Week 2 Assignment

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Personal Finance

SIXTH EDITION

Chapter 4

Using Tax Concepts for Planning*

Chapter Objective (1 of 2)

4.1 Provide a background on taxes

4.2 Explain how to determine your tax filing status

4.3 Demonstrate how to calculate your gross income

4.4 Show how deductions and exemptions can be used

Chapter Objective (2 of 2)

4.5 Explain how to determine your taxable income, tax liability, and refund or additional taxes owed

4.6 Explain how tax planning fits within your financial plan

Background on Taxes (1 of 10)

Taxes are an integral part of our economy

They are paid on earned income, consumer purchases, wealth transfers and capital assets

Special taxes are levied on things like alcohol, cigarettes and gasoline

Background on Taxes (2 of 10)

Corporations pay income tax on profits

Homeowners pay property taxes

Taxes are used to pay for government services and programs

Most individuals pay taxes at federal, state and local levels

Background on Taxes (3 of 10)

Federal tax system is administered by the Internal Revenue Service (IRS)

Taxes are paid in several ways

At the time of a transaction

Through payroll withholding

By making estimated quarterly payments

Tax year for federal income tax ends on Dec. 31 with taxes filed by April 15

Background on Taxes (4 of 10)

Tax Law Changes

Economic Growth and Tax Relief Reconciliation Act of 2001: tax cut package designed to provide short-term economic stimulus through tax relief for taxpayers

Provisions scheduled to phased in between 2001 and 2011 when the law was scheduled to expire

Background on Taxes (5 of 10)

Jobs and Growth Tax Relief Act of 2003: an act that accelerated much of the tax relief resulting from the 2001 Tax Relief Act

Individual rates lowered 2-3%

Child tax credit increased to $1,000

Standard deduction increased for married taxpayers

Background on Taxes (6 of 10)

Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010: Legislation that extended many of the previous tax law provisions through the year 2012

American Taxpayers Relief Act of 2012: Permanently set in place many provisions from the 2010 legislation

Background on Taxes (7 of 10)

Affordable Care Act of 2010: Legislation requiring everyone must obtain health insurance and report medical coverage status on their tax return

If proof of health insurance is not provided a penalty will be assessed

Background on Taxes (8 of 10)

Social Security and Medicare Taxes

Earned Income: Earned income represents salary or wages

FICA (Federal Insurance Contribution Act): Taxes paid to fund the Social Security System and Medicare

Medicare: a government health insurance program that covers people over age 65 and provides payments to health care providers in the case of illness

Background on Taxes (9 of 10)

Social Security and Medicare Taxes

Your employer matches the amount that is withheld from your wages

Social Security taxes equal 6.2% of your salary up to a maximum level of $118,500 as of 2015

Medicare taxes are 1.45 % of your earned income

Self-employed people must pay both parts of these taxes themselves—15.3%

Background on Taxes (10 of 10)

Personal income taxes: taxes imposed on income earned

If you earn income you must file a Form 1040, 1040A or 1040EZ to determine your tax liability

Filing deadline is April 15 of each year

Financial Planning Online

Go to www.irs.gov /

This Web site provides information about tax rates, guidelines, and deadlines

Filing Status

Taxpayers must specify a filing status for their tax return because different rates are associated with each status.

Single

Married filing jointly

Married filing separately

Head of household

Qualifying widow(er) with dependent child

Exhibit 4.1 Form 1040 (page 1)*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication. 2015 IRS forms can be obtained online from irs.gov.

Exhibit 4.1 Form 1040 (page 2)*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication. 2015 IRS forms can be obtained online from irs.gov.

Gross Income (1 of 5)

Gross income: all reportable income from any source, including salary, interest income, dividend income, and capital gains received during the tax year

Wages and Salaries—including bonuses, but excluding contributions to an employee sponsored retirement account

Interest income: interest earned from investments or loans to other individuals

Gross Income (2 of 5)

Dividend income: income received in the form of dividends paid on stocks or mutual funds

Capital gain: income earned when an asset is sold at a higher price than was paid for it

Short-term capital gain: a gain on assets that were held less than 12 months

Long-term capital gain: a gain on assets that were held for 12 months or longer

Gross Income (3 of 5)

Capital gains tax: the tax that is paid on a gain earned as a result of selling an asset for more than the purchase price

The tax rate on a long-term capital gain is lower than the tax rate on ordinary income

The tax rate that applies depends on your tax bracket but ranges between 0% and 20%

Gross Income (4 of 5)

Determining gross income

Gross income: all reportable income from any source, including salary, interest income, dividend income, and capital gains received during the tax year

Exhibit 4.2 Schedule B of Form 1040*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication. 2015 IRS forms can be obtained online from irs.gov.

Exhibit 4.3 Schedule D of Form 1040 (Page 1)*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication. 2015 IRS forms can be obtained online from irs.gov.

Exhibit 4.3 Schedule D of Form 1040 (Page 2)*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication. 2015 IRS forms can be obtained online from irs.gov.

