17 Retirement and Estate PlanningYOU MUST BE KIDDING, RIGHT.docx

17 Retirement and Estate Planning
YOU MUST BE KIDDING, RIGHT?
Rachel Jones is 27 years old, and she recently took a new job.
Rachel had accumulated $6000 in her previous employer's
401(k) retirement plan, and she withdrew it to help pay for her
wedding. How much less money will Rachel have at retirement
at age 67 if she could have earned 8 percent on the $6000?
A. $6000
B. $24,000
C. $96,000
D. $130,000
The answer is D. Spending retirement money for discretionary
purposes, instead of keeping it in a tax-deferred account where
it can compound for many years, is unwise. The lesson is to
keep your retirement money where it belongs!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Estimate your Social Security retirement income benefit.
Calculate the amount you must save for retirement in today's
dollars.
Distinguish among the types of employersponsored tax-
sheltered retirement plans.
Explain the various types of personally established tax-
sheltered retirement accounts.
Describe how to avoid penalties and make your retirement
money last.
Plan for the distribution of your estate and, if needed, use
trusts to lower estate taxes.
WHAT DO YOU RECOMMEND?
Juliana Pérez Rodríguez, age 48, worked for a previous
employer for eight years. When she left that job, Juliana left her
retirement money in that employer's definedcontribution plan. It
is now worth $120,000. After getting divorced and remarried

four years ago, she has been working as an assistant food
services manager for a convention center in Chicago, earning
$70,000 per year. Juliana contributes $233 each month (4
percent of her salary) to her account in her employer's 401(k)
retirement plan. Her employer provides a 100 percent match for
the first 4 percent of Juliana's salary contributions. Company
rules allow her to contribute a total of 8 percent on her own.
Juliana's 401(k) account balance at her new employer is
$21,000. Her husband Fernando, with whom she shares the same
birthday, is a computer programmer working on contract for
various companies and earns about $90,000 annually. When
Juliana returned from a vacation with her husband, she found
that her father had suffered a serious stroke. Despite undergoing
physical therapy, he is now in a nursing home and likely will be
there the rest of his life. Juliana is hoping that she and Fernando
can retire when they both are age 65.
What do you recommend to Juliana and Fernando on the subject
of retirement and estate planning regarding:
1.How much in Social Security benefits can each expect to
receive?
2.How much do they each need to save for retirement if they
want to spend at a lifestyle of 80 percent of their current living
expenses?
3.In which types of retirement plans might Fernando invest for
retirement?
4.What withdrawal rate might they use to avoid running out of
money during retirement?
5.What three types of actions might they take to go about
transferring their assets by contract to avoid probate?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success
by doing the following related retirement and estate planning:
1.Save continuously within a taxsheltered employer-sponsored
retirement plan at least the amount required to obtain the full

matching contribution from your employer.
2.Accept enough risk in investing to increase the likelihood that
you will have enough money in retirement.
3.Contribute to Roth IRA accounts to supplement your
employer-sponsored plans.
4.Keep your hands off your retirement money. Do not borrow it.
Do not withdraw it. When changing employers, roll over the
funds into the new employer's plan or a rollover IRA account.
5.To ease the transfer of your assets upon your death, learn how
to use contracts to avoid probate court and make a valid will.
Retirement is the time in life when the major sources of income
from earned income (such as salary or wages) changes to
sources like employerbased retirement benefits, private savings
and investments, income from Social Security, and perhaps
income from part-time employment. Retirement often is a
gradual transition from the workforce rather than sudden
cessation. Today, 30 percent of people age 65 to 69 are still
working.
retirementThe time in life when the major sources of income
change from earned income (such as salary or wages) to
employer-based retirement benefits, private savings and
investments, income from Social Security, and perhaps part-
time employment.
Planning for retirement has changed dramatically over the
years. Yesterday's employers provided pensions for a lifetime
that were commonly a reward for 20 or 30 years of working for
one company, but today fewer than one out of five employers
still offer them. Instead, half of today's employers offer
voluntary retirement plans to which employees may or may not
choose to contribute; the other half do not offer a retirement
plan. The biggest mistake people make in planning for
retirement is they spend too much on other things instead of
saving for retirement. Enjoying financial security during 20 or
more years of retirement is not a matter of luck. It takes
planning and action. The wise financial manager's philosophy
should be to save now so you can play later during your golden

years.
But many young people do not make such efforts early enough
in life. Two-thirds of workers age 25 to 34 are not saving at all
for retirement through their employers. The one-third that does
save has not saved much. Sixty percent say they have a balance
of less than $10,000, reports the Employee Benefits Retirement
Institute. A recent survey shows that 34 percent of Americans
report that they will work until they are at least 80 or until they
are too sick or die.
This is a crazy way to live: spending all one's money to pay for
day-to-day consumption expenses instead of saving for
retirement. Such people need to learn how to budget, save, and
invest. They also need to create a financial plan because if they
had a plan, they will save three times more than those without a
plan, thus better managing their financial futures.
Saving and investing 10 percent of your pay starting at age 25
can provide a lump sum of $1,540,000 at age 65, while saving
just 6 percent will provide only $924,000, more than one-third
less. These calculations are based on a salary of $40,000 with 3
percent annual pay increases and investments that earn an 8
percent annual return.
The fact today is that you—and only you—are responsible for
meeting your retirement needs. In addition, the responsibility of
investing funds for retirement and the risk of making poor
investments with these funds have been shifted from the
employer to the employee. And if your employer does not offer
a retirement plan, you can set one up yourself.
While starting a retirement program is important at a young age
so too is the process of estate planning. Estate
planning comprises the specific arrangements you make during
your lifetime for the administration and distribution of your
assets when you die. You need to learn how to transfer assets in
such a way that they go to your desired heirs and avoid
unnecessary probate court procedures. Most of your assets can
be set up to transfer automatically. For the remainder, you need
to prepare a will. Estate planning need not be overly

