MANAGING YOUR TAXESmyresource.phoenix.edu/secure/resource/FP101R5/Personal_Finance... · 136 MANAGING YOUR TAXES INTRODUCTION Taxes can take a big bite out of your budget, so your

Starting Point

Go to www.wiley.com/college/bajtelsmit to assess your knowledge of managingyour taxes.Determine where you need to concentrate your effort.

What You’ll Learn in This Chapter▲ The major features of the U.S. federal income tax system▲ Tax basics▲ How taxes are calculated▲ How to file tax returns▲ Tax planning strategies

After Studying This Chapter, You’ll Be Able To▲ File your taxes on time▲ Calculate taxable income and determine your tax liability▲ Select strategies to legally minimize the taxes you pay

3MANAGING YOUR TAXESThe Basics of the U.S. Tax System

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Copyright © 2012 John Wiley & Sons, Inc.

136 MANAGING YOUR TAXES

INTRODUCTIONTaxes can take a big bite out of your budget, so your strategies for legally min-imizing your taxes are crucial to your financial plan. It’s important to considerthe tax implications of your potential financial decisions and to be proactive indeveloping a plan to minimize tax payments. In this chapter, you’ll first exam-ine the main features of the federal income tax system and the requirements forfiling, calculating, and paying taxes. Federal income taxes are the focus of thischapter because they take the biggest tax bite. Finally, this chapter discusses themost common tax planning strategies.

3.1 The Basics of Federal Income Tax

There’s no question—the U.S. federal income tax system is complicated. Thestatutes and regulations that describe the tax laws fill literally thousands of pages,and it is estimated that the average taxpayer spends more than 10 hours per yearfilling out the required forms. It’s a good idea to make one of your personalfinancial goals to learn more about the tax system so that you can keep adequaterecords and reduce what you owe. Your income tax is one of your household’slargest cash outflows, and you work around four months out of the year just topay your federal taxes.

3.1.1 The Progressive U.S. Tax System

Although there have been many changes in the tax law throughout our country’shistory, the United States has always maintained a progressive tax, one thatimposes higher tax rates on taxpayers with higher incomes, requiring them to payproportionately more in taxes, through either higher tax rates or other rules.

In its infancy, the United States had no income tax at all. It wasn’t until the16th amendment to the U.S. Constitution was passed in 1913 that Congressimposed a tax on income, which was necessary to pay national security expensesassociated with World War I.

Since that time, tax rates have increased or decreased based on economicand political circumstances. Today, federal income taxes are used to finance manyworthwhile government activities, including the national defense, education,social programs, drug safety, transportation, and road maintenance.

Because a progressive tax is based on each taxpayer’s ability to pay, lower-income families do not bear a large tax burden. In fact, some people inthe United States pay no federal income tax at all. If you earned less than$8,450 in 2006 ($16,900 if married and filing jointly), you didn’t even needto file a tax return. As a result, high-income taxpayers account for the lion’sshare of all income tax revenues collected, and the poorest don’t pay any taxesat all.

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In contrast to a progressive tax, a regressive tax places a disproportionateburden on taxpayers with lower incomes. Any time the same tax rate is leviedon all taxpayers—as in the case of payroll, consumption, and sales taxes—thetax is regressive. This type of tax takes a bigger bite out of low-income families’disposable incomes. Although rich people spend more on food, clothing, andother consumer purchases than poor people, the proportion of their incomegoing to these categories is still lower, so the tax affects them less.

The tax that finances Social Security and Medicare, the federal systems forretirement income and retiree health care, is a classic example of a regressive tax.If you look at your pay stub, you’ll probably see an amount withheld for FICA(Federal Insurance Contributions Act), the tax that finances Social Security andMedicare. The FICA tax is regressive not only because everyone pays the samerate but also because there is a maximum income on which the Social Securityportion of the tax (6.2 percent) is imposed; earnings over the maximum are sub-ject only to the 1.45 percent Medicare portion of the tax.

The U.S. income tax system maintains its progressive nature through increas-ing marginal tax rates, exemptions, credits, and deductions. (A marginal tax rateis the rate that applies to your next dollar of income.) These features of the taxsystem imply that not all your income is taxable and your taxable income is notall taxed at the same rate.

The current tax rules assess taxes on taxable income—the amount of incomethat is subject to taxes under the law—according to a table of marginal tax rates.Marginal tax rates today are low by historical standards. Not only is the bottombracket lower than it’s been in decades, but the current top marginal tax rate,which applied to any income above $336,550 in 2006, is only 35 percent. Incomparison, the top bracket at the end of World War II was 94 percent onincome over $1 million.

3.1.2 The Internal Revenue Service

The Internal Revenue Service (IRS) is the government agency responsible forcollecting federal income taxes. Because there are sometimes ambiguities in thelaws, the IRS also writes regulations and makes rulings that interpret laws, oftengiving specific taxpayer examples for clarification. When there are disputes abouthow to interpret and apply these laws and regulations fairly, the federal tax courtsometimes hears cases and makes rulings. The Internal Revenue Code, a com-pilation of all tax laws passed by Congress, along with the IRS regulations andtax court judicial decisions, make up the totality of tax laws in the United States.

Although the IRS is often seen in a negative light—after all, nobody likesto pay taxes—it performs a truly amazing function, processing 130 millionindividual income tax returns each year, collecting more than $1.7 trillion intaxes, and issuing more than $200 billion in refunds, most within a few shortmonths.

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Congress has provided funding to further automate the process, a trend thatcauses some taxpayers concern as they envision a futuristic government withelectronic access to their most intimate financial information. More likely,though, honest taxpayers will benefit from further automation, and dishonestones will be more easily forced to pay their fair share. The IRS also offers manyfree services to taxpayers at its Web site, www.irs.gov. Publications on most taxtopics are available for download or by mail. The comprehensive tax prepara-tion reference IRS Publication 17, “Your Federal Income Tax,” is a must-have forindividuals who prepare their own taxes.

3.1.3 Tax Rate Schedules

Tax rate schedules show how much income tax must be paid for particular rangesof income. There are separate schedules for different household types. Figure 3-1shows two of these schedules—Schedule X, for single taxpayers, and ScheduleY-1, for married taxpayers filing jointly. Each schedule includes lists of incomeranges and rates.

Schedule X: 2006 Tax Rate Schedule for Single Filers

If your taxable income is:

But not You will TaxableOver: more than: owe: income over:

$0 $7,550 10% of $0 $7,550 $30,650 $755 � 15% of $7,550

$30,650 $74,200 $4,220 � 25% of $30,650 $74,200 $154,800 $15,108 � 28% of $74,200

$154,800 $336,550 $37,676 � 33% of $154,800 $336,550 � $97,653 � 35% of $336,550

Schedule Y-1: 2006 Tax Rate Schedule for Married Filing Jointly

If your taxable income is:

But not You will TaxableOver: more than: owe: income over:

$0 $15,100 10% of $0 $15,100 $61,300 $1,510 � 15% of $15,100 $61,300 $123,700 $8,440 � 25% of $61,300

$123,700 $188,450 $24,040 � 28% of $123,700 $188,450 $336,550 $42,170 � 33% of $188,450 $336,550 � $91,043 � 35% of $336,550

Figure 3-1

Marginal tax rates in 2006.

