Scenario

4 Managing Income Taxes

YOU MUST BE KIDDING, RIGHT?

Bharat Persaud's employer gave him a $2000 bonus last year, and when Bharat was filling out his federal income tax form, he discovered that $1000 of it moved him from the 15 percent marginal tax rate to 25 percent. How much additional income tax will Bharat pay on the $2000?

A. $150

B. $180

C. $250

D. $400

The answer is C. The federal marginal tax rate is applied to your last dollar of earnings. The first $1000 of Bharat's bonus is taxed at the marginal tax rate of 15 percent ($150), but the second $1000 is taxed at 25 percent ($250). Be aware of your marginal tax rate!

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

 Explain the nature of progressive income taxes and the marginal tax rate.

 Differentiate among the eight steps involved in calculating your federal income taxes.

 Use appropriate strategies to avoid overpayment of income taxes.

WHAT DO YOU RECOMMEND?

Timothy Edgar and Amber Szpanka plan to get married in two years. Timothy earns $44,000 per year managing a fast-food restaurant. He also earns about $10,000 per year selling jewelry that he designs at craft shows held monthly in various nearby cities. Right after they get married, Timothy plans to go back to college full time to finish the last year of his undergraduate degree. Amber earns $58,000 annually working as an institutional sales representative for an insurance company. Both Timothy and Amber each contribute $100 per month to their employer-sponsored 401 (k) retirement accounts. Timothy has little additional savings, but Amber has accumulated $18,000 that she wants to use for a down payment on a home. Amber also owns 300 shares of stock in an oil company that she inherited six years ago when the price was $90 per share; now the stock is worth $130 per share. Timothy and Amber live in a state where the state income tax is 6 percent.

What would you recommend to Timothy and Amber on the subject of managing income taxes regarding:

1. Using tax credits to help pay for Timothy's college expenses?

2. Determining how much money Amber will realize if she sells the stocks, assuming she pays federal income taxes at the 25 percent rate?

3. Buying a home?

4. Increasing contributions to their employer-sponsored retirement plans?

5. Establishing a sideline business for tax purposes for Timothy's jewelry operation?

YOUR NEXT FIVE YEARS

In the next five years, you can start achieving financial success by doing the following related to managing income taxes:

1. Sign up for tax-advantaged employee benefits at your workplace.

2. Contribute to your employer-sponsored 401(k) retirement plan at least up to the amount of the employer's matching contribution.

3. Buy a home to reduce income taxes.

4. Prepare your own tax return so you can learn how to reduce your income tax liability.

5. Maintain good tax records.

Managing your money includes not paying unnecessary sums to the government in taxes. Learning about tax-saving techniques will provide you with more money to do with what you want. “The avoidance of taxes is the only intellectual pursuit that carries any reward,” wrote economist John Maynard Keynes.

You should pay your income tax liabilities in full, but that's all—there is no need to pay a dime extra. To achieve this goal, you need to adopt a  tax planning  perspective designed to eliminate, reduce, or defer some income taxes. To get started, you should recognize that you pay personal income taxes only on your  taxable income . This amount is determined by subtracting various exclusions, adjustments, exemptions, and deductions from total income, with the result being the income upon which the tax is actually calculated. Details for these calculations are provided later. For now, simply remember that the main idea in managing income taxes is to reduce your taxable income as much as possible while maintaining a high level of total income. The result will lower your actual tax liability. Then you will have more money available every year to manage, spend, save, invest, and donate—activities that are the focus of this whole book.

tax planning Seeking legal ways to reduce, eliminate, or defer income taxes.

taxable income Income upon which income taxes are levied.

4.1 PROGRESSIVE INCOME TAXES AND THE MARGINAL TAX RATE

Taxes  are compulsory charges imposed by a government on its citizens and their property. The U.S. Internal Revenue Service (IRS) is the agency charged with the responsibility for collecting federal income taxes based on the legal provisions in the Internal Revenue Code.

taxes Compulsory government-imposed charges levied on citizens and their property.

4.1a The Progressive Nature of the Federal Income Tax

LEARNING OBJECTIVE 1

Explain the nature of progressive income taxes and the marginal tax rate.

Taxes can be classified as progressive or regressive. The federal personal income tax is a  progressive tax  because the tax rate progressively increases as a taxpayer's taxable income increases. A higher income implies a greater ability to pay. As  Table 4-1  shows, the higher portions of a taxpayer's taxable income are taxed at increasingly higher rates under the federal income tax.

progressive tax A tax that progressively increases as a taxpayer's taxable income increases.

A regressive tax operates in the opposite way. It is a tax imposed in such a manner that the tax rate stays the same for all income with the result that lower-income people pay proportionately more in taxes. An example is the state sales tax, since a rate of perhaps 7 percent might have to be paid by everyone regardless of income. One who earns $30,000 and spends $6,000 on food pays 1.5 percent on food purchases (7% × $6000 = $420/$30,000 = 1.4%). This compares to another person who earns $80,000 and spends $10,000 on food, thus paying less than 1 percent on sales tax on food purchases (7% × $10,000 − $700/$80,000 = 0.87%).

4.1b The Marginal Tax Rate Is Applied to the Last Dollar Earned

Note that the marginal tax brackets are progressive. The first portion of someone's income is taxed at the rate in the lowest bracket; the next portion is taxed at the next lowest rate; and the final portion of income is taxed an even higher rate. Because our tax system has graduated tax rates, you do not pay the same tax rate on every dollar subject to tax.

The  marginal tax bracket (MTB)  (or marginal tax rate)  is illustrated with the seven income-range segments are taxed at increasing rates as income goes up. The tax rates apply only to the income within each tax bracket range. Recall from  Chapter 1  that your marginal tax rate is the one that is applied to your last dollar of earnings.

marginal tax bracket (MTB)/ marginal tax rate One of seven income-range segments at which income is taxed at increasing rates. Also known as marginal tax rate.

Depending on their income, taxpayers fit into one of the brackets (as shown in  Table 4-1 ) and, accordingly, pay at one of those marginal tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent, or 39.6 percent. *  In addition, each year the dollar amounts for the taxable income brackets are adjusted for inflation to reduce the effects of inflation in a process called  indexing . This keeps taxpayers from being forced to pay more taxes as they receive raises.

indexing Yearly adjustments to tax brackets that reduce inflation's effects on tax brackets.

Table 4-1 The Progressive Nature of the Federal Income Tax

Single Individuals If taxable income is:	Marginal Tax Rate
Up to $9,075	10%
Over $9,075 but not over $36,900	15%
Over $36,900 but not over $89,350	25%
Over $89,350 but not over $186,350	28%
Over $186,350 but not over $405,100	33%
Over $405,100 but not over $406,750	35%
Over $406,750	39.6%

Your marginal tax rate is perhaps the single most important concept in personal finance. It tells you the portion of any extra taxable earnings—from a raise, investment income, or money from a second job—you must pay in income taxes. It also measures the tax reduction benefits of a tax-deductible expense that allows you to reduce your taxable income.

Consider this example of how the marginal tax rate might apply. Victoria Bassett is from Syracuse, New York (see  Figure 4-1 ). Because of the progressive provisions in the tax laws, part of her $60,000 income ($10,150 [$6200 1 $3950]) is not taxed, the next $9075 is taxed at 10 percent, the next $27,825 is taxed at 15 percent, and the remaining $12,950 of Victoria's $60,000 income is taxed at 25 percent. Thus, Victoria is in the 25 percent marginal tax bracket because the last dollar that she earned is taxed at that level. Her tax liability is $8,318.75 based on her $60,000 in income.

DO IT IN CLASS

Figure 4-1  How Your Income Is Really Taxed (Example: Victoria Bassett with a $60,000 Gross Income, and she is in the 25% marginal tax bracket)

DID YOU KNOW  

The United States Is Not a High-Tax Country

The tax burden in the United States is the lowest among industrialized countries in the world. Compared to countries that are members of the Organization for Economic Cooperation and Development (OECD), combined taxes in the United States are 33.4 percent. Seventeen countries have higher rates including Denmark (47.6%), Belgium (43.5%), France (42%), Australia (42.0%), Hungary (37.9%), Germany (36.1%), and United Kingdom (34.9%). The United States is far from a high-tax country. In fact, federal taxes on middle-income Americans are near historic lows.

The mathematics shown in  Figure 4-1  is based either on the IRS tax table (used for tax returns with incomes up to $100,000) or the tax-rate schedules (used for tax returns with incomes above $100,000). All information cited in this chapter is for income tax returns filed in 2015 for the previous year's income, unless otherwise noted.

4.1c Use Your Marginal Tax Rate to Help Make Financial Decisions

The marginal tax rate can affect many financial decisions that you make. Consider, for example, what happens if you are in the 25 percent marginal tax bracket and you make a $100 tax-deductible contribution to a charity. The charity receives the $100, and you deduct the $100 from your taxable income. This deduction results in a $25 reduction in your federal income tax ($100 × 0.25). In effect, you give only $75 (not $100) because the government, in effect, “gives” $25 to the charity.

4.1d Your Effective Marginal Tax Rate Is Higher

The  effective marginal tax rate  describes a person's total marginal tax rate on income after including federal, state, and local income taxes as well as Social Security and Medicare taxes. To determine your effective marginal tax rate on income, add all of these other taxes to your federal marginal tax rate.

effective marginal tax rate The total marginal rate reflects all taxes on a person's income, including federal, state, and local income taxes as well as Social Security and Medicare taxes.

For example, a single taxpayer earning a taxable income between $36,900 and $89,350 will pay federal income taxes at a marginal rate of 25 percent, a combined Social Security 6.2% *  and Medicare tax rate of 1.45% **  that totals 7.65 percent, ***  a state income tax rate of 6 percent, ****  and a city income tax rate of 2 percent. These taxes result in an effective marginal tax rate of 40 percent (25 + 7.65 + 6 + 2 = 40.65, about 40). Most employed taxpayers pay an effective marginal tax rate of 40 percent.

DID YOU KNOW  

How to Determine Your Marginal Tax Rate

You can determine your marginal tax rate by following this example.

1. Start with a single person who has a taxable income of $39,600, and looking at the illustrated tax table ( Table 4-3  on page 119), he/she finds his tax on that amount of income ($5763).

2. Add $100 to that income for a total of $39,700, and find the tax on that amount ($5788).

3. Calculate the difference between the two tax amounts ($5788–$5763). The extra $25 in taxes from a $100 increase in income reflects a federal marginal tax rate of 25 percent.

 CONCEPT CHECK 4.1

1. Distinguish between a progressive and a regressive tax.

2. What is a marginal tax bracket, and how does it affect taxpayers?

3. Explain why some taxpayers have a marginal tax rate as high as 40 percent.

4.2 EIGHT STEPS IN CALCULATING YOUR INCOME TAXES

LEARNING OBJECTIVE 2

Differentiate among the eight steps involved in calculating your federal income taxes.

There are eight basic steps in calculating federal income taxes:

1. Determine your total income.

2. Determine and report your gross income after subtracting exclusions.

3. Subtract adjustments to income.

4. Subtract either the IRS's standard deduction amount for your tax status or your itemized deductions.

5. Subtract the value of your personal exemptions.

6. Determine your preliminary tax liability.

7. Subtract tax credits for which you qualify.

8. Calculate the balance due the IRS or the amount of your refund.

Figure 4-2  graphically depicts these eight steps in the overall process of federal income tax calculation. The idea is to reduce your income so that you pay the smallest amount possible in income taxes. You do so by reducing total income by removing nontaxable income and then subtracting exclusions, deductions, exemptions, and tax credits, as indicated in the unshaded boxes in  Figure 4-2 .