complicated but you do need to do it. Details on all these topics
are in this chapter.
estate planningThe definite arrangements you make during your
lifetime that are consistent with your wishes for the
administration and distribution of your estate when you die.
17.1 UNDERSTANDING YOUR SOCIAL SECURITY
RETIREMENT INCOME BENEFITS
LEARNING OBJECTIVE 1
Estimate your Social Security retirement income benefit.
The whole retirement and estate planning process must begin
with improving your understanding of Social Security. This is
the program that fully one-half of young workers do not believe
will be around for them when they retire. Don't worry because
it will be! Older people are voters, too, and they (as well as
young people) will push to keep Social Security. In fact, some
politicians are arguing that the benefits should be expanded and
increased.
The Social Security program has become the most successful
and popular domestic government program in U.S. history.
Funding for Social Security benefits comes from a compulsory
payroll tax split equally between employees and employers.
Social Security taxes withheld from wages are called FICA
taxes (named for the Federal Insurance Contributions Act). The
amounts withheld are put into the Social Security trust fund
accounts from which benefits are paid to current program
recipients by the Social Security Administration (SSA).
FICA taxesA 6.2 percent tax paid by both the worker and
employer on the worker's employment income up to the
maximum taxable yearly earnings.
17.1a Your Taxes Support Social Security and Medicare
Benefits
Wage earners pay both FICA and Medicare taxes to the SSA.
The FICA tax is paid on wage income up to the maximum
taxable yearly earnings (MTYE), which comprises the maximum
amount to which the FICA tax is applied. The MTYE figure—
$117,000 for the most recent year—is adjusted annually for

inflation. The FICA tax rate is 12.4 percent, consisting of 6.2
percent paid by employees and 6.2 percent paid by employers
for their workers. Self-employed workers pay a FICA tax rate of
12.4 percent, twice that of wage earners, because they are their
own employers.
maximum taxable yearly earnings (MTYE)The maximum
amount to which the FICA tax is applied.
Wage earners and their employers also each pay a 1.45
percent Medicare tax on all earnings. The MTYE limit does not
apply to the Medicare tax; thus the 1.45 rate applies to all
employment income. Most workers pay 7.65 (6.2 + 1.45)
percent of their earnings to the SSA. For example, a person
earning $50,000 pays a combined FICA and Medicare tax of
$3825 ($50,000 × 0.0765), and a person earning $100,000 pays
$7650 ($100,000 × 0.0765).
Medicare taxA 1.45 percent tax paid by both the worker and
employer on all the worker's employment income.
17.1b It Takes a Minimum of Ten Years to Qualify for Full
Social Security Retirement Benefits
The Social Security program covers nine out of every ten U.S.
employees, although employees of some state governments are
exempt and instead are covered by their state's plan. To qualify
for Social Security retirement, survivors, or disability insurance
benefits for you and your family, you must accumulate
sufficient credits for employment in any work subject to the
FICA taxes. The periods of employment in which you earn
credits need not be consecutive. Military service also provides
credits. You earn Social Security credits for a certain amount of
work covered under Social Security during a calendar year. For
example, workers receive one credit if they earned $1200 (for
the most recent year) during any time during the year. You
receive a maximum of four credits if you earned $4800 (4 ×
$1200) during the year. The dollar figure required for each
credit earned is raised annually to keep pace with inflation.
Social Security creditsAccumulated quarterly credits to qualify
for Social Security benefits obtained by paying FICA taxes.

The number of credits you have earned determines your
eligibility for retirement benefits and for disability or survivors
benefits if you become disabled or die. The SSA recognizes four
statuses of eligibility.
FINANCIAL POWER POINT
Financing Social Security
Based on the Social Security Administration Trustees' best
estimate, program costs are projected to allow 100 percent of
scheduled benefits until 2033. While it is true that the Social
Security system has a long-term deficit, there is zero chance
that the program will be eliminated in its entirety. While many
young people doubt that Social Security will provide them with
benefits, there are solutions to the problem. Simple fixes that
actually will work and are favored by people of both political
parties and all age groups are to increase the wage cap, increase
the payroll tax, and change the benefit formula.
1.Fully InsuredFully insured status requires 40 credits (10 years
of work) and provides the worker and his or her family with
eligibility for benefits under the retirement, survivors, and
disability programs. Once obtained, this status cannot be lost
even if the person never works again. Although it is required to
receive retirement benefits, “fully insured” status does not
imply that the worker will receive the maximum benefits
allowable.
fully insured Social Security statusRequires 40 credits and
provides workers and their families with benefits under the
retirement, survivors, and disability programs; once status is
earned, it cannot be taken away even if the eligible worker
never works again.
2.Currently Insured To achieve currently insured status, six
credits must be earned in the most recent three years. This
status provides for some survivors or disability benefits but no
retirement benefits. To remain eligible for these benefits, a
worker must continue to earn at least six credits every three
years or meet a minimum number of covered years of work
established by the SSA.

3.Transitionally Insured Transitionally insured status applies
only to retired workers who reach the age of 72 without
accumulating 40 credits (ten years). These people are eligible
for very limited retirement benefits.
4.Not Insured Workers younger than age 72 who have fewer
than six credits of work experience are not insured.
17.1c You Can Obtain an Estimate of Your Social Security
Retirement Benefits
The Social Security Administration makes available your Social
Security Estimate that includes a record of your earnings
history, a record of how much you and your various employers
paid in Social Security taxes, and an estimate of the benefits
that you and your family might be eligible to receive now and in
the future. You can request a Social Security Estimate
at www.ssa.gov/estimator/.
Social Security EstimateOnline Information that the Social
Security Administration makes available to all workers, which
includes earnings history, Social Security taxes paid, and an
estimated benefit amount.
The actual dollar amount of your eventual Social Security
retirement benefits will be based on the average of the highest
35 years of earnings during your working years. In these
calculations, your actual earnings are first adjusted, or indexed,
to account for changes in average wages since the year the
earnings were received. The SSA then calculates your average
monthly indexed earnings during the 35 years in which you
earned the most. The agency applies a formula to these earnings
to arrive at your basic retirement benefit (or primary insurance
amount). This is the amount you would receive at your full-
benefit retirement age—currently 67 for those born in 1960 or
later.
basic retirement benefit/ primary insurance amountAmount of
Social Security benefits a worker would receive at his or her
full-benefit retirement age, which is 67 for those born after
1960.
full-benefit retirement ageAge at which a retiree is entitled to

