Chapter 4: Managing Income Taxes Garman/Forgue Personal Finance Tenth Edition PPT slide program prepared by Amy Forgue and Ray Forgue.

Copyright ©Cengage Learning. All rights reserved Introduction  Tax Planning: Seeking legal ways to reduce, eliminate, or defer income taxes.  Taxable Income: the income upon which income taxes are levied.

Copyright ©Cengage Learning. All rights reserved Your Next Five Years In the next five years : 1.Sign-up for tax-advantaged employee benefits at your workplace.

Copyright ©Cengage Learning. All rights reserved Your Next Five Years 2.Contribute to your employer-sponsored 401(k) retirement plan at least up to the amount of the employer’s matching contribution. 3.Buy a home to reduce income taxes. 4.Do your own tax return so you can learn how to reduce your income tax liability. 5.Maintain good tax records.

Copyright ©Cengage Learning. All rights reserved Learning Objective #1 Explain the nature of progressive income taxes and the marginal tax rate.

Copyright ©Cengage Learning. All rights reserved Income Taxes  Taxes are compulsory charges imposed by government on its citizens.  Internal Revenue Service (or IRS)  Internal Revenue Code

Copyright ©Cengage Learning. All rights reserved Progressive Taxes  The progressive nature of the federal income tax. A Progressive Tax is one that requires a higher tax rate as income increases. A Regressive Tax is one that demands a decreasing proportion of one’s income.

Copyright ©Cengage Learning. All rights reserved The Marginal Tax Rate  Marginal tax bracket (or MTB)  Marginal tax rate is the rate at which your last dollar of income is taxed.  Indexing

Table 4.1: Progressive Nature of the Federal Income Tax Taxable Income Rate First $ % Over $8350 but not over $33,950 15% Over $33,950 but not over $82,250 25% Over $82,250 but not over $171,550 28% Over $171,550 but not over $372,950 33% Over $372,950 35% Copyright ©Cengage Learning. All rights reserved.4 - 9

Copyright ©Cengage Learning. All rights reserved Marginal Tax Rate and Financial Decisions  Decreasing your taxable income saves you more in taxes as your marginal tax rate goes up.  Additional taxable income costs you more in taxes as your marginal tax rate goes up.  The amount saved or added is equal to your marginal tax rate times the amount the taxable income goes down or up.

Copyright ©Cengage Learning. All rights reserved Marginal Versus Average Tax Rates  Your effective marginal tax rate can be 43% when state income and Social Security taxes are included.  Your average tax rate is lower. Average tax rate: Proportion of total income paid in income taxes.

Figure 4.1: How Your Income Is Really Taxed Copyright ©Cengage Learning. All rights reserved

Concept Check 4.1  Distinguish between a progressive and a regressive tax.  What is a marginal tax bracket, and how does it affect taxpayers?  Explain why many taxpayers have a marginal tax rate as high as 43 percent. Copyright ©Cengage Learning. All rights reserved

Copyright ©Cengage Learning. All rights reserved Learning Objective #2 Differentiate among the eight steps involved in calculating your federal income taxes.

Copyright ©Cengage Learning. All rights reserved Steps in Calculating Your Income Taxes 1.Determine your total income. 2.Determine and report gross income after subtracting exclusions.

Copyright ©Cengage Learning. All rights reserved Steps in Calculating Your Income Taxes 3.Subtract adjustments to income to arrive at your adjusted gross income (AGI).

Copyright ©Cengage Learning. All rights reserved Steps in Calculating Your Income Taxes 4.Subtract either the IRS’s Standard Deduction for your tax status or itemize your deductions 5.Subtract the value of your personal exemptions. 6.Determine your preliminary tax liability.

Copyright ©Cengage Learning. All rights reserved Steps in Calculating Your Income Taxes 7.Subtract tax credits for which you qualify. 8.Calculate the balance due the IRS or the amount of your refund.

Figure 4.2: The Process of Income Tax Calculation Copyright ©Cengage Learning. All rights reserved

Copyright ©Cengage Learning. All rights reserved Total Income  Total Income: Compensation from all sources.

