Copyright © 2015, 2011, 2008 Pearson Education, Inc. Chapter 4, Unit E, Slide 1 Managing Money 4.

Copyright © 2015, 2011, 2008 Pearson Education, Inc. Chapter 4, Unit E, Slide 1

Managing Money4


Unit 4E

Income Tax


Income Tax Preparation Flow Chart


ExampleKaren earned wages of $38,200, received $750 in interest from a savings account, and contributed $1200 to a tax-deferred retirement plan. She was entitled to a personal exemption of $3900 and to deductions totaling $6100. find her gross income, adjusted gross income, and taxable income.


Example (cont)SolutionKaren’s gross income is the sum of all her income, which means the sum of her wages and her interest.

Gross income = $38,200 + $750 = $38,950

Her $1200 contribution to a tax-deferred retirement plan counts as an adjustment to her gross income, so her adjusted gross income (AGI) is

AGI = gross income – adjustments = $38,950 – $1200 = $37,750.


Example (cont)To find her taxable income, we subtract her exemptions and deductions.

Taxable income = AGI – exemptions – deductions = $37,750 – $3900 – $6100 = $27,750

Her taxable income is $27,750.


Filing Status

Single – unmarried, divorced, or legally separated Married filing jointly – married and you and your

spouse file a single tax return Married filing separately – married and you and

your spouse file two separate tax returns Head of household – unmarried and paying more

than half the cost of supporting a dependent child or parent

Tax calculations depend on your filing status, which consist of the following four categories:


Exemptions and Deductions

Exemptions are a fixed amount per person. Exemptions can be claimed for you and each of

your dependents. Deductions vary from one person to another.

A standard deduction depends on your filing status.

An itemized deduction is the sum of all the individual deductions to which you are entitled.

Both exemptions and deductions are subtracted from your adjusted gross income.


ExampleSuppose you have the following deductible expenditures: $2500 for interest on a home mortgage, $900 for contributions to charity, and $250 for state income taxes. Your filing status entitles you to a standard deduction of $6100. Should you itemize your deductions?SolutionThe total if your deductible expenditures is

$2500 + $900 + $250 = $3650. The standard deduction of $6100 will put you better off.


Tax Rates A progressive income tax means that people

with higher taxable income pay at a higher tax rate. Marginal tax rates are assigned to different

income ranges (or margins).


2013 Marginal Tax Rates, Standard Deductions, and Exemptions


Tax Credits and Deductions

A tax credit reduces your total tax bill by the full amount of the credit.

A tax deduction reduces your taxable income by the amount of the deduction.

As a rule, tax credits are more valuable than tax deductions.


ExampleSuppose you are in the 28% tax bracket. How much does a $1000 tax credit save you? How much does a $1000 charitable contribution (which is tax deductible) save you? Answer these questions both for the case in which you itemize deductions and for the case in which you take the standard deduction.


Example (cont)SolutionThe entire $1000 tax credit is a deducted from your bill and therefore saves you a full $1000 whether you itemize or take the standard deduction. In contrast $1000 deduction reduces your taxable income, not your total tax bill by $1000. For a 28% tax bracket, at best your $1000 deduction will save you $280. However, you will only have this $280 if you itemize deductions. If you itemized deductions are less than standard deductions, your contribution will save you nothing at all.


ExampleDrew is in the 15% marginal tax bracket. Marian is in the 35% marginal tax bracket. They each itemize their deductions. They each donate $5000 to charity. Compare their true costs for the charitable contributions.

SolutionThe $5000 contribution to charity is tax deductible. His contribution saves him 15% × $5000 = $750 in taxes. The true cost of his contribution is the contributed about minus his tax savings, or $4250.


Example (cont)For Marian, who is in the 35% tax bracket, the contribution saves $1750 in taxes. Therefore, the true cost of her contribution is $5000 – $1750 = $3250. The true cost of the donation is considerable lower for Marian because she is in a higher tax bracket.


FICA applies to the following: Income from wages (including tips) Self-employment

FICA does not apply to the following: Income from interest Income from dividends Profits from sales of stock

Some income is subject to Social Security and Medicare taxes, which are collected under the name FICA (Federal Insurance Contribution Act) taxes.

Social Security and Medicare Taxes


ExampleIn 2013, Jude earned $26,000 in wages and tips from her job waiting tables. Calculate her FICA taxes and her total tax bill including marginal taxes. What is her overall tax rate on her gross income, including both FICA and income taxes? Assume she is single and takes the standard deduction.Solution

FICA tax = 7.65% × $26,000 = $1989Now we must find her income tax. We get her taxable income by subtracting her exemptions.Taxable income = $26,000 – $3900 – $6100 = $16,000


Example (cont)From table 4.9, her income tax is 10% on the first $8925 of her taxable income and 15% on the remaining amount of $16,000 – $8925 = $7075. Therefore, her income tax is (10% × $8925) + (15% × $7075) = $1954.

total tax = FICA + income tax = $1989 + $1954 = $3943Her overall tax rate, including both FICA and income tax, is

Her overall tax rate is about 15.2%. She pays slightly higher in FICA tax than in income tax.

total tax $3943 0.152

gross income $26,000


Dividends and Capital Gains

Dividends (on stocks) Capital gains – profits from the sale of stock or

other property Short-term capital gains – profits on items sold

within 12 months of their purchase Long-term capital gains – profits on items held

for more than 12 months before being sold

Income with special tax treatment:


Tax-Deferred Income

Individual retirement accounts (IRAs) Qualified retirement plans (QRPs) 401(k) plans

Tax-deferred savings plans allow you to defer income taxes on contributions to certain types of savings plans. These include the following:


ExampleSuppose you are single, have a taxable income of $65,000, and make monthly payments of $500 to a tax deferred savings plan. How do the tax-deferred contributions affect your monthly take-home pay?

SolutionTable 4.9 shows your marginal tax rate is 25%. Each $500 contribution reduces your tax bill by

25% × $500 = $125While $500 goes into your tax-deferred savings account, your paychecks go down by only $500 – $125 = $375.

Copyright © 2015, 2011, 2008 Pearson Education, Inc. Chapter 4, Unit E, Slide 1 Managing Money 4.

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