full Social Security benefits; 67 for those born in 1960 or later.
You have three options regarding when to begin receiving
Social Security retirement benefits.
1.Begin Receiving Benefits at Your Full-Benefit Age Once you
have reached your full-benefit retirement age, you are eligible
to receive your basic monthly retirement benefit. You can begin
collecting these benefits even if you continue working full-or
part-time. Your level of employment income will not affect your
level of benefits, although it may affect the income taxes that
you pay on your Social Security benefits and the amount of your
Medicare premiums.
FINANCIAL POWER POINT
Verify Online the Accuracy of Your Social Security Statement
You have only three years to correct any errors in your Social
Security Statement. You should make sure that the SSA's
records are up to date and accurate by checking them online.
Open an account at the Social Security Administration
at www.ssa.gov/myaccount/ and check your Statement.
2.Begin Receiving Reduced Benefits at a Younger Age You can
choose to start receiving retirement benefits as early as age 62,
regardless of your full-benefit retirement age. If you do so,
however, your basic retirement benefit will be permanently
reduced approximately 6 percent for each year you start early.
Thus, if your full-benefit retirement age is 67, your benefits
will be permanently reduced 30 percent (5 years × 6 percent). If
you choose to take the earliest Social Security retirement
benefits, you will be ahead financially if you do not survive to
about age 80. Sixty percent of retirees elect to take their Social
Security benefits early.
People considering early Social Security retirement benefits
need to be aware that their checks will be further reduced if
they have earned income above the annual limit ($15,120 for the
most recent year). The reduction is $1 in benefits for every $2
in earnings. A person entitled to $1000 per month ($12,000 per
year) in early retirement benefits who has an earned income of
$20,000, for example, will be penalized $2440 in benefits on the

income above $15,120 ($20,000 − $15,120 = $4880/2). It is
possible to earn enough to completely eliminate your benefits,
so the decision to take Social Security benefits early requires
careful analysis.*
3. Begin Receiving Larger Benefits at a Later Age You can
delay taking benefits beyond your full-benefit retirement age. In
such a case, your benefit would be permanently increased by as
much as 8 percent per year. Once you reach age 70 the benefit
amount will no longer increase so there is no need to delay
receiving benefits beyond that age. You can continue to work
even after you begin taking these delayed benefits. Again, your
level of employment income will not affect your level of
benefits, but it may affect the income taxes that you pay on your
Social Security benefits and your Medicare premiums.
You can compute your own retirement benefit estimate using a
program that you can download to your computer
from www.ssa.gov/OACT/anypia/index.xhtml. To determine
which option is best for you, you can do the calculations for an
early, on-time, or delayed beginning start date. Also
see kiplinger.socialsecuritysolutions.com to determine the
optimal strategy for claiming benefits.
CONCEPT CHECK 17.1
1. List the key financial planning actions that individuals must
take during their working lives to prepare for retirement.
2. Summarize how workers become qualified for retirement
Social Security benefits.
3. Distinguish between the benefits provided under Social
Security for a worker who is fully insured and a worker who is
currently insured.
4. Explain what happens if you choose to retire earlier than your
full retirement age, which is probably 67.
17.2 HOW TO CALCULATE THE AMOUNT YOU MUST
SAVE FOR RETIREMENT IN TODAY's DOLLARS
Calculate the amount you must save for retirement in today's
dollars.

To plan for a financially successful retirement, you first need to
set a goal. Otherwise, as one of the most quoted figures in
sports, baseball legend Yogi Berra, says, “If you don't know
where you are going, you will end up somewhere else.”
Your retirement savings goal, or retirement nest egg, is the total
amount of accumulated savings and investments needed to
support your desired retirement lifestyle. Financial planners
often say that people need 80 to 100 percent of their pre-
retirement gross income (including Social Security benefits) to
meet their expenses in retirement and maintain their lifestyle.
This amount includes what you have to pay in income taxes.
Retirement savings goal (retirement nest egg)Total amount of
accumulated savings and investments needed to support a
desired retirement lifestyle.
Setting a personally meaningful retirement dollar goal helps
motivate people to take the necessary saving and investing
actions. If you begin to save and invest for retirement early in
life, the compounding effect on money over time will make it
fairly easy for you to reach your retirement savings goal. If you
start late, it will be difficult.
17.2a Projecting Your Annual Retirement Expenses and Income
“How large a retirement nest egg do I need?” To calculate this
amount, you can fill out the Run the Numbers worksheet,
“Estimating Your Retirement Savings Goal in Today's Dollars”
(page 514). Each spouse in a married couple should prepare a
worksheet rather than combine income and savings amounts.
17.2b An Illustration of Retirement Needs
Consider the case of Erik McKartmann, aged 35 and single, the
manager of a weight loss and fitness center in South Park,
Colorado. Erik currently earns $50,000 per year. He has been
contributing $165 per month ($1980 annually) into an
IRA account he set up several years ago before beginning his
current job. Erik hopes to retire at age 62.
DO IT IN CLASS
DID YOU KNOW
Women Should Save More for Retirement than Men

