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Planning Your Tax Strategy

C HAPTER 4. Planning Your Tax Strategy. Personal Finance. 7e. Kapoor Dlabay Hughes. 4-1. Taxes and Financial Planning. About one-third of each dollar you earn goes to pay taxes. An effective tax strategy is vital for successful financial planning.

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Planning Your Tax Strategy

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  1. CHAPTER4 Planning Your Tax Strategy Personal Finance 7e Kapoor Dlabay Hughes 4-1

  2. Taxes and Financial Planning • About one-third of each dollar you earn goes to pay taxes. • An effective tax strategy is vital for successful financial planning. • Understanding tax rules and regulations can help you reduce your tax liability. 4-2

  3. Taxes and Financial Planning (continued) • To help you cope with the many types of taxes you should... • Know current tax laws as they affect you. • Maintain complete and appropriate tax records. • Make purchase and investment decisions that reduce your tax liability. • Your tax planning should be targeted toward paying your fair share but still taking advantage of tax benefits. 4-3

  4. Four Types of Taxes • Taxes on purchases. • Sales tax & excise tax. • Taxes on property. • Real estate property tax. • Personal property tax. • Taxes on wealth. • Federal estate tax. • State inheritance tax. • Taxes on earnings. • Income tax. 4-4

  5. What Tax Records to Keep • Current tax forms and instruction booklets. • Social security numbers. • Copy of previous year’s returns. • W-2 forms from employers. • 1099 forms (interest, self employment). • 1098 (mortgage interest paid). • Receipts and documentation for expenses. • Investment & business expense documents. 4-5

  6. Computing Your Tax Liability • Step 1: Determining adjusted gross income. • First identify taxable income - the net income, after deductions, on which income tax is computed. Types of income subject to taxation include… • Earned income which usually include wages, salary, commissions, fees, tips or bonuses. • Investment income is money received in the form of dividends, interest or rent from investments. • Passive income results from business activities in which you do not directly participate such as a limited partnership. • Alimony, awards, lottery winnings and prizes. 4-6

  7. Computing Your Tax Liability(continued) • Total income is affected by exclusions. • Exclusions are amounts not included in gross income. • Exclusions are also referred to as tax-exempt income, which is income not subject to federal income tax. An example is interest on most state and city bonds. • Total income is also affected by tax-deferred income. This is income that will be taxed at a later date, such as earnings from an traditional individual retirement account (IRA). 4-7

  8. Computing Your Tax Liability(continued) • Adjusted gross income is is gross income after certain reductions have been made. These reductions are called adjustments to income, and include the following. • Contributions to a traditional IRA or Keogh. • Alimony payments. • Tax-deferred retirement plans, such as a 401(k)or a 403(b)(7) are a type of tax shelter. • Tax shelters are investments that provide immediate tax benefits and a reasonable expectation of a future financial return. 4-8

  9. Computing Your Tax Liability(continued) • Step 2: Computing Taxable Income. • A tax deduction is an amount subtracted from adjusted gross income (AGI) to arrive at taxable income. • You can subtract the standard deduction from AGI or itemize your deductions; • Itemized deductions can include items such as... • Medical and dental expenses >7.5% of AGI. • Taxes, interest, contributions and theft losses. • Moving, job-related, and miscellaneous expenses. 4-9

  10. Computing Your Tax Liability(continued) • Next subtract exemptions from AGI. • An exemption is a deduction for yourself, your spouse and qualified dependents. • The amount of the exemption for the 2004 tax year was $3,100 per person but this amount increases slightly each year. • After deducting exemptions you have your taxable income. 4-10

  11. Computing Your Tax Liability(continued) • Step 3: Calculating taxes owed. • The percent rates are the marginal tax rates on the last dollars of taxable income. • For example, after deductions and exemptions, a person in the 28% tax bracket pays 28 cents in taxes for every dollar of taxable income in that bracket. 4-11

  12. Computing Your Tax Liability(continued) • A person’s average tax rate is based on the total tax due divided by taxable income. This rate is less than a person’s marginal tax rate. • For example, if a person with a taxable income of $30,000 has a total tax bill of $3,000, their average tax rate is 10%. • Subtract tax credits. • A tax credit is an amount subtracted directly from the amount of taxes owed, such as the earned income or child and dependent care credits. 4-12

  13. $100 Tax Credit Reduces Your Taxes by $100 $100 Tax Deduction Amount Your Taxes are Reduced is Based on Your Tax Bracket Tax Credit versus Tax Deduction 4-13

  14. Determine tax withheld Making Tax Payments - Withholding W-2 Form 4-14

  15. Filing Your Federal Income Tax Return You must file if your gross income exceeds the allowed amount. This amount changes each year. • There are five filing status categories. • Single or legally separated. • 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). 4-15

