Pesonal finance 6th madura chapter 04 using tax concepts for planning

Chapter Objective 1 of 24.1 Provide a background on taxes 4.2 Explain how to determine your tax filing status 4.3 Demonstrate how to calculate your gross income 4.4 Show how deduction

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Chapter Objective (1 of 2)

4.1 Provide a background on taxes

4.2 Explain how to determine your tax filing status

4.3 Demonstrate how to calculate your gross

income

4.4 Show how deductions and exemptions can be used

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Background on Taxes (1 of 10)

• Taxes are an integral part of our economy

• They are paid on earned income, consumer

purchases, wealth transfers and capital assets

• Special taxes are levied on things like alcohol,

cigarettes and gasoline

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• Corporations pay income tax on profits

• Homeowners pay property taxes

• Taxes are used to pay for government services

and programs

• Most individuals pay taxes at federal, state and

local levels

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• Federal tax system is administered by the Internal

Revenue Service (IRS)

• Taxes are paid in several ways

– At the time of a transaction

• Tax year for federal income tax ends on Dec 31

with taxes filed by April 15

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• Tax Law Changes

2001: tax cut package designed to provide short-term economic stimulus through tax relief for taxpayers

 Provisions scheduled to phased in between 2001 and 2011 when the law was scheduled to expire

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accelerated much of the tax relief resulting from the

2001 Tax Relief Act

 Individual rates lowered 2-3%

 Child tax credit increased to $1,000

 Standard deduction increased for married taxpayers

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and Job Creation Act of 2010: Legislation that extended many of the previous tax law provisions through the

year 2012

set in place many provisions from the 2010 legislation

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– Affordable Care Act of 2010: Legislation requiring

everyone must obtain health insurance and report medical coverage status on their tax return

 If proof of health insurance is not provided a penalty will be assessed

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• Social Security and Medicare Taxes

wages

to fund the Social Security System and Medicare

covers people over age 65 and provides payments to health care providers in the case of illness

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• Social Security and Medicare Taxes

from your wages

 Social Security taxes equal 6.2% of your salary up to a maximum level of $118,500 as of 2015

 Medicare taxes are 1.45 % of your earned income

taxes themselves—15.3%

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• Personal income taxes: taxes imposed on income

earned

or 1040EZ to determine your tax liability

– Filing deadline is April 15 of each year

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Financial Planning Online

• Go to www.irs.gov/

• This Web site provides information about tax

rates, guidelines, and deadlines

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Filing Status

• Taxpayers must specify a filing status for their tax

return because different rates are associated with each status.

– Married filing jointly

– Married filing separately

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Exhibit 4.1 Form 1040 (page 1)*

*2014 IRS forms are displayed in this chapter because 2015 forms were not available at the time of main text publication 2015 IRS forms can be

obtained online from irs.gov

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Exhibit 4.1 Form 1040 (page 2)*

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Gross Income (1 of 5)

• Gross income: all reportable income from any

source, including salary, interest income, dividend income, and capital gains received during the tax year

contributions to an employee sponsored retirement account

loans to other individuals

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dividends paid on stocks or mutual funds

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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– 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

 The tax rate on a long-term capital gain is lower than the tax rate on ordinary income

 The tax rate that applies depends on your tax bracket but ranges between 0% and 20%

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• Determining gross income

including salary, interest income, dividend income, and capital gains received during the tax year

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Exhibit 4.2 Schedule B of Form 1040*

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Exhibit 4.3 Schedule D of Form 1040 (Page 1)*

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Exhibit 4.3 Schedule D of Form 1040 (Page 2)*

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• Determining gross income

income, interest income, dividend income, and capital gains

• Adjusted gross income: adjusts gross income for

contributions to IRAs, alimony payments, interest paid on student loans, and other special

circumstances

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Deductions and Exemptions (1 of 6)

• Standard deduction: a fixed amount that can be

deducted from adjusted gross income to

determine taxable income

– Affected by filing status and age

inflation

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EXHIBIT 4.4 Standard Deduction Amounts for the 2015 Tax Year

Married filing jointly and surviving spouses $12,600

Head of household 9,250

Single individuals 6,300

Married, filing separately 6,300

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• Itemized deductions: specific expenses that can

be deducted to reduce taxable income

primarily interest on mortgages

states on people who receive income from employers

in that state

 Local income taxes also deductible when itemizing

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estate in the county where the property is located

10.0% of adjusted gross income may also be itemized

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 Theft losses, job expenses if substantial

 Total deductible expenses to decide whether to itemize or use the standard deduction

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Exhibit 4.5 Schedule A of Form 1040 (Page 1)*

obtained online from irs.gov.