4.2a Determine Your Total Income

Practically everything you receive in return for your work or services and any profit from the sale of assets is considered income, whether the compensation is paid in cash, property, or services. Listing these earnings will reveal your  total income —compensation from all sources— and much of it, but not all, will be subject to income taxes.

total income Compensation from all sources.

Figure 4-2  The Steps in Calculating Your Income Taxes

For most people,  earned income  is income derived from active participation in a trade or business, including wages, salary, tips, commissions, and bonuses. It is reported to them annually on a Form W-2, Wage and Tax Statement. Employers must provide W-2 information (see  Figure 4-3 ) by January 31 of the year following the earned income. If you also receive income from interest or dividends or other sources, you will receive a Form 1099-INT or 1099-DIV, providing appropriate details. The IRS also receives the information on their Form 1099s, which it uses to verify the income you report.

earned income Compensation for performing personal services.

Income to Include The following types of income are included when you report your income to the IRS:

• Wages and salaries

• Commissions

• Bonuses

• Professional fees earned

• Hobby income

• Tips earned

• Severance pay

• Medical insurance rebates because of Patient Protection and Affordable Care Act

• Fair value of anything received in a barter arrangement

• Forgiven or cancelled debt (unless borrower is insolvent or bankrupt)

• Alimony received

• Scholarship and fellowship income spent on room, board, and other living expenses

• Grants and the value of tuition reductions that pay for teaching or other services

• Annuity and pension income received

Figure 4-3  W-2 Tax Form

• Withdrawals and disbursements from retirement accounts, such as an individual retirement account (IRA) or 401(k) retirement plan (discussed in  Chapter 17 , “Retirement and Estate Planning”)

• Military retirement income

• Social Security income (a portion is taxed above certain income thresholds)

• Disability payments received if you did not pay the premiums

• Damage payments from personal injury lawsuits (punitive damages only)

• Value of personal use of employer-provided car

• State and local income tax refunds (only if the taxpayer itemized deductions during the previous year)

• Employee productivity awards

• Awards for artistic, scientific, and charitable achievements unless assigned to a charity

• Prizes, contest winnings, and rewards

• Gambling and lottery winnings

• All kinds of illegal income

• Fees for serving as a juror or election worker

• Unemployment benefits

• Net rental income

• Royalties

• Investment, business, and farm profits

• Interest income (this includes credit union dividends)

• Dividend income (including mutual fund capital gains distributions even though they are reinvested)

Capital Gains and Losses Are Taxed at Special Low Rates An asset is property owned by a taxpayer for personal use or as an investment that has monetary value. Examples of assets include stocks, mutual funds, bonds, land, art, gems, stamps, coins, vehicles, and homes. The net income received from the sale of an asset above the costs incurred to purchase and sell it is a  capital gain .

capital gain The net income received from the sale of an asset above the costs incurred to purchase and sell it.

A capital loss results when the sale of an asset brings less income than the costs of purchasing and selling the asset. Capital gains and losses on investments must be reported on your tax return. Capital gains from the sale or exchange of property held for personal use, such as on a vehicle or vacation home, must be reported as income, but losses on such property are not deductible. There is no tax liability on any capital gain until the stock, bond, mutual fund, real estate, or other investment is sold.

A short-term gain(or loss) occurs when you sell an asset that you have owned for one year or less; it is taxed at the same rates as ordinary income, which is all income other than capital gains. A  long-term gain  (or loss ) occurs when you sell an asset that you have owned for more than one year (at least a year and a day), and it is taxed at special low rates. The long-term capital gains rate is zero for taxpayers in the 15 percent marginal tax bracket. The rate is 15 percent for those in the 25, 28, 33, and 35 percent brackets. It is 20 percent for those in the 39.6 percent tax bracket.

long-term gain / loss A profit or loss on the sale of an asset that has been held for more than a year.

Capital losses may be used first to offset capital gains on your tax return. If there are no capital gains, or if the capital losses are larger than the capital gains, you can deduct the capital loss against your other income, but only up to a limit of $3000 in one year. If your net capital loss is more than $3000, the excess may be carried forward to be deducted on the next tax year's form, again up to an annual $3000 maximum.

Dividends and Interest Are Treated Differently Owners of stocks in a corporation may receive dividends quarterly. These payments to shareholders are made out of current or accumulated earnings of a corporation and are taxable. Shareholders are annually sent tax forms 1099-DIV that explains what amounts must be reported to the IRS when taxes are filed. Dividends from most domestic corporations and many foreign companies are subject to the same favorable rates as capital gains. Dividends in the form of shares of stock are generally not taxable.

So called dividends are actually “interest” reported to taxpayers on Form 1099-INT when received from credit unions, cooperative banks, savings and loan associations, building and loan associations, and mutual savings banks. They are subject to ordinary income taxes. Dividends received from a life insurance policy are actually a refund of your premium and are not taxed.

4.2b Determine and Report Your Gross Income After Subtracting Exclusions

Gross income  consists of all income (both earned and unearned) received in the form of money, goods, services, and property before exclusions and deductions that a taxpayer is required to report to the IRS. To determine gross income, you need to determine which kinds of income are not subject to federal taxation and, therefore, need not be reported as part of gross income. These amounts are called  exclusions .

gross income All income in the form of money, goods, services, and/or property.

exclusions Income not subject to federal taxation.

DO IT IN CLASS

Income to Exclude The more common exclusions (some are subject to limits) are as follows:

• Gifts

• Inherited money or property

• Income from a carpool

• Income from items sold at a garage sale for a sum less than what you paid

• Cash rebates on purchases of new cars and other products

• Tuition reduction, if not received as compensation for teaching or service

• Federal income tax refunds

• State and local income tax refunds for a year in which you claimed the standard deduction

• Scholarship and fellowship income spent on course-required tuition, fees, books, supplies, and equipment (degree candidates only)

• Withdrawals from state-sponsored Section 529 plans (prepaid tuition and savings) used for education

• Prizes and awards made primarily to recognize artistic, civic, charitable, educational, and similar achievements

• Return of money loaned

• Withdrawals from medical savings accounts used for qualified expenses

• Earnings accumulating within annuities, cash-value life insurance policies, Series EE bonds, and qualified retirement accounts

• Interest income received on tax-exempt government bonds issued by states, counties, cities, and districts

• Life insurance benefits received

• Combat zone pay for military personnel

• Welfare, black lung, workers' compensation, and veterans' benefits

• Value of food stamps

• First $500,000 ($250,000 if single) gain on the sale of a principal residence

• Disability insurance benefits if you paid the insurance premiums

• Social Security benefits (except for high-income taxpayers)

• Rental income from a vacation home if not rented for more than 14 days

• First $5000 of death benefits paid by an employer to a worker's beneficiary

• Travel and mileage expenses reimbursed by an employer (if not previously deducted by the taxpayer)

• Employer-provided per diem allowance covering only meals and incidentals

• Amounts paid by employers for premiums for medical insurance, workers' compensation, and health and long-term care insurance

• Moving expense reimbursements received from an employer (if not previously deducted by the taxpayer)

• Employer-provided payments of $130 per month for transit passes and $250 a month for parking

• Value of premiums for first $50,000 worth of group-term life insurance provided by an employer

• Employer payments (up to $5000) for dependent care assistance (for children and parents)

• Benefits from employers that are impractical to tax because they are so modest, such as occasional supper money and taxi fares for overtime work, company parties, holiday gifts (not cash), and occasional theater or sporting events

• Employer contributions for employee expenses for education (up to $5250 annually)

• Employee contributions to flexible spending accounts

• Reimbursements from flexible spending accounts

• Interest received on Series EE and Series I bonds used for college tuition and fees

• Child support payments received

• Property settlement in a divorce

• Compensatory damages in physical injury cases

4.2c Subtract Adjustments to Income

In the process of determining your taxable income, you make  adjustments to income  (or adjustments). These are allowable subtractions from gross income, and include items such as moving expenses to a new job location (including college graduates who move to take their first job as long as it is at least 50 miles from their old residence); higher-education expenses for tuition and fees (up to $4000); student loan interest for higher education, including that paid by a parent ($2500 maximum); military reservists' travel expenses (for more than 100 miles); contributions to qualified personal retirement accounts (IRA and 401[k] accounts) and health savings accounts (up to $3300 for singles and $6550 for family coverage); alimony payments; interest penalties for early withdrawal of savings certificates of deposit;; and certain expenses of self-employed people (such as health insurance premiums). Adjustments are subtracted from gross income to determine  adjusted gross income (AGI) . Subtracting adjustments to income from gross income results in a subtotal.

adjustments to income Allowable subtractions from gross income.

adjusted gross income (AGI) Gross income less any exclusions and adjustments.

To illustrate the value of adjustments to income, consider that Jose Martinez from Columbia, South Carolina, has a gross income of $50,000. This past year he spent $1200 moving to Nashville, Tennessee, for a new job, and he also paid $2000 in higher-education expenses working on a graduate degree. The $3200 in adjustments reduces his gross income to $46,800, and therefore Jose saves $800 in income taxes because he is in the 25 percent marginal tax bracket ($3200 × 0.25).

Adjustments are called  above-the-line deductions  because they may be subtracted from gross income even if itemized deductions are not claimed. Adjustments may be taken regardless of whether or not the taxpayer itemizes deductions or takes the standard deduction amount (discussed next).

above-the-line deductions Adjustments subtracted from gross income whether taxpayer itemizes deductions or not.

ADVICE FROM A PROFESSIONAL

A Sideline Business Can Reduce Your Income Taxes

A sideline business can open many doors to tax deductions. You should never spend money simply for a tax deduction; however, if you're going to spend the money anyway, you should do everything you can to make it tax deductible.

By having your own business, every dollar you spend attempting to make a profit becomes tax deductible. While no deduction is allowed for personal expenses, you can deduct expenses for auto, travel, office, office equipment (e.g., desk, chair, computer), contributions to self-funded retirement accounts, health insurance premiums, educational expenses, entertainment, business gifts, and more. You can deduct salaries of employees, even if they are your children, other relatives, or friends.

The business does not have to be your primary employment. If you lose money in the business, you can deduct those losses from your other income. The IRS says that you must do what a “reasonable business person” would do to make a profit. If you do not meet that test, the IRS will classify the operation as a hobby, require you to report the income, and disallow all deductions.

James J. Williams

Hudson Valley Community College, Troy, New York

Table 4-2 Tax Rate Schedules

Single Individuals If taxable income is over—	But not over—	The tax is—
$         0	$   9,075	10% of the taxable income
$   9,075	$ 36,900	$907.50 plus 15% of the amount over $9,075
$ 36,900	$ 89,350	$5,081.25 plus 25% of the amount over $36,900
$ 89,350	$186,350	$18,193.75 plus 28% of the amount over $89,350
$186,350	$405,100	$45,353.75 plus 33% of the amount over $186,350
$405,100	$406,750	$117,541.25 plus 35% of the amount over $405,100
Over $406,750	No limit	$118,118.75 plus 39.6% of the amount over $406,750
Married Couples Filing Jointly If taxable income is over—	But not over—	The tax is—
$         0	$ 18,150	10% of the taxable income
$ 18,150	$ 73,800	$1815 plus 15% of the amount over $18,150
$ 73,800	$148,850	$10,162 plus 25% of the amount over $73,800
$148,850	$226,850	$28,925 plus 28% of the amount over $148,850
$226,850	$450,100	$50,765 plus 33% of the amount over $226,850
$405,100	$457,600	$109,587.50 plus 35% of the amount over $405,100
$457,600	No limit	$127,962.50 plus 39.6% of the amount over $457,600

DO IT IN CLASS

4.2d Subtract Either the IRS's Standard Deduction for Your Tax Status or Your Itemized Deductions

Taxpayers may reduce income further by the amount of the standard deduction. Or they can list their  itemized deductions , which are specific items that may be used to directly reduce income that may reduce the amount of your income subject to tax. You can itemize or use the standard deduction, and you want to use the larger of the two. The  standard deduction  is a fixed amount that all taxpayers (except some dependents) who do not itemize deductions regardless of their actual expenses may subtract from their adjusted gross income. In effect, it consists of the government's permissible estimate of any likely tax-deductible expenses these taxpayers might have. Two out of three taxpayers take the standard deduction.

itemized deductions Tax-deductible expenses.

standard deduction Fixed amount that all taxpayers may subtract from their adjusted gross income if they do not itemize their deductions.

