1. Prentice-Hall, Inc.1 Chapter 4 Tax Planning and Strategies

2. Prentice-Hall, Inc.2 How It All Began  In 1913, the 16th Amendment gave Congress the right to impose the first income tax  Initial tax rates ranged from 1 to 8%

3. Prentice-Hall, Inc.3 Importance of Tax Planning  Taxes are your largest annual expense  The average American works more than 4 months just to pay his/hers taxes

4. Prentice-Hall, Inc.4 Income Tax Structure  Income tax -- progressive tax meaning that the more you earn the more you pay  Tax brackets -- income ranges for which the same marginal tax rate applies  Marginal tax rate -- percentage of the last dollar that you earned that will go toward federal income taxes

5. Prentice-Hall, Inc.5 Income Tax Structure (cont’d)  Average tax rate -- average amount of every dollar you earned that was paid for federal income taxes  Effective marginal tax rate -- average amount of every dollar you earned that paid for all local, state, and federal income taxes

6. Prentice-Hall, Inc.6 Capital Gains Taxes and the Taxpayer Relief Act of 1997  Capital gains tax -- can be postponed until you sell an asset for a profit  Short-term capital gains -- gains made from assets held less than 12 months  Long-term capital gains -- gains made from assets held for 12 months or longer

7. Prentice-Hall, Inc.7 Tax Rates Associated With Capital Gains  These rates are dependent on how long the asset is held as well as the marginal tax bracket of the owner.  Short-term rate – 28%  Long-term rate – 20%, unless you’re in the 15% tax bracket and then it is 10%

8. Prentice-Hall, Inc.8 Tax Rates Associated With Capital Gains After 2000  Applies to assets purchased in or after 2001and held for 5 years  Long-term rate of 18%, unless you’re in the 15% tax bracket and then it is 8%

9. Prentice-Hall, Inc.9 What Does This Mean For You?  Avoid frequent trading  Buy low-turnover, “tax managed” mutual funds  Buy individual stocks and make your own mutual fund

10. Prentice-Hall, Inc.10 Capital Gains Taxes On Homes  Gains up to $500,000 for couples and $250,000 for individuals exempt from taxes  Home must be your principal residence  Must have lived there 2 of the last 5 years  No need to “rollover gain” as before the Taxpayer Relief Act of 1997

11. Prentice-Hall, Inc.11 Filing Status Classifications  Single  Married filing jointly  Married filing separately  Head of household

12. Prentice-Hall, Inc.12 Cost of Living Increases in the Tax Brackets  The tax brackets change annually to insure that no one pays more income tax just because earnings increased with inflation.  Bracket creep -- a tax liability increase caused by inflation.  Example -- the income minimum for the 28% tax bracket for joint filers increased from $42,350 to $43,050 in 1999.

13. Prentice-Hall, Inc.13 Paying Your Income Taxes  Withholdings -- tax payment from each paycheck, determined on the basis if income and W-4 form  Quarterly estimated payments  Payments with the tax return (the dreaded April 15th)  Withholdings from stock, retirement funds, and prize or gambling winnings

14. Prentice-Hall, Inc.14 Social Security or FICA  Social Security -- a mandatory insurance program administered by the federal government that provides support in the event of death, disability, health problems, or retirement.  Tax rate of 6.20% of gross salary  Social Security cap, adjusted annually for inflation, was $72,600 in 1999. Income over this amount is not taxed.

15. Prentice-Hall, Inc.15 Social Security or FICA (cont’d)  Medicare -- a health care insurance program for elderly and disabled.  Tax rate of 1.45% of gross salary, with no annual cap.  Total FICA tax rate -- 15.3% (12.4% Social Security + 2.9% Medicare).  You are only responsible for half of the tax unless you’re self-employed.

16. Prentice-Hall, Inc.16 State and Local Income Taxes  Most states impose an income tax; however, some, like Texas, do not.  Local income taxes are uncommon; but some larger cities, for example, New York City, impose such a tax.