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FOR EXAMPLE

Tax BracketsLet’s suppose that you’re a single filer and your taxable income is $65,000in 2006. Although this income puts you in the 25 percent tax bracket, thefirst $7,550 will be taxed at 10 percent, the income between $7,550 and$30,650 will be taxed at 15 percent, and the remainder will be taxed at 25percent, for a total of $12,808 in taxes owed. Now what happens if youearn another $1,000? Because having taxable income of $66,000 wouldn’tpush you into a new tax bracket, the calculation of your taxes will be exactlythe same except that you’ll apply the 25 percent rate to an additional$1,000—resulting in an additional $250 in federal income taxes (25 per-cent of $1,000).

A tax bracket is the range of taxable income to which a particular mar-ginal tax rate applies. Taxpayers sometimes use this term to describe the high-est bracket that applies to their income. Thus, a single filer who, in 2006,told you that she was “in the 25 percent bracket,” meant that her taxableincome was between $30,650 and $74,200. As you can see, you pay lowertax rates on your first dollars of income and higher rates on later dollars ofincome.

For example, Schedule X indicates that the tax rate on the first $7,550 oftaxable income in 2006 is only 10 percent. Thus, if you were a single filer withtaxable income of $7,550 or less, you would be in the lowest tax bracket andpay only 10 percent of your taxable income in taxes. Unless your taxable incomefalls in the lowest tax bracket, the same marginal tax rate does not apply to yourentire taxable income.

Because you can’t do much about what tax bracket you fall in, much of taxplanning is aimed at minimizing your average tax rate, or the proportion oftotal taxable income paid in taxes, for a given level of income.

Your average tax rate is calculated as follows:

Average tax rate � Taxes paid/Taxable income

For some purposes, it may be useful to consider the proportion of your totalincome paid in taxes (as opposed to taxable income as in the definition just pro-vided). You may also see this ratio referred to as your average tax rate. Becauseof the progressive, or increasing, tax rate schedule, your average tax rate willalways be less than your marginal tax rate.

Let’s return to the previous scenario involving taxable income of $65,000and taxes of $12,808. Although the marginal tax rate is 25 percent (your highest

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bracket), the average tax rate is only 19.7 percent: Figure 3-2 shows theproportion of taxable income paid in taxes and average tax rates for taxpayersat various income levels.

3.1.4 Inflation Indexing of Tax Brackets

The levels of income that trigger each successive increase in tax rate are auto-matically increased each year to account for inflation. This feature of the tax sys-tem has been in place since 1981—a year of double-digit inflation. This systembanks on the fact that the income levels for each bracket will be higher nextyear than they are today. The fact that certain aspects of our tax law are indexedfor inflation is an important protection for taxpayers in lower tax brackets. Thegovernment doesn’t want households to have an extra tax burden unless they’reactually experiencing a higher level of purchasing power.

Figure 3-2

Taxes paid, after-tax income, and average tax rates for selected taxableincome levels.

$-

$120,000

$160,000

$100,000

$140,000

$80,000

$60,000

$40,000

$20,000

After-tax income Taxes owed

$10

11.5%

$20

Taxable Income ($000)

13.3%

19.7%

22.7%

25.9%

$40 $80 $160

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3.1.5 The Marginal Tax Effect

The tax laws include many rules that can reduce your taxable income. For exam-ple, you can subtract contributions to certain employer-provided retirement plansfrom your gross income before you calculate your tax. When making decisions,you should always consider the marginal tax effect—the reduction in taxesowed as a result of a financial decision.

As discussed in Section 1.4, effective decision making requires that you eval-uate your alternatives based on the effect on your finances. In estimating themarginal tax effect, you should apply a tax rate that includes all types of taxesthat the income would otherwise be subject to—usually federal income tax, stateincome tax, Social Security, and Medicare tax.

Some people also pay state and local taxes on income. Suppose Jeremiah hasa taxable income of $40,000 (25 percent federal tax bracket) and lives in a statewith a 5 percent state income tax. His next dollar of taxable income will be sub-ject to 25 percent � 5 percent � 7.65 percent Social Security and Medicare tax,for a total of 37.65 percent paid in taxes.

Suppose Jeremiah has the opportunity to work overtime for his employerand expects to earn an additional $2,000. How much better off will he be if hedecides to do so? Because his additional earnings will be subject to the 37.65percent marginal tax rate, he will net only $2,000 � (1 � 0.3765) � $1,247after taxes.

Although this chapter covers only the basics, there are many situations inwhich tax rules make certain financial decisions more attractive than others.It is always important to focus on the marginal tax effects when evaluatingoptions.

3.2 Calculating Taxable Income and Taxes Owed

Although many people whine about filling out their tax forms as April 15approaches, individuals who have their finances in order generally find that com-pleting tax forms is fairly painless. The steps involved in calculating how muchtax you owe are illustrated in Figure 3-3. In this section, we review terminologyand rules and then look at how tax forms are filled out.

3.2 CALCULATING TAXABLE INCOME AND TAXES OWED 141

1. What is the purpose of the IRS?

2. Explain the difference between marginal tax rate and average taxrate.

S E L F - C H E C K

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3.2.1 Reporting Income

As indicated in Figure 3-3, the first step in doing your taxes is to calculateyour income. The calculation of income for tax purposes requires that youreport most types of income and then make certain allowed adjustments tothat income:

▲ Gross income is your income from all sources. However, some categoriesof income are excluded to arrive at total income on your tax forms, anamount that can be thought of as gross taxable income.

▲ Gross taxable income is income from all sources, less allowedexclusions.

Table 3-1 details what is included and what is excluded in reporting totalincome. For example, you don’t have to report scholarships used for tuition andcourse-related expenses or child support payments received from an ex-spouse.You do, however, have to report scholarships and grants applied to room andboard expenses.

5. Look up:Your tax on Tax Table

Equals:Tentative Tax

6. Minus:CreditsEquals:

Total Tax Owed

7. Minus:Taxes already paid (payroll withholding

and estimated taxes)Equals:

Balance Due or Amount or Refund4. Minus:

ExemptionsEquals:

Taxable Income

1. Start with:Income from all sources less exclusions

Equals:Total Income

2. Minus:Adjustments to total income

Equals:Adjusted Gross Income

3. Minus:Standard deduction or itemized

deductions

Figure 3-3

Steps in calculating federal income taxes owed.

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For most people, the largest source of total income is earned income fromemployment—salaries, hourly wages, bonuses, tips, and commissions—all ofwhich is included in gross taxable income. Other sources of gross taxable incomeinclude business income, investment income, alimony, unemployment compen-sation, and retirement benefits.

Unearned income may include interest and dividends from investments, netbusiness income, rents, and royalties you received during the year, annuity andpension income, awards for scientific and charitable achievement, gambling andlottery winnings, and scholarships spent on room and board.