The standard deduction amount depends on  filing status , a description of your marital status on the last day of the year. A return can be filed with a status of a single person, a married person (filing separately or jointly), a head of household, or qualifying widow or widower. Certain tax benefits apply to each filing status. For example, the standard deduction amounts are $6200 for single individuals and twice as much, $12,400, for married people filing jointly.

filing status Description of a taxpayer's marital status on the last day of the tax year.

Additional standard deductions if age 65 or blind are permitted. The additional standard deduction for those age 65 or older or who are blind is $1200 for married individuals and surviving spouses. It is $1550 for singles age 65 or older or blind filers.

Taxpayers can take the greater of the standard deduction or itemizations but not both. For example, a single person might list all of his or her tax deductions and find that they total $6800, which is more than the standard deduction amount of $6200, so he or she takes the $6800. Someone else with calculated deductions of $4900 can instead take the standard deduction of $6200.

The tax form lists the following six classifications of itemized deductions:

1. Medical and Dental Expenses

2. Taxes You Paid

3. Interest You Paid

4. Gifts to Charity

5. Casualty and Theft Losses

6. Job Expenses and Most Other Miscellaneous Deductions

Examples of deductions in each of these categories follow. Note that the deduction amounts allowed are reduced for very high income taxpayers.

DID YOU KNOW  

Income Taxes and Same-Sex Couples

Same-sex couples who are legally married in a state are treated as married for all federal income tax purposes. Thus, they may file joint federal income tax returns in all 50 states. State income forms may be filed only in those states that recognize their marriages.

1. Medical and Dental Expenses (Not Paid by Insurance) in Excess of 10.0 Percent of Adjusted Gross Income *

• Medicine and drugs

• Insurance premiums for medical, long-term care, and contact lenses

• Medical services (doctors, dentists, nurses, hospitals, long-term health care, acupuncture, chiropractor)

• Sterilizations and prescription contraceptives

• Costs of a physician-prescribed course of treatment for obesity

• Expenses for prescription drugs/programs to quit smoking

• Medical equipment and aids (contact lenses, eyeglasses, hearing devices, orthopedic shoes, false teeth, wheelchair lifts)

Charitable contributions—even in cash—are typically tax deductible if you itemize deductions.

FINANCIAL POWER POINT  

MAGI Is Used for the Health Care Penalty Tax

Modified adjusted gross income (MAGI). This is the total of adjusted gross income plus any deductions for IRA contributions, student loan interest or tuition, excluded foreign income, and interest from EE savings bonds used to pay higher education expenses. And it is the figure the IRS uses to calculate one's health care penalty. For most people, MAGI is the same as AGI.

• Fees for childbirth preparation classes

• Costs of sending a mentally or physically challenged person to a special school

• Home improvements made for the physically disabled (ramps, railings, widening doors)

• Travel and conference registration fees for a parent to learn about a child's disease

• Long-term care policy premiums and nursing home expenses

• Transportation costs to and from locations where medical services are obtained, using a standard flat mileage allowance

2. Taxes You Paid

• Real estate property taxes (such as on a home or land)

• Personal property taxes (such as on an automobile or boat when any part of the tax is based on the value of the asset)

• State, local, and foreign income taxes

• Health care penalty tax, which is the greater of a flat dollar amount per individual of $325 or 2 percent of the individual's MAGI in 2015 or $695 or 2.5 percent of MAGI in 2016; afterwards it is indexed to inflation.

DO IT IN CLASS

3. Interest You Paid

• Interest paid on home mortgage loans

• “Points” treated as a type of prepaid interest on the purchase of a principal residence

• “Points” paid when refinancing a home mortgage (portion deducted over life of the loan)

• Interest paid on home-equity loans

• Interest paid on loans used for investments

4. Gifts to Charity

• Cash contributions to qualified organizations such as churches, schools, and charities (receipt required for $250 or more)

• Noncash contributions at fair market value (what a willing buyer would pay to a willing seller); IRS says that personal property must be in “good used condition or better” to qualify

• Mileage allowance for travel and out-of-pocket expenses for volunteer charitable work

• Charitable contributions made through payroll deduction

• Contributions to charity up to $100,000 from one's individual retirement account (IRA) for those age 70½ or older

5. Casualty and Theft Losses (Not Paid by Insurance) in Excess of 10 Percent of Adjusted Gross Income

• Casualty losses (such as from storms, vandalism, and fires) in excess of $100

• Theft of money or property in excess of $100

• Mislaid or lost property if the loss results from an identifiable event that is unexpected or unusual (such as catching a diamond ring in a car door and losing the stone)

6. Job Expenses and Most Other Miscellaneous Deductions in Excess of 2 Percent of Adjusted Gross Income (Partial Listing)

• Union or professional association dues and membership fees

• Subscriptions to magazines, journals, and newspapers used for business or professional purposes

• Books, software, tools, and supplies used in a business or profession

• Cost of computers and cell phones required as a condition of your job

• Clothing and uniforms not suitable for off-the-job usage as ordinary wearing apparel (protective shoes, hats, safety goggles, gloves, uniforms), laundering and cleaning

• Unreimbursed employee business expenses (but only a portion of the cost of meals and entertainment), including long-distance telephone calls, cleaning and laundry, and car washes of business vehicle

• Investment-related expenses (e.g., computer software, fees for online trading, adviser fees, investment club expenses, IRA fees, safe-deposit box rental, subscriptions to investment magazines and newsletters, tax preparation charges)

• Legal fees that pertain to tax advice in a divorce or alimony payments

• Travel costs between two jobs, using a flat mileage allowance

• Job-related car expenses (but not commuting to a regular job), using a flat mileage allowance or actual expenses

• Commuting costs to a temporary workplace

• Commuting costs that qualify as a business or education expense

• Medical examinations required (but not paid for) by an employer to obtain or keep a job

• Appraisal fees for charitable donations or casualty losses

• Education expenses if required to keep your job or improve your job or professional skills (but not if the training readies you for a new career)

DID YOU KNOW  

Deduction for Work-Related Education as a Business Expense

If you are an employee and can itemize your deductions, you may be able to claim a deduction for the expenses you pay for your work-related education. Your deduction will be the amount by which your qualifying work-related education expenses plus other job and certain miscellaneous expenses is greater than 2% of your adjusted gross income.

Work-related education is that which meets at least one of the following two tests: (1) The education is required by your employer or the law to keep your present salary, status or job, and the required education must serve a bona fide business purpose of your employer, and (2) The education maintains or improves skills needed in your present work. However, even if the education meets the above tests, it is not qualifying work-related education if it: (1) Is needed to meet the minimum educational requirements of your present trade or business, or (2) Is part of a program of study that will qualify you for a new trade or business. You can deduct the costs of qualifying work-related education as a business expense even if the education could lead to a degree.

If you are self-employed, you deduct your expenses for qualifying work-related education directly from your self-employment income.

DID YOU KNOW  

The Best Tax Guides and Other Help

Your Federal Income Tax: For Individuals, Publication 17, is the IRS's detailed 100-plus-page book for preparing your income taxes. A good, readable tax guide is the annual J. K. Lasser's Your Income Tax ( www.jklasser.com/ ). All federal income tax forms, regulations, guides, and answers to frequently asked questions can be obtained from the IRS at (800) TAX-3676, or at  www.irs.gov . The IRS help line is (800) TAX-1040. Most taxpayers can obtain free tax preparation from the Volunteer Income Tax Assistance (VITA) program (www.vita-volunteers .org/index.htm, or call (800) 906–9887).

• Job-hunting expenses for typing, printing, resume advice, career counseling, want ads, telephone calls, mailing costs, job placement agency fees, and travel for seeking a job in your current career field

• 50 percent of food and 100 percent of transportation and entertainment costs for job hunting (which does not have to be successful) in your current career

• 100 percent of gambling losses that offset reported gambling income (not subject to 2% AGI floor)

• 100 percent of business expenses for workers with disabilities (not subject to 2% AGI floor)

4.2e Subtract the Value of Your Personal Exemptions

An  exemption  (or personal exemption ) is a legally permitted amount deducted from adjusted gross income based on the number of people supported by the taxpayer's income. A  dependent  is a relative or household member for whom an exemption may be claimed. Thus, exemptions may be claimed for the taxpayer and qualifying dependents, such as a spouse (if filing jointly), children, parents, and other dependents earning less than a specific income and for whom the taxpayer provides more than half of their financial support. For example, a husband and wife with two young children would have four exemptions.

exemption (or personal exemption) Legally permitted amount deducted from AGI based on the number of people that the taxpayer's income supports.

dependent A relative or household member for whom an exemption may be claimed on one's income taxes.

A person can serve as an exemption on only one tax return—his or her own or another person's (usually a parent). Each exemption reduces taxable income by $3950. The value of an exemption is phased out for those with extremely high incomes.

4.2f Determine Your Preliminary Tax Liability

The steps detailed to this point have explained how to determine your taxable income. Taxable income is calculated by taking the taxpayer's gross income, subtracting the adjustments to income, subtracting the amount permitted for the number of exemptions allowed, and subtracting either the standard deduction or total itemized deductions.

The amount of taxable income is then used to determine taxpayers' preliminary tax liability via the tax tables or tax-rate schedules for his or her filing status (such as single or married filing jointly). The following examples illustrate how to determine tax liability.  Table 4-3  shows segments of the tax table.

DO IT IN CLASS

1. A married couple filing jointly has a gross income of $50,000, adjustments of $4700, two exemptions ($3950 each), and itemized deductions of $8285. They take the standard deduction of $12,400 because their itemized deductions do not exceed that amount.

Gross income	$50,000
Less adjustments to income	−4,700
Adjusted gross income	45,300
Less standard deduction for married couple	−12,400
Subtotal	32,900
Less value of two exemptions	−7,900
Taxable income	25,000
Tax liability (from  Table 4-3 )	$ 2,846

2. A single person has a gross income of $56,000, adjustments of $4050, one exemption, and itemized deductions of $8400. She subtracts her itemized deductions because the amount exceeds the $6200 standard deduction value.

Gross income	$56,000
Less adjustments to income	−4,050
Adjusted gross income	51,950
Less itemized deductions	−8,400
Subtotal	43,550
Less value of one exemption	−3,950
Taxable income	39,600
Tax liability (from  Table 4-3 )	$ 5,763

3. A married couple with a gross income of $137,000 has adjustments of $4000, two exemptions, and itemized deductions of $9800. The standard deduction value for a married couple is taken because it exceeds the itemized deductions.

Gross income	$137,000
Less adjustments to income	−4,000
Adjusted gross income	133,000
Less standard deduction	−12,400
Subtotal	120,600
Less value of two exemptions	−7,900
Taxable income	112,700
Tax liability (from  Table 4-2 ) *	$ 19,887.50

*  The tax liability is calculated from the tax-rate schedules in  Table 4-2  because the taxable income exceeds $100,000. The tax liability is computed on taxable income as follows: $112,700 − $73,800 = $38,900 × 0.25 = $9,725 + $10,162.50 = $19,887.50.