Copyright ©Cengage Learning. All rights reserved Total Income  Income you might receive: Wages and Salaries Commissions Tips Earned Interest and Investment Income Retirement Income Scholarships Bonuses

Copyright ©Cengage Learning. All rights reserved Total Income  Also include capital gains and losses in total Income. Long-term gains (or losses) are taxed at 10 or 15%. Short-term gains (or losses) are taxed at your marginal tax rate.

Figure 4.3: W-2 Form Copyright ©Cengage Learning. All rights reserved

Copyright ©Cengage Learning. All rights reserved Gross Income  Determine and report your gross income

Copyright ©Cengage Learning. All rights reserved Gross Income  Certain types of income such as gifts that do not have to be reported are called exclusions. : Gifts Inherited money or property Life insurance benefits Child support payments Scholarships

Copyright ©Cengage Learning. All rights reserved Subtract Adjustments to Income  Adjustments to Income are subtractions allowed for such things as IRA contributions, alimony paid, student loan interest paid.  Adjusted Gross Income (or AGI) is the result after subtracting adjustments from gross income.

Copyright ©Cengage Learning. All rights reserved Deductions  Subtract either the IRS’s standard deduction for your tax status or your itemized deductions whichever is greater.  Standard deduction depends on filing status. $5,700 for single individuals (2009) $11,400 for married couples (2009)

Copyright ©Cengage Learning. All rights reserved Itemized Deductions  Medical and dental expenses  You may subtract amounts that exceed 7.5% of your AGI.

Copyright ©Cengage Learning. All rights reserved Itemized Deductions  Taxes you paid: Real Estate Property Taxes (home or land) Certain Personal Property Taxes State, Local, and Foreign Income Taxes State and Local Sales Taxes (instead of state and local income taxes)

Copyright ©Cengage Learning. All rights reserved Itemized Deductions  Certain interest you paid Interest Paid on Home Mortgage Loans Mortgage Interest “Points” Interest paid on loans used for investments

Copyright ©Cengage Learning. All rights reserved Itemized Deductions  Gifts to charity of cash or goods

Copyright ©Cengage Learning. All rights reserved Itemized Deductions  Uninsured casualty and theft losses that exceed 10% of your AGI

Copyright ©Cengage Learning. All rights reserved  Miscellaneous deductions in excess of 2% of adjusted gross income  Other miscellaneous deductions allowed at 100%: Gambling losses Business expenses for workers with disabilities Itemized Deductions

Copyright ©Cengage Learning. All rights reserved Exemptions  Exemptions (or Personal Exemptions) are based on the number of people supported by the taxpayer’s income.  Each exemption reduces taxable income by $3650 (2009).

Copyright ©Cengage Learning. All rights reserved Exemptions  Claiming another person as an exemption requires that you provide more than one-half of their support.  What if you are claimed as an exemption? If someone else claims you, you cannot claim yourself. The opposite is also true.

Copyright ©Cengage Learning. All rights reserved Your Preliminary Tax Liability  Determine your preliminary tax liability based on your taxable income using the tax-rate schedule or tax table.  Taxable income is the amount remaining after subtracting adjustments, deductions and exemptions from your gross income.

Table 4.3: Tax Table Example AtLess LeastThanSingleMarried 23,550 23, ,600 23, ,050 26, ,100 26, ,300 26, ,350 26, Copyright ©Cengage Learning. All rights reserved

Copyright ©Cengage Learning. All rights reserved Subtract Tax Credits  Subtract tax credits for which you qualify from your preliminary tax liability.  Tax Credit: Dollar-for-dollar decrease in tax liability.

Copyright ©Cengage Learning. All rights reserved Tax Credits  American Opportunity Tax Credit  Lifetime Learning Credit  First-Time Home Buyer Credit  Earned Income Credit

Copyright ©Cengage Learning. All rights reserved Tax Credits  Child Tax Credit  Child and Dependent Care Credit  Retirement Savings Contribution Credit  Energy-Savings Tax Credits

Copyright ©Cengage Learning. All rights reserved Final Tax Liability  After subtracting your credits from your preliminary tax liability you arrive at your final tax liability.  Add up all prior payments from tax withholding or estimated tax payments.  Calculate the balance due the IRS or the amount of your refund.