Women save less in their 401(k) accounts than men resulting in
smaller balances at retirement. Women participate in 401(k)
plans at the same rate as men but they save only 6.9 percent
compared to 7.6 percent for men, according to consulting firm
Aon Hewitt. Women, more than men, also often fail to take
advantage of the full matching contribution from their
employers.
More than 20 percent of workers are not saving enough in their
retirement accounts to take advantage of the company match.
Even in the 21st century women still do not earn as much, on
average, as men. Because of their lower incomes and longer
longevity women receive less Social Security income than men
(about $13,100 annually compared with over $17,200 annually
for men). Women reaching age 65 are expected to live, on
average, an additional 21.4 years compared to 19.1 for men;
therefore women should save more for retirement than men.
1. Erik has chosen not to develop a retirement budget at this
time. Instead, he simply multiplied his current salary by 80
percent to arrive at an estimate of the annual income (in current
dollars) needed in retirement of $40,000 ($50,000 × 0.80). This
amount was entered on line 1 of the worksheet. If Erik wants to
increase the amount of dollars to support a higher retirement
lifestyle, he can simply increase the percentage in the
calculation.
2. Erik checked the Social Security Administration to estimate
his benefits in today's dollars. At age 62, he could expect a
monthly benefit of $1100 (in current dollars). Multiplying by 12
gave an expected annual Social Security benefit of $13,200 (in
current dollars), which Erik entered on line 2 of the worksheet.
3. Line 3 of the worksheet, which calls for Erik's expected
pension benefit, is appropriate for defined-benefit plans. After
discussing his expected employer pension with the benefits
counselor at work, Erik found that his anticipated benefit under
the plan would amount to approximately $5800 annually,
assuming that he remained with the company until his
retirement, so he entered that figure on line 3.

4. Erik adds lines 2 and 3 to determine his total estimated
retirement income from Social Security and his employer
pension. The amount on line 4 would be $19,000 ($13,200 +
$5800).
5. Subtracting line 4 from line 1 reveals that Erik would need an
additional income of $21,000 ($40,000 − $19,000) in today's
dollars from savings and investments to meet his annual
retirement income needs.
6. At this point, Erik has considered only his annual needs and
benefits. Because he plans to retire at age 62, Erik will need
income for 20 years based on his life expectancy. (Of course,
Erik could live well into his 80s, which would mean that he
would need to save even more.) Using Appendix A-4 and
assuming a return that is 3 percent above the inflation rate, Erik
finds the multiplier 14.8775 where 3 percent and 20 years
intersect. He then calculates that he needs an additional amount
of $312,427 (14.8775 × $21,000) at retirement. That's a big
number! And it is in current dollars. The number does not
dissuade Erik from saving because he knows he has time and the
magic of compounding on his side.
7. Erik's current savings and investments can be used to offset
the $312,427 he will need for retirement. Erik has zero savings
in his employer's 401(k) account; however, he does have some
money invested in an IRA ($24,000), plus some other
investments ($13,000). These amounts are totaled ($37,000) and
recorded on line 7E.
8. If left untouched, the $37,000 that Erik has built up will
continue to earn interest and dividends until he retires. Because
he has 27 more years until retirement, Erik can use Appendix A-
1 and, assuming a growth rate of 3 percent over 27 years, find
the factor 2.2213 and multiply it by the total amount in line 7.
Erik's $37,000 should have a future value of $82,188 at his
retirement, so he puts this amount on line 8.
9. Subtracting line 8 from line 6 reveals that Erik's retirement
nest egg will need an additional $230,239 ($312,427 − $82,188)
at the time of retirement.

10. Using Appendix A-3 and a growth rate of 3 percent over 27
years, Erik finds a factor of 40.7096. When divided into
$230,239, it reveals that he needs savings and investments of
$5656 per year until retirement.
11. Erik records his current savings and investments of $1980
per year on line 11.
12. Erik subtracts line 11 from line 10 to determine the
additional amount of annual savings that he should set aside in
today's dollars to achieve his retirement goal. His shortfall
totals $3676 per year. By saving an extra $306 each month
($3676 ÷ 12), he can reach his retirement goal established in
step 1.
17.2c Suggestions for Funding Erik's Retirement Goal
Erik needs to continue what he is doing—saving and
investing—plus save a little more so he can enjoy his lifestyle
when his full-time working career ends. Erik should discuss
with his benefits counselor how much he can save and invest via
the company's new 401(k) program.
Erik needs to save more for retirement. He should contribute an
additional $3676 per year, which is only another $306 per
month, into his employer's 401(k) plan—that is, about 7.3
percent of his salary. To create an extra margin of safety he
could save even more of his salary, if the rules of his
employer's retirement plan permit it. His employer might also
make a matching contribution (discussed later) of some or all of
Erik's 401(k) contributions.
Understanding your Social Security and employer-based
retirement benefits is a first step in retirement planning.
DID YOU KNOW
Online Retirement Planning Calculators
Research suggests that those who calculate how much they need
to save often end up having a more financially successful
retirement. In your assumptions, perhaps use a 5 percent long-
term rate of return minus a 3 percent annual inflation rate, and
try more than one calculator:
• AARP (www.aarp.org/work/retirement-

planning/retirement_calculator.xhtml)
• American Savings Education Council's Ballpark Estimate
(www. choosetosave.org/ballpark/)
• CNNMoney.com (www.money.cnn.com/calculator/retirement/r
etirement-need/)
• E*Trade
(www.us.etrade.com/e/t/plan/retirement/quickplan?vanity=quick
plan)
• Fidelity (www. fidelity. com/calculators-tools/retirement-
quick-check)
• The Motley Fool
(www.partners.leadfusion.com/tools/motleyfool/retire02a/tool.f
cs?v=76620)
• MarketWatch.com (www.marketwatch.com/retirement/tools/ret
irement-planning-calculator)
• T. Rowe Price's
(www3.troweprice.com/ric/ricweb/public/ric.do?WTAFeaturedR
esult=retirement%20calculator)
RUN THE NUMBERS
Estimating Your Retirement Savings Goal in Today's Dollars
This worksheet will help you calculate the amount you need to
set aside each year in today's dollars so that you will have
adequate funds for your retirement. The example here assumes
that a single person is now 35 years old, hopes to retire at age
62, has a current income of $50,000, currently saves and invests
about $1980 per year, contributes zero to an employer-
sponsored retirement plan, anticipates needing a retirement
income of $40,000 per year assuming a spending lifestyle at 80
percent of current income ($50,000 × 0.80), and will live an
additional 20 years beyond retirement. Investment returns are
assumed to be 3 percent after inflation—a reasonable but
conservative estimate for a typical portfolio. The financial
needs would differ if the growth rate of the investments were
less than 3 percent. This approach simplifies the calculations
and puts the numbers to estimate retirement needs into today's

