Chapter 3 Taxes in Your Financial Plan McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Taxes in Your Financial Plan Chapter Learning Objectives LO3.1 Identify the major taxes paid by people in our society LO3.2 Calculate taxable income and the amount owed for federal income tax LO3.3 Prepare a federal income tax return LO3.4 Select appropriate tax strategies for various life situations

Planning Your Tax Strategy Learning Objective LO3.1 Identify the Major Taxes Paid by People in Our Society Planning Your Tax Strategy Start planning for taxes …. Know current tax laws as they affect you Maintain complete and appropriate tax records Make purchase and investment decisions that reduce your tax liability Goal: Paying your fair share but still taking advantage of tax benefits.

Types of Taxes Taxes on Purchases Sales tax & excise tax Taxes on Property Real estate property tax Personal property tax Taxes on Wealth Federal estate tax State inheritance tax Taxes on Earnings Income tax and Social Security

Learning Objective LO3.2 Calculate Taxable Income and the Amount Owed for Federal Income Tax Step 1: Determine AGI AGI = Adjusted Gross Income Taxable Income Net income = income on which tax is computed Gross income minus allowable deductions

Learning Objective LO3.2 Calculate Taxable Income Main Components of Gross Income Earned income Usually includes wages, salary, commissions, fees, tips, and bonuses Investment income Money received in the form of dividends, interest, or rent from investments Passive income Results from business activities in which you do not directly participate, such as a limited partnership Other income Alimony, awards, lottery winnings, and prizes

Learning Objective LO3.2 Calculate Taxable Income Total income is affected by: Exclusions Amounts excluded from gross income Also referred to as tax-exempt income; income not subject to federal income tax Example = interest on most state and city bonds Tax-deferred income Income that will be taxed at a later date, such as earnings from an traditional individual retirement account (IRA)

Learning Objective LO3.2 Calculate Taxable Income Adjusted gross income (AGI) Gross income reduced by certain adjustments, described below The basis for computing various deductions Adjustments to income Reduce AGI Contributions to a traditional IRA or Keogh Alimony payments

Learning Objective LO3.2 Calculate Taxable Income Step 2: Computing Taxable Income Tax deduction = amount subtracted from adjusted gross income (AGI) to arrive at taxable income Standard deduction Itemized deductions

Calculate Taxable Income Itemized Deductions Medical & dental expenses (>7.5% of AGI) Taxes Interest Contributions Casualty and theft loses Moving expenses Job-related and other miscellaneous expenses

Calculate Taxable Income Exemptions Exemptions  subtracted from AGI An exemption = a deduction for yourself, your spouse, or qualified dependents The amount of the exemption for the 2011 tax year is $3,700 per person After deducting exemptions, you have your taxable income

Tax Record-Keeping System

Learning Objective LO3.2 Calculate Taxes Owed Step 3: Calculating taxes owed Tax table rates = marginal rates The tax rate paid on the last (or next) dollar of taxable income. Example: After deductions and exemptions, a person in the 35% tax bracket pays 35 cents in taxes for every dollar of taxable income in that bracket.

2011 IRS Tax Brackets

Tax on a married taxpayer’s income of $90,025 2011 IRS Tax Example Tax on a married taxpayer’s income of $90,025

Learning Objective LO3.2 Calculate Taxes Owed The average tax rate = the total tax due divided by taxable income Average tax rate < marginal tax rate Example: Taxable income = $90,025 Total tax bill = $14,756 Average tax rate = 16.4% ($14,756 / $90,025)

Learning Objective LO3.2 Calculate Taxes Owed Alternative minimum tax (AMT) Paid by taxpayers with high amounts of certain deductions and various types of income Designed to ensure that those who receive tax breaks also pay their fair share of taxes

Learning Objective LO3.2 Calculate Taxes Owed Tax credits Amount subtracted directly from the amount of taxes owed Examples: Earned income credits Foreign tax credits Child and dependent care credits Retirement tax credits Adoption tax credits Education credits to offset college education expenses

Tax Credit versus Tax Deduction Reduces Your Taxes by $100 $100 Tax Deduction Amount Your Taxes are Reduced is Based on Your Tax Bracket

Determining Your Tax Liability

Learning Objective LO3.2 Calculate Taxes Owed Step 4: Making Tax Payments Payroll Withholding Based on the number of exemptions and the expected deductions claimed Estimated Quarterly Payments Estimated tax payments made throughout the year based on income made during the year and reported on Form 1099.

