LN04_Keown_856526_PF_07_LN04

Chapter 4

Tax Planning and Strategies

© 2016 Pearson Education, Inc. All rights reserved. 4-2

Learning Objectives

1. Identify and understand the major federal income tax features that affect all taxpayers.

2. Describe other taxes that must pay.

3. Understand what is taxable income and how taxes are determined.


Learning Objectives

4. Choose the tax form that’s right for you, file and survive an audit if necessary.

5. Calculate your income taxes.

6. Minimize your taxes.


Introduction

• Most financial decisions are affected by taxes.

• Need to understand how taxes are imposed.

• What strategies are used to reduce taxes and what role does tax planning have in personal financial planning?


The Federal Income Tax Structure

• Progressive or graduate tax

• Tax rates and tax brackets

• Personal exemption

• Itemized or standard deductions

• Taxable income



• Taxable income is a function of adjusted gross income (AGI), deductions, and exemptions.

• AGI = taxable income from all sources minus specific adjustments but before deducting standard or itemized deductions



• Assume you are in the 15% tax bracket. Does that mean you pay 15% of your taxable income in taxes?

• The last dollar earned is taxed at 15%. Earlier income is taxed at the lower rate.


Marginal Versus Average Taxes

• Average Tax Rate—the average amount of your total income taken away in taxes

• Marginal Tax Rate (or marginal tax bracket)—the percentage of the last dollar earned that goes to pay taxes

• Tax-deferred—income on which the payment of taxes is postponed


Effective Marginal Tax Rate

• The rate you pay when all income taxes are combined (federal, state, city, Social Security taxes, etc.).

• Is greater than the marginal tax rate on federal income taxes.


Capital Gains andDividend Income

• Capital asset—an asset your own

• Capital gain—what you make if you sell a capital asset for a profit

• Capital loss—what you lose when you sell a capital asset for a loss

• Capital gains tax—tax you pay on your capital gains


Capital Gains andDividend Income

• Lower tax rate on both the long-term capital gains and on dividends.

• Long-term capital gains tax on profits from the sale of stocks and bonds, not gains from sale of collectibles.

• Capital gains are not claimed or taxed until the asset is sold.


Long-Term CapitalGains on Homes

• Capital gains taxes for most homeowners on sale of their homes

• Exemption up to $500,000 for couples filing jointly ($250,000) filing single on sale of principal residence

• Must have been occupied for 2 of the 5 years prior sale


Filing Status

• Single

• Married Filing Jointly and Surviving Spouses

• Married Filing Separately

• Head of Household


Cost of Living Increases in Tax Brackets, Exemptions, and Deductions

• Tax brackets change annually to reflect changes in the cost of living (inflation)

• Standard deductions and personal exemptions are increased to reflect inflation

• Bracket Creep—tax increase caused by inflation increasing wages


Paying Your Income Taxes

• Pay-as-you-go basis

• Withholding from wages

• Quarterly estimated taxes sent to the IRS

• Payments with tax return

• Withholdings from stock dividends, retirement funds, and prize winnings


Paying Your Income Taxes

• You have some control over how much is deducted for taxes from your wages.

• Withholdings are determined by income level and information on W-4 form.

• W-4 form (usually filled out with new employer)—marital status, number of exemptions claimed


Other Taxes

• Income-Based Taxes:– Social Security or FICA– State and local income taxes

• Non-income-based taxes– Excise taxes– Property taxes– Gift and estate taxes


Calculating Your Taxes

• Must you file a tax return?

• Depends on income, filing status, age, whether you can be claimed as dependent

• Dependent—person you support financially

• Calculate taxes anyway to get any refund due to you


Step 1: Determining Gross or Total Income

• Sum of all taxable income from all sources

• Active income—income from wages or a business

• Portfolio or investment income—securities

• Passive income—activities in which the taxpayer does not actively participate


Step 2: Calculating Adjusted Gross Income (AGI)

• Gross income less allowable adjustments

• Adjustments include:– Retirement contributions– Student loan interest paid– Moving expenses– Health Savings Account contributions– Unreimbursed educator expenses


Step 3: Subtracting Deductions • Take greater deduction between standard

and itemized deduction

• Itemize deductions—list of deductible expenses: medical expenses, tax expenses, mortgage interest payments, etc.

