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Chapter 4

Chapter 4. Managing Income Taxes. Learning Objectives. Explain the nature of progressive income taxes and the marginal tax rate. Learn the eight steps involved in calculating your federal income taxes. Use appropriate strategies to avoid overpayment of income taxes. Goals:

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Chapter 4

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  1. Chapter 4 Managing Income Taxes

  2. Learning Objectives • Explainthe nature of progressive income taxes and the marginal tax rate. • Learn the eight steps involved in calculating your federal income taxes. • Use appropriatestrategiesto avoid overpayment of income taxes.

  3. Goals: • To avoid paying unnecessary sums of money to the government in taxes…PAY YOUR FAIR SHARE, BUT NO MORE! • To do this, we must understand tax rules and regulations that will help us reduce our tax liability • The more we understand, the better we will be at tax planning: making decisions that will reduce, defer, or eliminate some income taxes • FYI: • Your tax liability (obligation) is based on your taxable income • Reducing our taxable income will reduce our tax liability

  4. 1. Progressive Taxes AND THE Marginal Rate • Income tax is a progressive tax • Progressive vs. Regressive taxes • Marginal Tax Bracket • Our income is taxed at six different rates • Our MTB is the rate that is applied to our last dollar of earnings • Average tax rate: the proportion of our total income that we pay in income taxes

  5. WHO MUST FILE? You must file if your gross income exceeds the allowed amount: S = $9750 or if a dependent $5950 M/J = $19,500 • There are five filing status categories. • Single • Married, filing jointly • Married, filing separately • Head of household • Unmarried individual or surviving spouse who maintains a household for a child or dependent relative • Qualifying widow or widower (2 years)

  6. 1. Determine Your Total Income • Total Income: Compensation from all sources. • Wages and Salaries • Commissions • Tips Earned • Gambling and Lottery Winnings • Gifts • Federal income tax refunds • Capital gains and losses • … and more (see pg 110)

  7. W-2 Form

  8. 2. Subtract Adjustments to Income to Find Your AGI Examples of items to be subtracted: • Educator expenses • Alimony paid • Interest on student loans • Moving expenses for new job • …and more (page 112) = Adjusted Gross Income (or AGI)

  9. CHOOSE THE HIGHER AMOUNT IN ORDER TO ARRIVE AT THE LOWEST POSSIBLE TAXABLE INCOME 3. Subtract Deductions • Use either the IRS’s standard deduction for your tax status or your itemized deductions • Standard deduction depends on filing status • $ 5,950 for single individuals • $11,900 for married couples • Itemized deductions can include: • A % of Medical and dental expenses • Taxes you paid (Real Estate / Property Taxes, State & Local Income Tax, etc.or State Sales Tax) • Interest Paid on Home Mortgage Loans • Gifts to charity • Casualty and theft losses • A % of Job Expenses and Miscellaneous deductions • And more! (see page 114-117)

  10. 4. Subtract Exemptions to find Your Preliminary Taxable Income • Exemption: a specific amount ($3800) deducted from AGI – based on # of people supported by your income • Eachexemption reduces taxable income by $3800 • Yourself, spouse, and qualified dependents • Certain criteria for “dependent” status • Important: If someone else claims you, you cannot claim yourself = Your Taxable Income

  11. 5. Determine Your Preliminary Tax Liability • Look up your taxable income in the Tax Tables to find your preliminary tax liability for the year • Be sure to look at the correct filing status You’re almost done! FULL SCENARIO OF THIS ON PG 118!!

  12. 6. Subtract Tax Credits for Which You Qualify • Tax Credit: Dollar-for-dollar decrease in tax liability • You may take tax credits even if you don’t itemize • Credits are subject to income limits • Nonrefundable vs. Refundable tax credits • Hope Scholarship Credit • Lifetime Learning Credit • Earned Income Credit • Child Tax Credit • Child and Dependent Care Credit • Retirement Savings Contribution Credit • http://www.walletpop.com/blog/2010/01/22/common-tax-credits-explained/ • = Total Tax Liability PG. 119-120

  13. Credits compared to Deductions? • One is directly subtracted from your tax liability • The other is subtracted from your taxableincome, so itreduces your overall tax liability by a certain percentage • Your AGI is $60,000 and your itemized deductions total $10,000. • What is worth more (and by how much)?… • an additional $1,000 deduction or • a $1,000 tax credit? AGI = $60,000 - $10,000(Itemized deductions) $50,000 Tax Liability for $50,000 => $8850 AGI = $60,000 - $11,000(Additional $1000 deduction) $49,000 Tax Liability for $49,000 => $8600 • Additional $1000 deduction reduces tax liability to: $8600 (Reduces it by $250) • A $1000 tax credit reduces tax liability to: $7850 (Reduces it by $1000)

  14. Tax Liability • Compare your Total Tax Liability to the amount you actually paid (refer to your W-2) • Calculate the balance due the IRS or the amount of your refund

  15. “Overwithholding” creates a Tax Refund • 4 out of 5 taxpayers purposely do this • Average refund last year = $3000 • Should it be viewed as a “windfall”? • What about the opportunity cost? • Should it be viewed as a form of “forced savings”? • Why not save on your own… and earn interest? • GOAL: to BREAK-EVEN • Decrease the amount withheld by adjusting your W-4

  16. Avoid Taxes Through Proper Planning • Practice legal tax avoidance, not tax evasion • Which one is legal? • Many strategies for reducing taxes • Reduce taxable income via your employer • Flexible Spending Account (use-it-or-lose-it!) • Defined Contribution (401K) retirement plans

  17. Use Tax-Sheltered Investments to Reduce Tax Liability • Tax-Sheltered Investments: Investments that yield returns that are tax advantaged • Investments using pretax dollars • Investments that offer tax-deferred growth • IRA investments • Roth IRA investments • Qualified Tuition (529) programs • Govt. savings bonds • Municipal bonds

  18. Other Strategies to Reduce Tax Liability • Postpone Income • Accelerate Deductions • Shift income to a child • Bunch deductions / prepay some items

  19. Top 3 Mistakes in Managing Income Taxes • Turning all your income tax planning over to someone else • Overwithholding too much income to receive a refund next year • Ignoring the impact of income taxes in your personal financial planning

  20. Rules for Dependents: http://www.irs.gov/publications/p929/ar02.html#en_US_2012_publink1000203740 2012 1040 tax form: http://www.irs.gov/pub/irs-pdf/f1040.pdf 2012 Schedule A: http://www.irs.gov/pub/irs-pdf/f1040sa.pdf 2012 1040 EZ: http://www.irs.gov/pub/irs-pdf/f1040ez.pdf

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