dollars. The amount saved must be higher if substantial
inflation occurs.
Example
Your Numbers
1.…
YOU MUST BE KIDDING, RIGHT?
Bharat Persaud's employer gave him a $2000 bonus last year,
and when Bharat was filling out his federal income tax form, he
discovered that $1000 of it moved him from the 15 percent
marginal tax rate to 25 percent. How much additional income
tax will Bharat pay on the $2000?
A. $150
B. $180
C. $250
D. $400
The answer is C. The federal marginal tax rate is applied to
your last dollar of earnings. The first $1000 of Bharat's bonus is
taxed at the marginal tax rate of 15 percent ($150), but the
second $1000 is taxed at 25 percent ($250). Be aware of your
marginal tax rate!
LEARNING OBJECTIVES
After reading this chapter, you should be able to:
Explain the nature of progressive income taxes and the
marginal tax rate.
Differentiate among the eight steps involved in calculating
your federal income taxes.
Use appropriate strategies to avoid overpayment of income
taxes.
WHAT DO YOU RECOMMEND?
Timothy Edgar and Amber Szpanka plan to get married in two
years. Timothy earns $44,000 per year managing a fast-food
restaurant. He also earns about $10,000 per year selling jewelry

that he designs at craft shows held monthly in various nearby
cities. Right after they get married, Timothy plans to go back to
college full time to finish the last year of his undergraduate
degree. Amber earns $58,000 annually working as an
institutional sales representative for an insurance company.
Both Timothy and Amber each contribute $100 per month to
their employer-sponsored 401 (k) retirement accounts. Timothy
has little additional savings, but Amber has accumulated
$18,000 that she wants to use for a down payment on a home.
Amber also owns 300 shares of stock in an oil company that she
inherited six years ago when the price was $90 per share; now
the stock is worth $130 per share. Timothy and Amber live in a
state where the state income tax is 6 percent.
What would you recommend to Timothy and Amber on the
subject of managing income taxes regarding:
1. Using tax credits to help pay for Timothy's college expenses?
2. Determining how much money Amber will realize if she sells
the stocks, assuming she pays federal income taxes at the 25
percent rate?
3. Buying a home?
4. Increasing contributions to their employer-sponsored
retirement plans?
5. Establishing a sideline business for tax purposes for
Timothy's jewelry operation?
YOUR NEXT FIVE YEARS
In the next five years, you can start achieving financial success
by doing the following related to managing income taxes:
1.Sign up for tax-advantaged employee benefits at your
workplace.
2.Contribute to your employer-sponsored 401(k) retirement plan
at least up to the amount of the employer's matching
contribution.
3.Buy a home to reduce income taxes.
4.Prepare your own tax return so you can learn how to reduce

your income tax liability.
5.Maintain good tax records.
Managing your money includes not paying unnecessary sums to
the government in taxes. Learning about tax-saving techniques
will provide you with more money to do with what you want.
“The avoidance of taxes is the only intellectual pursuit that
carries any reward,” wrote economist John Maynard Keynes.
You should pay your income tax liabilities in full, but that's
all—there is no need to pay a dime extra. To achieve this goal,
you need to adopt a perspective designed to eliminate, reduce,
or defer some income taxes. To get started, you should
recognize that you pay personal income taxes only on your .
This amount is determined by subtracting various exclusions,
adjustments, exemptions, and deductions from total income,
with the result being the income upon which the tax is actually
calculated. Details for these calculations are provided later. For
now, simply remember that the main idea in managing income
taxes is to reduce your taxable income as much as possible
while maintaining a high level of total income. The result will
lower your actual tax liability. Then you will have more money
available every year to manage, spend, save, invest, and
donate—activities that are the focus of this whole book.
tax planningSeeking legal ways to reduce, eliminate, or defer
income taxes.
taxable incomeIncome upon which income taxes are levied.
are compulsory charges imposed by a government on its
citizens and their property. The U.S. Internal Revenue Service
(IRS) is the agency charged with the responsibility for
collecting federal income taxes based on the legal provisions in
the Internal Revenue Code.
taxesCompulsory government-imposed charges levied on
citizens and their property.
Explain the nature of progressive income taxes and the marginal

tax rate.
Taxes can be classified as progressive or regressive. The federal
personal income tax is a because the tax rate progressively
increases as a taxpayer's taxable income increases. A higher
income implies a greater ability to pay. As shows, the higher
portions of a taxpayer's taxable income are taxed at increasingly
higher rates under the federal income tax.
progressive taxA tax that progressively increases as a taxpayer's
taxable income increases.
A regressive tax operates in the opposite way. It is a tax
imposed in such a manner that the tax rate stays the same for all
income with the result that lower-income people pay
proportionately more in taxes. An example is the state sales tax,
since a rate of perhaps 7 percent might have to be paid by
everyone regardless of income. One who earns $30,000 and
spends $6,000 on food pays 1.5 percent on food purchases (7%
× $6000 = $420/$30,000 = 1.4%). This compares to another
person who earns $80,000 and spends $10,000 on food, thus
paying less than 1 percent on sales tax on food purchases (7% ×
$10,000 − $700/$80,000 = 0.87%).
Note that the marginal tax brackets are progressive. The first
portion of someone's income is taxed at the rate in the lowest
bracket; the next portion is taxed at the next lowest rate; and the
final portion of income is taxed an even higher rate. Because
our tax system has graduated tax rates, you do not pay the same
tax rate on every dollar subject to tax.
The is illustrated with the seven income-range segments are
taxed at increasing rates as income goes up. The tax rates apply
only to the income within each tax bracket range. Recall
from that your marginal tax rate is the one that is applied to
your last dollar of earnings.
marginal tax bracket (MTB)/ marginal tax rateOne of seven
income-range segments at which income is taxed at increasing
rates. Also known as marginal tax rate.
Depending on their income, taxpayers fit into one of the

