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  • 1. Planning Your Tax Strategy Personal Finance C HAPTER 4 Kapoor Dlabay Hughes 7e 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.
  • 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. 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.
  • 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.
  • 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.
  • 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).
  • 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.
  • 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 loses.
        • Moving, job-related, and miscellaneous expenses.
  • 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 2001 tax year was $2,900 per person but this amount increases slightly each year.
      • After deducting exemptions you have your taxable income.
  • 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.
  • 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.
  • 13. Tax Credit versus Tax Deduction 4-13 $100 Tax Credit Reduces Your Taxes by $100 $100 Tax Deduction Amount Your Taxes are Reduced is Based on Your Tax Bracket
  • 14. W-2 Form
    • Determine tax withheld
    Making Tax Payments - Withholding 4-14
  • 15. Filing Your Federal Income Tax Return
    • 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 You must file if your gross income exceeds the allowed amount. This amount changes each year.
  • 16. Which Tax Form Should You Use?
    • 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.
    1040EZ 4-16
  • 17. Decide Which Tax Form to Use
    • 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.
    (continued) 1040A 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).
  • 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.
  • 20. Tax Information Sources
    • The IRS has methods of assistance.
      • Publications and forms 1-800-TAX-FORM.
      • 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.
  • 21. Tax Information Sources
    • 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.
    (continued) 4-21
  • 22. Tax Information Sources
    • 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.
    (continued) 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.
  • 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 the taxes you owe, such as not reporting all income.
  • 25. Tax-Planning Strategies
    • 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 (continued)
  • 26. Tax-Planning Strategies
    • 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.
    (continued) 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.
  • 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.