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Chapter 4 – Tax Planning

• Intent – not to make you tax experts

– But appreciate major features of tax laws

• Key concepts – deductions and sheltered income

• Progressive (graduated) rates

– Earn more, pay higher rate

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Forms

• 1040 EZ – under $50,000 and no dependents; interest under $1,500

• 1040 A – under $50,000 but may have dividends/interest

• 1040 – “long form”, only one permitting itemized deductions

• All may be filed electronically• Electronic refunds even with paper forms

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Filing Status

• Single

• Married Filing Jointly

• Married Filing Separately

• Head of Household– Unmarried with dependents

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Which Form Did You Use?(Show of Hands)

• Didn’t have to file

• 1040 EZ

• 1040 A

• 1040

• How many used a paid tax preparer?

• How many filed electronically?

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Recent Changes

• Econ Growth and Tax Relief Act- 2001– Phases in reduced tax rates affecting all

brackets; gave rebates

• Jobs Growth and Tax Relief Act – 2003– Dividends and long-term capital gains tax

rates reduced to 15%• Previously, dividends taxed at ordinary rates (up

to 40%) and cap gains at 20%

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2004 Rates on Taxable Income(Married filing Jointly)

Tax Rate Income Range

10% $1 to $14,300

15 14,300 to 58,100

25 58,100 to 117,250

28 117,250 to 178,650

33 178,650 to 319,100

35 over 319,100

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Calculating Taxes

• Taxes – largest annual expenditure• Generally singles file if earn over $7,800

– Lower if you are a dependent or have investment income

• Gross income less adjustments, standard or itemized deductions and personal exemptions equals taxable income– Use tax tables or rate schedules

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2004 $75,000 Taxable Income(Married Filing Jointly)

First $14,300 @ 10% = $1,430

Next 43,800 * @15% 6,570

Next 16,900 ** @ 25% 4,225

$75,000 $12,225

* (58,100 - 14,300) * 15% = 6,570

** (75,000 – 58,100) * 25% 4,225

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Marginal Rate

• Brackets – rate applied to a range of income

• Marginal rate – rate on next dollar of income– Important effect on taxes of changing income

or deductions– Needed for financial decisions– Include all taxes that change

• Social Security (FICA), state income taxes

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Other Taxes

• On income – FICA, Medicare, state and local income tax

• Non-income – sales, excise, real and personal property, inheritance

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Capital Gains

• Gain or loss on an investment (capital asset)– Stocks, bonds, real estate– Gain/loss – difference of cost and sale price

• Gains and losses offset each other– Largest net loss deductible is $3,000

• Long-term gain rate lower than short-term– 15% tax imposed when asset is sold

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Gross Income

• Taxable income from all sources:– Wages, salaries and tips– Dividend and interest income and capital

gains (Schedules B and D)– IRA distributions and pensions– Rental income, unemployment insurance,

some social security and state tax refunds– Equals Total Income – Line 22

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Adjusted Gross Income

Total income less adjustments

IRA contribution, health insurance for self-employed, interest on some student loans, medical savings, some moving expenses

Equals Adjusted Gross Income (AGI)

Lines 36 and 37

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Tax Impact Retirement Savings401 (k) Plans – employer sponsored

Contributions not included in Line 7 wagesReduces total income, Line 22Various contribution limits, generally $13,000

Individual Retirement Accounts (IRA)Contributions (Line 25) reduces AGIDeduct $3,000 contribution if not covered by another plan

Not taxed until withdrawal; penalty if early

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Deductions

• Itemized or standard, whichever fits best– Standard: $4,850 for singles, $9,700 joint– Use Schedule A for itemized deductions

• AGI less deductions, less $3,100 per person personal exemption, equals taxable income

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Itemized Deductions

• Medical (if over 7.5% of AGI)

• State & local income and property taxes

• Mortgage interest, points; some HE int.

• Gifts to charity

• Casualty and theft losses (limited)

• Miscellaneous (limited)

• Total limited if AGI over $140,000

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Summary

Gross Income from all sources

+ or – AdjustmentsIRA, student loans, and other adjustments

= Adjusted Gross Income (AGI)

- Standard or Itemized Deductions

- Personal Exemptions

= Taxable Income

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Calculating Taxable Income

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Other Info

• Late filing after April 15– Extension but must pay estimated tax

• Audits – more likely if earn more– Need good records.

• Preparation: self-help to part-time "experts" to professionals (CPA's)– Not licensed or tested

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Tax Planning I

• Minimize unnecessary payments

• Strategy #1 – Maximize deductions– Tax-deferred retirement savings plans– Use home as tax shelter– Shift and bunch deductions

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Tax Planning II

• Look to capital gains income– Long-term gains tax rate lower (15%)

• Shift income to family members in lower brackets– Big risk – lost control over kids’ spending

• Receive tax-exempt income (municipals)

• Defer taxes through retirement accounts

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Web Readings Next Class

• Savings Bonds

• E-payments (see Assignments)

Go to http://www.publicdebt.treas.gov

Click Savings Bond Wizard – left column

Click More about Savings Bonds (on left)

Click Bond Owner Manual (center)