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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
19601960 April 8April 8 19971997 April 26April 26
19651965 April 5April 5 19981998 April 27April 27
19701970 April 16April 16 19991999 April 28April 28
19751975 April 14April 14 20002000 April 30April 30
19801980 April 19April 19 20012001 April 27April 27
19851985 April 10April 10 20022002 April 19April 19
19901990 April 20April 20 20032003 April 19April 19
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