brackets (as shown in ) and, accordingly, pay at one of those
marginal tax rates: 10 percent, 15 percent, 25 percent, 28
percent, 33 percent, 35 percent, or 39.6 percent. In addition,
each year the dollar amounts for the taxable income brackets are
adjusted for inflation to reduce the effects of inflation in a
process called . This keeps taxpayers from being forced to pay
more taxes as they receive raises.
indexingYearly adjustments to tax brackets that reduce
inflation's effects on tax brackets.
Table 4-1The Progressive Nature of the Federal Income Tax
Single Individuals If taxable income is:
Marginal Tax Rate
Up to $9,075
10%
Over $9,075 but not over $36,900
15%
25%
28%
33%
35%
Over $406,750
39.6%
Your marginal tax rate is perhaps the single most important
concept in personal finance. It tells you the portion of any extra
taxable earnings—from a raise, investment income, or money
from a second job—you must pay in income taxes. It also
measures the tax reduction benefits of a tax-deductible expense
that allows you to reduce your taxable income.
Consider this example of how the marginal tax rate might apply.
Victoria Bassett is from Syracuse, New York (see ). Because of
the progressive provisions in the tax laws, part of her $60,000
income ($10,150 [$6200 1 $3950]) is not taxed, the next $9075

is taxed at 10 percent, the next $27,825 is taxed at 15 percent,
and the remaining $12,950 of Victoria's $60,000 income is
taxed at 25 percent. Thus, Victoria is in the 25 percent marginal
tax bracket because the last dollar that she earned is taxed at
that level. Her tax liability is $8,318.75 based on her $60,000 in
income.
DO IT IN CLASS
Figure 4-1How Your Income Is Really Taxed (Example:
Victoria Bassett with a $60,000 Gross Income, and she is in the
25% marginal tax bracket)
The United States Is Not a High-Tax Country
The tax burden in the United States is the lowest among
industrialized countries in the world. Compared to countries
that are members of the Organization for Economic Cooperation
and Development (OECD), combined taxes in the United States
are 33.4 percent. Seventeen countries have higher rates
including Denmark (47.6%), Belgium (43.5%), France (42%),
Australia (42.0%), Hungary (37.9%), Germany (36.1%), and
United Kingdom (34.9%). The United States is far from a high-
tax country. In fact, federal taxes on middle-income Americans
are near historic lows.
The mathematics shown in is based either on the IRS tax
table (used for tax returns with incomes up to $100,000) or
the tax-rate schedules (used for tax returns with incomes above
$100,000). All information cited in this chapter is for income
tax returns filed in 2015 for the previous year's income, unless
otherwise noted.
The marginal tax rate can affect many financial decisions that
you make. Consider, for example, what happens if you are in the
25 percent marginal tax bracket and you make a $100 tax-
deductible contribution to a charity. The charity receives the
$100, and you deduct the $100 from your taxable income. This
deduction results in a $25 reduction in your federal income tax
($100 × 0.25). In effect, you give only $75 (not $100) because

the government, in effect, “gives” $25 to the charity.
The describes a person's total marginal tax rate on income after
including federal, state, and local income taxes as well as Social
Security and Medicare taxes. To determine your effective
marginal tax rate on income, add all of these other taxes to your
federal marginal tax rate.
effective marginal tax rateThe total marginal rate reflects all
taxes on a person's income, including federal, state, and local
income taxes as well as Social Security and Medicare taxes.
For example, a single taxpayer earning a taxable income
between $36,900 and $89,350 will pay federal income taxes at a
marginal rate of 25 percent, a combined Social Security
6.2% and Medicare tax rate of 1.45% that totals 7.65 percent, a
state income tax rate of 6 percent, and a city income tax rate of
2 percent. These taxes result in an effective marginal tax rate of
40 percent (25 + 7.65 + 6 + 2 = 40.65, about 40). Most
employed taxpayers pay an effective marginal tax rate of 40
percent.
How to Determine Your Marginal Tax Rate
You can determine your marginal tax rate by following this
example.
1.Start with a single person who has a taxable income of
$39,600, and looking at the illustrated tax table ( on page 119),
he/she finds his tax on that amount of income ($5763).
2.Add $100 to that income for a total of $39,700, and find the
tax on that amount ($5788).
3.Calculate the difference between the two tax amounts ($5788–
$5763). The extra $25 in taxes from a $100 increase in income
reflects a federal marginal tax rate of 25 percent.
CONCEPT CHECK 4.1
1. Distinguish between a progressive and a regressive tax.
2. What is a marginal tax bracket, and how does it affect
taxpayers?
3. Explain why some taxpayers have a marginal tax rate as high

as 40 percent.
Differentiate among the eight steps involved in calculating your
federal income taxes.
There are eight basic steps in calculating federal income taxes:
1. Determine your total income.
2. Determine and report your gross income after subtracting
exclusions.
3. Subtract adjustments to income.
4. Subtract either the IRS's standard deduction amount for your
tax status or your itemized deductions.
5. Subtract the value of your personal exemptions.
6. Determine your preliminary tax liability.
7. Subtract tax credits for which you qualify.
8. Calculate the balance due the IRS or the amount of your
refund.
graphically depicts these eight steps in the overall process of
federal income tax calculation. The idea is to reduce your
income so that you pay the smallest amount possible in income
taxes. You do so by reducing total income by removing
nontaxable income and then subtracting exclusions, deductions,
exemptions, and tax credits, as indicated in the unshaded boxes
in .
Practically everything you receive in return for your work or
services and any profit from the sale of assets is considered
income, whether the compensation is paid in cash, property, or
services. Listing these earnings will reveal your —compensation
from all sources— and much of it, but not all, will be subject to
income taxes.
total incomeCompensation from all sources.
Figure 4-2The Steps in Calculating Your Income Taxes
For most people, is income derived from active participation in
a trade or business, including wages, salary, tips, commissions,
and bonuses. It is reported to them annually on a Form W-2,

