 4 Tax Planning and Strategies Tax Planning and Strategies