• Standard deduction—government’s best estimate of what the average person would deduct if itemizing


Step 4: Claiming Your Exemptions

• Exemption—deduction for each person supported by the income on a tax return

• An exemption includes yourself, spouse, or dependents

• Dependent must qualify as child or dependent


Step 5: Calculating Your Taxable Income, and From That, Calculating Your Base Income Tax

• Taxable income—subtract deductions and exemptions from AGI

• Base income tax—intersection of filing status and taxable income in the federal income tax tables

• Alternative minimum tax (AMT) ensures that wealthy pay enough taxes


Step 6: Subtract Your Credits andDetermine Your Taxes Due

• Tax credits reduce actual taxes paid

• Tax credits phase out as AGI increases

• Child credit• Education credits• Child and dependent care credit• Earned income credit• Health care premium credit• Adoption credit


Other Filing Considerations

• Choosing the right form between 1040EZ, 1040A, or 1040

• Depends on dependents, income, itemizing


Other Filing Considerations

• File by Mail or Electronic Filing (e-file)

• Benefits of e-filing include:– Faster refunds– More accurate returns– Quick electronic confirmation– Delete the paperwork—nothing to mail– Federal/state e-filing


Filing Late and Amended Returns

• File Late—Form 4868—request an extension if unable to file by April 15th and include estimated tax payment

• Amended Return—Form 1040X—file within 3 years of original tax date

• Amend the state and local forms as well


Being Audited

• Audit—an examination of tax return by IRS

• Randomly selected—higher odds if you have been audited in the past

• Asked to send additional information in mail or IRS face-to-face interview.

• Reexamine areas in question, get all data and records, appeal audit outcome if necessary.


Help in Preparing Taxes

• Handle taxes by yourself.

• Use IRS publications, IRS hotlines, & self-help publications and computer programs.

• Hire a tax specialist.


Model Taxpayers: The Taylors File Their Federal Tax Return

• Chuck and Dianne Taylor

• Using the various steps in calculating taxes for Form 1040


Tax Strategies to Lower Your Taxes

1. Maximize deductions.2. Look to capital gains and dividend income.3. Shift income to family member in lower tax

brackets.4. Receive tax-exempt income.5. Defer taxes to the future.


Maximize Deductions—reduce taxable income to its minimum

• Use tax-deferred retirement programs.

• Use your home as a tax shelter.

• Shift and bunch deductions


Look to Capital Gains and Dividend Income

• Long-term capital gains rate is lower than ordinary income tax rate– No tax for those in the 10 and 15 percent tax brackets– 15 percent tax for those in the 25 to 35 percent tax

brackets– 20 percent tax for those in the 36.9 percent tax bracket

• Don’t have to claim capital gains until asset is sold.

• Qualified dividends from corporations are taxed at same low rates as long-term capital gains.


Shift Income to Family Members in Lower Tax Brackets

• Can be complex and involve lawyers and establishment of trusts.

• Simpler way is to make gifts—recipients do not pay taxes on gifts either.

• Allowed to give $14,000 tax free per year to as many recipients as donor wishes.

• Gift some of your estate while still alive.


Receive Tax-Exempt Income

• Interest from state and local government debt such as bonds is tax-exempt

• The higher your marginal tax bracket, the more beneficial tax-free income is.

• Calculate the equivalent taxable yield to determine which is the better investment


Defer Taxes to the Future

• Tax-deferred retirement plans allow you to defer tax payments to the future.

• Roth IRAs allow taxes to be paid on contributions and never again.

• Capital gains taxes are postponed until you sell the asset.


Summary

• Taxable income is a function of AGI, deductions and exemptions.

• Apart from federal income tax, there are Social Security and Medicare taxes, state and local taxes, excise, sales, property, and gift and estate taxes.

• To calculate taxes, determine total income, adjusted gross income, taxable income, then the taxes your owe.


Summary

• It is important to know if you must file a return, when to file, use the right form, and the information needed for the return.

• Obtain the help you need for filing returns from the IRS, self-help tax books, and computer programs and tax specialists.

• There are five general strategies that can be used to reduce taxes to a minimum.

LN04_Keown_856526_PF_07_LN04

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