Gross Income (5 of 5)

Determining gross income

Determined by adding your salary, net business income, interest income, dividend income, and capital gains

Adjusted gross income: adjusts gross income for contributions to IRAs, alimony payments, interest paid on student loans, and other special circumstances

Deductions and Exemptions (1 of 6)

Standard deduction: a fixed amount that can be deducted from adjusted gross income to determine taxable income

Not affected by income

Affected by filing status and age

Adjusted by the IRS each year to keep pace with inflation

Deductions and Exemptions (2 of 6)

EXHIBIT 4.4 Standard Deduction Amounts for the 2015 Tax Year
Filing Status	Standard Deduction
Married filing jointly and surviving spouses	$12,600
Head of household	9,250
Single individuals	6,300
Married, filing separately	6,300

Deductions and Exemptions (3 of 6)

Itemized deductions: specific expenses that can be deducted to reduce taxable income

Interest expense - interest paid on borrowed money—primarily interest on mortgages

State income tax: an income tax imposed by some states on people who receive income from employers in that state

Local income taxes also deductible when itemizing

Deductions and Exemptions (4 of 6)

Real estate tax: a tax imposed on a home or other real estate in the county where the property is located

Medical expenses: medical expenses in excess of 10.0% of adjusted gross income may also be itemized

Charitable gifts

Gifts to qualified organizations

Cash or property

Be sure to keep receipts and records of gifts

Deductions and Exemptions (5 of 6)

Other expenses

Theft losses, job expenses if substantial

Summary of deductible expenses

Total deductible expenses to decide whether to itemize or use the standard deduction

Exhibit 4.5 Schedule A of Form 1040 (Page 1)*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication. 2015 IRS forms can be obtained online from irs.gov.

Financial Planning Online

Go to www.turbotax.com

Use the tools on this Web site to estimate your tax liability for the year and tax refund if applicable

You will need to input income, filing status, exemptions and deductions to obtain the estimates

Deductions and Exemptions (6 of 6)

Exemptions

Personal exemption: an amount that can be deducted for each person who is supported by the income reported on a tax return

Usually one exemption each for the filer, the spouse and each dependent child

Deducted from gross income to determine taxable income

Taxable Income and Taxes (1 of 5)

Taxable income: adjusted gross income less deductions and exemptions

Calculating Taxes

Dependent upon taxable income and filing status

Progressive tax—a tax system where a positive relationship exists between an individual’s income level and tax rate

Exhibit 4.6 Tax Rate Schedules for 2015 (1 of 4)

EXHIBIT 4.6 Tax Rate Schedules for 2015
Tax Rate–Single Taxpayers – 2015
Taxable income:
Over—	But not over—	Tax	+%	On amount over—
$ 0	$ 9,225	$ 0.00	10	$ 0
9,225	37,450	922.50	15	9,225
37,450	90,750	5,156.25	25	37,450
90,750	189,300	18,481.25	28	90,750
189,300	411,500	46,075.25	33	189,300
411,500	413,200	119,401.25	35	411,500
413,200	------------	119,996.25	39.6	413,200

Exhibit 4.6 Tax Rate Schedules for 2015 (2 of 4)

EXHIBIT 4.6 Tax Rate Schedules for 2015
Tax Rates–Married Individuals Filing Jointly and Surviving Spouses – 2015
Taxable income:
Over—	But not over—	Tax	+%	On amount over—
$ 0	$ 18,450	$ 0.00	10	$ 0
18,450	74,900	1,845.00	15	18,450
74,900	151,200	10,312.50	25	74,900
151,200	230,450	29,387.50	28	151,200
230,450	411,500	51,577.50	33	230,450
411,500	464,850	111,324.00	35	411,500
464,850	------------	129,996.50	39.6	464,850

Exhibit 4.6 Tax Rate Schedules for 2015 (3 of 4)

EXHIBIT 4.6 Tax Rate Schedules for 2015
Tax Rates–Married Individuals Filing Separately – 2015
Taxable income:
Over—	But not over—	Tax	+%	On amount over—
$ 0	$ 9,225	$ 0.00	10	$ 0
9,225	37,450	922.50	15	9,225
37,450	75,600	5,156.25	25	37,450
75,600	115,225	14,693.75	28	75,600
115,225	205,750	25,788.75	33	115,225
205,750	232,425	55,662.00	35	205,750
232,425	------------	64,989.25	39.6	232,425

Exhibit 4.6 Tax Rate Schedules for 2015 (4 of 4)

EXHIBIT 4.6 Tax Rate Schedules for 2015
Tax Rates – Head of household – 2015
Taxable income:
Over—	But not over—	Tax	+%	On amount over—
$ 0	$ 13,150	$ 0.00	10	$ 0
13,150	50,200	1,315.00	15	13,150
50,200	129,600	6,872.50	25	50,200
129,600	209,850	26,722.50	28	129,600
209,850	411,500	49,192.50	33	209,850
411,500	439,000	115,737.00	35	411,500
439,000	------------	125,362.00	39.6	439,000

