Using tax concepts for planning

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Chapter 4

Using Tax

Concepts for

Planning

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• 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

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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

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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

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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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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

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

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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

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Exhibit 4.4: Standard Deduction Amounts for the 2000 Tax Year

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• 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

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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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– 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

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• Expenses for transportation to and from care

• Accident and health insurance premiums

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• 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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Education, Inc All rights

Taxable Income and Taxes

• Taxable income: adjusted gross income

less deductions and exemptions

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– 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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– 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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– 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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– 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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– 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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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

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