Wage and Tax Statement. Employers must provide W-2
information (see ) by January 31 of the year following the
earned income. If you also receive income from interest or
dividends or other sources, you will receive a Form 1099-INT
or 1099-DIV, providing appropriate details. The IRS also
receives the information on their Form 1099s, which it uses to
verify the income you report.
earned incomeCompensation for performing personal services.
Income to Include The following types of income are included
when you report your income to the IRS:
• Wages and salaries
• Commissions
• Bonuses
• Professional fees earned
• Hobby income
• Tips earned
• Severance pay
• Medical insurance rebates because of Patient Protection and
Affordable Care Act
• Fair value of anything received in a barter arrangement
• Forgiven or cancelled debt (unless borrower is insolvent or
bankrupt)
• Alimony received
• Scholarship and fellowship income spent on room, board, and
other living expenses
• Grants and the value of tuition reductions that pay for
teaching or other services
• Annuity and pension income received
Figure 4-3W-2 Tax Form
• Withdrawals and disbursements from retirement accounts,
such as an individual retirement account (IRA) or 401(k)
retirement plan (discussed in , “Retirement and Estate
Planning”)
• Military retirement income
• Social Security income (a portion is taxed above certain
income thresholds)

• Disability payments received if you did not pay the premiums
• Damage payments from personal injury lawsuits (punitive
damages only)
• Value of personal use of employer-provided car
• State and local income tax refunds (only if the taxpayer
itemized deductions during the previous year)
• Employee productivity awards
• Awards for artistic, scientific, and charitable achievements
unless assigned to a charity
• Prizes, contest winnings, and rewards
• Gambling and lottery winnings
• All kinds of illegal income
• Fees for serving as a juror or election worker
• Unemployment benefits
• Net rental income
• Royalties
• Investment, business, and farm profits
• Interest income (this includes credit union dividends)
• Dividend income (including mutual fund capital gains
distributions even though they are reinvested)
Capital Gains and Losses Are Taxed at Special Low RatesAn
asset is property owned by a taxpayer for personal use or as an
investment that has monetary value. Examples of assets include
stocks, mutual funds, bonds, land, art, gems, stamps, coins,
vehicles, and homes. The net income received from the sale of
an asset above the costs incurred to purchase and sell it is a .
capital gainThe net income received from the sale of an asset
above the costs incurred to purchase and sell it.
A capital loss results when the sale of an asset brings less
income than the costs of purchasing and selling the asset.
Capital gains and losses on investments must be reported on
your tax return. Capital gains from the sale or exchange of
property held for personal use, such as on a vehicle or vacation
home, must be reported as income, but losses on such property
are not deductible. There is no tax liability on any capital gain
until the stock, bond, mutual fund, real estate, or other

investment is sold.
A short-term gain(or loss) occurs when you sell an asset that
you have owned for one year or less; it is taxed at the same
rates as ordinary income, which is all income other than capital
gains. A ) occurs when you sell an asset that you have owned
for more than one year (at least a year and a day), and it is
taxed at special low rates. The long-term capital gains rate is
zero for taxpayers in the 15 percent marginal tax bracket. The
rate is 15 percent for those in the 25, 28, 33, and 35 percent
brackets. It is 20 percent for those in the 39.6 percent tax
bracket.
long-term gain / lossA profit or loss on the sale of an asset that
has been held for more than a year.
Capital losses may be used first to offset capital gains on your
tax return. If there are no capital gains, or if the capital losses
are larger than the capital gains, you can deduct the capital loss
against your other income, but only up to a limit of $3000 in
one year. If your net capital loss is more than $3000, the excess
may be carried forward to be deducted on the next tax year's
form, again up to an annual $3000 maximum.
Dividends and Interest Are Treated Differently Owners of
stocks in a corporation may receive dividends quarterly. These
payments to shareholders are made out of current or
accumulated earnings of a corporation and are taxable.
Shareholders are annually sent tax forms 1099-DIV that
explains what amounts must be reported to the IRS when taxes
are filed. Dividends from most domestic corporations and many
foreign companies are subject to the same favorable rates as
capital gains. Dividends in the form of shares of stock are
generally not taxable.
So called dividends are actually “interest” reported to taxpayers
on Form 1099-INT when received from credit unions,
cooperative banks, savings and loan associations, building and
loan associations, and mutual savings banks. They are subject to
ordinary income taxes. Dividends received from a life insurance
policy are actually a refund of your premium and are not taxed.

consists of all income (both earned and unearned) received in
the form of money, goods, services, and property before
exclusions and deductions that a taxpayer is required to report
to the IRS. To determine gross income, you need to determine
which kinds of income are not subject to federal taxation and,
therefore, need not be reported as part of gross income. These
amounts are called .
gross incomeAll income in the form of money, goods, services,
and/or property.
exclusionsIncome not subject to federal taxation.
DO IT IN CLASS
Income to Exclude The more common exclusions (some are
subject to limits) are as follows:
• Gifts
• Inherited money or property
• Income from a carpool
• Income from items sold at a garage sale for a sum less than
what you paid
• Cash rebates on purchases of new cars and other products
• Tuition reduction, if not received as compensation for
teaching or service
• Federal income tax refunds
• State and local income tax refunds for a year in which you
claimed the standard deduction
• Scholarship and fellowship income spent on course-required
tuition, fees, books, supplies, and equipment (degree candidates
only)
• Withdrawals from state-sponsored Section 529 plans (prepaid
tuition and savings) used for education
• Prizes and awards made primarily to recognize artistic, civic,
charitable, educational, and similar achievements
• Return of money loaned
• Withdrawals from medical savings accounts used for qualified
expenses
• Earnings accumulating within annuities, cash-value life

