Chapter 3

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 tax liability
Goal: Paying your fair share but still taking
advantage of available tax benefits
3 Taxes in Your Financial
Plan
Planning Your Tax
Strategy
3-1

Objective 1
Identify the Major Taxes Paid by
People in Our Society
 Taxes on Purchases
– Sales tax and excise tax (e.g., gas, cigarettes)
 Taxes on Property
– Real estate property tax
– Personal property tax
 Taxes on Wealth
– Federal estate tax
– State inheritance tax
 Taxes on Earnings
– Income tax and Social Security tax
3-2

The Progressive Nature of
the Federal Income Tax
• Progressive tax – takes a larger
percentage of income from high-
income taxpayers than low-income
taxpayers.
– Federal income tax
• Regressive tax – as income rises, the
tax demands a decreasing proportion
of a person’s income as income
increases.
– State sales tax

Objective 2
Calculate Taxable Income and the
Amount Owed for Federal Income Tax
Step 1: Determine AGI
Gross income:
Earned income (wages, salary, tips, bonuses)
Investment income (dividends, interest)
Passive Income (business limited partnerships)
AGI = Adjusted Gross Income
Gross income minus adjustments
3-4

Objective 2
Calculate 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
3-5

Calculate Taxable Income
Exemptions
Exemptions  also subtracted from AGI
– An exemption = a deduction for yourself,
your spouse, and qualified dependents
(increases annually for inflation)
– After deducting deductions and exemptions
from AGI, you have taxable income
3-6

Objective 2
Calculate 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.
3-7

Objective 2
The average tax rate = the total tax due
divided by taxable income
• Average tax rate < marginal tax rate
• Example:
– Taxable income = $40,000
– Total tax bill = $6,344
– Average tax rate = 15.9%
» ($6,344 / $40,000)
3-8

Objective 2
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
3-9

Objective 2
Tax Credits
– Amount subtracted directly from the
amount of taxes owed
– Examples:
• Earned income credit
• Foreign tax credits
• Child and dependent care credits
• Retirement tax credits (for savings plans)
• Adoption tax credits
• Hope Scholarship and Lifetime Learning credits
3-10

Tax Credit Versus Tax Deduction
$100 Tax Credit
Reduces Your Taxes by $100
$100 Tax Deduction
Amount Your Taxes are Reduced
is Based on Your Tax Bracket
3-11
Example: $5,000 x .25 mtb = $1,250 of tax savings

Determini
ng Your
Tax
Liability
3-12

Objective 2
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.
Who has to send the IRS estimated tax payments?
3-13

Objective 2
Step 5: Watching Deadlines-Avoiding 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
3-14

Objective 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 with 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.
3-15

Which Tax Form Should You
Use?
• ≈ 400 federal tax forms and schedules
• Basically the choice is between 3 forms
1040-EZ- (under $100k income, no itemizing/credits, no > $1,500 interest)
1040A- (IRA and child care credit, <$100k income, no itemizing)
1040- (“long form;” all income, credits, itemized deductions)
• Which form to use? It depends…
– Type of income
– Amount of income
– Number of deductions
– Complexity of tax situation
3-16

Completing the Federal Income
Tax Return
 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)
 Refund or amount you owe
• Refunds can be directly deposited to your bank account.
• Payments may be directly debited from your bank account.
 Your signature = Most common filing error 3-17

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
3-18
Also tax preparation software, Free File Alliance
(online filing), IRS services and VITA volunteers

Evaluating Tax Services
Factors to consider:
• Training and experience of 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?
3-19

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%
3-20

What if Your Return is
Audited?
≈ 0.6% 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
3-21

Objective 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
(e.g., deductions & credits, HSAs, tax-deferred/tax-free investing)
– Financial decisions related to purchasing,
investing, and retirement planning are the most
heavily affected by tax laws (e.g., home, IRAs)
– Keep good tax records (W-2s, 1099s, receipts, copies)
• Tax Evasion
– Illegally not paying all the taxes you owe, such
as not reporting all income 3-22

Tax Planning Strategies
Minimizing Taxes
If you expect Then you should Because
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 deductions Greater benefit
Accelerate income Taxed at lower rate
3-23

Wrap Up
• Chapter Quiz
• Concept Check 3-1: Which Type of Tax?
• Is it Taxable? Is it Deductible?
• Concept Check 3-2- Tax Deduction or
Tax Credit?
• Concept Check 3-3- Which Tax Form?
• Concept Check 3-4- Tax-Exempt or Tax-
Deferred?

Chapter 3

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Chapter 3