CHAPTER 15 The Basic Federal Income Tax Structure Chapter 15: Tax Structure1

EIGHT PLANNING AREAS, AGAIN S: Safety through Risk Management Planning E:Educational Planning C:Cash Mgt., Savings, Credit, and Debt Planning U:Ultimate Disposition through Estate Planning R:Retirement Planning I:Investment Planning T:Tax Planning Y:Yearning for Financial Independence Planning Chapter 15: Tax Structure2

INTRODUCTION  Method of tax computation can help a taxpayer  utilize all allowable deductions to reduce taxes  develop tax planning strategies to minimize long-term tax liability  avoid violating tax limits or rules  make improved financial decisions with full consideration of tax implications Chapter 15: Tax Structure3

Basic Income Tax Structure Chapter 15: Tax Structure4

COMPUTATION OF FEDERAL TAXABLE INCOME  Calculation of Gross Income  Earned Income  W2 / 1099  Portfolio Income  Interest  Bank interest 1099-INT  Dividends  1099-DIV  Report separate if exceeds 1,500  Max tax 15%  Capital Gains and Losses Chapter 15: Tax Structure5

Capital Gains and Losses  Calculation of Gross Income (Contd.)  Long-term vs. Short-term Gains or Losses  Long-term = 365 days + 1  Current tax rate max of 15%  Wash Sales  Cannot take loss on an asset that is “replaced” with a similar asset within 30 days prior to or after a sale  61 days  Capital Gains and Sale of Residence  House for Sale  MFJ 500,000 of profit is tax free  Could include vacation home  Renews every 2 years  Selling at a Loss  No deduction for selling at a loss Chapter 15: Tax Structure6

Capital Gains Tax Calculation Chapter 15: Tax Structure7

COMPUTATION OF FEDERAL TAXABLE INCOME (Contd.)  Passive Income  Tax shelters etc as long as no material participation  Can only offset passive gains with passive losses  Passive losses can be carried forward  Real estate exception  If own at least 10%, make decisions, and AGI < 100K  Can use up to 25,000 to offset regular income  Miscellaneous Income  Tax-exempt Income: Municipal Bonds  Exempt from federal taxes and state taxes if purchased from resident state.  Social Security Income  Might be taxable  Non-taxable Income  Gifts  Death benefits  Adjustments to Gross Income  Business expenses for the self employed  Interest rate penalties for early withdrawal of savings CDs  Alimony payments  Contributions to qualified retirement programs Chapter 15: Tax Structure8

Tax-exempt Yields and Equivalent Taxable Yields Chapter 15: Tax Structure9 Use to compare the yield on a muni to the yield on a govt or corp bond. Take the yield on a muni, compare to the yield displayed for your tax bracket. If muni yield greater, buy the muni. If the other yield is greater, buy the govt or corporate bond.

Calculate taxable equivalent yield Chapter 15: Tax Structure10 Example the muni pays 8% and the corp bond pays 10%. Fed tax rate = 28%. Choose the muni!!

FEDERAL TAXABLE INCOME (Contd.)  Retirement plan adjustments to AGI  See the retirement plan chapter  Deduction from AGI  Standard or itemized deductions  Medical excess of 7.5% of AGI  State and local taxes (property and income)  Equity interest expense  Charitable contributions must be < 50% of AGI  Business use of home (home office rules)  Casualty and theft losses  Moving expenses  Miscellaneous expenses  Exemptions Chapter 15: Tax Structure11

2008 Standard Deductions Chapter 15: Tax Structure12 Standard Deductions Single / MFS5450 HH80,000 MFJ10,900 Phaseout of itemized deductions MFJ159,950 Single Dependent Exemptions3500 Phaseout of personal exemptions S159,950 MFS HH MFJ239,950

Chapter 15: Tax Structure13 FEDERAL TAXABLE INCOME (Contd.)  Itemized Deductions  Medical Expenses  Only excess of 7.5% of AGI  Doctors, prescriptions, insurance, home renovation if needed  State and Local Taxes  Real estate taxes and property taxes  Not FICA or state sales taxes  Interest Expense  On investment loans (to amount of investment income)  On mortgage or home equity loans  Charitable Contributions  Max 50% AGI (capital gain property max 20% AGI)

Chapter 15: Tax Structure14 Deductibility of Interest Expense

Chapter 15: Tax Structure15 FEDERAL TAXABLE INCOME (Contd.)  Itemized Deductions  Business Use of a Home  Essential for running a business even if only paperwork  Exclusive use  If depreciate space; reduce tax free gains from later sale of the home  Casualty or Theft Losses  Minimum amount per loss $100  Maximum deduction excess over 10% of AGI  Moving Expenses  Unreimbursed expenses  House hunting trips not included  Miscellaneous Expenses  Only to the extent that exceed 2% of AGI  Safe deposit box  Tax counsel and preparation

Chapter 15: Tax Structure16 EDUCATION PROVISIONS  Modification of Education IRAs  Coverdell Education Savings Accounts  Maximum $2,000  Qualified Tuition Programs  Section 529  Employer-Provided Educational Assistance  Maximum allowed is 5,250  Extended to graduate programs also  Student Loan Interest Deduction  Up to $2,500 of interest deductible  Whether you itemize or not  Deduction for Higher Education Expenses  Cannot claim when Hope or Lifetime Learning credit is claimed

Chapter 15: Tax Structure17 COMPUTATION OF INCOME TAX  Average tax rate  Tax liability divided by taxable income  Marginal Tax Rate  Tax on the next dollar earned  The only relevant tax rate for making financial decisions

Chapter 15: Tax Structure18 COMPUTATION OF INCOME TAX  Taxable Income = $90,000  Tax = 8, ((.25*(90,000 – 63,700)) = ,575 =  Marginal tax rate = 25%  ATR =

Chapter 15: Tax Structure19 COMPUTATION OF INCOME TAX  Tax Credits  Child and Dependent Care Credit  can deduct from 20 to 35% of the expenses  Earned Income credit  Education credits  Child Tax credit $1,000 per child  Certain purchases can qualify for credits  Purchase of hybrid vehicles  Renovation of certain kinds of property  Renovation with certain eco-friendly improvements

TAXATION OF CORPORATIONS C Corporations – The Tax Relief Act of 2001 left intact the current corporate tax rate schedule for the majority of C corporations S Corporations – If a person owns a closely held business, an S election should be investigated – S corporations may be preferable because of the potential for a double tax on the ultimate sale by a C corporation of its assets with a resulting liquidation. – Using S corporations does have drawbacks Chapter 15: Tax Structure20