Chapter 3 Taxes in Your Financial Plan Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written

Chapter 3Taxes in Your

Financial Plan

Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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Taxes in Your Financial Plan Chapter Learning ObjectivesLO3.1 Identify the major tax types in our societyLO3.2 Calculate taxable income and the amount

owed for federal income taxLO3.3 Prepare a federal income tax returnLO3.4 Select appropriate tax strategies for

various life situations


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Planning Your Tax StrategyStart planning for taxes ….

• Know current tax laws as they affect you• Maintain complete and appropriate tax records • Make purchase and investment decisions that

reduce your tax liability

Goal: Paying your fair share but still taking advantage of tax benefits.

Learning Objective LO3.1Identify the Major Taxes Paid by People in Our Society


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Types of Taxes1. Taxes on Purchases

◦Sales tax and excise tax2. Taxes on Property

◦Real estate property tax◦Personal property tax

3. Taxes on Wealth◦Federal estate tax◦State inheritance tax

4. Taxes on Earnings◦ Income tax and Social Security


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Learning Objective LO3.2Calculate Taxable Income and the Amount Owed for Federal Income Tax

Step 1: Determine AGIAGI = Adjusted Gross IncomeTaxable Income

Net income = income on which tax is computedGross income minus allowable deductions


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Main Components of Gross Income

Earned income o Usually includes wages, salary, commissions,

fees, tips, and bonuses Investment income

o Money received in the form of dividends, interest, or rent from investments

Passive income o Results from business activities in which you

do not directly participate, such as a limited partnership

Other incomeo Alimony, awards, lottery winnings, and prizes


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Total Income Is Affected by…Exclusions

◦Amounts excluded from gross income◦Also referred to as tax-exempt income; income

not subject to federal income tax Example = interest on most state and city bonds

Tax-deferred income ◦Income that will be taxed at a later date, such as

earnings from an traditional individual retirement account (IRA)


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Adjusted Gross Income (AGI)Gross income reduced by certain

adjustments, described belowAdjustments to income

◦Reduce AGI◦Contributions to a traditional IRA or Keogh◦Alimony payments

A tax shelter is an investment that provides immediate tax benefits


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Taxable Income

Step 2: Computing Taxable IncomeTax deduction = amount subtracted from

adjusted gross income (AGI) to arrive at taxable income

◦Standard deduction◦ Itemized deductions


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Calculate Taxable Income Itemized Deductions

Medical & dental expenses (>10% of AGI)TaxesInterestContributions Casualty and theft losesMoving expensesJob-related and other miscellaneous

expenses (>2% of AGI)


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Calculate Taxable Income ExemptionsExemptions subtracted from AGI

◦An exemption = a deduction for yourself, your spouse, or qualified dependents

◦The amount of the exemption for the 2014 tax year is $3,950 per person

◦After deducting exemptions, you have your taxable income


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Tax Record-Keeping SystemExhibit 3-2


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Calculating Taxes OwedStep 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.


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2014 IRS Tax Brackets

Rate on Taxable Income Single Taxpayers Married Taxpayers

Filing Jointly Head of Households

10% up to $9,075 up to $18,150 up to $12,950

15% $9,076-$36,900 $18,151-$73,800 $12,951-$49,400

25% $36,901-$89,350 $73,801-$148,850 $49,401-$127,550

28% $89,351-$186,350 $148,851-$226,850 $127,551-$206,600

33% $186351-$405100 $226,851-$405,100 $206,601-$405,100

35% $405,101-$406,750 $405,101-$457,600 $405,101-$432,20039.6% Over $406,751 Over $457,601 Over $432,201


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2014 IRS Tax ExampleTax on a married taxpayer’s income of $90,025

Taxable Income $90,025

From To

10% 0 $18,150 $18,150.00 $1,81515% $18,150 $73,800 $55,650.00 $8,34825% $73,800 $148,850 $16,225.00 $4,056

$14,219

Average Rate 15.8% =$14,219 / $90,025Marginal Rate 25%

Married Taxpayers Filing Jointly Taxable Amount Tax Due

Rate on Taxable Income


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Average and Marginal Tax RatesThe average tax rate = the total tax due divided by taxable income