Learning Objective LO3.2 Calculate Taxes Owed Step 5: Watching Deadlines-Avoiding Penalties Form 4868  automatic six-month extension Submit estimated tax due with Form 4868 by April 15 Penalties & Interest Underpayment of quarterly estimated taxes may require paying interest on the amount owed Underpayment due to negligence or fraud can result in penalties of 50 to 75 percent

Learning Objective LO3.3 Prepare a Federal Income Tax Return Every citizen or resident of U.S. and every U.S. citizen who is a resident of Puerto Rico is required to file income tax. Five filing status categories: Single or legally separated Married, filing jointly Married, filing separately Head of household Unmarried individual or surviving spouse who has a child or dependent relative Qualifying widow or widower with a dependent (2 years)

Which Tax Form Should You Use? ≈ 800 federal tax forms and schedules Basically the choice is between 3 forms 1040EZ 1040A 1040 - Used by 60% Which form to use? Type of income Amount of income Number of deductions Complexity of tax situation Used by 20% of taxpayers

Completing the Federal Income Tax Return Filing status and exemptions Income Adjustments to income Tax computation Tax credits Other taxes (such as from self-employment) Payments (total withholding and other payments) Refund or amount you owe Refunds can be directly deposited to your bank account. Payments may be directly debited from your bank account. Your signature = Most common filing error

Federal Income Tax Form 1040

How Do I File My State Tax Return? All but 7 states have a state income tax Most states’ tax rate ranges from 1 to 10 percent States usually require income tax returns to be filed when the federal income tax return is due

How Do I File My Taxes Online? Tax preparation software H&R Block At Home (formerly Tax Cut) and TurboTax are two of the most popular tax preparation software packages Using software can save 10 or more hours Tax software allows you to complete needed tax forms Print and mail the forms or file online e-filing refunds usually take 3 weeks Cost for e-filing = $5 - $40

Selecting Tax Software Considerations: Personal situation Special tax situation Features in the software “Audit check” Future planning State tax filing online Technical aspects Hardware and operating system requirements Online support

How Do I File My Taxes Online? Free File Alliance Online tax preparation and filing free to many taxpayers (depends on income) Go to: http://www.irs.gov Select: “Free File” Various qualification criteria to file free; use “Guide Me to a Service” Connect to selected firm’s website Use form’s online software to prepare and file tax return

Available Tax Assistance Sources IRS Services Publications and forms 1-800-TAX-FORM www.irs.gov Recorded messages 1-800-829-4477 Phone hot line 1-800-829-1040 Walk-in service at an IRS office

Available Tax Assistance Sources Tax publications e.g. Ernst and Young Tax Guide and J.K. Lasser’s Your Income Tax The Internet Tax preparation software companies Tax Preparation Services Tax preparers charge between $40 and $2,000, depending on the complexity of the return Over 40 million U.S. taxpayers pay someone else to do their taxes

Types of Tax Preparation Services One-person, local offices to large firms such as H & R Block “Enrolled agents” = Government-approved tax experts CPA Tax Accountants Attorneys

Evaluating Tax Services Factors to consider: Training and experience of the tax professional Fee for preparing taxes and how determined Questionable deductions suggested? If return is audited, will the preparer represent the client? Is tax preparation the main business activity, or is it a front for other financial products?