  16. Which Tax Form Should You Use? 1040EZ • This is the form for those with the least complicated situations. Quick and easy to file. • Single or married filing jointly, under age 65 and with no dependents. • Income consisted of wages, salaries, and tips, and no more than $400 of taxable interest. • Your taxable income is less than $50,000. • You do not itemize deductions, or claim any adjustments to income or any tax credits. 4-16

  17. Decide Which Tax Form to Use (continued) 1040A • Taxable income less than $50,000. • Adjustments to income are allowed. • Tax credits for child care and dependent care are allowed. • Required to use this form if income is over $50,000. Use if you itemize deductions. • Used to amend a previously filed return. 1040 1040X 4-17

  18. Completing Your Federal Income Tax Return • In summary the steps to completing your return include: • Filing status and exemptions. • Income. • Adjustments to income. • Tax computation. • Tax credits. • Other taxes (such as from self-employment) • Payments (total withholding and other payments). 4-18

  19. Completing Your Federal Income Tax Return • Determine if you are due a refund or owe tax. • Refunds can be sent directly to your bank account. • Sign your return. 4-19

  20. Tax Information Sources • The IRS has methods of assistance. • Publications and forms 1-800-TAX-FORM. • http://www.irs.gov • Recorded messages 1-800-829-4477. • Phone hot line 1-800-829-1040. • Walk-in service at an IRS office. • CD-ROM the IRS sells that has forms and pubs. • Tax publications e.g. Ernst and Young Tax Guide. • The Internet. • Tax preparation software companies. 4-20

  21. Tax Information Sources (continued) • Electronic filing. • Currently over 45 million people file their returns this way. • Returns are generally received within three weeks. • Tax preparers charge between $15 and $70 to submit a return for electronic filing. • Telefile is a way to file by phone if you are using form 1040EZ. 4-21

  22. Tax Information Sources (continued) • Tax preparation services. • Range from a one-person office to large firms such as H & R Block. • Government-approved tax experts are called enrolled agents. • Accountants. • Attorneys. • If your professional tax preparer makes a mistake, you are still responsible for paying the correct amount, plus any interest and penalties. 4-22

  23. What if Your Return is Audited? • About 0.6% of all returns are audited. • If you claim large or unusual deductions you are more likely to be audited. • There are three types of audits. • Correspondence for minor questions. • Office audit takes place at an IRS office. • Field is the most complex, with an IRS agent visiting you at your home, your business or your accountant’s office. • You have audit rights, including time to prepare for the audit, and clarification. 4-23

  24. Tax-Planning Strategies • Practice tax avoidance. • Legitimate methods to reduce your tax obligation to your fair share but no more. • Financial decisions related to purchasing, investing, and retirement planning are the most heavily affected by tax laws. • Tax Evasion. • Illegally not paying all thetaxes you owe, such as not reporting all income. 4-24

  25. Tax-Planning Strategies (continued) • To minimize taxes owed... • If you expect to have the same or a lower tax rate next year, accelerate deductions into the current year. • If you expect to have a lower or the same tax rate next year, delay the receipt of income until next year. • If you expect to have a higher tax rate next year, delay deductions since they will have a greater benefit. • If you expect to have a higher tax rate next year, accelerate the receipt of income to have it taxed at the current lower rate. 4-25

  26. Tax-Planning Strategies (continued) • Owning a home is one of the best tax shelters because you can deduct mortgage loan interest and property taxes when you itemize. This reduces your taxable income. • Use your home equity line of credit to buy a car or consolidate debt, since the interest you pay can be deducted when you itemize. • Job-related expenses may be allowed as itemized deductions. • Using tax-exempt investments, such as municipal bonds can help reduce your taxes. 4-26

  27. Tax-Planning Strategies (continued) • Long-term capital gains taxed at a lower rate. • Held more than one year. • Put money in tax-deferred investments. • Series EE U.S. Treasury bonds interest is exempt if used for tuition. • Tax-deferred annuities. • Take advantage of tax-deferred retirement plans. • 401(k) plans $12,000 maximum in 2003. • Establish a Keogh plan if self-employed. 4-27

  28. Tax-Planning Strategies (continued) • Long-term capital gains on the sale of a home are excluded from taxes up to a certain amount. • Owning your own business has tax advantages, such as deducting health/life insurance costs, but have to pay self-employment tax (Social Security). • Children’s investments and income shifting (<$1500) • Traditional IRA limit was $3,000 in 2002. • Roth IRA dollars are not taxed when withdrawn. • Education IRA savings - earnings are tax free. • 529 savings plans are state-run, tax-deferred. 4-28

  29. The End

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