insurance policies, Series EE bonds, and qualified retirement
accounts
• Interest income received on tax-exempt government bonds
issued by states, counties, cities, and districts
• Life insurance benefits received
• Combat zone pay for military personnel
• Welfare, black lung, workers' compensation, and veterans'
benefits
• Value of food stamps
• First $500,000 ($250,000 if single) gain on the sale of a
principal residence
• Disability insurance benefits if you paid the insurance
premiums
• Social Security benefits (except for high-income taxpayers)
• Rental income from a vacation home if not rented for more
than 14 days
• First $5000 of death benefits paid by an employer to a
worker's beneficiary
• Travel and mileage expenses reimbursed by an employer (if
not previously deducted by the taxpayer)
• Employer-provided per diem allowance covering only meals
and incidentals
• Amounts paid by employers for premiums for medical
insurance, workers' compensation, and health and long-term
care insurance
• Moving expense reimbursements received from an employer
(if not previously deducted by the taxpayer)
• Employer-provided payments of $130 per month for transit
passes and $250 a month for parking
• Value of premiums for first $50,000 worth of group-term life
insurance provided by an employer
• Employer payments (up to $5000) for dependent care
assistance (for children and parents)
• Benefits from employers that are impractical to tax because
they are so modest, such as occasional supper money and taxi
fares for overtime work, company parties, holiday gifts (not

cash), and occasional theater or sporting events
• Employer contributions for employee expenses for education
(up to $5250 annually)
• Employee contributions to flexible spending accounts
• Reimbursements from flexible spending accounts
• Interest received on Series EE and Series I bonds used for
college tuition and fees
• Child support payments received
• Property settlement in a divorce
• Compensatory damages in physical injury cases
In the process of determining your taxable income, you
make (or adjustments). These are allowable subtractions from
gross income, and include items such as moving expenses to a
new job location (including college graduates who move to take
their first job as long as it is at least 50 miles from their old
residence); higher-education expenses for tuition and fees (up to
$4000); student loan interest for higher education, including
that paid by a parent ($2500 maximum); military reservists'
travel expenses (for more than 100 miles); contributions to
qualified personal retirement accounts (IRA and 401[k]
accounts) and health savings accounts (up to $3300 for singles
and $6550 for family coverage); alimony payments; interest
penalties for early withdrawal of savings certificates of
deposit;; and certain expenses of self-employed people (such as
health insurance premiums). Adjustments are subtracted from
gross income to determine . Subtracting adjustments to income
from gross income results in a subtotal.
adjustments to incomeAllowable subtractions from gross
income.
adjusted gross income (AGI)Gross income less any exclusions
and adjustments.
To illustrate the value of adjustments to income, consider that
Jose Martinez from Columbia, South Carolina, has a gross
income of $50,000. This past year he spent $1200 moving to
Nashville, Tennessee, for a new job, and he also paid $2000 in

higher-education expenses working on a graduate degree. The
$3200 in adjustments reduces his gross income to $46,800, and
therefore Jose saves $800 in income taxes because he is in the
25 percent marginal tax bracket ($3200 × 0.25).
Adjustments are called because they may be subtracted from
gross income even if itemized deductions are not claimed.
Adjustments may be taken regardless of whether or not the
taxpayer itemizes deductions or takes the standard deduction
amount (discussed next).
above-the-line deductionsAdjustments subtracted from gross
income whether taxpayer itemizes deductions or not.
A Sideline Business Can Reduce Your Income Taxes
A sideline business can open many doors to tax deductions. You
should never spend money simply for a tax deduction; however,
if you're going to spend the money anyway, you should do
everything you can to make it tax deductible.
By having your own business, every dollar you spend
attempting to make a profit becomes tax deductible. While no
deduction is allowed for personal expenses, you can deduct
expenses for auto, travel, office, office equipment (e.g., desk,
chair, computer), contributions to self-funded retirement
accounts, health insurance premiums, educational expenses,
entertainment, business gifts, and more. You can deduct salaries
of employees, even if they are your children, other relatives, or
friends.
The business does not have to be your primary employment. If
you lose money in the business, you can deduct those losses
from your other income. The IRS says that you must do what a
“reasonable business person” would do to make a profit. If you
do not meet that test, the IRS will classify the operation as a
hobby, require you to report the income, and disallow all
deductions.
James J. Williams
Hudson Valley Community College, Troy, New York

Table 4-2 Tax Rate Schedules
Single Individuals If taxable income is over—
But not over—
The tax is—
$ 0
$ 9,075
10% of the taxable income
$ 9,075
$ 36,900
$907.50 plus 15% of the amount over $9,075
$ 36,900
$ 89,350
$5,081.25 plus 25% of the amount over $36,900
$ 89,350
$186,350
$186,350
$405,100
$405,100
$406,750
Over $406,750
No limit
$118,118.75 plus 39.6% of the amount over $406,750
Married Couples Filing Jointly If taxable income is over—
But not over—
The tax is—
$ 0
$ 18,150
10% of the taxable income
$ 18,150
$ 73,800
$1815 plus 15% of the amount over $18,150
$ 73,800
$148,850

$10,162 plus 25% of the amount over $73,800
$148,850
$226,850
$226,850
$450,100
$405,100
$457,600
$457,600
No limit
$127,962.50 plus 39.6% of the amount over $457,600
DO IT IN CLASS
Taxpayers may reduce income further by the amount of the
standard deduction. Or they can list their , which are specific
items that may be used to directly reduce income that may
reduce the amount of your income subject to tax. You can
itemize or use the standard deduction, and you want to use the
larger of the two. The is a fixed amount that all taxpayers
(except some dependents) who do not itemize deductions
regardless of their actual expenses may subtract from their
adjusted gross income. In effect, it consists of the government's
permissible estimate of any likely tax-deductible expenses these
taxpayers might have. Two out of three taxpayers take the
standard deduction.
itemized deductionsTax-deductible expenses.
standard deductionFixed amount that all taxpayers may subtract
from their adjusted gross income if they do not itemize their
deductions.
The standard deduction amount depends on , a description of
your marital status on the last day of the year. A return can be
filed with a status of a single person, a married person (filing
separately or jointly), a head of household, or qualifying widow

or widower. Certain tax benefits apply to each filing status. For
example, the standard deduction amounts are …

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