Average tax rate < marginal tax rate

Example:◦Taxable income = $90,025 ◦Total tax bill = $14,219◦Average tax rate = 15.8%

($14,219 / $90,025)


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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


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Tax CreditsAmount subtracted directly from the

amount of taxes owedExamples:

◦Earned income credits◦Foreign tax credits◦Child and dependent care credits◦Savers credit (formerly retirement tax

credits)◦Adoption tax credits◦Education credits to offset college education

expenses


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Tax Credit versus Tax Deduction

$100 Tax CreditReduces Your Taxes by $100

$100 Tax DeductionAmount of Tax Reduction

is Based on Your Tax Bracket


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Determining Your Tax Liability


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Making Tax Payments

Step 4: Making Tax Payments Payroll Withholding

Based on the number of exemptions and the expected deductions claimed

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


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Deadlines and Penalties

Step 5: Deadlines and PenaltiesForm 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


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Learning Objective LO3.3 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 has a child or dependent relative

◦ Qualifying widow or widower with a dependent (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.


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Which Tax Form Should You Use?≈ 800 federal tax forms and schedulesBasically the choice is between 3 forms

1040EZ1040A1040 - Used by 60%

Which form to use?◦ Type of income◦ Amount of income◦ Number of deductions◦ Complexity of tax situation

Used by 20% of taxpayers


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Completing the Federal Income Tax Return1. Filing status and exemptions2. Income3. Adjustments to income4. Tax computation5. Tax credits6. Other taxes (such as from self-

employment)


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Completing the Federal Income Tax Return7. Payments (total withholding and other

payments)8. Refund or amount you owe

o Refunds can be directly deposited to your bank account

o Payments may be directly debited from your bank account

9. Your signature = Most common filing error


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How Do I File My State Tax Return?All but 7 states have a state income

taxMost states’ tax rates range from 1 to

10 percentStates usually require income tax

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


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How Do I File My Taxes Online?Tax preparation software

◦ H&R Block At Home and TurboTax are two of the most popular tax preparation software packages Using software can save 10 or more hours

◦Tax software allows you to complete needed tax forms

◦Print and mail the forms or file online e-filing refunds usually take 3 weeks Cost for e-filing = $5 - $40


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Selecting Tax SoftwareConsiderations:

◦Personal situation ◦Special tax situation ◦Features in the software

“Audit check” Future planning State tax filing online

◦Technical aspects Hardware and operating system requirements Online support


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How Do I File My Taxes Online?Free File Alliance

◦Online tax preparation and filing free to many taxpayers (depends on income)

◦Go to: http://www.irs.gov ◦Select: “Free File”◦Various qualification criteria to file free; use

“Guide Me to a Service”◦Connect to selected firm’s website◦Use form’s online software to prepare and file

tax return


http://www.irs.gov/

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Available Tax Assistance Sources

IRS Services1. Publications and forms

1-800-TAX-FORM www.irs.gov

2. Recorded messages 1-800-829-4477

3. Phone hot line 1-800-829-1040

4. Walk-in service at an IRS office5. Interactive tax assistant6. DVD7. IRS2Go App


http://www.irs.gov/

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Available Tax Assistance Sources

Tax Publications ◦ e.g. Ernst and Young Tax Guide and J.K.

Lasser’s Your Income TaxThe Internet

◦ Tax preparation software companiesTax Preparation Services

◦ Tax preparers charge between $40 and $2,000, depending on the complexity of the return

◦ Over 40 million U.S. taxpayers pay someone else to do their taxes


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Types of Tax Preparation ServicesOne-person, local offices to large

firms such as H & R Block“Enrolled agents” = Government-

approved tax experts CPA Tax AccountantsAttorneys


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Evaluating Tax ServicesFactors to consider:Training and experience of the tax professionalFee for preparing taxes and how determinedQuestionable 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?


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Tax Service WarningsUltimately 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%


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What if Your Return is Audited?