Table 3-1: What Is and What Is Not Included in Gross TaxableIncome

Included

Alimony Investment gains/losses

Business or partnership income Moving expense reimbursement

Commissions, fees (if deducted) Wages, salaries, tips, bonuses

Dividends Pension income

Employer-paid disability income Property rental income/loss

Gambling winnings and prizes Royalties

Hobby income Unemployment compensation

Interest

Not Included

Annuities* Long term care benefits

Child support Military cost-of-living allowance

Disability payments* Qualified benefits paid by employer*

Gifts Required travel expenses paid byemployer*

Inheritance Scholarships and fellowships*

Insurance claim payments State and local bond interest

Jury awards Workers compensation payments

Life insurance proceeds Welfare

Long-term capital gain on saleof primary residence*

*Limitations apply to these categories.


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Employers and financial institutions must report the amounts they pay toyou each year, and you generally receive a copy of this report in January fol-lowing the tax year (Form W-2 for employment income and Form 1099for other types of income), but you are also required to report other income(e.g., cash tips received by a waiter), even if these amounts do not appear onyour W-2.

Your taxable income, as reported on your W-2, excludes any payments madeon your behalf for tax-qualified health insurance and retirement plans—in otherwords, those amounts get taken off the top of your income and are not taxed.In addition to reporting profits from businesses, you may sometimes be able tosubtract losses by entering a negative number in the business income category.However, the tax laws limit the deduction of losses to situations in which youactively participate in the management of the business.

Gross income also includes any capital gain, or increase in value, of taxableinvestments that you sold during the year. For example, if you sold a rental prop-erty during the year for $100,000 and you had only paid $80,000 for it, youowe tax on the $20,000 capital gain. Note that even though you may havereceived the whole $100,000 in cash flow that year, you report only the gain fortax purposes.

If you hold an investment longer than a year, the gain is subject to a spe-cial lower tax rate—5 percent for taxpayers in the 10 and 15 percent taxbrackets and 15 percent for those in higher tax brackets. These rates alsoapply to certain dividend income. A special capital gain rule applies to prof-its on the sale of your primary residence, defined as where you lived for twoof the five years before the sale. You can exclude up to $250,000 of the gainon the sale of your home ($500,000 for married couples) from your totalincome.

3.2.2 Adjusted Gross Income

Certain expenses are subtracted from total income to arrive at adjusted grossincome (AGI). Although many of the allowed adjustments to total income aresubject to income limitations, they can significantly reduce your taxes and maynot require you to itemize deductions to qualify. Some of these adjustmentsinclude

▲ deduction for unreimbursed expenses up to $250 for teachers of kinder-garten through grade 12.

▲ deductible individual retirement account contributions up to $4,000.▲ interest paid on student loans during the year.▲ tuition and fees for higher education up to $4,000.▲ deduction for one-half of the Social Security taxes paid on business income.▲ deduction for moving expenses, if required for a new job.

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Without itemizing, you can also make adjustments for one-half of the SocialSecurity taxes paid on business income and for moving expenses, if required fora new job. To see if you qualify for these or other adjustments to total income,you should consult the applicable IRS publications.

3.2.3 Standard vs. Itemized Deductions

You may deduct certain expenses from your AGI to arrive at the taxable amount:You can either claim a specified standard deduction, a dollar amount based onfiling status that is subtracted from AGI in calculating taxable income, or item-ize your deductions. With itemized deductions, you report and deduct actualexpenses in certain allowed categories to arrive at taxable income. The amountof the standard deduction increases annually with inflation and depends on yourfiling status. For tax year 2006, the allowed standard deduction amounts were

▲ Single: $5,150.▲ Married filing jointly: $10,300.▲ Married filing separately: $5,150.▲ Head of household: $7,550.▲ Qualified widower: $10,300.

If your deductible expenses are greater than the standard deduction, and providedthat you’ve kept careful records, you report itemized deductions on Schedule A.Although you don’t have to provide supporting documentation when you file yourreturn, you must be able to produce proof of the expense if the IRS requests it.

For example, if you’ve made charitable contributions during the year,you should have a statement or receipt that acknowledges your donation. But ifyou take the standard deduction, you don’t have to keep this type of record.If you itemize, you must file the long form 1040 instead of the 1040A or 1040EZ.The categories for itemized deductions include medical and dental expenses,taxes, some types of interest, gifts to charity, casualty and theft losses, jobexpenses, and most other miscellaneous deductions.

The percentage of people who itemize deductions increases with income.This makes sense because people with greater income are likely to have greaterexpenses, most notably for mortgage interest and taxes, so the amount of theiractual expenses is more likely to exceed the standard deduction. We discuss eachcategory of itemized deductions in more detail next.

Medical and Dental Expenses

You can deduct out-of-pocket medical and dental expenditures for health insur-ance premiums, services (e.g., doctors, dentists, optometrists, nurses, hospitals),prescriptions, eyeglasses, hearing aids, travel for medical purposes, special schoolingfor disabled children, nursing homes, alternative medicine (e.g., chiropractors,


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acupuncturists), and other medical expenses if their sum is above 7.5 percent ofyour AGI. IRS Publication 502 lists legally deductible expenses.

If your expenses are paid by your health insurer or employer, you can’tdeduct them—you can deduct only unreimbursed expenses. To determine yourdeduction, you total your medical and dental expenses and then subtract 7.5 per-cent of your AGI. The remainder is your deduction.

Taxes You PaidYou may deduct state and local income taxes you paid during the tax year, realestate property taxes paid on your primary residence, and personal property taxes(imposed in some states on cars and other personal property). If you take adeduction for state taxes, you may have to make an adjustment to your incomein a later year for state tax refunds.

Interest You PaidPerhaps the most beneficial of all deductions is the mortgage interest deduction.You can deduct interest paid on your mortgage and home equity loans as wellas certain charges, such as points or loan origination fees.

Sometimes, you can’t deduct the full amount of points in the year paid butmust spread them out over the life of the loan. Interest paid on credit cards,personal loans, and car loans is not deductible.

Gifts to CharityThe tax laws allow you to deduct contributions made to charitable organiza-tions. There are separate lines on which to report cash donations and non-cash donations.

Noncash contributions include food donated to the local food bank or usedclothing given to a local charity. You can deduct only the current market valueof the items donated, however. If you’re uncertain of an item’s worth, you shouldconsider what the item would sell for at a flea market, or, for a fee, you can geta list of fair market values for commonly donated items from www.taxsave.com.

People who are actively involved in volunteer organizations can also deductexpenses incurred in their volunteer work, including mileage expenses.

Casualty and Theft LossesSuppose your car, which was worth $3,000, was stolen during the year, and youdid not have theft insurance on it. For such an unreimbursed loss, the tax lawallows you to deduct the amount of the loss that exceeds 10 percent of yourAGI, less $100.

Job Expenses and Miscellaneous DeductionsMany people incur expenses required for their employment but are not reim-bursed for them by their employer (e.g., union dues, licenses and fees, books

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and professional software, professional liability insurance, tools and supplies, jobhunting costs, travel costs). Ordinary and necessary job-related expenses aredeductible if they exceed 2 percent of your AGI.

Several special rules apply to the miscellaneous deductions category. Gam-bling losses up to the amount of reported gambling income can be deductedwithout regard to the 2 percent limitation. Disabled workers are also allowed todeduct all their job-related expenses.

Totaling Your Itemized DeductionsAfter calculating your deductions, you total them and compare the amount tothe standard deduction. Note that although it’s a good idea to claim all deduc-tions to which you are entitled, unusually large deductions might subject yourreturn to increased scrutiny by the IRS.

