Download Chapter 4

Chapter 4
Using Tax
Concepts for
Planning
Copyright ©2004 Pearson Education, Inc. All rights reserved.
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
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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
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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
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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
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Financial Planning Online:
Internal Revenue Service
• Go to: http://www.irs.gov
• This Web site provides information
about tax rates, guidelines, and
deadlines.
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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
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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%
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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
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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
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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
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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
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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
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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
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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
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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
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Deductions and Exemptions
Exhibit 4.4: Standard Deduction Amounts for the 2000 Tax Year
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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
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Financial Planning Online:
State Income Tax Rates
• Go to:
http://taxes.yahoo.com/statereport.html
• This Web site provides income tax rates
and information on personal exemptions
for each state.
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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
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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
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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
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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
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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)]
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Taxable Income and Taxes
Exhibit 4.6: Individual Tax Rates for the Year 2000 (Panels A and B)
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Taxable Income and Taxes
Exhibit 4.6: Individual Tax Rates for the Year 2000 (Panels C and D)
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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
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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
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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
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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
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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
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Financial Planning Online:
Tax Information Resource
• Go to: http://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.
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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?
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Integrating the Key Concepts
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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
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