© 2008 Thomson South-Western

CHAPTER 3

MANAGING YOUR TAXES

3-2

Principles of Federal Income Taxes

Typical American family pays about a third of its gross income in various types of taxes

Internal Revenue Service (IRS) is responsible for the administration and enforcement of federal tax laws

3-3

Economics of Income Taxes

Federal income taxes are assessed according to a progressive tax structure

– the larger the taxable income, the higher the tax rate

The next higher rate applies only to the additional income in that bracket, not to the entire income.

Tax brackets, standard deductions, and personal exemptions are indexed to inflation.

3-4

Economics of Income Taxes

Tax rate for each bracket is called the marginal tax rate

Relating the tax liability to the level of taxable income earned, tax rate is called the average tax rate– It is lower than the marginal rate

3-5

2005 Tax Rate Schedule(single taxpayers)

3-6

Examples: Jason and David

Jason’s marginal tax rate = 25%

Jason’s average tax rate = 16.7%

David’s marginal tax rate = 28%

David’s average tax rate = 21.1%

3-7

More Principles of Taxation

Filing Status a factor in determining amount of income tax paid.– Single– Married filing jointly– Married filing separately– Head of household– Qualifying widow/widower with dependent child

3-8

More Principles of Taxation

Taxes are due on a pay-as-you-go basis– Employer withholds taxes all year– Self-employed deduct and pay taxes

Taxes paid are:– Federal income taxes– State income taxes– Local income taxes – Social Security taxes

• Medicare component

3-9

It's Taxable Income that Matters

Taxable Income

is the amount of our income on which we calculate taxes owed.

3-10

All income subject to federal income taxes3 classifications of income that must be kept separate for deduction purposes

Active Income

Wages & salaries

Alimony received

Business & farm income

Prizes, awards, gambling winnings

Portfolio Income

Interest

Dividends

Capital gains

Most types of investment earnings

Passive Income

Income from real estate (unless real estate is your primary business)

Limited

partnerships &

tax shelters

Gross Income

3-11

Tax-Exempt Income

Either totally or partially excluded from gross income for income tax purposes:

Child support received

Insurance reimbursements

Gifts (limits apply)

Scholarships (some limits)

Tax refunds

Return of original investment capital

3-12

Adjustments to Gross Income (AGI)

Items that can be subtracted from gross income.

Some items included:

– Traditional IRA contributions (some limits)

– Self-employment tax—50% of amount paid

– Alimony paid– Penalty on early withdrawal of savings

3-13

The subtotal obtained when adjustments are subtracted from gross income.

Used to limit certain itemized deductions and other calculations

Adjusted Gross Income (AGI)

3-14

Deductions

Standard deduction – the blanket amount allotted for various deductible expenses taxpayers normally incur

Itemized Deductions – if deductible expenses are greater than the standard deduction, deductions may be itemized instead.

3-15

– Medical and dental expenses

– State and local income taxes

– Property taxes

– Home mortgage interest

– Charitable contributions

– Casualty and theft losses

Itemized Deductions

3-16

Exemptions

Self and dependents supported by the taxpayer’s income– You are an exemption on your own return

unless you can be claimed by someone else

Children, spouses, elderly parents are other examples of exemptions.

Each person can be claimed on only 1 tax return

3-17

Tax Credits versus Tax Deductions

Credits directly reduce the amount of taxes you owe.

Deductions are subtracted from your AGI and reduce your taxable income.

Which results in lower taxes?

3-18

Tax Credits versus Tax Deductions

A $1000 tax credit reduces tax by much more than a deduction.

* Tax liability is figured as follows: the first $7,300 of taxable income is taxed at 10 percent, the balance at 15 percent.

3-19

Tax Forms and Schedules

Variations of Form 1040

If more detail required, taxpayers also must file other forms and schedules.

3-20

Common Tax Forms and Schedules

3-21

3-22

Example: 2005 Tax Return of the Beckers

3-23

Example: 2005 Tax Return of the Beckers

3-24

Other Filing Considerations

Quarterly payment of estimated taxes

April 15 filing deadline

Filing extensions

Amended returns (1040X)

Audited returns

3-25

Preparing Your Tax Return

Do it yourself Get help from the IRS Use professional services

– Tax services – Certified public accountants (CPAs)– Enrolled agents (EAs)– Tax attorneys

Use tax software Computer-based tax returns Taxpayer is responsible for accuracy!

3-26

Effective Tax Planning

Tax avoidance is legal. Tax evasion is not!

Reduce taxes– Maximize deductions and/or credits – Income shifting– Tax deferral– Tax-free income