3.2.4 Exemptions

The last step in calculating your taxable income is to subtract the appropriateamount for your exemptions. An exemption is an amount of money that you’reallowed to subtract for each qualifying person in your household. This usuallymeans one exemption each for yourself, your spouse, and each of your depen-dents. A dependent is a member of a household who receives at least half ofhis or her support from the head of the household.

The allowed exemption amount was $3,300 in 2006, and it increases annu-ally with inflation and is phased out for high-income taxpayers. A person canbe claimed as an exemption on only one tax form. So if your daughter is beingclaimed as a dependent on your tax form, she can’t take an exemption on herown tax form. Note that the marginal benefit to a family is higher if the exemp-tion is claimed by the taxpayer in the highest tax bracket.

3.2.5 Final Calculation of Taxes Owed

Subtracting your deductions and exemptions from your AGI yields your taxableincome. You use this amount to calculate your taxes. Figure 3-4 shows how eachlayer of income is taxed. In financial planning, you always consider the effectson the last layer of income.

You can find the appropriate tax amount easily by using the tax table pro-vided in the instruction booklet that comes with your tax forms. AlthoughSection 3.1.2 illustrates the increasing marginal tax rates by explaining howeach layer of income is taxed, individual taxpayers are not expected to do thatcalculation themselves. Instead, the IRS has precalculated the tax. So all youhave to know is your taxable income, and you can look up the tax amountthat you must pay. When you’ve determined your tentative tax, you’re almostdone.


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Applying Available CreditsTax credits directly reduce the taxes you owe. The currently available creditsinclude credits for foreign taxes paid, child and dependent care expenses, elderlyand disabled status, education expenses, retirement contributions, dependentchildren, and adoption.

Several of the available credits are particularly helpful for working par-ents and contribute to the progressive nature of the tax system. In additionto a flat credit per child under 17, you can take a credit for some of the costsof child care. For lower-income families in which both parents are employed,the Earned Income Credit can significantly reduce taxes paid. Some collegestudents may also qualify for this tax credit. The Hope Scholarship Creditand the Lifetime Learning Credit are important for college students to beaware of. Contributions to retirement savings accounts may also qualify forcredits.

Figure 3-4

The taxation of your income, by layer.

0%

100%

90%

60%

5 0%

80%

70%

40 %

30 %

20%

10%

Taxa

ble

Inco

me

Tax on layer

Layers of totalincome $60,000

Adj

uste

d G

ross

Inc

ome

Standard deduction = $4,750 $ 0$ 0

10% Bracket (taxable incomefrom $0 to $7,000)

$ 700

15% Bracket (taxable incomefrom $7,000 to $28,400)

$3,210

$9,860

25% Bracket (taxable incomefrom $28,400 to $52,200)

$5,950

Personal exemption = $3,050

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Although many credits are fairly straightforward, some have specific incomelimitations or are phased out for higher-income families, so you may have to usean IRS worksheet to determine your eligibility for them. All credits except forthe child tax credit require the filing of a special form (referenced on the appro-priate line of Forms 1040 and 1040A). All the required forms and informationon these credits are available on the IRS Web site, www.irs.gov.

Alternative Minimum TaxSome taxpayers end up owing more in taxes than the calculation discussed sofar would indicate because of the alternative minimum tax (AMT). This taxwas originally designed to ensure that high-income people couldn’t take advan-tage of too many special tax rules to avoid paying their fair share of taxes, butin recent years, it has also affected many middle-income taxpayers.

The AMT works this way: You recalculate your taxes under a different set ofrules in which many of the current deductions, exemptions, and special taxbreaks do not apply. If the tax calculated in that way is larger than the one cal-culated in the normal way, you must pay the AMT, a higher tax amount. Whetheryou should take the time to do this depends on whether your tax situationincludes many of the AMT “triggers.” Some of the triggers for AMT liability ina given year include

▲ a large number of exemptions claimed.▲ exercise of incentive stock options.▲ long-term capital gains.▲ large itemized deductions, particularly for medical expenses or second

home mortgage interest.

If any of these apply to you, you should follow the directions for calculation ofthe AMT to see whether it applies. Don’t be surprised if it does—more than 2.7million taxpayers were subject to it for tax year 2003, and the AMT is estimatedto reach more than 35 million within the next decade. The IRS automaticallycalculates the AMT based on your submitted tax form, so if you neglect to doso and therefore underpay your taxes, you may end up paying additional inter-est and penalties. (Tax preparation software and tax professionals automaticallycalculate the AMT.)

3.2.6 Paying Taxes

Taxes are supposed to be paid on your income as you receive it. However, ourtax system is complex enough that it isn’t always easy to determine exactly howmuch you must pay until the year ends and you actually prepare your return.You must estimate this amount throughout the year to ensure that you payenough.


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For earned income from employment, the payment of estimated taxes is usu-ally accomplished through payroll withholding, whereby the employer takesmoney out of your income for the government. The amount of tax withheld isbased on expected income and your estimated number of exemptions, as indi-cated on a W-4 form, the Employee’s Withholding Allowance Certificate. Youcomplete a W-4 form whenever you begin a new job. The lower the number ofexemptions claimed, the larger the amount withheld. Alternatively, if you don’texpect to owe any taxes—if you have fairly low income—you can indicate thatyou are tax exempt so that no taxes will be withheld.

Most taxpayers have more withheld than they will owe and receive a refund(without interest). Even if an appropriate number of exemptions is claimed onthe W-4, you may still end up overpaying in withholding because the amountwithheld assumes that you’ll take the standard deduction.

If you are self-employed or have investment income that hasn’t been sub-ject to withholding, you must still pay your taxes in advance of the April 15due date. The law requires that you pay the tax in quarterly estimated taxinstallments during the tax year (on April 15, June 15, September 15, andJanuary 15). If you underpay, you are subject to penalties. To avoid under-payment penalties, you should make sure that the total of your withholdingplus estimated tax payments is at least as much as 100 percent of your prioryear’s tax owed.

If you’re self-employed, you are likely to owe additional taxes beyond thefederal income tax. Self-employed individuals report total business revenues andcertain deductible expenses on Schedule C. The difference between their rev-enues and expenses is taxable and therefore must be reported as business income(or loss) on their 1040 form. Individuals who report self-employment incomeare also required to file a Schedule SE (for self-employment) with their federaltax forms. This worksheet determines the Social Security and Medicare payrolltaxes owed on business income. Whereas wage and salary workers split the 15.3 per-cent tax with their employer (each paying 7.65 percent), self-employed peopleare their own employers and thus must pay both portions. The combined effectof federal and state income taxes plus the Social Security and Medicare tax is ahefty bite out of business income, sometimes more than 50 percent for those inthe highest marginal income tax bracket.

If your total withholding and estimated taxes paid during the year are lessthan the amount of taxes you owe for the year, you must include a check forthe remainder with your submitted form. If you’ve paid too much in withhold-ing, you’re entitled to a refund. You may receive a refund even when you didn’thave sufficient income to require any payment of taxes. This occurs becauseCongress has made certain tax credits refundable—that is, you can get them evenif you have no taxes owed to credit them against. The most important refund-able tax credit is the additional child tax credit, which allows some householdsto receive the credit even if they owed no tax.

