1. Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 4 Using Tax Concepts for Planning

2. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-2 Chapter Objectives Explain how to determine your tax filing status Explain how to calculate your gross income Demonstrate how deductions and exemptions can be used

3. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-3 Chapter Objectives Explain how to determine your taxable income, tax liability, and refund or additional taxes owed Demonstrate how to fill out a tax form and determine your tax liability

4. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-4 Background on Taxes Financial planning involves decisions that affect your income –Whether or not to take a second job –Deciding to finance a home –Investment decisions –Contributing to a retirement account These decisions affect the amount of taxes you pay and therefore affect your wealth

5. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-5 Background on Taxes Taxes are paid at the federal, state, and local levels The purpose of taxes is to fund government activities The federal tax system is administered by the Internal Revenue Service This chapter focuses on the federal income tax process

6. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-6 Financial Planning Online: Internal Revenue Service Go to: http://www.irs.govhttp://www.irs.gov This Web site provides information about tax rates, guidelines, and deadlines.

7. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-7 Background on Taxes Social Security and Medicare Taxes –Wages are subject to FICA –FICA (Federal Insurance Contribution Act): Taxes paid to fund the Social Security System and Medicare –Medicare: a government health insurance program that covers people over age 65 and provides payments to health care providers in the case of illness

8. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-8 Background on Taxes Social Security and Medicare Taxes –Your employer matches the amount that is withheld from your wages Social Security taxes equal 6.2% of your salary up to a maximum level of $84,900 Medicare taxes are 1.45 % of your entire salary –Self-employed people must pay both parts of these taxes themselves — 15.3%

9. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-9 Background on Taxes Personal income taxes: taxes imposed on income earned –If you earn income you must file a Form 1040 to determine your tax liability –Filing deadline is April 15 of each year

10. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-10 Background on Taxes Tax Relief Act of 2001 –Lower taxes rates phased in gradually until 2010 –Impact various adjustments made to determine personal income taxes –Designed to provide both a short-term stimulus to the economy and long-term tax relief for individual taxpayers

11. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-11 Filing Status Taxpayers must specify a filing status for their tax return because different rates are associated with each status. –Single –Married filing joint return –Married filing separate return –Head of household –Qualifying widow(er) with dependent child

12. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-12 Gross Income Gross income: all reportable income from any source, including salary, interest income, dividend income, and capital gains received during the tax year –Wages and Salaries — including bonuses, but excluding contributions to an employee sponsored retirement account –Interest income: interest earned from investments or loans to other individuals

13. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-13 Gross Income –Dividend income: income received in the form of dividends paid on stocks or mutual funds –Capital gain: income earned when an asset is sold at a higher price than was paid for it Short-term capital gain: a gain on assets that were held less than 12 months Long-term capital gain: a gain on assets that were held for 12 months or longer

14. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-14 Gross Income –Capital loss: a loss that results from selling an asset at a lower price than was paid for it –Capital gains tax: the tax that is paid on a gain earned as a result of selling an asset for more than the purchase price

15. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-15 Gross Income Determining gross income –Adjusted gross income: the amount calculated by adjusting gross income for contributions to individual retirement accounts, alimony payments, interest paid on student loans, and other special circumstances All of these items related to gross income are reported on Form 1040

16. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-16 Deductions and Exemptions Standard deduction: a fixed amount that can be deducted from adjusted gross income to determine taxable income –Not affected by income –Affected by filing status and age –Marriage penalty: term used to describe the fact that many two-income married people pay more in taxes than if they were single

17. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-17 Deductions and Exemptions Exhibit 4.4: Standard Deduction Amounts for the 2000 Tax Year

18. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-18 Deductions and Exemptions Itemized deductions: specific expenses that can be deducted to reduce taxable income –Interest expense: interest paid on borrowed money — primarily interest on mortgages and student loans –State income tax: an income tax imposed by some states on people who receive income from employers in that state

19. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-19 Financial Planning Online: State Income Tax Rates Go to: http://taxes.yahoo.com/statereport.html http://taxes.yahoo.com/statereport.html This Web site provides income tax rates and information on personal exemptions for each state.

20. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-20 Deductions and Exemptions –Real estate tax: a tax imposed on a home or other real estate in the county where the property is located –Medical expenses Amounts paid for prevention, diagnosis or alleviation of physical or mental defects or illness Amounts paid to affect any structure or function of the body

21. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-21 Deductions and Exemptions Expenses for transportation to and from care Accident and health insurance premiums –Charitable gifts –Other expenses Casualties or thefts Job-related expenses Compare the total allowable itemized deductions to the standard deduction and use the larger

22. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-22 Deductions and Exemptions Exemption: an amount that can be deducted for each person who is supported by the income reported on a tax return –Usually one exemption each for the filer, the spouse and each dependent child –Deducted from gross income to determine taxable income

23. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-23 Taxable Income and Taxes Taxable income: adjusted gross income less deductions and exemptions Taxes –Depends on taxable income and filing status –Progressive: a term used to characterize a tax system where a positive relationship exists between an individual’s income level and tax rate

24. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-24 Taxable Income and Taxes –Determining your tax liability Determine filing status and follow the instructions on the tax schedule Tax Liability = Tax on Base + [Percentage on Excess over the Base x (Taxable Income – Base)]

25. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-25 Taxable Income and Taxes Exhibit 4.6: Individual Tax Rates for the Year 2000 (Panels A and B)

26. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-26 Taxable Income and Taxes Exhibit 4.6: Individual Tax Rates for the Year 2000 (Panels C and D)

27. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-27 Taxable Income and Taxes –Marginal tax bracket: the tax rate imposed on any additional (marginal) income earned Tax credits: amounts that offset taxes; the full amount of the tax credit is subtracted from taxes owed

28. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-28 Taxable Income and Taxes –Child tax credit: a tax credit allowed for each child in a household who is less than 17 years old (reduced or eliminated for households in high-income brackets) Gradually increasing from $600 in 2001 to $1,000 in 2010 Available as a refund to low-income workers who owe no income tax

29. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-29 Taxable Income and Taxes –College expense credits: tax credits for parents who incur college expenses, based on the amount of financial support they provide Section 529 College Savings Plan –Allows tax benefits for parents who set aside money for their children’s future college expenses –Available to all parents, regardless of income

30. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-30 Taxable Income and Taxes –Earned income credit: a special credit for taxpayers who earn low incomes; can reduce the amount of taxes owed –Other tax credits are also available, for example for child care and adoptions

31. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-31 Focus on Ethics: Reducing Your Taxes Resist the temptation to under report income The IRS usually uncovers such behavior There are many legal ways to reduce taxes File on time

32. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-32 Financial Planning Online: Tax Information Resource Go to: http://www.taxplanet.comhttp://www.taxplanet.com This Web site provides useful information on the most recent tax rates, forms, laws, and issues. Search for a particular tax topic in which you are interested.

33. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-33 How Tax Planning Fits within Your Financial Plan The key tax planning decisions for building your financial plan are: –What tax savings are currently available to you? –How can you increase your tax savings in the future?

34. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-34 Integrating the Key Concepts

35. Copyright ©2004 Pearson Education, Inc. All rights reserved.4-35 Integrating the Key Concepts Part 1: Financial Planning Tools –In Chapter 2 we learned about personal financial statements –In Chapter 3 we learned about time value of money –In Chapter 4 we learned about tax planning Part 2: Liquidity Management Part 3: Financing Part 4: Protecting Your Wealth Part 5: Investing Part 6: Retirement and Estate Planning