Personal Finance SIXTH EDITION Chapter Using Tax Concepts for Planning* Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Chapter Objective (2 of 2) 4.5 Explain how to determine your taxable income, tax liability, and refund or additional taxes owed 4.6 Explain how tax planning fits within your financial plan Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (2 of 10) • 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (3 of 10) • Federal tax system is administered by the Internal Revenue Service (IRS) • Taxes are paid in several ways – At the time of a transaction – Through payroll withholding – By making estimated quarterly payments • Tax year for federal income tax ends on Dec 31 with taxes filed by April 15 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (4 of 10) • Tax Law Changes – Economic Growth and Tax Relief Reconciliation Act of 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (5 of 10) – Jobs and Growth Tax Relief Act of 2003: an act that 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (6 of 10) – Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010: Legislation that extended many of the previous tax law provisions through the year 2012 – American Taxpayers Relief Act of 2012: Permanently set in place many provisions from the 2010 legislation Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (7 of 10) – 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Taxable Income and Taxes (1 of 5) • Taxable income: adjusted gross income less deductions and exemptions • Calculating Taxes – Dependent upon taxable income and filing status – Progressive tax—a tax system where a positive relationship exists between an individual’s income level and tax rate Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Exhibit 4.6 Tax Rate Schedules for 2015 (1 of 4) EXHIBIT 4.6 Tax Rate Schedules for 2015 Tax Rate–Single Taxpayers – 2015 Taxable income: Over— $ But not over— $ 9,225 Tax $ +% 0.00 10 On amount over— $ 9,225 37,450 922.50 15 9,225 37,450 90,750 5,156.25 25 37,450 90,750 189,300 18,481.25 28 90,750 189,300 411,500 46,075.25 33 189,300 411,500 413,200 119,401.25 35 411,500 413,200 119,996.25 39.6 413,200 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Exhibit 4.6 Tax Rate Schedules for 2015 (2 of 4) EXHIBIT 4.6 Tax Rate Schedules for 2015 Tax Rates–Married Individuals Filing Jointly and Surviving Spouses – 2015 Taxable income: Over— $ But not over— $ 18,450 Tax $ +% 0.00 10 On amount over— $ 18,450 74,900 1,845.00 15 18,450 74,900 151,200 10,312.50 25 74,900 151,200 230,450 29,387.50 28 151,200 230,450 411,500 51,577.50 33 230,450 411,500 464,850 111,324.00 35 411,500 464,850 129,996.50 39.6 464,850 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Exhibit 4.6 Tax Rate Schedules for 2015 (3 of 4) EXHIBIT 4.6 Tax Rate Schedules for 2015 Tax Rates–Married Individuals Filing Separately – 2015 Taxable income: Over— $ But not over— $ 9,225 Tax $ +% 0.00 10 On amount over— $ 9,225 37,450 922.50 15 9,225 37,450 75,600 5,156.25 25 37,450 75,600 115,225 14,693.75 28 75,600 115,225 205,750 25,788.75 33 115,225 205,750 232,425 55,662.00 35 205,750 232,425 64,989.25 39.6 232,425 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Exhibit 4.6 Tax Rate Schedules for 2015 (4 of 4) EXHIBIT 4.6 Tax Rate Schedules for 2015 Tax Rates – Head of household – 2015 Taxable income: Over— $ But not over— $ 13,150 Tax $ +% 0.00 10 On amount over— $ 13,150 50,200 1,315.00 15 13,150 50,200 129,600 6,872.50 25 50,200 129,600 209,850 26,722.50 28 129,600 209,850 411,500 49,192.50 33 209,850 411,500 439,000 115,737.00 35 411,500 439,000 125,362.00 39.6 439,000 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Taxable Income and Taxes (2 of 5) – 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)] Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Taxable Income and Taxes (3 of 5) • Tax credits: specific amounts used to directly reduce tax liability – Child tax credit: a tax credit allowed for each child in a household Currently $1,000 Available as a refund to low-income workers who owe no income tax In 2017 the credit will not be allowed to exceed the taxpayer’s liability Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Taxable Income and Taxes (4 of 5) – College expense credit: a tax credit allowed to those who contribute toward their dependents’ college expenses – Coverdell Savings Accounts: tax-free accounts that can be used for a variety of school expenses – 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Taxable Income and Taxes (5 of 5) – 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Financial Planning Online • 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Tax Planning Fits Within Your Financial Plan (1 of 5) • 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? – Should you increase/decrease the amount of your withholding – What records should you keep? Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Tax Planning Fits Within Your Financial Plan (2 of 5) EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan GOALS FOR TAX PLANNING Reduce taxable income (thereby reducing taxes paid) to the extent allowable by the IRS 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Tax Planning Fits Within Your Financial Plan (3 of 5) EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan Long-Term Tax Plan: Reduce Taxes by: Comment 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Tax Planning Fits Within Your Financial Plan (4 of 5) EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan 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 at $200 Category Gross Income Current Situation Long-Term Plan $38,000 $38,000 $0 $5,000 $38,000 $33,000 – Deductions $6,300 $6,800 – Exemptions $4,000 $4,000 $27,700 $22,200 $3,693.75 $2,868.75 – IRA contribution = Adjusted gross income = Taxable income Tax liability (based on applying tax rates to the taxable income) 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved How Tax Planning Fits Within Your Financial Plan (5 of 5) EXHIBIT 4.7 Application of Tax Concepts to Stephanie Spratt’s Financial Plan 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 taxdeductible 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 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved ... Reserved Background on Taxes (10 of 10) • Personal income taxes: taxes imposed on income earned – If you earn income you must file a Form 1040 , 1040 A or 1040 EZ to determine your tax liability – Filing... Background on Taxes (2 of 10) • 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... payments • Tax year for federal income tax ends on Dec 31 with taxes filed by April 15 Copyright © 2017, 2014, 2011 Pearson Education, Inc All Rights Reserved Background on Taxes (4 of 10) • Tax Law