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You should try to minimize the amount of refund you’ll receive because over-paying taxes is essentially like giving the government a zero-interest loan. Sometaxpayers like to overpay their taxes, although this strategy doesn’t make goodfinancial sense.

3.3 Filing Your Federal Tax Return

Filing a tax return involves reporting income to the IRS on official tax forms andpaying any outstanding taxes owed. In this section, we explain the requirementsfor filing.

3.3.1 Filing Status

Whether you must file a federal return depends primarily on your filing status,income, and age. Your filing status identifies your household type. Because yourfiling status may change, every year you must identify yourself as one of the fol-lowing (based on your status as of the last day of the year):

▲ Single: Unmarried or legally separated from your spouse.▲ Married filing jointly: Married couple filing a single tax return, even if

only one spouse had income.▲ Married filing separately: Married couple filing separate tax returns, each

reporting his or her own income and allowed deductions from income.▲ Head of household: Single person who lives with and pays more than

half of the support for a dependent child or relative.▲ Qualifying widow(er) with dependent child: Person whose spouse died

within two years of the tax year and who lives with and pays more thanhalf of the support for a dependent child.

3.3.2 Income

Your taxable income is a major determinant of whether you must file a taxreturn and, of course, also determines the amount of taxes you pay. The IRS

3.3 FILING YOUR FEDERAL TAX RETURN 151

1. Define alternative minimum tax, payroll withholding, and capitalgain.

2. List some possible deductions a taxpayer may itemize.

3. What is the result when you subtract adjustments from total income?

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defines your AGI as the total of your earned income (e.g., salaries, wages, tips,bonuses, commissions) plus unearned income (e.g., interest, dividends,capital gains, rents, royalties, net business income) minus certain allowedadjustments.

You are allowed to subtract certain amounts from your AGI to get yourtaxable income. The most important are called exemptions and deductions.You get a personal exemption of $3,300 (in 2006, indexed for inflation) foreach qualifying person in your household, including yourself and eachdependent, although this allowance is phased out for very high-incomehouseholds.

Also, you receive a standard deduction for certain qualifying expenses onwhich you are not taxed. The standard deduction for single taxpayers in 2006was $5,150, whereas married couples filing jointly were allowed to deduct$10,300, and heads of household could deduct $7,550. Standard deductions arehigher for people who are age 65 and older and for people who are blind.

The allowed deductions are indexed for inflation so that the amount you candeduct increases annually. If your annual expenses in certain allowed categoriesexceed, in total, the standard deduction for your filing status, you should item-ize instead of using the standard deduction. Itemizing deductions involves filingan additional form on which you detail all deductions. Whereas the standarddeduction is available without proof of expenses, you must keep supporting doc-umentation for all itemized deductions.

If your earned income is no more than the total of your exemptions andstandard or itemized deductions, your taxable income is zero, and you need notfile a return. For a single taxpayer, this means that you could have earned upto $3,330 � $5,150 � $8,450 in 2006 without having to file.

Married couples filing jointly had to file if they earned more than $6,600 �$10,300 � $16,900. Of course, if you made less than these amounts but hadtaxes withheld from your pay, you would need to file in order to get a refund.

In addition to exemptions and deductions, you can also use a tax credit toreduce the taxes you owe. Tax credits, unlike exemptions and deductions, donot represent adjustments to your income. Rather, they are subtracted directlyfrom the taxes you owe.

3.3.3 Age

Age affects your obligation to file and pay taxes. For example, the larger stan-dard deduction for individuals age 65 and older means that they can earn moreincome without being taxed. In certain circumstances, dependent children up toage 24 do not have to file. However, even if your parents claim you as a depen-dent, you still need to file a return if any of these apply:

▲ Your earned income was more than $5,150 (based on 2006 tax law).

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▲ Your unearned income (such as earnings on investment accounts) wasmore than $750.

▲ Your gross income was more than the larger of $750 or your earnedincome (up to $5,150) plus $250.

In addition, you should file if you want to get a refund of taxes withheld fromyour income or if you qualify for a tax credit.

3.3.4 When and Where to File Taxes

There are very specific rules for when and where you file your taxes. Failure tomeet these requirements is a violation of the tax law and may subject you tointerest and penalties. It may also take longer to receive any refund.

Tax returns must be postmarked by midnight on April 15 of the year fol-lowing the tax year. So for income you earned in 2005, you had to file yourreturn by April 15, 2006. If April 15 falls on a day that the post office is closed,the due date is extended by one day. You can extend the deadline by fourmonths, to August 15, by filing Form 4868, Application for Automatic Exten-sion, on or before the April 15 deadline.

If four months is still not enough time, you can file another form to get anadditional extension to October 15. About 9 million taxpayers request exten-sions each year. Although it might seem like a good way to avoid doing yourtaxes, extensions do not extend the deadline for paying the actual taxes, so youstill have to include a check for any estimated amount you owe or be subject topenalties and interest. If you discover that you made a mistake on a prior year’staxes, you may file an amended return using Form 1040X for up to three yearsafter the original tax year. The IRS receives about 4 million amended returnsa year.

The IRS operates several service centers where tax returns are processed.When you get your tax forms in the mail, they include a preprinted address labelthat directs your return to the appropriate service center. Even if you file yourtaxes electronically, the IRS still sends you the label. You can also find out whereto mail it by checking your zip code at www.irs.gov.

Many taxpayers choose to file their taxes electronically, either online, throughtheir tax accountant, or by telephone. The IRS e-file uses online automation toreplace many of the manual steps needed to process paper returns, resulting infaster processing with fewer errors (fewer than 1 percent of all electronic taxreturns included errors in 2002). Most professional tax preparation services andsoftware packages offer, and even encourage, electronic filing, but you can alsodo so on your own.

Although using e-file supposedly does not increase your chances of beingaudited, it does allow the IRS to better track the information contained inyour forms—with paper forms, the IRS only inputs into its database certain

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data items from each return. If you have a very simple return, as is the casefor college students, for example, you can even file electronically by tele-phone, entering the information by using your telephone keypad. A TeleFilepackage is automatically sent to any taxpayer who filed a Form 1040EZ inthe previous tax year.

3.3.5 IRS Forms

You have a choice of three primary tax forms:

▲ Form 1040, known as the long form.▲ Form 1040EZ.▲ Form 1040A.

Which form to use depends on your filing status, your income (type andamount), and the deductions and credits you can claim.

Even if you qualify to use either of the short forms (1040EZ or 1040A), youcan use the standard 1040 long form instead. Depending on your income, deduc-tions, and credits, you may need to include additional forms. Your tax formsmay be filled out by hand, typed, or completed electronically. You can also paya professional tax preparer to complete your tax return, although you still needto collect the necessary documentation and give it to the preparer.

Software packages such as TurboTax and TaxCut can make completing yourreturn and identifying the appropriate forms easier. These programs walk youthrough the entry of information by asking questions and then fill in the appro-priate forms. After you use one of these programs, it remembers informationfrom previous years, which makes it less likely that you’ll forget potential deduc-tions or credits. This can also help you avoid some common errors.