Table 4-3 Tax Table *

*  These segments of the tax table are derived from the IRS tax-rate schedule illustrated in  Table 4-2 .

4.2g Subtract Tax Credits for Which You Qualify

You may be able to lower your preliminary tax liability through tax credits. A  tax credit  reduces your tax liability dollar for dollar whereas a tax deduction reduces the amount of your taxable income, which is used to calculate your tax liability. Tax credits are more valuable because they reduce your tax liability by one dollar for every dollar of the credit. Tax deductions, on the other hand, reduce your tax liability by your tax rate for every dollar of the deduction. A $1000 tax deduction saves $250 in taxes if you are in the 25 percent bracket, but a $1000 tax credit saves you $1000.

tax credit Dollar-for-dollar decrease in tax liability; also known as credit.

You may take tax credits regardless of whether you itemize deductions. A  nonrefundable tax credit  may reduce your tax liability to zero (0), but not below. Thus if the nonrefundable credit amount exceeds the tax you owe, you are not given a refund of the difference. A  refundable tax credit  can reduce your tax liability to below zero (0), and the excess amount will be refunded. To get a refundable tax credit, you must file an income tax return. Credits are often subject to income limits, meaning that high-income taxpayers may not be eligible for a particular credit.

nonrefundable tax credit A tax credit that can reduce one's tax liability only to zero; however, if the credit is more than the tax liability, the excess is not refunded.

refundable tax credit A tax credit that can reduce one's income tax liability to below zero with the excess being refunded to the taxpayer.

Health Insurance Premium Tax Credit The health Insurance Premium Tax credit is part of the Affordable Care Act provisions, and it provides that individuals and families may take a tax credit to help them afford health insurance coverage purchased through an Affordable Insurance Exchange offered through the federal and/or state government. The health insurance premium tax credit is refundable so taxpayers who have little or no income tax liability can still benefit. The credit also can be paid in advance to a taxpayer's insurance company to help cover the cost of premiums.

DID YOU KNOW  

About the Alternative Minimum Tax

The alternative minimum tax (AMT) takes back some of the tax breaks allowed for regular tax purposes for very high-income taxpayers who previously were entirely escaping paying income taxes through legitimate means. Some high-income taxpayers are pushed into paying the higher AMT tax instead of the regular tax when claiming excess itemized deductions, certain tax-exempt interest, and/or a substantial number of exemptions. When the value of those benefits is added back to one's income, it may result in an AMT calculation that exceeds one's regular tax. About four million taxpayers pay the AMT tax rate at 26 or 28 percent, which typically amounts to an additional tax liability of about $3900.

American Opportunity Tax Credit The  American Opportunity Tax Credit  provides an up to $2500 per student tax credit to help defray college expenses for the first four years of postsecondary education. The tax credit is for 100 percent of qualified tuition, fees, books, and course materials paid by the taxpayer during the taxable year not to exceed $2000, plus 25 percent of the next $2000 in qualified tuition, fees, and course materials. The maximum total credit is $2500. The money must have been spent for qualified tuition and expenses for textbooks, supplies, equipment, and student activity fees if required as a condition of enrollment. The credit can be claimed in two taxable years for individuals enrolled on at least a halftime basis during any part of the year. Forty percent of the credit (up to $1000) is refundable.

American Opportunity Tax Credit A partially refundable tax credit of up to $2500 a year to help defray college expenses for the first four years of postsecondary education.

Lifetime Learning Credit The  lifetime learning credit  (nonrefundable) may be claimed every year for tuition and related expenses paid for all years of postsecondary education undertaken to acquire or improve job skills. The expenses for one or more courses may be for yourself, your spouse, or your dependents. The student need not be pursuing a degree or other recognized credential. This credit amounts to 20 percent of the first $10,000 paid, for a maximum of $2000 for all eligible students in a family. There is no limit on the number of years the credit may be taken for the student. The Lifetime Learning and American Opportunity credits may not be claimed for the same student expenses for the same tax year.

lifetime learning credit A nonrefundable tax credit that may be claimed every year for tuition and related expenses paid for all years of postsecondary education undertaken to acquire or improve job skills.

Earned Income Credit The  earned income credit (EIC)  (or earned income tax credit [EITC]) is refundable, and it may be claimed not only by workers with a qualifying child but also, in certain cases, by childless workers. The maximum credit is $496 with no qualifying children, $3305 with one child, $5460 with two children, and $6143 with three or more children. For married taxpayers with one child, the credit begins to phase out if adjusted gross income is $23,260.

earned income credit (EIC) A refundable tax credit that may be claimed by workers with a qualifying child and in certain cases by childless workers.

Child and Dependent Care Credit The  child and dependent care credit  is for workers who pay employment-related expenses if the care for children under age 13 and/or other dependents gives them the freedom to work. Depending on your income, the credit may be up to 35 percent of qualifying care expenses of up to $3000 (or a credit of $1050) for one dependent and of up to $6000 of care expenses for two or more dependents (or a credit of $2100). The credit is limited to the liability, but part or all of the credit may be refundable as an “additional child tax credit,” which is discussed below.

child and dependent care credit A nonrefundable tax credit that may be claimed by workers who pay employment-related expenses for care of a child or other dependent if that care gives them the freedom to work seek work, or attend school full time.

Child Tax Credits Taxpayers can claim a child tax credit (CTC) of up to $1000 per child under age 17. The child tax credit is nonrefundable. Some parents also may qualify for a refundable additional child tax credit if the child portion of the child and dependent care tax credit exceeds their tax liability.

Adoption Credit An adoption tax credit (refundable) of up to $13,190 is available for the qualifying costs of an adoption.

DID YOU KNOW  

Nearly Half of Households Pay No Income Tax

The Tax Policy Center reports that between 40 and 50 percent of all households paid no federal income tax in recent years. Thus millions of Americans paid nothing toward our national defense, foreign aid, or federal parks.

Of those not paying federal income taxes, 57 percent did not earn enough to pay Social Security payroll and Medicare taxes, 21 percent are elderly, 14 percent earn less than $20,000, and 8 percent are others, which totals 100 percent. The households qualified for enough credits, deductions, and exemptions to eliminate their federal tax liability. These people do pay excise taxes on gasoline and various taxes on telephone services, gasoline, tires, aviation, alcohol, and tobacco, and they may pay state and local income taxes as well as sales taxes.

Most Americans work and pay federal income taxes. Three-quarters of them pay more in payroll taxes that fund Social Security and Medicare than they do in federal income taxes.

Mortgage Interest Credit A mortgage interest tax credit (nonrefundable) of up to $2000 for mortgage interest paid may be claimed under special state and local government programs that provide a “mortgage credit certificate” for people who purchase a principal residence or borrow funds for certain home improvements. The home must not cost more than 90 to 110 percent of the average area purchase price.

Retirement Savings Contribution Credit A nonrefundable retirement savings contribution credit (also known as a saver credit) of up to $1000 is available. The tax credit is calculated based on a percentage of your retirement contributions. For single individuals, a 50 percent credit applies on the amount saved (up to $2000) if AGI does not exceed $18,000, a 20 percent rate applies if AGI does not exceed $19,500, and a 10 percent rate applies if AGI does not exceed $30,000. For married persons, the thresholds are $36,000, $39,000, and $60,000.

Elderly or Disabled Tax Credit Lower income individuals who are age 65 or older or who are permanently and totally disabled may claim a nonrefundable federal tax credit that can be as much as $1125.

4.2h Calculate the Balance Due the IRS or the Amount of Your Refund

After taking all your tax credits, if the amount withheld (shown on your W-2 form) plus any estimated tax payments you made is greater than your final tax liability, then you are entitled to receive a  tax refund .

tax refund Amount the IRS sends back to a taxpayer if withholding and estimated payments exceed the tax liability.

If the amount is less than your final tax liability, then you have a tax balance due. If you owe money, you pay by check, money order, or credit card. The IRS imposes a convenience fee of 2.5 percent of the amount charged on a credit card.

4.2i Which Tax Form Do You Use to File?

To file your income tax return, you record all your tax information on the correct tax form and submit it to the Internal Revenue Service by mail or electronically. Use the IRS tax form that is appropriate for your circumstances:

• Form 1040EZ. You are single or married, under age 65, and have no dependents; your income consists of less than $100,000 in wages, salary, and tips, and no more than $1500 in interest; and you do not claim any tax credits or adjustments or itemize deductions.

• Form 1040A. Your income is less than $100,000 and you use the standard deduction and/or take adjustments to income or tax credits.

• Form 1040. You itemize your deductions and you do or do not make contributions to a qualified retirement plan or take adjustments to income or tax credits.  Figure 4-4  shows a completed 1040 Form for a taxpayer.

• Form 1040X. You are eligible for a deserved refund or refundable tax credit, or you want to correct any tax filing mistake(s) or claim overlooked deductions for any of the past three years.

4.2j File on Time and Check the Status of Your Refund

You should file your return on time—usually by April 15—to avoid a penalty. If you owe the IRS and you are broke, you can borrow to pay the taxes or contact the IRS about setting up an installment plan to repay the debt within three years.

Taxpayers hear from the IRS within three weeks if they have failed to sign the return, neglected to attach a copy of the Form W-2, made an error in arithmetic, owe a tax penalty, or figured the tax incorrectly. Once taxpayers file their federal return, they can track the status of their refunds by using the “Where's My Refund?” tool, located on the front page of  www.irs.gov .

DID YOU KNOW  

Sean's Success Story

Sean is one smart fellow. After learning a lot about how to avoid income taxes, he took action. Sean recently made a down payment and bought a foreclosed home with a $120,000, 4 percent, 20-year mortgage. The more than $14,000 in interest (from  Table 9-4  on page 273) and $1500 in real estate property taxes together put him well over the $6200 standard deduction threshold. Therefore, he can take all kinds of other deductions on his tax return, such as cash and non-cash charitable contributions, mileage allowance and out-of-pocket expenses for volunteer charitable work, personal property taxes on his auto and boat, expenses for business magazines and newspapers to better manage his investments, and software to help prepare his income taxes. He started to contribute the maximum $3000 annually to his retirement account. Now Sean is researching all the tax credits to determine if he qualifies for any of them.

DID YOU KNOW  

Money Websites for Managing Income Taxes

Informative websites for managing income taxes, including preparing your own income tax form are:

Bankrate.com 's tax estimator ( www.bankrate.com/calculators/tax-planning/1040-form-tax-calculator.aspx )

Bankrate.com  ( www.bankrate.com/finance/taxes/check-taxes-in-your-state.aspx )

Center for American Progress ( www.americanprogress.org/issues/2012/02/corporate_profits.xhtml )

Dinkytown's tax estimator ( www.dinkytown.net/java/Tax1040.xhtml )

H&R Block's TaxCut ( www.hrblock.com/tax-software/index.xhtml )

Internal Revenue Service ( www.irs.gov )

IRS Publication 17  ( www.irs.gov/publications/p17/ )

Lasser's Your Income Tax  ( www.jklasser.com/ )

Quicken's TurboTax ( turbotax.intuit.com/ )

TaxACT ( www.taxact.com )

Volunteer Income Tax Assistance ( www.irs.gov/Individuals/Free-Tax-Return-Preparation-for-You-by-Volunteers )

Worldwide-Taxes.com  ( www.worldwide-tax.com/#partthree )

4.2k File Your Income Taxes Electronically for Free and Get Your Refund Within Ten Days

Over 70 percent of taxpayers pay someone to prepare the return, even though it is not complicated for most taxpayers. To file your income taxes online by yourself, visit the website of the Internal Revenue Service ( www.irs.gov ) and click on “IRS E-file.” Alternatively, you may choose to click on “IRS Free File” because it provides options for free brand-name tax software or online fillable forms plus free electronic filing for most taxpayers. E-filers may request that their refund be deposited directly into their bank account, and it usually will be deposited within ten days of filing. Ninety percent of taxpayer's returns are filed electronically. The average refund last year was just over $3000.