Taxable Income and Taxes (2 of 5)

Determining your tax liability

Determine filing status and follow the instructions on the tax schedule

Tax Liability = Tax on Base + [Percentage on Excess over the Base x (Taxable Income – Base)]

Taxable Income and Taxes (3 of 5)

Tax credits: specific amounts used to directly reduce tax liability

Child tax credit: a tax credit allowed for each child in a household

Currently $1,000

Available as a refund to low-income workers who owe no income tax

In 2017 the credit will not be allowed to exceed the taxpayer’s liability

Taxable Income and Taxes (4 of 5)

College expense credit: a tax credit allowed to those who contribute toward their dependents’ college expenses

Coverdell Savings Accounts: tax-free accounts that can be used for a variety of school expenses

Section 529 College Savings Plan

Allows tax benefits for parents who set aside money for their children’s future college expenses

Available to all parents, regardless of income

Taxable Income and Taxes (5 of 5)

Earned income credit: a credit used to reduce tax liability for low-income taxpayers

Other tax credits are also available, for example for child care and adoptions

Financial Planning Online

Go to turbotax.intuit.com/tax-tools/

This Web site provides an estimate of your tax liability for the year and the tax refund that you may receive, based on your income, filing status, exemptions and deductions.

How Tax Planning Fits Within Your Financial Plan (1 of 5)

The key tax planning decisions for building your financial plan are:

What tax savings are currently available to you?

How can you increase your tax savings in the future?

Should you increase/decrease the amount of your withholding

What records should you keep?

How Tax Planning Fits Within Your Financial Plan (2 of 5)

EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan
GOALS FOR TAX PLANNING
1. Reduce taxable income (thereby reducing taxes paid) to the extent allowable by the IRS. 2. Reduce taxes paid by deferring income.
ANALYSIS
Present Situation:
Gross Income = $38,000
Federal Income Taxes = $3,693.75
Taxes (excluding FICA) as a Percentage of Income = 10%
Reduce Taxes by:	Comment
Increasing deductions?	The only qualified deduction I had was a charitable contribution of $200, so this is not an option for me this year.
Reducing gross income?	I did not contribute any portion of my income to an individual retirement account or a qualified retirement plan.
Total tax savings?	$0 per year

How Tax Planning Fits Within Your Financial Plan (3 of 5)

EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan
Long-Term Tax Plan:
Reduce Taxes by:	Comment
Increasing deductions?	If I purchase a home, the interest expense on my mortgage loan, as well as the real estate taxes, will help boost my itemized deductions. These deductions will likely be higher than the standard deduction to which I would be entitled. In addition, my sales taxes can be counted toward my itemized deductions.
Reducing gross income?	I can also contribute to an IRA or to my employer’s qualified retirement plan. If I can afford to contribute $5,000 of my salary to either the IRA or the qualified plan, I will reduce my gross income and defer taxes on that portion of my income.
Tax savings (computed below)	$877.50

How Tax Planning Fits Within Your Financial Plan (4 of 5)

EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan
To compute my estimated tax savings, I will compare the taxes paid under my current situation to what I would pay if I bought a home and paid $6,000 in mortgage interest and real estate taxes and contribute $5,000 to my IRA. My estimated tax deduction will be $600 and my charitable contributions will remain at $200.
Category	Current Situation	Long-Term Plan
Gross Income	$38,000	$38,000
– IRA contribution	$0	$5,000
= Adjusted gross income	$38,000	$33,000
– Deductions	$6,300	$6,800
– Exemptions	$4,000	$4,000
= Taxable income	$27,700	$22,200
Tax liability (based on applying tax rates to the taxable income)	$3,693.75	$2,868.75
Approximate Total Tax Savings = $825.00 per year*
*Actual tax savings will change each year as the mortgage interest declines, as changes occur in other itemized deductions, and as the standard deduction increases.

How Tax Planning Fits Within Your Financial Plan (5 of 5)

EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan

DECISIONS

Decisions Regarding Tax Savings for This Year:

So far I have only taken advantage of one tax reduction strategy.

Decisions Regarding Tax Savings in the Future:

I can improve my cash flows over time by taking advantage of tax deductions. If I buy a home, the interest that I would pay on the mortgage loan, as well as the real estate taxes I would be assessed, is tax-deductible. The purchase of a home would likely increase my monthly cash outflows, but I would benefit from deducting the interest payments and real estate taxes as itemized deductions, thereby reducing my taxable income. As my income increases, my tax bracket may increase. I need to maximize my potential tax savings to limit the taxes I will pay. I should contribute the maximum allowable amount to my retirement plan (without compromising my cash budget) so that I can take full advantage of the related tax savings. Also, I hope to buy a home in the future. The interest I will pay on a mortgage loan for this home will be high, but I will enjoy tax savings, while also building equity in my home.