Tax Service Warnings Ultimately you are responsible for providing complete and accurate information If your professional tax preparer makes a mistake, you are still responsible for paying the correct amount, plus any interest and penalties. Hiring a tax preparer does not guarantee that you will pay the correct amount Beware of tax preparers that offer refunds in advance “Refund anticipation loans” can charge interest rates in excess of 300%

What if Your Return is Audited? ≈ 1.0% of all returns are audited If you claim large or unusual deductions you are more likely to be audited. Three types of audits: Correspondence audit for minor questions Office audit takes place at an IRS office Field audit is the most complex, with an IRS agent visiting you at your home, your business or your accountant’s office

What if Your Return is Audited? Audit Rights Request time to prepare Clarification of items being questioned Right to appeal audit results When Audited: Decide whether to bring you tax preparer, accountant or lawyer Be on time for your appointment; bring only relevant documents Present evidence in a logical, calm, and confident manner; maintain a positive attitude Make sure your information is consistent with tax law Keep your answers aimed at the auditor’s questions

Learning Objective LO3.4 Select Appropriate Tax Strategies Tax Planning Strategies Practice tax avoidance Legitimate methods to reduce your tax obligation to your fair share but no more Financial decisions related to purchasing, investing, and retirement planning are the most heavily affected by tax laws Tax Evasion Illegally not paying all the taxes you owe, such as not reporting all income

Tax Planning Strategies Minimizing Taxes If you expect Then you should Because The same or a lower tax rate next year Accelerate deductions into this year Greater benefit to higher rate The same tax rate next year Delay income into next year Delay paying taxes A higher tax rate next year Delay deductions Greater benefit Accelerate income Taxed at lower rate

Tax-Planning Strategies Consumer Purchasing Home ownership One of the best tax shelters Deduct mortgage loan interest and property taxes Reduces your taxable income Use home equity line of credit to buy a car or consolidate debt Interest deductible

Tax-Planning Strategies Consumer Purchasing Job-related expenses may be allowed as itemized deductions Union dues Business tools Job search costs Health care expenses like FSA’s (Flexible Spending Accounts) allow you to reduce your taxable income when paying for health related expenses

Tax-Planning Strategies Investment Decisions Tax Exempt Investments Interest income from municipal bonds are exempt from federal and some state taxes Tax Deferred Investments Tax deferred annuities Section 529 education savings plans Retirement Plans -IRA, Keogh or 401(k) A type of tax shelter

Tax-Planning Strategies Investment Decisions Capital Gains Profits from the sale of stocks, bonds or real estate Long-term capital gains (held more than one year) taxed at a lower rate Self Employment Advantage: Owning your own business can have tax advantages Disadvantage: Business owners have to pay additional taxes

Tax-Planning Strategies Investment Decisions Children’s Investments Children under 19 or a full-time student under 24 with investment income of more than $1,900 is taxed at parents’ top rate Under $1,900 qualifies for a $950 deduction, with remainder taxed at child’s rate Retirement Plans - Traditional IRA - Roth IRA - Education IRA - Keogh Plan - 401 (K) Plan

Changing Tax Strategies IRS Changes: IRS modifies tax filing procedures each year Congress passes legislation to change the tax code each year. Take advantage of these changes for personal financial planning Personal Changes: Consider changes in your personal situation and income Monitor your tax strategies to best serve your daily needs and long-term financial goals

Flat or VAT Tax? Flat tax VAT = Value-Added Tax All taxpayers pay the same rate Would increase taxes for many VAT = Value-Added Tax Taxes a product at each stage in the manufacturing process Tends to start small and rise over time

Chapter Summary Learning Objective LO3.1 Tax planning can influence spending, saving, borrowing, and investing decisions. An awareness of income taxes, sales taxes, excise taxes, property taxes, estate taxes, inheritance taxes, gift taxes, and Social Security taxes is vital for successful financial planning.

Chapter Summary Learning Objective LO3.2 Taxable income is determined by subtracting adjustments to income, deductions, and allowances for exemptions from gross income. Your total tax liability is based on the published tax tables or tax schedules, less any tax credits.

Chapter Summary Learning Objective LO3.3 The major sections of Form 1040 provide the basic framework for filing your federal income tax return. Main sources of tax assistance: IRS services and publications Other publications The Internet Computer software Professional tax preparers such as commercial tax services, enrolled agents, accountants, and attorneys.

Chapter Summary Learning Objective LO3.4 Reduce your tax burden through careful planning and making financial decisions related to consumer purchasing, and the use of debt, investments, and retirement planning.