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• Go to www.turbotax.com

• Use the tools on this Web site to estimate your tax

liability for the year and tax refund if applicable

– You will need to input income, filing status, exemptions

and deductions to obtain the estimates

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• Exemptions

– Personal exemption: an amount that can be deducted for each person who is supported by the income

reported on a tax return

and each dependent child

income

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Taxable Income and Taxes (1 of 5)

• Taxable income: adjusted gross income less

deductions and exemptions

• Calculating Taxes

relationship exists between an individual’s income level and tax rate

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Exhibit 4.6 Tax Rate Schedules for 2015

(1 of 4)

EXHIBIT 4.6 Tax Rate Schedules for 2015

Tax Rate–Single Taxpayers – 2015

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(2 of 4)

Tax Rates–Married Individuals Filing Jointly and Surviving Spouses – 2015

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(3 of 4)

Tax Rates–Married Individuals Filing Separately – 2015

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(4 of 4)

Tax Rates – Head of household – 2015

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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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• Tax credits: specific amounts used to directly

reduce tax liability

– Child tax credit: a tax credit allowed for each child in a

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– College expense credit: a tax credit allowed to those

who contribute toward their dependents’ college expenses

be used for a variety of school expenses

 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 credit used to reduce tax liability for low-income taxpayers

– Other tax credits are also available, for example for

child care and adoptions

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• Go to turbotax.intuit.com/tax-tools/

• This Web site provides an estimate of your tax

liability for the year and the tax refund that you may receive, based on your income, filing status, exemptions and deductions.

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How Tax Planning Fits Within Your

• The key tax planning decisions for building your

financial plan are:

withholding

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EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan

GOALS FOR TAX PLANNING

1 Reduce taxable income (thereby reducing taxes paid) to the extent allowable by the IRS.

2 Reduce taxes paid by deferring income.

ANALYSIS

Present Situation:

Gross Income = $38,000

Federal Income Taxes = $3,693.75

Taxes (excluding FICA) as a Percentage of Income = 10%

Reduce Taxes by: Comment

Increasing deductions? The only qualified deduction I had was a charitable contribution of $200, so

this is not an option for me this year.

Reducing gross income? I did not contribute any portion of my income to an individual retirement

account or a qualified retirement plan.

Total tax savings? $0 per year

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Long-Term Tax Plan:

Increasing deductions? If I purchase a home, the interest expense on my mortgage loan, as

well as the real estate taxes, will help boost my itemized deductions These deductions will likely be higher than the standard deduction to which I would be entitled In addition, my sales taxes can be counted toward my itemized deductions.

Reducing gross income? I can also contribute to an IRA or to my employer’s qualified retirement

plan If I can afford to contribute $5,000 of my salary to either the IRA

or the qualified plan, I will reduce my gross income and defer taxes on that portion of my income.

Tax savings (computed below) $877.50

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To compute my estimated tax savings, I will compare the taxes paid under my current situation to what I would pay if I bought a home and paid $6,000 in mortgage interest and real estate taxes and contribute

$5,000 to my IRA My estimated tax deduction will be $600 and my charitable contributions will remain

Tax liability (based on applying

tax rates to the taxable income) $3,693.75 $2,868.75

Approximate Total Tax Savings = $825.00 per year *

*Actual tax savings will change each year as the mortgage interest declines, as changes occur in other itemized deductions, and as the standard deduction increases.

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DECISIONS

Decisions Regarding Tax Savings for This Year:

So far I have only taken advantage of one tax reduction strategy.

Decisions Regarding Tax Savings in the Future:

I can improve my cash flows over time by taking advantage of tax deductions If I buy a home, the

interest

that I would pay on the mortgage loan, as well as the real estate taxes I would be assessed, is

tax-deductible The purchase of a home would likely increase my monthly cash outflows, but I would benefit from deducting the interest payments and real estate taxes as itemized deductions, thereby reducing my taxable income

As my income increases, my tax bracket may increase I need to maximize my potential tax savings to limit the taxes I will pay I should contribute the maximum allowable amount to my retirement plan

(without compromising my cash budget) so that I can take full advantage of the related tax savings Also, I hope to buy a home in the future The interest I will pay on a mortgage loan for this home will be high, but I will enjoy tax savings, while also building equity in my home.

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