Concept Check 4.2  Give five examples of income that must be included in income reported to the Internal Revenue Service.  How are long-term and short-term capital gains treated differently for income tax purposes?  Give five examples of income that is excluded from IRS reporting. Copyright ©Cengage Learning. All rights reserved

Concept Check 4.2  List three examples of adjustments to income.  Distinguish between a standard deduction and a personal exemption.  What advice on filing a Form 1040X can you offer someone who did not file a federal income tax return last year or in any one of the past three years?  List five examples of tax credits. Copyright ©Cengage Learning. All rights reserved

Copyright ©Cengage Learning. All rights reserved Learning Objective #3 Use appropriate strategies to avoid overpayment of income taxes.

Copyright ©Cengage Learning. All rights reserved Avoid Taxes Through Proper Planning  Practice legal tax avoidance, not tax evasion.

Copyright ©Cengage Learning. All rights reserved Avoid Taxes Through Proper Planning  A dollar saved from taxes is really two dollars - or more. The opportunity cost of the use of the dollar paid as taxes. Earning another dollar to replace one given to the IRS. Earnings on a dollar not given to the IRS.

Copyright ©Cengage Learning. All rights reserved Reduce Taxable Income Via Your Employer  Premium only plan  Transportation reimbursement plan  Flexible Spending Account (or FSA or Expense Reimbursement Account)

Copyright ©Cengage Learning. All rights reserved Reduce Taxable Income Via Your Employer  Defined Contribution Retirement Plan 401(k) Retirement Plan  Matching Contributions

Copyright ©Cengage Learning. All rights reserved Make Tax-Sheltered Investments  Tax-Sheltered Investments: Investments that yield returns that are tax advantaged.

Copyright ©Cengage Learning. All rights reserved Make Tax-Sheltered Investments  Investing with pretax income  Tax-deferred investment growth  IRA\Roth IRA

Copyright ©Cengage Learning. All rights reserved Make Tax-Sheltered Investments  Coverdell Education Savings Account  Qualified Tuition (Section 529) programs  Govt. savings bonds

Copyright ©Cengage Learning. All rights reserved Make Tax-Sheltered Investments  Municipal bonds  Capital Gains on Housing

Copyright ©Cengage Learning. All rights reserved Reducing Taxable Income: Other Strategies  Postpone income.  Bunch deductions.  Take all of your legal tax deductions.

Copyright ©Cengage Learning. All rights reserved Comparing Taxable and After- Tax Yields  After-tax yield taxable yield formula:  After-tax yield equals  The taxable yield times  (1 - federal marginal tax rate)  Example for someone with a 35% MTR: 5.7% taxable x ( ) 5.7% x 0.65 The answer is a 3.71 after-tax yield

Concept Check 4.3  Distinguish between two types of tax- sheltered investment returns.  Explain how to reduce income taxes via your employer, and name three employer- sponsored plans that do so. Copyright ©Cengage Learning. All rights reserved

Concept Check 4.3  Summarize the differences between an IRA and a Roth IRA.  Identify three strategies to avoid overpayment of income taxes, and summarize each. Copyright ©Cengage Learning. All rights reserved

Copyright ©Cengage Learning. All rights reserved Top 3 Financial Missteps in Managing Income Taxes People slip up in managing income taxes when they do the following: 1.Turn all your income tax planning over to someone else. 2.Overwithhold income to receive a refund next year. 3.Ignore the impact of income taxes in personal financial planning.

Do It NOW! Managing your income taxes should not wait until you file in the spring. Start today by: 1.Projecting your taxable income and total withholding for this year. 2.Estimating your federal tax liability based on your income projection using this year’s tax tables or schedules. Copyright ©Cengage Learning. All rights reserved

Do It NOW! 3.Revising your W-4 form with your employer as necessary to withhold more if you estimate owing more in taxes or to withhold less to get an immediate raise in take-home pay if you expect a refund. Copyright ©Cengage Learning. All rights reserved