≈ 1.0% of all returns are auditedIf you claim large or unusual deductions

you are more likely to be auditedThree 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


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What if Your Return is Audited?Audit Rights

◦Request time to prepare◦Clarification of items being questioned◦Right to appeal audit results

When Audited:◦Decide whether to bring your tax preparer,

accountant or lawyer◦Be on time and bring only relevant documents◦Present evidence in a logical, calm, and

confident manner; maintain a positive attitude◦Make sure your information is consistent with

tax law◦Keep your answers aimed at the auditor’s

questions


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Learning Objective LO3.4Select Appropriate Tax Strategies

Tax Planning StrategiesPractice 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


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Tax Planning StrategiesMinimizing Taxes

If you expect Then you should BecauseThe 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


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Tax-Planning StrategiesConsumer PurchasingHome ownership

◦ One of the best tax shelters ◦ Deduct mortgage loan interest and

property taxes ◦ Reduces your taxable income

Use home equity line of credit to buy a car or consolidate debt◦ Interest deductible


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Tax-Planning StrategiesConsumer PurchasingJob-related expenses may be allowed

as itemized deductions◦ Union dues◦ Business tools◦ Job search costs

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


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Tax-Planning StrategiesInvestment DecisionsTax Exempt Investments

◦ Interest income from municipal bonds are exempt from federal and some state taxes

Tax Deferred Investments◦Tax deferred annuities◦Section 529 education savings plans◦Retirement Plans - IRA, Keogh or 401(k)

A type of tax shelter


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Tax-Planning Strategies Investment DecisionsCapital Gains

◦ Profits from the sale of stocks, bonds or real estate

◦ Long-term capital gains (held more than one year) taxed at a lower rate

Self Employment Advantage: Owning your own business can

have tax advantagesDisadvantage: Business owners have to pay

additional taxes


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Children’s Investments◦ Children under 18 or a full-time student under

24 with investment income of more than $2,000 is taxed at parents’ top rate

◦ Under $2,000 qualifies for a $1,000 deduction, with remainder taxed at child’s rate

Retirement and Education Plans◦ Traditional IRA - Roth IRA - Education IRA◦ Keogh Plan - 401(K) Plan

Tax-Planning Strategies Investment Decisions


Retirement PlansTraditional IRA

◦Available to people who are not participating in an employer sponsored program.

◦Amounts withdrawn are included in gross income.

Roth IRA◦Contributions not tax deductible.◦Amounts withdrawn are not included in gross

income.

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Education Plans & Retirement PlansCoverdell Education Savings Account

◦Educational uses for kindergarten through college-age.

529 Plan◦Qualified educational expenses.

Keogh Plan◦Self-employed retirement plan

401(K) Plan◦Tax-deferred retirement plan

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Changing Tax StrategiesIRS Changes:

◦IRS modifies tax filing procedures each year ◦Congress passes legislation to change the

tax code each year◦Take advantage of these changes for

personal financial planningPersonal Changes:

◦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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Flat or VAT Tax?Flat tax

◦All taxpayers pay the same rate◦Would increase taxes for many

VAT = Value-Added Tax◦Taxes a product at each stage in the

manufacturing process◦Tends to start small and rise over time


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Chapter SummaryLearning Objective LO3.1

Tax planning can influence spending, saving, borrowing, and investingdecisions.

An awareness of income taxes, sales taxes, excise taxes, property taxes,estate taxes, inheritance taxes, gift taxes,and Social Security taxes is vital for successful financial planning.


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Taxable income is determined by subtracting adjustments to income, deductions, and allowances for exemptions from gross income.

Your total tax liability is based on the published tax tables or tax schedules, less any tax credits.


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The major sections of Form 1040 provide the basic framework for filing your federal income tax return.

Main sources of tax assistance:◦IRS services and publications◦Other publications◦The Internet◦Computer software◦Professional tax preparers such as commercial

tax services, enrolled agents, accountants, and attorneys


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Chapter SummaryLearning Objective LO3.4Reduce your tax burden through careful

planning and making financial decisions related to consumer purchasing, and the use of debt, investments, and retirement planning.


Documents

Chapter 3 Taxes in Your Financial Plan Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written