3.3.6 The Most Common Filing Errors

No one has ever argued that filing taxes is easy. Even people with advanced degreesmake mistakes on their tax returns. But these mistakes can cost you money. Yourrefund might be delayed. Or, worse yet, you might have to pay additional taxes,interest, and penalties. According to the IRS, the most common mistakes are1:

▲ math errors, both addition and subtraction. Math errors are the number-one mistake. Don’t forget to clearly indicate negative numbers, preferablyby using parentheses.

▲ incorrect or missing Social Security numbers for members of the house-hold.

▲ incorrect tax entered from the tables.▲ withholding and estimated tax payments entered on the wrong lines.

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▲ computation errors in figuring the child and dependent care credits andthe Earned Income Credit. Also, missing or incorrect identification num-bers for child-care providers.

Although somewhat less common than the preceding errors, the IRS also seespeople make mistakes such as:

▲ not signing and dating the return. No signature, no refund!▲ forgetting to report interest and dividend income. The IRS gets indepen-

dent verification of this from your financial institution.▲ not including all the required forms, especially those indicating taxes

withheld (e.g., W-2, 1099).▲ making out the check incorrectly (wrong amount, failure to sign). If your

tax payment doesn’t get to the IRS by the filing deadline because there isno signature, you are subject to penalties and interest.

▲ putting insufficient postage on the envelope. The post office then returnsthe envelope to you, and you could miss your filing deadline.

▲ giving the incorrect address for refunds. The IRS has refund checks total-ing $80 million that came back as undeliverable.

▲ checking more than one filing status. For example, you can’t be marriedand single at the same time.

3.4 Tax Planning Strategies

Understanding income taxation is important because it helps you anticipate thetax consequences of your financial decisions. The tax laws may often make onestrategy clearly preferable to another—for example, one investment alternativemay offer tax benefits, while another doesn’t. Also, your tax knowledge will helpyou evaluate whether you need to consult a tax professional and to prepare thenecessary information for your financial planner. If your taxes are simple, youshould be able to handle them yourself. If your situation is more complex, youmight benefit from a tax specialist’s more detailed legal knowledge.

3.4 TAX PLANNING STRATEGIES 155

1. What are the three primary tax forms?

2. What are filing status options for married people?

3. List five of the most common filing errors.

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Tax planning strategies are those intended to:

▲ reduce taxable income.▲ defer taxable income.▲ receive income that is subject to lower tax rates.▲ increase deductions and exemptions from income.▲ maximize tax credits.

3.4.1 Tax Evasion vs. Tax Avoidance

Effective personal financial management requires minimizing unnecessary cashoutflows—including any unnecessary taxes. Of course, you must pay taxes thatyou legally owe. Tax evasion is the deliberate failure to pay taxes that are legallyowed, and it is against the law.

Examples of tax evasion include failure to report tip income or earningsreceived “under the table.” Because waiters and waitresses usually earn more intips than they earn in wages, the IRS regularly audits these jobs to estimate aver-age tips and requires that employers withhold sufficient taxes from the employ-ees’ wage income, sometimes leaving them with very little in their paychecks.However, restaurant workers usually receive more in tips than what is reportedby their employers in these audits, thus resulting in under-withholding.

Working under the table means working for someone who pays you in cashand doesn’t withhold taxes. This is illegal. It is suspected that many farm andagricultural workers and their employers, particularly in areas near the U.S. bor-ders, evade taxes in this way. Because these workers are often transient, it is dif-ficult to catch them.

Although tax evasion is illegal and can have serious consequences, there isnothing illegal about tax avoidance. When you use your knowledge of the taxrules to make financial decisions that reduce the taxes you owe, you are ensur-ing that you do not pay more taxes than you legally owe. The money you savein taxes can be applied to achieving your financial goals.

Consider the example of tax-deductible versus nondeductible investmentcontributions. A tax-deductible investment allows you to invest without payingtaxes on the money first. So, $1,000 of income results in $1,000 invested. If youinvest instead in something without that tax benefit, then you pay taxes on the$1,000 in income first, leaving substantially less to actually invest. If your mar-ginal federal income tax rate is 25 percent and your state tax is 5 percent, youwill have only $700 left to invest after taxes.

Tax avoidance requires thoughtful planning. In general, tax planning is the ongo-ing process of using the provisions of the tax law to reduce your taxes or defer themto later years. As you begin to work toward long-term financial goals, you shouldconsider not just the current year’s taxes but the taxes in future years, too. Becausetax laws frequently change, you should try to stay informed about new rules.

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Tax evasion is a crime and can, sometimes, result in imprisonment. When acrime boss is successful in avoiding prosecution for murder and other mayhem,federal officials sometimes choose to prosecute for tax evasion instead becauseit’s easier to prove. In 1930, for example, gangster Al Capone was sentenced to11 years in prison for his failure to pay taxes for 4 years.

3.4.2 Reducing Taxable Income

You can reduce taxable income without reducing gross income. Many employersoffer the opportunity to make pretax contributions to employee benefit andretirement plans, and they often match a portion or all of your contribution.This is a great benefit you should take advantage of if it is offered because thelaw allows you to use your pretax income to buy your benefits. Federal, state,and local income taxes as well as Social Security payroll taxes are calculatedbased on the income left after these expenditures have been made. You savewhatever tax you would have paid on that income, and your employer saves itsportion of the Social Security tax.

Many large employers also allow employees to take advantage of flexiblespending accounts, reimbursement accounts for qualified medical and child-care expenses. Each pay period, the employer subtracts a certain amount fromyour paycheck and deposits it in your flexible spending account. The amountdeposited is not part of your taxable income. However, these accounts may haverestrictions on when you can spend the money, so you need to make sure youknow how your plan works. You can obtain reimbursement from the account asyou incur qualified expenses, such as child-care expenses. This allows you to pay

FOR EXAMPLE

Saving on Health CareSuppose you work for an employer that offers you the opportunity to pur-chase your health insurance with pretax dollars at a cost of $300 per month.Your friend Jonah, who earns the same salary, has no health insurancethrough his employer and pays out of pocket, again for $300 monthly. Howmuch better off are you than your friend if you are both subject to a mar-ginal tax rate of 30 percent? Your taxable income will now be lower by the$300 amount, so you’ll be able to avoid paying $90 per month in taxes($300 � 0.30), or $1,080 per year. Jonah must pay taxes on his full earn-ings. In effect, the tax deductibility allows you to get a $1,080 discount onthe cost of the health insurance (equal to your tax savings), money that youcan apply to one of your financial goals.


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for your child care with pretax dollars, substantially reducing your out-of-pocketcost because you save the amount in taxes you would have paid.

If your marginal tax rate is 20 percent (15 percent federal � 5 percent state tax)and you normally pay $5,000 per year for child care, you can save about $1,000 intaxes ($5,000 � 0.2) for the year with a flexible spending account. If you insteadpaid taxes on the $5,000 in taxable earnings, you’d have only $4,000 left after taxes[$5,000 � (1 – 0.2) � $4,000]—not enough to pay for your child care.

Investment real estate owners are allowed some deductions that aren’t actu-ally out-of-pocket expenses. A profitable investment property may produce a taxloss that can be applied against other income to reduce taxes. Therefore, tax-payers in high tax brackets often consider investing in real estate properties thatwill produce a tax loss after expenses.