17. Prentice-Hall, Inc.17 Other Non-Income-Based Taxes That You Face  Excise “sin taxes” and state sales taxes -- imposed when goods are purchased  Real estate and property taxes -- imposed annually or semi-annually on assets owned  Gift and estate taxes -- imposed when assets are transferred from one owner to another

18. Prentice-Hall, Inc.18 Calculating Your Taxes  Who has to file an income tax return?  Determining gross or total income  Calculating adjusted gross income (AGI)  Subtracting deductions  Claiming your exemptions  Calculating your base income tax  Determining your credits  Determining your final tax liability

19. Prentice-Hall, Inc.19 Who Has to File an Income Tax Return?  Everyone who earns more than $14,400 must file an income tax return.  Some people who earn less, depending on age, filing status, and dependency status must file a return.  People who have more than $700 of unearned income must file.  Note: All thresholds are for 1999 and are adjusted annually for inflation.

20. Prentice-Hall, Inc.20 Sources of Taxable Income  Wages, salaries, and tips  Capital gains, dividends, and interest  Alimony  Pension funds and IRA distributions  Business and farm income  Rental and royalty income  Social Security and unemployment benefits

21. Prentice-Hall, Inc.21 Sources of Tax-Exempt Income  Roth IRA earnings  State and local municipal bond interest  Gifts and inheritances  Child support payments  Federal income tax refunds  Veterans’ and welfare benefits

22. Prentice-Hall, Inc.22 Subtracting Adjustments to Calculate AGI – Alimony payments – Selected moving expenses – Selected IRA and other retirement contributions – 50% for Social Security and Medicare (self-employed only) – Penalties for early withdrawal – Student loan interest, with limitations

23. Prentice-Hall, Inc.23 Subtracting Deductions from AGI  Itemized deductions (Normally, you must first own a home.)  Standard deductions

24. Prentice-Hall, Inc.24 IRS Limits on Itemized Deductions  Medical and dental expenses -- must exceed 7.5% of AGI  Selected tax expenses  Home mortgage and investment interest payments  Gifts to charity -- Keep good records, but must have receipt if the gift is more than $250

25. Prentice-Hall, Inc.25 IRS Limits on Itemized Deductions (cont’d)  Casualty and theft loss -- first $100 of loss is excluded, and remaining losses are deductible only to the extent they exceed 10% of AGI.  Miscellaneous deductibles -- must exceed 2% of AGI.  Percentage of itemized deductions lost for filers above a certain income level.

26. Prentice-Hall, Inc.26 Standard Deductions  Single -- $4,300 (1999)  Married filling jointly -- $7,200 (1999)  Head of household -- $6,350 (1999)  Married filing separately -- $3,600 (1999)  Note: thresholds are indexed to inflation

27. Prentice-Hall, Inc.27 Using Standard or Itemized??  Take the larger of the two amounts  If close, consider bunching deductions  Don’t let laziness or poor recordkeeping cost you money!

28. Prentice-Hall, Inc.28 Additional Deductions for Elderly or Blind Taxpayers  Unmarried taxpayer -- $1,050 ($2,100 if both elderly and blind).  Married taxpayer -- $850 ($1,700 if both elderly and blind).  Amounts shown are for 1999 and are adjusted annually for inflation.

29. Prentice-Hall, Inc.29 Claiming Your Exemptions  Exemptions are meant to provide everyone with some untaxed income, provided you don’t earn too much.  Personal exemptions -- $2,750 (1999).  Dependency exemptions – Three-step dependency test  Exemption phaseout.

30. Prentice-Hall, Inc.30 Calculating Your Base Income Tax on Taxable Income  Tax tables in the booklet.  Tax rate schedules -- must be used if income exceeds $100,000.  Alternative minimum tax -- to prevent the very wealthy from using the tax breaks to pay little or no tax.