4.2l People Pay Their Income Taxes in One or Two Ways

The federal income tax is a “pay as you go” tax. Through  payroll withholding , an employer takes a certain amount from an employee's income as a prepayment of an individual's tax liability for the year and sends those dollars to the IRS, where they are credited to that particular taxpayer's account. People who are self-employed or who receive substantial income from an employer that is not required to practice payroll withholding, such as lawyers, accountants, consultants, and owners of rental property, must pay  estimated taxes . They are required to estimate their tax liability and pay their estimated taxes in advance in quarterly installments on April 15, June 15, September 15, and the following year's January 15.

payroll withholding The IRS requirement that an employer withhold a certain amount from an employee's income as a prepayment of that individual's tax liability for the year. It is sent to the government where it is credited to the taxpayer's account.

estimated taxes People who are self-employed or receive substantial income from an employer that is not required to practice payroll withholding (such as lawyers and owners of rental property) are required by the IRS to estimate their tax liability and pay their taxes in advance in quarterly installments.

 CONCEPT CHECK 4.2

1. Give five examples of income that must be included in income reported to the Internal Revenue Service.

2. How are long-term and short-term capital gains treated differently for income tax purposes?

3. Give five examples of income that is excluded from IRS reporting.

4. List three examples of adjustments to income.

5. Distinguish between a standard deduction and a personal exemption.

6. What advice on filing a Form 1040X can you offer someone who did not file a federal income tax return last year or in any one of the past three years?

7. List five examples of tax credits.

Figure 4-4  Federal Income Tax Form 1040 (Yasuo Konami)

4.3 STRATEGIES TO REDUCE YOUR INCOME TAXES

LEARNING OBJECTIVE 3

Use appropriate strategies to avoid overpayment of income taxes.

While the U.S. tax laws are strict and punitive about compliance (although the IRS audits less than 0.5 percent of all returns), they remain neutral about whether the taxpayer should take advantage of every “tax break” and opportunity possible. The strategies described here will help you to reduce your tax liability.

4.3a Practice Legal Tax Avoidance, Not Tax Evasion

Tax evasion  involves deliberately and willfully hiding income, falsely claiming deductions, or otherwise cheating the government out of taxes owed. It is illegal. A waiter who does not report tips received and a babysitter who does not report income are both evading taxes, as is a person who deducts $150 in charitable contributions but who does not actually make the donations.

tax evasion Deliberately and willfully hiding income from the IRS, falsely claiming deductions, or otherwise cheating the government out of taxes owed; it is illegal.

Tax avoidance  means reducing tax liability through legal techniques. It involves applying knowledge of the tax code and regulations to personal income tax planning. Tax evasion results in penalties, fines, interest charges, and a possible jail sentence. In contrast, tax avoidance boosts your income because you pay less in taxes. As a result, you will have more money available to spend, save, invest, and donate.

tax avoidance Reducing tax liability through legal techniques.

4.3b Strategy: Reduce Taxable Income via Your Employer

It may seem illogical to suggest that to lower your tax liability you should reduce your income. But it is not. The objective is to reduce taxable income. Reducing your federal taxable income also will reduce the personal income taxes imposed by state and local governments. Four useful ways of reducing taxable income are premium-only plans, transit spending account, dependent care flexible spending accounts, and defined-contribution retirement plans.

Premium-Only Plan Many large employers offer a premium-only plan (POP) that allows employees to withhold a portion of their pretax salary to pay their premiums for employer-provided health benefits. Benefits could include health, dental, vision, and disability insurance. Amounts withheld are not reported to the IRS as taxable income. For example, if Nhon Ngo, a restaurant manager in Dallas, has $400 per month ($4800 annually) withheld through his employer to pay for his share of the employer-sponsored health insurance premium, he saves as much as $1920 ($4800 × 0.40 [his effective marginal tax rate]) a year because he does not have to send that amount to the government in taxes.

Transit Spending Account A transportation reimbursement plan is a similar pretax program. This employer plan allows you the opportunity to save money by using payroll deduction with pretax salary dollars to pay for work-related transportation expenses, such as transit passes ($130) and qualified parking ($250). If Nhon contributes $380 in pretax income to his employer's transportation plan, he saves as much as $152 ($380 + $130 = $380 × 0.40).

Flexible Spending Account A benefit for employees who pay for child care or provide care for a parent is a salary reduction plan known as a flexible spending account (FSA), also called a flexible spending arrangement. An FSA allows an employee (and an employer) to fund qualified expenses on a pretax basis through salary reduction to pay for out-of-pocket unreimbursed expenses for medical and dental expenses (maximum for employees is $2500 annually) and dependent care (maximum is $5000 annually). The expenses are those that are not covered by insurance. Examples are annual deductibles, office co-payments, orthodontia, prescriptions, and over-the-counter drugs for which one has a doctor's prescription. Paper forms or an  FSA debit card , sometimes known as a Flexcard, may be used to spend the funds. The salary reductions are not included in the individual's taxable earnings reported on Form W-2, and reimbursements from an FSA account are tax free.

FSA debit card (also known as Flexcard) A card used to access and spend funds from a flexible spending account.

FINANCIAL POWER POINT  

File IRS Form 1040X to Obtain Refunds for Previous Years

Anyone who was eligible for a refundable tax credit or neglected to take a deduction may file an  amended return  to receive it retroactively for the previous three tax years using Form 1040X. Use this easy-to-complete form to obtain a deserved refund or correct any tax filing mistakes on an original or previously filed return.

amended return A special tax return form (Form 1040X) that may be filed to obtain a deserved refund or correct any tax filing mistakes on an original or previously filed return for the previous three years.

FSAs are subject to a “ use-it-or-lose-it rule ,” which means that any unspent dollars in the account at the end of the year are forfeited and not returned to the employee. As a result, you should make conservative estimates of your expenses when you elect your FSA choices. For example, if you had $1000 withheld for medical expenses but spent only $700 over the year, the balance of $300 will go back to your employer, not to you. The IRS does allow a 21½-month additional “grace period” if one's employer permits such an extension.

use-it-or-lose-it rule An IRS regulation requiring that unspent dollars in a flexible spending account at the end of a calendar year be forfeited, unless the employer allows a 2 1/2-month grace period for spending the funds.

In summary, suppose Nhon in the preceding example has $4800 annually withheld through his employer's premium only plan to be used to pay out-of-pocket medical expenses, another $380 to the transit reimbursement plan, plus another $3000 to pay out-of-pocket expenses for dependent care of his child.

Defined-Contribution Retirement Plan Contributing money to a qualified employer-sponsored retirement plan also reduces income taxes. A  defined-contribution retirement plan  (discussed in  Chapter 17 ) is an IRS-approved retirement plan sponsored by an employer to which employees may make pretax contributions that lower their tax liability. The most popular plan is known as a 401(k) retirement plan, although other variations exist as well.

defined-contribution retirement plan IRS-approved retirement plan sponsored by employers that allows employees to make pretax contributions that lower their tax liability.

The amount of money that an employee contributes to his or her individual account via salary reduction also does not show up as taxable income on the employee's W-2 form. For example, if you contribute $2000 to your employer's retirement plan and you are in the 25 percent tax bracket, this immediately saves you at least $500 ($2000 × 0.25) that you will not have to pay in taxes.

An extra benefit of a defined-contribution retirement plan is that employers often offer full or partial  matching contributions  to employees' accounts up to a certain proportion. For example, if you invest $2000 into your 401(k) plan and your employer matches half of what you contribute, that is an immediate return of 50 percent ($1000 / $2000) on your investment! The employer's “match” is essentially free money.

matching contributions Employer programs that match employees' 401 (k) contributions up to a particular percentage.

All of the dollars in a qualified retirement plan are likely to be invested in mutual funds where they will grow free of income taxes. Income taxes must eventually be paid when withdrawals are made, presumably during retirement when the marginal tax rate may be lower than during one's working years.

4.3c Strategy: Prune Taxable Investments

If you have some investments in your portfolio that have lost value, you may want to sell them before the end of the a year. Then you can use those capital losses to offset any capital gains earned that year from other investments. If you do not have gains to offset, you can deduct up to $3000 annually in losses against your regular income. Another strategy is to donate stocks that have appreciated in value to charity. In addition to obtaining the substantial charitable tax deduction, you avoid having to pay taxes on the gain.

4.3d Strategy: Make Tax-Sheltered Investments

Investments are often made with  after-tax dollars , which means that the individuals earned the money and paid income taxes on it. Then they take their after-tax money and invest it. The returns earned from these investments typically again result in taxable income. Investment alternatives are examined in  Chapters 13  through  16 .

after-tax dollars Money on which an employee has already paid taxes.

Tax laws encourage certain types of investments or other taxpayer behaviors by giving them special tax advantages over other activities, and as a result, numerous  tax-sheltered investments  exist. A tax shelter is any financial arrangement (as a certain kind of investment) that results in a reduction or elimination of taxes due. The tax laws allow certain income to be exempt from income taxes in the current year or permit an adjustment, reduction, deferral of income tax liability. When making investment decisions, investors should consider tax-sheltered investments.

tax-sheltered investments A financial arrangement that results in a reduction or elimination of taxes due.

DID YOU KNOW  

Top 1% of Income Earners Are Doing Well

IRS data show that the top 1 percent of taxpayers (1.4 million households out of 140 million filing tax returns) earned 20 percent of all the income reported, and they paid 38 percent of federal individual income taxes paid. Their adjusted gross incomes begin about $400,000 for a family of four, and they paid an average tax rate of 29 percent.

Invest with Pretax Income Making an investment contribution with pretax income means that you do not have to pay taxes this year on the income. In effect, investing with pretax income is an interest-free deferral of income taxes to another year. Examples include contributions to work-related retirement plans and flexible spending arrangements.

Make Your Investments Grow Tax Sheltered When income, dividends, or capital gains are  tax sheltered , the investor does not pay the current-year tax liability on the income and instead shifts the income and any tax liability to a later year. This benefit is substantial. Investments can grow faster because the money that would have gone to the government in taxes every year can remain in the investment for many years to accumulate. In effect, the government “loans” taxfree money to taxpayers to help fund their investment and retirement plans. The tax-free growth of such investments is called tax-sheltered compounding.

tax sheltered Income, dividends, or capital gains that are allowed to grow without taxes until distributions are taken.

FINANCIAL POWER POINT  

Create Future Tax-Free Income with Your Refund

You can instruct the IRS to deposit your tax refund directly into a Roth IRA. This IRA account can be opened online in minutes without making an initial deposit. All the money will grow tax-free, and future withdrawals will be tax-free too.

Seven Examples of Tax-Sheltered Investments Numerous tax-sheltered investments exist, and some popular ones follow.

Roth IRA Accounts  Contributions (up to $5500 annually) to a  Roth IRA  accumulate tax-free and withdrawals are tax-free. There is no tax break on contributions, as they are made with after-tax money. This is an excellent investment vehicle for people with a long-term investment horizon who want to save more money for retirement than they can through an employer-sponsored retirement plan. All types of IRA accounts and other retirement plans are examined in  Chapter 17 . IRAs are examined in  Chapter 17 .

