1. Chapter 14
Tax Planning

2. Chapter Goals Discuss the widespread role of taxation in PFP.
Develop a knowledge of key tax planning strategies.
Compare the tax benefits of major investment vehicles.
Understand and complete a tax return.

3. Income Taxation
Income taxes are a nondiscretionary cost in household operations, with the outlay dependent on both revenues and expenses.
Decision making in most household activities is influenced by taxes.
On the following slide, we consider a brief example of the tax impact in each area of the financial plan.

4. Income Taxation, cont. Examples of tax impact on financial plan:
Cash Flow Planning: Taxes influence the timing of transactions and preparation for payment of sums due.
Investments: The calculation of returns is often done on an after-tax basis.
Financing: The calculation of the cost of borrowing is done on an after-tax basis.
Risk Management: There is often a clear preference for tax-deductible employee health and life insurance.
Retirement Planning: There is a substantial benefit when saving through qualified retirement – pension vehicles.
Estate Planning: Tax minimization comprises a large part of estate planning activities.

5. Income Tax Format
Income earners are taxed on an individual basis except for married couples, whose income is generally combined for income tax purposes.
The income tax return resembles a household cash flow statement in form.
Adjustments are made for certain expenses. The net is the adjusted income figure called adjusted gross income (AGI).
Deductions follow based on fairness, popularity, and society’s goals, and exemptions allowed based on the number of people in the household and other factors. The result is the amount available to be taxed, called taxable income.

6. Income Tax Format, cont.
We can summarize the individual income tax return, IRS Form 1040, as follows:

7. Tax Planning: A General Analysis
Tax planning is the analysis and implementation of strategies to reduce tax expenditures. It also involves the scheduling of tax payments and the programming of tax-related cash outlays.
Your overall goal is generally to minimize taxes, provided that doing so is consistent with efficient household operations.
Alternatively, the goal is to maximize your after-tax returns on investments including your investment in human assets.
A tax planning statement provides a projection of future tax expenses by year.

8. Marginal Analysis
In making tax-planning decisions you must often weigh the benefits of alternative approaches.
The Decisions often depend on your marginal tax bracket. It is to be distinguished from the average tax bracket.

9. Marginal Analysis, cont.
We obtain the total marginal tax bracket as follows:

10. Marginal Analysis, cont.
You can use the marginal tax bracket to compare alternative investments on an “apples to apples” basis.
Doing so is necessary because market forces adjust prices for investments with tax benefits and reduce their pretax returns to investors.
Two approaches:
After-Tax Return = Pretax Return × (1 – marginal tax bracket)
Pretax Equivalent Returns = After-Tax Returns /(1-marginal tax bracket)

11. Tax Planning Strategies
We can use a number of techniques to reduce our taxes. Many of these techniques involve planning well before the actual tax return needs to be filed. They include:
Increasing deductible expenses.
Deferrals.
Conversions.
Eliminations.
Timing of income and expenses.
Tax planning for investments.

12. Increasing Deductible Expenses and Credits
By carefully going through IRS publications or a good tax-planning manual you may be able to develop new deductions or credits.
Clustering can be a productive tax-planning tool:
If you have medical or miscellaneous expenditures that fall below the 7.5 percent or 2 percent limitations, respectively, you may be able to pay and group two years’ outlays together in one year to bring your deductible expenditures above their respective floors.
This strategy is aided by the ability of individuals to deduct expenses on a when paid rather than an accrual basis.

13. Tax Deferral
Tax deferral: Postponing taxes to be paid today to some time in the future.
Tax deferral can provide sizeable benefits due to your ability to use that money in the interim.
Tax deferral is the key to the benefits of a pension or deductible IRA.
Taxes are deferred on the portion of salary placed in the pension or IRA as well as on the interest, dividends, and capital gains earned while it is in this tax shelter:
Taxes are paid on withdrawals and in many cases for the remainder upon death.

14. Conversion
Conversion involves the change from one amount of tax due to a lower one.
Shifting Income: Transferring income from a person in a higher bracket to someone in a lower bracket. Typically, it involves changing from being taxed at ordinary income rates to being taxed at more favorable capital gains rates.
Transforming Income: Changing income from a high tax to a lower tax status. Typically, it involves changing from being taxed at ordinary income rates to being taxed at more favorable capital gains rates.

