Foundations of Personal Finance Ch. 7

7 Income and Taxes

Objectives Identify different types of income and employee benefits. Relate taxation to government spending. List goods and services government provides. Identify different types of taxes. Identify common tax forms. continued

Objectives Describe basic procedures for filing a tax return. Explain the purposes and function of the Social Security system.

The Many Forms of Income Income is money earned from employment and investments Governments tax income and assets to create revenue that is used to provide public goods and services

Foundations of Personal Finance Ch. 7 Money Earned from Work Income received from employment is earned income continued

Money Earned from Work Earned income includes wage (minimum wage for many unskilled and beginning workers) piecework income salary commission tip bonus

Employee Benefits Some of the most valuable forms of employee compensation are not monetary Employee benefits often include paid vacation, holiday, and sick leave life and health insurance employer-sponsored retirement savings plan

Business Profit Income Income earned by the self-employed Disadvantages of self-employment: Must arrange and pay for own employee benefits; can be costly Must pay entire Social Security and Medicare tax, rather than half the cost

Foundations of Personal Finance Ch. 7 Payroll Deductions Net income (take-home pay) is gross income minus payroll deductions continued

Payroll Deductions Deduction can lower a paycheck by 20 percent or more Bonuses increase gross income continued

Payroll Deductions Common payroll deductions: FICA (Federal Insurance Contributions Act): Social Security and Medicare Federal withholding tax State and city withholding taxes, if applicable Other benefits (insurance purchased through employers)

Money Earned Outside Work Unearned income—income received from sources other than employment earnings from investments, sale of assets, and interest paid on savings and bonds Social Security and retirement account payments rent, inheritance, awards, gifts, alimony unemployment compensation

The Importance of Taxes Foundations of Personal Finance Ch. 7 The Importance of Taxes Government uses its taxing authority to generate revenue to provide goods and services for public’s benefit stabilize the economy address social challenges influence behavior

Federal Government Spending Limited resources force governments to make choices A budget reflects priorities and goals of government and its people When government spends more than it collects, it must borrow money Deficit spending increases the national debt continued

Federal Government Spending Foundations of Personal Finance Ch. 7 Federal Government Spending

In Your Opinion What changes should be made to the way the government spends taxpayers’ money?

Mandatory Expenses Payments that must be made, even if the government must borrow money to do so Make up more than 60 percent of federal government’s budget Include entitlement programs and interest on the national debt continued

Mandatory Expenses Entitlement programs: Social Security Medicare Medicaid (for older adults and people with disabilities) Veterans’ pensions and medical care Nutrition and housing assistance Unemployment compensation Federal employee retirement benefits

Discretionary Expenses An expense that can be adjusted according to needs and revenues Include national defense expenses Include nondefense expenses: Costs of government operations and programs Funds given to state and local governments

State and Local Government Spending Foundations of Personal Finance Ch. 7 State and Local Government Spending Taxation and government spending vary widely between states and between cities Most state and local government revenues come from personal and corporate income taxes sales tax real estate and personal property taxes continued

State and Local Government Spending Foundations of Personal Finance Ch. 7 State and Local Government Spending

Types of Taxes Direct—paid directly to government by taxpayers Indirect—imposed on one party, but paid by another Progressive—imposes a higher tax rate on those with higher incomes continued

Foundations of Personal Finance Ch. 7 Types of Taxes Regressive—has effect of imposing a higher tax rate on those with lower incomes Proportional—imposes same tax rate on all regardless of income differences

What Is Taxed? Personal income tax—your income Purchase tax—goods and services Excise tax—sale and transfer of certain items, including air travel, phone service, gasoline continued

Foundations of Personal Finance Ch. 7 What Is Taxed? Property tax—real estate property tax and personal property tax Wealth tax—assets (estate and gift taxes)

Foundations of Personal Finance Ch. 7 Paying Income Taxes Internal Revenue Service (IRS) collects federal income taxes State tax returns are filed with departments of revenue in states that collect taxes

Your Employer’s Role Employees fill out Form W-4 Employers withhold taxes from employees’ paychecks At start of year, employers mail Form W-2 to employees continued

Foundations of Personal Finance Ch. 7 Your Employer’s Role Form W-4—taxes withheld depend on earnings and number of allowances claimed continued

Foundations of Personal Finance Ch. 7 Your Employer’s Role Form W-2—previous year’s pay and tax deductions are given

Preparing Your Return Each year taxpayers must file a tax report with the government showing the taxes owed Choose one of three common forms: 1040EZ, 1040A, or 1040

Choosing a Tax Form Use Form 1040, long form, if income is over a certain amount when adjustments to income, itemized tax deductions, and tax credits can reduce taxes continued

Foundations of Personal Finance Ch. 7 Choosing a Tax Form Use short forms, 1040A or 1040EZ, if income falls into certain limits deductions aren’t itemized

Figuring Taxable Income Calculate gross income based on Forms W-2 and 1099s Calculate adjusted gross income by subtracting adjustments from total income Subtract allowable exemptions and deductions