3.4.3 Deferring Taxable Income

For some employer retirement plans, you can make investment contributions ona pretax basis and therefore avoid current income taxes on that income. (SeeChapter 14 for more on retirement plans.) These plans also allow you to deferpaying taxes on the investment earnings in the plan. If you earn $1,000 in invest-ment income in a taxable account—such as interest on your bank savingsaccount—you owe taxes on those earnings in the year received, with the actualamount owed being a function of your marginal tax rate (including state andfederal income tax).

With a tax-deferred account, you don’t pay tax on it until you withdraw it,which may be many years away. At that point, you may be in a lower marginaltax bracket. But even if you’re not, you will benefit from the time value ofmoney—it’s always better to pay a given amount in the future than it is to paythe amount today because a dollar today is worth more than a dollar in thefuture.

Retirement plans can have great tax benefits. If you aren’t fortunate enoughto have a retirement plan option with your current employer, tax rules allow youto set up an individual retirement account (IRA). There are two types of IRAs:

▲ A traditional IRA allows you to subtract your annual contribution to theaccount from income and to defer the payment of taxes until withdrawal.Note that this type of IRA has a tax effect similar to that of employment-based retirement plans.

▲ A Roth IRA does not allow you to take a current deduction, so youmust make the contribution with after-tax dollars. However, assumingthat you use the funds for retirement or other allowed purposes, younever have to pay tax on the money again—the account, including allaccumulated investment earnings, can grow tax free, and you can with-draw the money at retirement without paying any taxes on it.

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Another way to defer taxable income is to postpone receiving the incomeuntil a future tax year. Suppose a family friend hires you to build a deck in thefall of 2006. You know that your 2006 income is relatively high because youworked the whole year. Because you’ll be attending college in 2007, you expectto be in a lower tax bracket that year. If you can delay the receipt of paymentfor your deck-building services until 2007—possibly by waiting to bill yourfriend—you won’t have to pay the tax until 2007, and you’ll reduce the overalltax owed (because you’ll be in a lower tax bracket). Certain professions—smallbusinesses and consulting practices, for example—can often take advantage ofthis type of tax strategy.

3.4.4 Receiving Income That Is Subject to Lower Tax Rates

Capital gains and certain dividends from long-term investments are taxed at alower rate than ordinary income. For this reason, an important tax strategy is toavoid investments that pay you current income (interest or dividends) in favorof those that provide returns in the form of increased value. Because a capitalgain is not reported on your taxes until you sell the asset, you can accumulatesubstantial wealth without incurring any current tax.

When you realize a gain on a qualifying investment, you pay at a lower taxrate, in most cases 15 percent. Your home has an even greater advantage in thisrespect because most capital gains from the sale of your primary residence aretax free.

Families can achieve lower taxes overall by shifting some income to house-hold members who are in lower tax brackets. For example, you can give taxableinvestment accounts to your children. You are allowed to make gifts of up to$12,000 each per year tax free to as many people as you want without thereceiver having to declare it as income. Children can earn up to $750 in invest-ment income per year without paying any tax. If the child is under age 14, thenext $750 in unearned income is taxed at the child’s marginal tax rate (10 per-cent), and unearned income above $1,500 is taxed at the parent’s marginal taxrate (under a rule commonly referred to as the “kiddie tax”).

Children age 14 and over pay their own tax rate on all income over $750.So, if you have $12,000 in a taxable savings account earning 4 percent per year,or $480, you can avoid the taxes you would normally have to pay on the inter-est earnings by gifting the account to your child, who can receive the interestwithout any taxes being owed.

3.4.5 Increasing Deductions and Exemptions from Income

To maximize your tax deductions, you should plan ahead for the record keepingand timing of expenditures. Careful record keeping helps ensure that you are report-ing all deductible expenses. When you have a choice as to when to incur anexpense, you should consider how the timing will affect your taxes. To get an idea


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of how many people apply this rule to their finances, go to an office supply or com-puter store on New Year’s Eve. The store will probably be packed because Decem-ber 31 is the last day to make purchases that can be deducted for the tax year.

It’s a good idea to roughly estimate your expected tax liability before Decem-ber 31. Any deductible expenditures have a much lower effective cost than actualcost because you would otherwise be paying some of that money in taxes.Another example of strategic end-of-year expenditures involves the timing ofuninsured medical procedures. Let’s say that in tax year 2006, you’ve alreadyincurred sufficient medical costs (greater than 7.5 percent of the AGI) to qual-ify for the medical expense deduction. Any additional uninsured medicalexpenses—including out-of-pocket premiums, deductibles and copays, doctorvisits, surgery, vision care, and prescriptions—can all be itemized in 2006, reduc-ing the effective cost by the amount of your marginal tax bracket. If you need anew pair of glasses, this is the time to get them. Making charitable contributionsis another way to increase deductions. You should keep track of all the timesyou’ve taken clothing to Goodwill or donated food.

Although it’s always a good idea to get receipts, they’re only required by theIRS for large contributions of cash or goods. In high-tax years, you should con-sider making an end-of-year contribution to your favorite charity. If you donatea total of $400, it could save you $100 to $200 in taxes, depending on your taxbracket, substantially reducing the effective cost of making the contribution.

Your home also has some tax-sheltering value. In addition to its capital gainadvantage, mortgage interest and property taxes are both deductible, so your homeis an incredible tax shelter. You should also consider taking advantage of home equityloans. Not only do they usually have a lower interest rate than consumer loans, butthe interest on up to $100,000 in home equity loans ($50,000 for single or marriedfiling separately) is tax deductible, reducing the effective cost even more.

To see how home ownership can produce tax benefits, consider the differencebetween two taxpayers, each in the 25 percent marginal tax bracket. Assume thatthe first one is a renter and the second is a homeowner. Both have identical annualhousing expenditures of $12,000 per year. The renter cannot deduct any of this;the homeowner, however, can deduct all the mortgage interest and property taxes.That’s like cash in the pocket! Plus, the home can increase in value tax free.

Exemptions are another type of deduction from your income. For example,expectant parents have moved up the date of their Caesarian sections from Jan-uary 1 to December 31 in order to gain a tax exemption on the surgery.

3.4.6 Maximizing Tax Credits

Many people are eligible for various tax credits but don’t claim them. This gener-ally happens when they either don’t know about the credits or haven’t kept ade-quate records to claim them. Your tax planning strategy should therefore includea careful review of available credits and evaluation of your eligibility for each.

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SUMMARYYour financial plan will benefit from your knowledge of the tax code and howto avoid overpaying your taxes. It’s important to think about the tax implicationsof your financial decisions. The U.S. tax system is progressive, although less sotoday than it was originally. Keeping your finances in order can help you fileyour taxes on time and accurately. You should use tax planning strategies, suchas pretax investing, to your advantage.

KEY TERMSAdjusted gross income (AGI) Earned income and unearned income mi-

nus certain allowed adjustments to income.

Alternative minimum tax A federal income tax designed to ensure(AMT) that people who receive certain tax breaks

pay their fair share of taxes.

Average tax rate The proportion of a taxpayer’s total taxableincome that goes to paying taxes.