Roth IRA An individual retirement account of investments made with after-tax money; the interest on such accounts is allowed to grow tax-free, and withdrawals are also tax-free.

Individual Retirement Accounts  The amount contributed (up to $5500 annually) to a traditional  individual retirement account (IRA)  is considered an adjustment to income, which reduces your current-year income tax liability. Investments inside the IRA (such as stocks and stock mutual funds) accumulate tax sheltered. Income taxes are owed on the eventual withdrawals, likely during retirement.

individual retirement account (IRA) Investment account that reduces current year income, and the funds in the account accumulate tax-free.

Coverdell Education Savings Accounts  Contributions of up to $2000 per year of after-tax money may be made to a  Coverdell education savings account  (also known as an education savings account and formerly known as an “education IRA”) to pay future education costs. Earnings accumulate tax-free, and withdrawals for qualified expenses are tax-free. The money can be used to pay for public, private, or religious school expenses, in college or graduate school. It can pay for tuition, fees, room and board, tutoring, uniforms, home computers, Internet access and related technology, transportation, and extended day care.

Coverdell education savings account (or education savings account) An IRS-approved way to pay the future education costs for a child younger than age 18 whereby the earnings accumulate tax-free and withdrawals for qualified expenses are tax-free.

Qualified Tuition Programs  There are two types of qualified tuition programs, and these are known as 529 plans. Under the prepaid educational service plan, an individual purchases tuition credits today for use in the future. Also known as a state-sponsored prepaid tuition plan, this program allows parents, relatives, and friends to purchase a child's future college education at today's prices by guaranteeing that amounts prepaid will be used for the future tuition at an approved institution of higher education in a particular state. The funds may be used to pay for tuition only—not room, board, or supplies.

The second qualified IRS Section 529 tuition program, called a college savings plan, is set up for a designated beneficiary. You may contribute up to $14,000 per year per child of after-tax money to a 529 college savings plan. Withdrawals are tax-free if made for qualified education expenses such as tuition, room, and board. If one child does not go to college, the funds may be transferred to another relative. One may contribute to both a Section 529 plan and a Coverdell education savings account for the same beneficiary in the same year.

Government Savings Bonds  Series EE and Series I government savings bonds are promissory notes issued by the federal government. The income is exempt from state and local taxes. You may defer the income tax until final maturity (30 years) or report the interest annually. Reporting the interest in a child's name is advisable especially when it can be offset totally by the child's standard deduction. You may exclude accumulated interest from bonds from income tax in the year you redeem the bonds to pay qualified educational expenses. (See  Chapter 14  for information on similar bonds.)

Tax-Exempt Municipal Bonds  Tax-exempt municipal bonds (also called munis) are long-term debts issued by local governments and their agencies that are used to finance public improvement projects. Interest is free from federal and state taxes if the bond is purchased in one's state of residence. Taxpayers in higher-income brackets (28 percent or more) often take advantage of these kinds of investments. (See  Chapter 14 .) Smart investors choose the bonds that pay the better return after payment of income taxes. The formula to decide whether a taxable investment or nontaxable investment is better for you appears in the box “How to Compare Taxable and After-Tax Yields” on page 129.

DID YOU KNOW  

Saving for a Child's College Education

Good ways to save for a child's college education while taking advantage of some income tax breaks are as follows:

The Section 529 College Savings Plan is named after the related section of the Internal Revenue Service Code, and all states have established at least one Section 529 college savings plan. Deposits into a 529 plan are not deductible, but withdrawals (including tax-free growth) for qualified educational expenses are tax-free.

A Coverdell Education Savings Account accepts nondeductible contributions up to a maximum of $2000 per year for a child younger than 18 to pay his or her future education costs. The money and earnings on the account may be withdrawn tax-free to pay for qualified expenses.

Individual Retirement Accounts (IRAs) are designed primarily for retirement savings but under certain circumstances withdrawals can be used to pay for qualified college expenses for the account holder, child or grandchild. Early withdrawal penalties are waived if the funds are used for education expenses.

A custodial account may be opened in the name of a child younger than age 14 under the provisions of the Uniform Gifts to Minors Act. College students usually are in the 10 or 15 percent tax bracket and they may be able to sell assets given to them without paying any capital gains taxes. The kiddie tax also applies to income of a minor child earned off the assets (such as interest and dividends). For children younger than age 18, the first $1000 of unearned income (the income earned from an investment) earned on custodial account assets is taxfree to the child. The next $1000 is taxed at the child's tax rate. Income in excess of $2000 is taxed at the parent's (likely higher) rate. When a child is age 18, he or she pays taxes based on his or her own income tax bracket.

Discount bonds (also called zeroes or zero coupon bonds) are corporate and government bonds that pay no annual interest. Instead, discount bonds are sold to investors at sharp discounts from their face value, which may be redeemed at full value upon maturity. For example, a $10,000 Series EE savings bond sold by the federal government can be purchased for $5000, one-half its face amount. The interest accumulates within the bond itself, and this phantom income earned by a child is generally so small that little, if any, income taxes are due each year as the bond matures. Taxes on the interest earned each year may be deferred until redemption and are tax-free when the proceeds are used to fund a child's college education.

DID YOU KNOW  

How to Compare Taxable and After-Tax Yields

Investors may choose to put their money into vehicles that provide taxable income, such as stocks, corporate bonds, and stock mutual funds. Taxpayers also have the opportunity to lower their income tax liabilities by investing in tax-exempt municipal bonds, money market funds that invest in municipal bonds, and other tax-exempt ventures. (These investment alternatives are discussed in  Chapter 14 .)

Because of their tax-exempt status, these investments offer lower nominal returns than taxable alternatives. But after considering the effects of taxes, the actual return to an investor on a tax-exempt investment may be higher than the after-tax yield on a taxable corporate bond.

To find out whether a taxable investment pays a higher after-tax yield than a tax-exempt alternative, the investor must determine the after-tax yield of each alternative. The  after-tax yield  is the percentage yield on a taxable investment after subtracting the effect of federal income taxes that will need to be paid on the investment. The after-tax yield on a tax-exempt investment is the same as the nominal yield because you do not have to pay income taxes on income from this kind of investment. So the question is, “How does the investor calculate the after-tax yield on a taxable investment?”

after-tax yield The percentage yield on a taxable investment after subtracting the effect of federal income taxes that will need to be paid on the investment.

DO IT IN CLASS

When you know the taxable yield, use Equation (4.1) to determine the equivalent after-tax yield on a taxable investment. Only then can you decide which investment is better. For example, suppose Bobby Bigbucks pays income taxes at the 35 percent combined federal and state marginal tax rate and is considering buying either a municipal bond that pays a 3.5 percent yield or a taxable corporate bond that pays a 5.7 percent yield. Equation (4.1) calculates the equivalent after-tax yield on the corporate bond:*

The answer is 3.71 percent. Thus, a 5.7 percent taxable yield is equivalent to an after-tax yield of 3.71 percent. Eureka! Bobby now knows that he should buy the corporate bond paying 5.7 percent because its after-tax yield of 3.71 percent is higher than the 3.5 percent paid by the municipal bond. These differences may look small, and they are, but over time they add up. For example, the extra 0.21 percent (3.71 − 3.50) yield on a $20,000 bond investment for 20 years amounts to $840 [$20,000 × 0.0021 × 20 (bond interest is not compounded)]. That's real money!

The higher your federal tax rate, the more favorable tax-exempt municipal bonds become as an investment compared with taxable bonds. The tax-exempt status of municipal bonds does not apply to capital gains. When you sell an investment for more than what you paid for it, you will owe federal income taxes on the capital gain.

* This and similar equations can be found and used on the Garman/Forgue companion website.

† The formula can be reversed to solve for the equivalent taxable yield when one knows the tax-exempt yield. To continue the example, the return for Bobby on a 3.71 percent tax-exempt bond is equivalent to a taxable yield of 5.7 percent [3.71 ÷ (1.00 − 0.35)]. If Bobby finds a tax-exempt bond paying more than 3.71 percent, he should consider buying it.

Capital Gains on Housing  A big tax shelter is available to homeowners when they sell their homes. Those with appreciated principal residences are allowed to avoid taxes on capital gains of up to $500,000 if married and filing jointly and on gains up to $250,000 if single. The home must have been owned and used as the taxpayer's private residence for two out of the five years immediately prior to the date of the sale.

4.3e Strategy: Defer Income

A popular way to reduce income tax liability is to shelter income by deferring it. You will not have to pay taxes on income earned after December 31st until April the following year or 15 months in the future. This goal is achieved by purposefully making arrangements to receive some of this year's income in the next year, when your marginal tax rate might be lower, perhaps only 25 percent rather than 28 percent. A 3 percent tax savings (paying at the 25 percent rate rather than 28 percent) on $3000 of income is $90 ($3000 × 0.03), enough to pay for a good meal in a restaurant. Your employer might be willing to give you a bonus or commission check in January rather than in December, and those who are self-employed can ask clients and customers to wait until January to pay their bills.

DID YOU KNOW  

Tax Reform Proposals: Flat Tax and Value-Added Tax

Politicians and pundits are talking about tax reform that overhauls the huge and complicated U.S. tax code. Many want to eliminate certain tax deductions and simplify the tax code. This is difficult to do since the vested interests that obtained a deduction in the first place will fight to maintain the popular deductions for interest paid on home loans, contributions to charity, interest on loans for investing, contributions to retirement plans, and tax credits for child and dependent care.

Some call for a  flat tax  as a substitute for our current tax system. This is an income tax having but a single rate for all taxpayers regardless of income level and type. Economists suggest that a single rate, perhaps 22 percent, might replace the revenue currently derived from the present multiple tax rates. However, for most taxpayers this would result in a tax increase.

flat tax An income tax having but a single rate for all taxpayers regardless of income level and type.

Another idea is a federal  value-added tax (VAT) , which is essentially a federal retail sales tax. It is a tax, perhaps 10 percent, on the calculated “value added” to a product or material at each stage of manufacture or distribution; thus it is a form of consumption tax paid by consumers. Even though every company that handles a product from raw material to finished goods must pay a VAT to the government, businesses would actually pay nothing since they receive tax credits for all the VAT they pay to suppliers. Over 40 industrialized countries have VATs.

value-added tax A federal retail sales tax on the estimated “value added” to a product or material at each stage of manufacture or distribution.

Capital gains are taxable income but up to $500,000 for couples might be exempt on a profitable sale.

You might expect to be in a lower tax bracket in the following year because you anticipate fewer sales commissions or know that you will not work full time. For example, if you return to school, have a child, or decide to travel. Retired people may be able to postpone withdrawals of income from retirement plans, and entrepreneurs may delay billing customers for work.

ADVICE FROM A PROFESSIONAL

Consider the Tax Consequences of Buying a Home to Reduce Income Taxes

Brianna Pallagrosi of Rome, New York, took a sales position at a retail chain store two years ago, where she earned a gross income of $46,736. Brianna wisely made a $1000 contribution to her IRA. Her itemized deductions came to only $4400, so she took the standard deduction and personal exemption amounts. The result was a tax liability of $5425. Brianna was not happy about paying what she thought was a large tax bill that year.