Foundations of Personal Finance Ch. 7 Figuring Taxes Owed IRS tax tables show taxes owed based on taxable income Reduce the amount owed with tax credits

Filing on Time Filing deadline for federal taxes and most state taxes is April 15 Tax avoidance—falsely reducing taxes Tax evasion—failing to declare all income or falsifying documents

State and Local Tax Forms Foundations of Personal Finance Ch. 7 State and Local Tax Forms 43 states collect income taxes Taxpayers in states that collect personal income taxes must submit state tax forms

Electronic Filing Advantages of filing tax returns online: It’s simple and quick If refund is due, it arrives sooner TeleFile allows taxpayers to file simple tax returns with touch-tone phones

Sources of Tax Information and Assistance The IRS answers tax questions through free booklets, recorded messages, and a Web site Tax preparation services fill out tax forms for a fee Many taxpayers use tax preparation guides and software

IRS Audits A detailed examination of taxpayer’s tax returns by the IRS During audit, taxpayers must answer IRS’s questions and provide documentation when asked Taxpayers have legal protections in their dealings with the IRS

Foundations of Personal Finance Ch. 7 Tax System Reform Legislators make laws that raise or lower taxes make the tax burden fairer simplify the system achieve other desired outcomes

Tax Legislation Many citizens are concerned about rising taxes Questions asked when tax policy changes: Will revenues generated by the new tax exceed administration costs? Will it be fair to all taxpayers? Will it impact the economy negatively?

Paying Social Security Taxes FICA taxes calculated as a percentage of income; deducted from gross pay Employers and workers split FICA taxes Employees pay 6.2 percent for Social Security and 1.45 percent for Medicare Employers contribute an additional 7.65 percent continued

Paying Social Security Taxes Foundations of Personal Finance Ch. 7 Paying Social Security Taxes The self-employed pay all FICA taxes themselves Federal government receives FICA contributions and credits them to employees’ accounts

Your Social Security Number Social Security Administration uses SSNs to keep records of earnings; records determine benefit amounts IRS uses SSN as taxpayer ID number Each SSN is unique Safeguard your SSN

Social Security Benefits If you work, your Social Security taxes pay for benefits others receive When you no longer work (retire, become disabled, or die), you and your dependents will get benefits provided by other workers’ Social Security taxes continued

Social Security Benefits Types of benefits: Retirement Disability Survivors’ Benefits for divorced people

Social Security System Reform Benefits paid out will soon exceed tax collection Social Security fund will be depleted; no money to pay benefits of workers paying into the system now Taxes may have to be raised, benefits decreased, or both

Central Ideas of the Chapter Taxes reduce each individual’s income and wealth. The taxes of many make it possible for government to provide public goods and services that benefit all.

Glossary of Key Terms Back bonus. Money added to an employee’s base pay. It is usually a reward for performance or a share of business profits. commission. Income paid as a percentage of sales made by a salesperson. compensation. Payment and benefits received for work. disability. A limitation that affects a person’s ability to function in major life activities.

Glossary of Key Terms earned income. Income from employment. Back earned income. Income from employment. employer-sponsored retirement savings plan. A tax-deferred investment program that helps employees save for retirement. employee benefit. A form of nonmonetary compensation received in addition to a wage or salary.

Glossary of Key Terms Back entitlement. A government payment or benefit promised by law to eligible citizens, such as Social Security and Medicare benefits, unemployment benefits, veterans’ services, food stamps, and housing assistance. exemption. A tax benefit that reduces the amount of income a person is taxed on.

Glossary of Key Terms Back FICA (Federal Insurance Contributions Act). The law that requires the collection of social security payroll taxes. Form W-2. A Wage and Tax Statement that states the amount an employee was paid in the previous year. It also gives the amounts of income, Social Security, and Medicare taxes withheld from an employee’s income during the year.

Glossary of Key Terms Back Form W-4. The Employee’s Withholding Allowance Certificate that tells the employer how much tax to withhold from an employee’s paycheck. gross income. A worker’s earnings before deductions. interest. Payments from financial institutions, businesses, and government to use customers’ money.

Glossary of Key Terms Back Medicaid. A government program administered by the states that pays certain health care costs for eligible low-income individuals and families. Medicare. A federal government program that helps pay the medical expenses of people 65 and older and others with certain disabilities.

Glossary of Key Terms Back minimum wage. The lowest hourly wage employers can pay most workers by law. net income. Gross income (plus bonuses) minus payroll deductions. payroll deduction. An amount subtracted from gross income. piecework income. A wage that is based on a rate per unit or item completed.

Glossary of Key Terms Back salary. Payment for work that is expressed as an annual figure. Social Security. The federal government’s program for providing income when earnings are reduced or stopped because of retirement, disability, or death. tax credit. An amount that can be subtracted from the taxes a worker owes, if eligible.

Glossary of Key Terms Back tax deduction. An expense that can be subtracted from a worker’s taxable income. tip. Money paid for service beyond what is required. unearned income. Earnings from sources other than work. wage. A payment in exchange for an employee’s labor or services. The payment, which is usually in money, is paid by the hour, day, or by the piece.