Chapter 3

Learning Objectives (part 1 of 2) Describe the basic federal tax model Distinguish between adjustments to income and itemized deductions Determine the economic value of an itemized deduction Compute the tax liability for any filing status and level of taxable income Determine a person's marginal tax rate

Learning Objectives (part 2 of 2) Decide how much in federal taxes you will withhold on your paycheck Determine the tax impact of a capital gain or a capital loss Discuss some of the differences in taxation among the various states Understand the likelihood of having your tax return audited Know how to do your own research on a tax question

How is taxable income computed? Total Income - Adjustments to Gross Income = Adjusted Gross Income or AGI - Standard Deduction or Itemized Deductions (whichever is larger) -Personal Exemptions = Taxable Income

How is the tax refund or payment due computed? Based on your taxable income, determine your tax liability, then Tax liability - Credits + Other taxes owed = Total taxes for the year - Taxes paid to date = Taxes Refund to be received or tax due

What is included in gross income? (part 1 of 2) Wages Salaries taxable interest ordinary dividends business income (or loss)

What is included in gross income? (part 2 of 2) capital gain (or loss) taxable portion of total pensions and annuities alimony received taxable portion of Social Security benefits.

What are the adjustments to gross income? (part 1 of 2) IRA deduction student loan interest deduction moving expenses (when they qualify)

What are the adjustments to gross income? (part 2 of 2) Keogh contributions self-employed SEP and SIMPLE plan contributions alimony paid

What are the filing statuses and the standard deductions (for 2000) for each category? Single$4,400 Head of Household6,450 Married filing jointly7,350 Married filing separately3,675 Surviving spouse7,350

What are the itemized deductions categories? (part 1 of 2) Medical and dental expenses (only to the extent they exceed 7.5% of AGI) Taxes Interest expenses Gifts to Charity (not to exceed 50% of AGI)

What are the itemized deductions categories? (part 2 of 2) Casualty and theft losses (reduced by $100 per event, and only to the extent they exceed 10% of AGI) Job related expenses and most miscellaneous deductions (only to the extent they exceed 2% of your AGI) Miscellaneous Deductions

How do Itemized Deductions affect Taxable Income? If the taxpayer does not itemize => No change (even those things that claim to be tax deductible If the taxpayer does itemize => Taxable Income reduced only by the amount itemized deductions exceed the standard deduction for the filing status

Exemptions Automatic exemption for one’s self, unless declared as an dependent on another’s tax return Spouse (if married filing jointly) One for each dependent (must show Social Security number)

Marginal Tax Rate Rate at which any incremental income is taxed The relevant tax rate to use for most decision making purposes (except where income such as capital gains is taxed at a different rate

Are there tax breaks for educational expenses? Might qualify as itemized deduction (subject to 2% rule) if required by an employer to keep a job Hope Credit (under certain conditions, up to $1,500 per year) Lifetime learning credit (under certain conditions, up to $1,000 credit)

How much withholding should I claim? 3 strategies Over withhold (forced savings) Target exact amount due Under withhold (but not enough to trigger interest or penalties)

Capital Gains and Capital Losses (part 1 of 2) Gain or loss = Selling proceeds (less commissions) – Cost basis (net of commissions) One year divides short term from long term Gains and losses are matched against each other

Capital Gains and Capital Losses (part 2 of 2) Gains taxed at CG tax rate (20% or 10%) losses written off (up to $3,000 per year) Personal assets such as cars are only subject to capital gain rules Homes may be exempt from capital gains rules under certain conditions

What increases the chances of being audited? High income Self-employed Deductions exceed guideline amounts (known only to IRS) Employed in job associated with tendency to underreport Live in a sparsely populated state

How do state income taxes affect my marginal tax rate? State income taxes are not taken as an itemization on one’s federal tax return: MTRcombined = MTRfederal + MTRstate. State taxes are itemized on the federal return: MTRcombined = MTRfederal+ MTRstate x (1 – MTRfederal).