Gross income	$46,736
Less adjustment to income	−1,000
Adjusted gross income	45,736
Less value of one exemption (old figure)	−3,800
Subtotal	41,936
Less standard deduction (old figure)	−5,950
Taxable income	35,986
Tax liability (from old tax table not shown)	$ 5,425

Last year, Brianna did not receive a raise. Nonetheless, Brianna continued to contribute $1000 into her IRA. To reduce her federal income taxes, she also became a homeowner after using some inheritance money to make the down payment on a condominium. During the year, she paid out $9126 in mortgage interest expenses and $1995 in real estate taxes. After studying various tax publications, Brianna determined that she had $3814 in other itemized deductions that, when combined with the interest and real estate taxes, then came to a grand total of $14,935. These deductions reduced Brianna's tax liability dramatically.

Gross income	$46,736
Less adjustment to income	−1,000
Adjusted gross income	45,736
Less itemized deductions	−14,935
Subtotal	30,801
Less value of one exemption	−3,950
Taxable income	26,851
Tax liability (from  Table 4-3 )	$ 3,573

Brianna correctly concluded that the IRS “paid” $1852 ($5425 − $3573) toward the purchase of her condominium and her living costs because she did not have to forward those dollars to the government. An additional benefit for Brianna is that she now owns a home whose value could appreciate in the future. Buying a home often reduces one's income taxes.

Frances C. Lawrence

Louisiana State University

4.3f Strategy: Accelerate Deductions

This strategy allows you to lower your taxable income sooner rather than later, which is usually a good idea. Many people find that they do not have enough itemized deductions to exceed the standard deduction amount. By shifting the payment dates of some deductible items, you can increase your deductions. For example, if a single person has about $6000 of deductible expenses this year, she could prepay some items in December to push the total over the $6200 threshold and benefit by taking the excess deductions now. The next year, she can take the standard deduction amount instead of itemizing.

This process is known as accelerating deductions. Items that may be prepaid include medical expenses, dental bills, real estate taxes, state and local income taxes, the January payment of estimated state income taxes, personal property taxes that have been billed (e.g., on autos and boats), dues in professional associations, and charitable contributions. You may mail the payments or charge them on credit cards by December 31.

4.3g Strategy: Take All of Your Legal Tax Deductions

Although you should not spend money just to create a tax deduction, you are encouraged to take all of the deductions to which you are entitled. One way to increase itemized deductions, for example, is to purchase a home with a mortgage loan. The large amounts of money homeowners expend for both interest and real estate taxes are deductible. Plus, if your property taxes and interest exceed the standard deduction amount, then you are able to take additional deductions that were ineligible because of the threshold.

DID YOU KNOW  

Bias Toward Avoiding Risk

People engaged in managing income taxes have a bias toward certain behaviors that can be harmful, such as a tendency toward avoiding risk. People often are worried that taking too many deductions on their income tax return will risk an audit so they do not take deductions they actually deserve. What to do? Reject this tendency and take your deductions because the odds of an audit for most of us is well under 1 percent, and even then the IRS is likely to accept all of one's deductions.

DID YOU KNOW  

Your Worst Financial Blunders in Managing Income Taxes

Based on others' financial woes, you will make mistakes in personal finance when you:

1. Turn all your income tax planning over to someone else instead of doing it yourself.

2. Over withhold your income taxes to receive a big refund next year.

3. Ignore the impact of income taxes in your personal financial planning.

Here are some other approaches to increase your deductions and keep more tax dollars in your pocket. Assume you are in the 25 percent marginal tax bracket and itemize deductions. Cash contributions made to people collecting door to door or at a shopping center during holidays are deductible, even though receipts are not given. Fifty dollars in contributions deducted can save you $12.50 in taxes. Instead of throwing out an old television set, donate it. An $80 charitable contribution for a TV will save you $20 in taxes. These amounts may sound like “small change,” but lots of little tax deductions can quickly add up to more than $100, and that soon becomes real money!

Expenses for business-related trips can be a fruitful area for tax deductions. If you are in the 25 percent tax bracket and take one business trip per year, perhaps incurring $800 in deductible expenses, you will save $200 in taxes, assuming your miscellaneous deductions already exceed 2 percent of your AGI. The IRS also permits tax deductions for the costs expended on occasional job-hunting trips. In other words, depending on your tax bracket, the U.S. government pays the bill for 25 percent of such expenditures.

4.3h Strategy: Shift Income to a Child

A parent who runs his or her own business may pay a child up to $10,150 ($6200 [value of standard deduction]) + $3950 [value of exemption]) in “earned income” before any income tax liability occurs. This assumes the child has no other income. Thus, the parent can deduct the payments as business expenses.

However, giving unearned income to children is treated differently by the IRS.  Unearned income  is interest from a savings account, bond interest, alimony, and dividends from stock that comes from investments. This excludes income from wages or self-employment.

unearned income Investment returns in the form of rents, dividends, capital gains, interest, or royalties.

The kiddie tax is applied to a child's unearned income of more than $2,000, and it impacts children under age 19 (or up to 24 for full-time students). The tax is meant to discourage parents from reducing their own taxes by shifting lots of investment income to their children, who generally have lower tax brackets.

DID YOU KNOW  

Turn Bad Habits into Good Habits

Do You Do This?	Do This Instead!
Did not file an income tax return assuming your employer withheld sufficient funds	File a return to obtain amounts over withheld
Pay too much in income taxes	Use the strategies in this chapter to reduce your tax liability
Wish you could itemize instead of using the standard deduction	Buy a home so you can deduct mortgage interest and property taxes as well as take other deductions
Forget to take certain tax credits in the last three years	File 1040X amended returns to claim the credits and obtain the refunds
Neglect to save for retirement	Save money by contributing to a qualified retirement plan
Let a tax preparer fill out your income tax forms every year	Get smart about how to reduce your income tax liability and to use software and prepare your own taxes

Under the Kiddie tax, a parent can shift income-generating investment assets to the name of a child who then may receive $1000 tax-free. The next $1000 of such unearned income is taxed at the child's tax rate, often only 10 percent. All of the child's unearned income in excess of $2000 is taxed at the parent's tax rate, which could be as high as 39.6 percent.

4.3i Strategy: Buy and Manage a Real Estate Investment

DO IT NOW!

You know more about personal finance after reading this chapter, so get started right now by:

1. Projecting your taxable income and total withholding for this year.

2. Estimating your federal tax liability based on your income projection using this year's tax tables or schedules.

3. Revising your W-4 form with your employer as necessary to withhold more if you estimate owing more in taxes or to withhold less.

Tax losses  are paper losses in the sense that they may not represent actual out-of-pocket dollar losses, and they are created when deductions generated from an investment (such as depreciation and net investment losses) exceed the income from an investment.

tax losses Created when deductions generated from an investment (such as depreciation and net investment losses) exceed the income from an investment.

Taxpayers are allowed to deduct certain real estate losses against ordinary taxable income, such as salary, interest, dividends, and self-employment earnings. Deductions are allowed for real estate investors who (1) have an adjusted gross income of $150,000 or less and (2) actively participate in the management of the property. Here the investor may deduct up to $25,000 of net losses from a “passive investment,” such as real estate, against income from “active” sources, such as salary. For example, a residential real estate investment property might generate an annual cash income $1000 greater than the out-of-pocket operating costs associated with it. However, after depreciation expenses on the building are taken as a tax deduction, the resulting $1500 tax loss may then be used to offset other income. (For more details, see  Chapter 16 , “Real Estate and High-Risk Investments.”)

 CONCEPT CHECK 4.3

1. Distinguish between two types of tax-sheltered investment returns.

2. Explain how to reduce income taxes via your employer, and name three employer-sponsored plans to do so.

3. Summarize the differences between an individual retirement account (IRA) and a Roth IRA.

4. Identify three strategies to avoid overpayment of income taxes, and summarize the essence of each.

WHAT DO YOU RECOMMEND NOW?

Now that you have read the chapter on managing income taxes, what advice can you offer Timothy and Amber in the case at the beginning of the chapter regarding:

1. Using tax credits to help pay for Tom's college expenses?

2. Determining how much money Amber will realize if she sells the stocks, assuming she pays federal income taxes at the 25 percent rate?

3. Buying a home?

4. Increasing contributions to their employer-sponsored retirement plans?

5. Establishing a sideline business for Tom's jewelry operation?

BIG PICTURE SUMMARY OF LEARNING OBJECTIYES

L01 Explain the nature of progressive income taxes and the marginal tax rate

The federal personal income tax is a progressive tax because the tax rate increases as a taxpayer's taxable income increases. The marginal tax rate is applied to your last dollar of earnings. Your effective marginal tax rate is probably 40 percent.

L02 Differentiate among the eight steps involved in calculating your federal income taxes

There are eight steps in calculating your income taxes. Certain types of income may be excluded. Regulations permit you to subtract adjustments to income, exemptions, deductions, and tax credits before determining your final tax liability.

L03 Use appropriate strategies to avoid overpayment of income taxes

You can reduce your tax liability by following certain tax avoidance strategies, such as putting your money in tax-sheltered investments, reducing taxable income via your employer, and investing pretax money for tax-deferred compounding. Other strategies are to postpone income, accelerate deductions, take all your legal deductions, and buy and manage a real estate investment.

LET'S TALK ABOUT IT

1. During Slow Economic Times. Congress reduced taxes on middle- and low-income taxpayers with the expectation that they will spend most of that money and help create more economic growth. Was this idea good or not, and why?

2. Filing a Tax Return. Many college students choose not to file a federal income tax return, assuming that the income taxes withheld by employers “probably” will cover their tax liability. Is such an assumption correct? What are the negatives of this practice if the employers withheld too much in income taxes? What are the negatives if the employers did not withhold enough in income taxes? Will any tax credits be lost?

3. Fairness of Capital Gains. Long-term capital gains are taxed at a rate of 20, 15 or 5 percent, or zero (0). What is your opinion on the fairness of these lower capital gains tax rates as compared with the marginal rates applied to income earned from employment that range as high as 39.6 percent?

4. Reporting Cash Income. Some college students earn money that is paid to them in cash and then do not include this as income when they file their tax returns. What are the pros and cons of this practice?

5. Sideline Business. Identify one possible sideline business that you might engage in to reduce your income tax liability.

6. Tax Credits. Name three tax credits that a college student might take advantage of while still in school or during the first few years after graduation.

7. Reduce Tax Liability. Identify five strategies to reduce income tax liability that you may take advantage of in the future.

8. Taxable Income or Exclusions? Review the list of exclusions on pages 112 and 113 and select 3 you think ought to be classified as taxable income rather than exclusions.

9. Eliminate Tax Credits. Review the list of tax credits on pages 119 and 121 and select 2 you think ought to be eliminated, and explain your reasoning.

10. Strategies to Reduce Income Taxes. Review the list of strategies to reduce your income taxes on pages 125 through 133 and select 2 you think you might use in the future, and explain your reasoning.

DO THE MATH

1. Calculate Tax Liability. What would be the tax liability for a single taxpayer who has a gross income of $39,700? (Hint: Use  Table 4-2 , and don't forget to first subtract the value of a standard deduction and one exemption.)

2. Marginal Tax Rate. What would be the marginal tax rate for a single person who has a taxable income of (a) $40,210, (b) $47,800, (c) $56,100, and (d) $90,230? (Hint: Use  Table 4-2 .)

3. Determine Tax Liability. Find the tax liabilities based on the taxable income of the following people: (a) married couple, $74,125; (b) married couple, $53,077; (c) single person, $27,880; (d) single person, $59,000. (Hint: Use  Table 4-3 .)

DO IT IN CLASS PAGE 118

4. Use Tax Rate Schedule. Benjamin Addai determined the following tax information: gross salary, $60,000; interest earned, $90; IRA contribution, $1000; personal exemption, $3950; and itemized deductions, $5900. Calculate Benjamin's taxable income and tax liability filing single. (Hint: Use  Table 4-2 .)