15. Elimination of Taxes
Tax elimination involves not paying taxes at all on a specific type of income being generated. Permanent elimination of taxes can be a particularly powerful tool.
Some methods include:
Gifts to charities.
Transfers to children.
Establishment of Roth IRAs.
Structuring of employee benefits.

16. Gifts to Charities
Many charitable donations are in the form of cash, check or property.
Those donations, made in property form, are based on fair market value, not cost.
If you donate an investment to a charity, the capital gains tax on any increase in the value of the investment, which under normal circumstances would have had to be paid by you when it was sold, is eliminated.
Therefore, charitable gifts have two tax benefits, a tax deduction for the contribution and the elimination of any capital gains tax.

17. Transfers to Children
The first $800 of investment income earned by a child under 14 is not subject to tax.
For example, assume you transferred $10,000 worth of bonds with an income of 8 percent per year to your child who had no other income. The amount would be tax free to your child whereas retaining it in your name would result in your paying taxes on the income generated, based on your marginal tax bracket.
For children under 14, amounts of investment income over $1,600 are taxed at the parent’s rate; amounts between $800 and $1,600 are taxed at the minimum rate, currently 10 percent.

18. Roth IRAs
Roth IRAs are IRAs that are never subject to income taxation once sums are placed into them.
Deposits into Roth IRAs are made with after-tax dollars - dollars of income on which taxes have been paid.
There are restrictions on the amount of money you can deposit in your Roth IRAs, generally $4,000 per person per year with a phase-out based on income.
It is also possible to transfer money from a regular to a Roth IRA, after paying a tax on the money transferred.

19. Structuring of Employee Benefits
Certain benefits provided to employees are not taxable to them.
One of those benefits is medical coverage.
Dollar for dollar it can be preferable for both employee and employer to contract for extra benefits rather than salary, with income taxes eliminated for employees and Social Security taxes eliminated for both the employee and employer.

20. Timing of Income and Expenses
The timing of income and expenses involves optional selection of the year in which to report transactions.
The simplest use of timing methods is to maximize tax-deductible payments in the current year.
Your marginal tax bracket may vary from year to year because of such factors as fluctuations in income earned, unusually high or low deductible expenses, or just a change in the country’s taxation methods or tax brackets.
Cash basis accounting for tax purposes makes it easier to shift income and expenses.

21. Tax Planning for Investments
Tax planning for investments is generally weighted more heavily toward the timing of revenue transactions.
The principal tax planning tools for household operating activities, on the other hand, are often heavily weighted toward the timing of expenditures by year.
The reason is that the receipt of income from job-related activities is often beyond the control of the taxpayer whereas an investor often has a choice as to when to sell an investment and declare the gain.

22. Tax Planning for Investments, cont.
There are four types of income from financial investment activities.
Ordinary income.
Dividend income.
Short-term Capital Gains and Losses.
Long-term Capital Gains and Losses.
Ordinary income: Taxed at normal rates based on your taxable income. It is appropriate for interest or other operating income from investments. It is taxed at the same rate as income from job-related activities.

23. Tax Planning for Investments, cont.
Dividend Income: Received on payouts from corporations.
Qualified dividends are eligible for special taxation. The maximum federal tax rate for years will be 15 percent. The minimum rate is 5 percent for and 0 percent for 2008.
To receive the tax benefit, common stock dividends must have been taxed on a corporate level. Although most common stock dividends will qualify, only a fraction of preferred stocks will.
To receive the benefit the shares must be held for at least 60 days prior to the payment and cannot be paid to a tax-deferred account such as a pension.

24. Tax Planning for Investments, cont.
Short-term Capital Gains and Losses: arise from gains and losses when sales prices for investments are compared with their costs.
The tax code defines short term as sales that are made in one year or less from the date of purchase.
In the absence of long-term transactions, short-term gains and losses are taxable at ordinary income rates.
Net short-term losses are limited to $3,000 per year, but amounts in excess of $3,000 can be carried forward to future years indefinitely until the entire amount is utilized.