Capital gain Profit on the sale of an investment. This profitis subject to a lower tax rate if the investmenthas been held for more than one year.

Dependent A member of a household who receives atleast half of his or her support from thehead of the household.

Earned income Income from salaries, wages, tips, bonuses,commissions, and other sources.

Exemption The dollar amount per household memberthat is subtracted from adjusted gross incomein calculating taxable income.

Federal Insurance Contributions A payroll tax levied on earned income byAct (FICA) tax the U.S. government to fund Social Security

1. What are the two types of IRAs?

2. Define tax evasion and tax avoidance.

3. Is working under the table legal?

S E L F - C H E C K

KEY TERMS 161

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and Medicare. Stands for Federal InsuranceContributions Act tax.

Filing status The household type, for tax filing purposes.

Flexible spending account An account maintained by an employer inwhich the pretax earnings of an employeeare set aside and can be used for reimburse-ment of qualified medical and child-care expenses.

Gross income Income from all sources, including earnedincome, investment income, alimony, un-employment compensation, and retirementbenefits.

Gross taxable income Income from all sources, less allowed exclu-sions.

Internal Revenue Code A compilation of all statutes, regulations, andcourt decisions relating to U.S. income tax.

Individual retirement A retirement account that allows theaccount (IRA) holder to subtract current contributions

from taxable income and to defer income taxuntil withdrawal at retirement.

Internal Revenue Service The U.S. government agency that is re-(IRS) sponsible for collecting federal income taxes

and enforcing tax laws and regulations.

IRS e-file A system that enables the electronic filing offederal tax returns.

Itemized deductions An alternative to the standard deduction inwhich the taxpayer reports and deducts ac-tual expenses in certain allowed categories toarrive at taxable income.

Marginal tax effect The change in taxes owed as a result of a fi-nancial decision.

Marginal tax rate Tax rate imposed on a taxpayer’s next dollarof income.

Payroll withholding Money regularly withheld from employees’pay by employers for payment of the em-ployees’ taxes.

Progressive tax A tax that requires higher-income taxpayersto pay proportionately more in taxes thanother taxpayers, through either higher taxrates or other rules.

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Regressive tax A tax that places a disproportionate financialburden on low-income taxpayers.

Roth IRA An individual retirement account to whichcontributions are made with after-tax dol-lars but in which investment earnings andwithdrawals at retirement are tax free.

Standard deduction A dollar amount based on filing status thatis subtracted from adjusted gross income incalculating taxable income.

Tax avoidance Strategic use of knowledge of tax rules toavoid overpayment of taxes.

Tax bracket The range of income to which a particularmarginal tax rate applies.

Tax credit A reduction applied directly to taxes owedrather than to income that is subject totaxes.

Tax evasion Deliberate nonpayment of taxes legallyowed.

Taxable income The amount of income that is subject totaxes under the law.

Total income Gross income less certain exclusions al-lowed by the IRS.

Unearned income Income from investments, interest, divi-dends, capital gains, net business income,rents, and royalties.

KEY TERMS 163

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ASSESS YOUR UNDERSTANDINGGo to www.wiley.com/college/bajtelsmit to assess your knowledge of managingyour taxes.Measure your learning by comparing pre-test and post-test results.

Summary Questions

1. The current U.S. federal tax rates are considered to be the highest everrelative to historical rates. True or false?

2. A progressive tax is one in which:(a) you pay more if you earn more.(b) you pay less if you earn more.(c) you pay the same, regardless of earnings.(d) taxes are used for progressive services.

3. If your taxable income falls in the lowest tax bracket:(a) you pay no taxes.(b) your taxes are computed based on the AMT.(c) you receive the Earned Income Credit.(d) all your taxable income is taxed at the same rate.

4. Interest earned on bank deposits is classified as:(a) earned income.(b) an adjustment to income.(c) interest income.(d) capital gains.

5. Which of the following tax forms is known as the long form?(a) 1040A(b) 1040B(c) 1040C(d) 1040EZ

6. Tips you receive must be reported as income on your tax form. Trueor false?

7. Which of the following types of taxes paid is not an allowed itemizeddeduction?(a) property taxes on your home(b) personal property taxes(c) state income taxes(d) use taxes

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8. A $1,000 tax credit would be more beneficial than a $1,000 tax deduc-tion. True or false?

9. The amount of taxes withheld from your paycheck depends on yourexpected income and number of exemptions. True or false?

10. One reason to give investment accounts to children is that:(a) children pay no taxes.(b) accounts of children are not audited by the IRS.(c) their income would be subject to lower tax rates.(d) all of the above are correct.

11. Which of the following retirement accounts allows tax-free withdrawalsat retirement?(a) 401(k) plans(b) traditional IRAs(c) Roth IRAs(d) 403(b) plans

Applying This Chapter

1. If you file a return as a single person with a taxable income of $25,000in 2006, which tax bracket are you in?

2. If you are in the lowest tax bracket in 2006, how much income will besubject to that tax rate?

3. June’s 85-year-old father has lived with her family for all of tax year2006. June is receiving a stipend of $15,000 per year from her father’sestate for taking care of him. His total expenses were $20,000. Can sheclaim him as a dependent for 2006?

4. Rashid has a total income of $21,000 in 2006 and tuition expenses of$1,000, resulting in an AGI of $20,000. He can claim an exemption forhimself in the amount of $3,300, and he incurred the following expensesduring the year: medical expenses, $500; property taxes, $1,500; mort-gage interest, $5,000; state income taxes, $500. If the standard deductionfor a single filer in 2006 is $5,150, should Rashid itemize deductions?Why or why not?

5. Tamika tore a knee ligament in 2006 and had to undergo arthroscopicsurgery. Her total medical expenses were $8,000, but her health insurancecovered all but $2,400. If her AGI is $20,000, how much of this out-ofpocket cost can she deduct on her taxes if she itemizes her deductions?

6. You earned less than $3,000 from your part-time job last year. Shouldyou file an income tax return? Explain.

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7. Explain why you would choose to itemize deductions, from a strategicstandpoint.

8. Explain why capital gains are preferable to earned income, from a taxstandpoint.

9. In what ways is a home a tax shelter?

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YOU TRY IT

You Be the Tax AdvisorFor each of the following taxpayer characteristics, de-sign potential strategies for minimizing taxes:

1. real estate investor in a high tax bracket2. working parents with preschoolers3. college student who is independent of parents

Capital GainsJack Spratt has an investment that gives him $1,000per year in interest income. His friend Peter Pump-kineater has been telling Jack that he should invest insomething that provides him with capital gains instead

of interest. This year, for example, Peter sold someshares of a mutual fund (which he had held for morethan one year) for a $1,000 profit. Assuming that Jackand Peter are both in the top marginal tax bracket (35percent), how much difference did the type of incomethey received from these two investments make to thetaxes owed on the income?

Calculating Your WithholdingHow much should you have withheld from your pay-check? Go to the IRS Web site, www.irs.gov/individuals,and use the withholding calculator there to find out.

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MANAGING YOUR TAXESmyresource.phoenix.edu/secure/resource/FP101R5/Personal_Finance... · 136 MANAGING YOUR TAXES INTRODUCTION Taxes can take a big bite out of your budget, so your