DO IT IN CLASS PAGE 114

5. Use Tax Rate Schedule. Samual Clark determined the following tax information: salary, $144,000; interest earned, $2000; qualified retirement plan contribution, $7000; personal exemption, $3950; itemized deductions, $10,000. Filing single, calculate Samual's taxable income and tax liability. (Hint: Use  Table 4-2 .)

DO IT IN CLASS PAGE 114

6. Review  Figure 4-1  on page 107 and comment on the logic of how different segments of Victoria's income is taxed.

DO IT IN CLASS PAGE 107

FINANCIAL PLANNING CASES

CASE 1

The Johnsons Calculate Their Income Taxes

Several years have gone by since Harry and Belinda graduated from college and started their working careers. They both earn good salaries. They believe that they are paying too much in federal income taxes. The Johnsons' total income last year included Harry's salary of $63,000 and Belinda's salary of $84,000. She contributed $3000 to her 401 (k) for retirement. She earned $400 in interest on savings and checking and $3000 interest income from the trust that is taxed in the same way as interest income from checking and savings accounts. Harry contributed $3000 into a traditional IRA.

(a) What is the Johnsons' reportable gross income on their joint tax return?

(b) What is their adjusted gross income?

(c) What is the total value of their exemptions?

(d) How much is the standard deduction for the Johnsons?

(e) The Johnsons are buying a home that has monthly mortgage payments of $3000, or $36,000 a year. Of this amount, $32,800 goes for interest and real estate property taxes. The couple has a $14,000 in other itemized deductions. Using these numbers and  Table 4-2 , calculate their taxable income and tax liability.

(f) Assuming they had a combined $22,000 in federal income taxes withheld, how much of a refund will the Johnsons receive?

(g) What is their marginal tax rate?

(h) List three additional ways that the Johnsons might reduce their tax liability next year.

CASE 2

Victor and Maria Reduce Their Income Tax Liability

The year before last, Victor earned $51,000 from his retail management position, and Maria began working full-time and earned $45,000 as a medical technician. After they took the standard deduction and claimed four exemptions (themselves plus their two children), their federal income tax liability was about $12,000. After hearing from friends that they were paying too much in taxes, the couple vowed to try to never again pay that much. Therefore, the Hernandezes embarked on a yearlong effort to reduce their income tax liability. This year they tracked all of their possible itemized deductions, and both made contributions to qualified retirement plans at their places of employment.

DO IT IN CLASS PAGE 114

(a) Calculate the Hernandezes' income tax liability for this year as a joint return (using  Table 4-2 ) given the following information: gross salary income (Victor, $56,000; Maria, $51,000); state income tax refund ($400); interest on checking and savings accounts ($250); holiday bonus from Maria's employer ($375); contributions to qualified retirement accounts ($5500); itemized deductions (real estate taxes, $2600; mortgage interest, $6300; charitable contributions, $2500); and exemptions for themselves and their two children ($3950 each).

(b) List five additional strategies that Victor and Maria might consider for next year's tax planning to reduce next year's tax liability.

CASE 3

Julia Price Thinks About Reducing Her Income Taxes

Julia does well financially because she earns a good salary as an engineer, is somewhat frugal, and is making the maximum contribution to her employer-sponsored retirement plan. After reading about ways to decrease her income tax liability, she has some thoughts. Buying a home is an option, but Julia is worried about the changing prices of housing. As an accomplished sculptural artist, she is thinking about creating a sideline business to sell some of her work and convert some everyday expenses into business expenses. She is considering taking a tax-deductible job-hunting trip and then stretching the trip into a vacation. Also on her possibilities list is to start a master's degree program in engineering to enhance her skills. Finally, Julia figures she could contribute $200 a month to a Roth IRA account. Offer your opinions about her thinking.

CASE 4

A New Family Calculates Income and Tax Liability

Jerri Nichols and her two children, Austin and Alexandra, moved into the home of her new husband, Samuel Glenner, in Ames, Iowa. Jerri is employed as a librarian, and her husband sells cars. The Glenner family income consists of the following: $40,000 from Jerri's salary; $42,000 from Samuel's salary; $10,000 in life insurance proceeds from a deceased aunt; $140 in interest from savings; $4380 in alimony from Jerri's ex-husband; $14,200 in child support from her ex-husband; $500 cash as a Christmas gift from Samuel's parents; and a $1600 tuition-and-books scholarship Jerri received to go to college part time last year.

(a) What is the total of the Glenner reportable gross income?

(b) After they put $5600 into qualified retirement plan accounts last year, what is their adjusted gross income?

(c) How many exemptions can the family claim, and how much is the total value allowed the household?

(d) How much is the allowable standard deduction for the household?

(e) Their itemized deductions are $13,100, so should they itemize or take the standard deduction?

(f) What is their taxable income for a joint return?

(g) What is their final federal income tax liability, and what is their marginal tax rate? (Hint: Use  Table 4-2 .)

(h) If Jerri's and Samuel's employers withheld $18,000 for income taxes, does the couple owe money to the government or do they get a refund? How much?

CASE 5

Taxable Versus Tax-Exempt Bonds

Dario Flores, radio station manager in Franklin County, New Jersey, is in the 25 percent federal marginal tax bracket and pays an additional 5 percent in income taxes to the state of New Jersey. Dario currently has more than $20,000 invested in corporate bonds bought at various times that are earning differing amounts of taxable interest: $10,000 in ABC earning 5.9 percent; $5000 in DEF earning 5.5 percent; $3000 in GHI earning 5.8 percent; and $2000 in JKL earning 5.4 percent. What is the after-tax return of each investment? To calculate your answers, use the after-tax yield formula (or the reversed formula) on page 129, or the Garman/Forgue companion website.

DO IT IN CLASS PAGE 129

CASE 6

Taxable Versus Nontaxable Income

Identify each of the following items as either part of taxable income or an exclusion, adjustment, or an allowable itemized deduction from taxable income for Brian Collins and Morgan Smithfield, a married couple from San Diego:

DO IT IN CLASS PAGES 112 AND 116

(a) Brian earns $45,000 per year.

(b) Brian receives a $1000 bonus from his employer.

(c) Morgan receives $40,000 in commissions from his work.

(d) Morgan receives $300 in monthly child support from his ex-wife.

(e) Brian pays $200 each month in alimony.

(f) Brian contributes $2000 to his retirement account.

(g) Morgan inherits a car from his aunt that has a fair market value of $3000.

(h) Morgan sells the car and donates $1500 to his aunt's church.

(i) Brian receives a $5000 gift from his mother.

BE YOUR OWN PERSONAL FINANCIAL MANAGER

1. keep Track of Your Sources of Income. Complete Worksheet 19: My Sources of Taxable Income from “My Personal Financial Planner” to record all of your various income sources throughout the tax year so that you will not forget to report them to the Internal Revenue Service. Record the names of the income sources in the spaces provided. Record the amounts in the appropriate spaces.

2. Estimate Your Income Tax Liability. Complete Worksheet 20: Estimate Your Income Tax Liability from “My Personal Financial Planner” to determine an estimate of your income tax liability (for either last year or next year).

3. Should You File an Income Tax Return to Obtain a Refund? Complete Worksheet 21: Determining Whether I Should File for a Refund from “My Personal Financial Planner.” Even if you are not required to file a return perhaps because you did not earn enough money, you should file if you have a refund coming—that is, if you had more taxes withheld from your paychecks than you ultimately owed. Follow the steps to make the determination.

4. Strategies to Reduce Your Income Tax Liability. Complete Worksheet 22: Strategies to Reduce My Income Tax Liability from “My Personal Financial Planner.” There are several ways to reduce your income tax liability. For each strategy that might be of interest, make checkmarks to identify what characteristics you like about each and which strategies you might follow during your tax-paying life.

ON THE NET

Go to the Web pages indicated to complete these exercises.

1. IRS Publication 17. Go to the Internal Revenue Service website address  www.irs.gov/publications/p17/ . There you will find the IRS's entire Publication 17 online. This is the government's detailed explanation of all aspects of federal income taxes where you can look up almost any possible tax question. Summarize your observations about this publication.

2. Estimate Your Tax Refund. Visit the website for  BankRate.com  ( www.bankrate.com/calculators/tax-planning/1040 -form-tax-calculator.aspx )to estimate your tax refund. Fill in a few numbers and get an answer.

3. Estimate Your Income Taxes. Enter your filing status, income, deductions and credits and the calculator at Dinkytown ( www.dinkytown.net/java/Tax1040.xhtml ) and based on your inputs (filing status, income, deductions, and credits) and projected withholdings for the year, it can estimate your tax refund or amount you may owe the IRS next year.

4. Check Taxes in Your State to Determine Your Effective Tax Rate. Visit Bankrate.com's website www.bankrate .com/finance/taxes/check-taxes-in-your-state.aspx. There you will find a map of states. Click to find your state income tax, if applicable. What is your combined federal and state marginal tax rate? Add in another 7.65 percent for Social Security and Medicare taxes to determine your effective marginal tax rate.

ACTION INYOLYEMENT PROJECTS

1. Telephone the Internal Revenue Service. Dial 1 (800) TAX-3676 (or 1 (800) 829–3676) to pose a question for an IRS spokesperson. Think of a question before you call. Perhaps it has to deal with whether or not you qualify for a specific tax credit, can deduct expenses for a sideline business, or can make Roth IRA contributions. Write a summary of your findings.

2. Tax Reform Proposals. Type “tax reform” into your browser and skim read what you find of interest on three websites. Write a summary of your findings and include your views of what reform(s) you might prefer.

3. Who Pays Income Taxes? Type “income taxes, who pays” into your browser and skim read what you find of interest on three websites. For starters, you will discover that close to half of Americans do not pay any federal income taxes at all and that the top 1 percent of earners pay close to 40 percent of all personal income tax revenues. Write a summary of your findings, and cite your sources.

4. Tax Bills Lowest Since 1950s. Read the  FactCheck.org  article on taxes in the United States at  factcheck.org/2012/07/tax-facts-lowest-rates-in-30-years/ . In addition, search the Web for a more recent report on the same topic and write a summary of your findings.

5. Corporate and Individual Tax Rates Around the World. Comparing taxes on individuals and businesses around the world is extremely challenging. Some countries have a value-added tax paid by consumers. Others provide free health care to citizens, while people in some countries have to pay health care premiums. Review the table provided by  Worldwide-Taxes.com  at  www.worldwide-tax.com/#partthree , and write a brief summary of your impressions.

6. Corporate Tax Avoidance. Read the article on the Center for American Progress ( www.americanprogress.org/issues/2012/02/corporate_profits.xhtml ) to discover how many billions the large multinational corporations in the United States do or do not pay in income taxes in this country. Write a summary of your findings.

visit the Garman/Forgue companion website at  www.cengagebrain.com .

*  The history of the latest year when the highest federal marginal tax rates in the United States was applied to taxable income is as follows: 1953 (92%); 1980 (70%); 1986 (50%); 2000 (39.6%); and 2012 (35%).

*  The 6.2 percent Social Security tax is applied to wages up to $117,000.

**  The Medicare tax is applied to all wages regardless of amount.

***  “Higher-income” taxpayers earning $200,000+, about 4.7 million returns, which is 3.2 percent of all returns, also must pay two additional Medicare taxes: A 3.8 percent surtax on net investment income and a 0.9 percent Medicare contributions tax on self-employment earnings. Those earning $400,000+ also pay a 20 percent rate on all long-term capital gains.

****  Check income tax rates in various states at  www.bankrate.com/taxes.aspx

*  If you or your spouse is age 65 or older, medical expenses exceeding 7.5 percent of AGI may be claimed.