25. Tax Planning for Investments, cont.
Long-term Capital Gains and Losses: Long-term transactions for financial securities are those that are held for more than one year.
Long-term capital gains on these securities are-tax favored, having a minimum federal rate of 5 percent and a maximum rate of 15 percent.
Long-and short-term investment transactions are netted against one another.

26. Tax Planning Strategies
Take Capital Losses
This strategy proposes that you take advantage of losses on current holdings by selling the shares.
If they are sold within the current year, you realize the tax benefit from the loss earlier than if you postpone the sale.
The benefit of this strategy is limited to $3,000 of capital losses net of capital gains for the year.
In addition, the tax benefit from the losses must be measured against the potential investment gains in continuing to hold the shares.
Take Capital Losses to Offset Capital Gains
Driven by the desire to reduce or eliminate taxes on gains on already sold securities.
It is done by selling shares with losses to the extent of gains or for $3,000 more of losses than gains.

27. Tax Planning Strategies, cont.
Postpone Capital Gains to the New Year.
This strategy defers taxes by postponing gains until the New Year.
It is subject to the same provision that it must be measured against the risk of changes in stock prices - in this case, share declines in the interim while waiting to sell.
Postpone Sales until Investments Are Held More than One Year.
Investments that you have held for more than one year are subject to favorable long-term capital gains tax rates.
Therefore, if you have a material gain, you may benefit by waiting until the investment has been held more than one year before selling.

28. Tax-Advantaged Investments
Tax-Advantaged Investment Structures: Entities that provide an umbrella of tax benefits for investments made within the entity.
Pension Plans and Regular IRAs: One of a few entities that allow pretax dollars to be invested.
Roth IRAs: Require that after-tax dollars be placed into them. Not subject to any further taxation.
Employer Nonqualified Plans: Certain employer plans offer both pretax-dollars deposits and tax deferral for nonqualified plans.
Tax-Deferred Annuities: Investments in which after-tax dollars are placed into entities. The tax on all earnings on deposits is deferred until withdrawals are made.
Life Insurance: Sums deposited and accumulated in life insurance policies beyond policy costs, called cash value, earn income that grows tax deferred.

29. Individual Tax-Advantaged Investments
Tax-advantaged individual investments: Those in which the specific investment, not the overall investment structure, provides the tax benefit.
Home: Interest to finance the home is tax deductible as are real estate taxes.
Real Estate Investment: Real estate that you don’t reside in full time but is intended as an investment allows tax deductibility of interest, taxes, and other operating costs. It also allows you to take tax deductible depreciation on the investment.
Municipal Bonds: Most municipal bond interest is free from federal taxation. When you purchase qualified municipal bonds of the state you live in, your interest is not subject to state and local taxes either.

30. Individual Tax-Advantaged Investments, cont.
Series EE Bonds: U.S. government bonds.
Effective May 2005, new bonds purchased will earn a fixed rate of interest.
For bonds purchased between May 1995 and April 2005 the interest rate floats with 5-year U.S. Government Treasury Securities and pays 85 or 90 percent of that rate depending on the issue date of the bond.
Interest is not paid out but deferred until the bonds are cashed in.
U.S. Government Bonds: Although subject to federal taxation, U.S. Government bonds are free of state and local taxes. This tax benefit is only useful, of course, in states that assess income taxes.
Tax-Sheltered Investments: The federal government has elected to bestow tax benefits on several investments, including oil and gas, low-income housing, rehabilitation of classics, tax credits on certain investments, and others.

31. Chapter Summary
Taxes enter into virtually all major elements of financial planning.
There is a variety of tax planning strategies. These include increasing expenses and credits, deferral of taxes, conversion, shifting income, transforming income, elimination of taxes, and the timing of income and expenses.
Among the tax-advantaged investment structures are pension plans and regular IRAs, Roth IRAs, nonqualified plans, tax-deferred annuities, and life insurance.
Individual tax-advantaged investments include the home, other real estate, municipal bonds, series EE bonds, U.S. Government Bonds, and other tax-sheltered investments.