31. Prentice-Hall, Inc.31 Determining Your Credits  Child credit  Hope Scholarship credit  Lifetime Learning credit  Child and dependent care credit  Earned income credit (EIC)  Adoption credit  Other credits, such as elderly and disabled taxpayer credits

32. Prentice-Hall, Inc.32 Other Filing Considerations  Picking the right form  Determining how to file  Filing late or amended returns  Where to get help

33. Prentice-Hall, Inc.33 Choosing a Tax Form  1040EZ – taxable income less than $50,000 – can’t itemize or claim dependents  1040A – taxable income less than $50,000 – allows for more sources of income

34. Prentice-Hall, Inc.34 Choosing a Tax Form (cont’d)  1040 “long form” – allows the use of schedules – only form that allows you to itemize deductions  Know the schedules

35. Prentice-Hall, Inc.35 How To File?  Electronic Filing –Refund within 3 weeks –Less chance of processing error –Cost?  Filing by mail

36. Prentice-Hall, Inc.36 Filing Late and Amended Returns  Filing late – Form 4868 – Penalties -- 10% of tax bill  Amended returns – Form 1040X – Limitations -- 3 years after the original tax due date

37. Prentice-Hall, Inc.37 Reasons for Being Audited  Random  Previous errors  High income level  Filing a Schedule C  Audits allow the IRS to conduct spot checks of returns to ensure compliance to the tax laws and regulations

38. Prentice-Hall, Inc.38 Preparing for an Audit  Reexamine the areas in question  Gather all supporting data  Anticipate any probable questions  Hire a tax accountant or attorney (if necessary)  Note: the best way to win an audit is to keep excellent records

39. Prentice-Hall, Inc.39 Appealing an Audit Outcome  Appeal with the auditor  Appeal with the auditor’s manager  File a formal appeal  Go to tax court

40. Prentice-Hall, Inc.40 Help in Preparing Your Taxes  IRS Publication 17  IRS hotline  Self-help tax publications  Computer programs  Videos  Tax specialists--be sure to start early

41. Prentice-Hall, Inc.41 Tax Planning to Minimize Payments  Maximize your deductions.  Look to capital gains income in particular if you are in the top tax brackets.  Receive tax-exempt income such as income for municipal bonds.  Defer taxes to the future.

42. Prentice-Hall, Inc.42 Maximizing Your Deductions  Using tax-deferred retirement programs to reduce taxes.  Using your home as a tax shelter.  Shifting and bunching your deductions.

43. Prentice-Hall, Inc.43 Look to Capital Gains Income  Long-term capital gains rates are taxed less than your earned income. In some cases as much as 19.6% less.  Taxes are postponed until the assets are sold.

44. Prentice-Hall, Inc.44 Shift Income to Family in Lower Tax Brackets  Gifts -- $10,000 per person ($20,000 per couple) per year tax-free.  Trusts -- hold property for another.

45. Prentice-Hall, Inc.45 Receive Tax-Exempt Income  Municipal bond interest from state and local government debt.  The higher your marginal tax bracket, the more beneficial tax-free income is.

46. Prentice-Hall, Inc.46 Defer Taxes to the Future  Traditional IRAs,401(k) plans, and Keogh plans defer taxes to the future.  Roth IRA earnings are never taxed.  Long-term capital gains taxes are not paid until the asset is sold.

47. Prentice-Hall, Inc.47 Summary  Know the U.S. tax code and your marginal tax bracket -- use both for tax planning to minimize tax payments.  Use adjustments, exemptions, and deductions to calculate your taxable income.  Use credits to reduce your tax liability.

48. Prentice-Hall, Inc.48 Summary (cont’d)  Know who must file, how, and when.  Know how and where to get help filing.  Know how to prepare for an audit.

49. Prentice-Hall, Inc.49 Summary (cont’d)  Know how to use tax strategies to reduce your tax liability – maximize deductions – look to capital gains income – shift income – look to tax-exempt income – defer taxes