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SOLUTIONS MANUAL CHAPTER Managing Income Taxes ANSWERS TO CHAPTER CONCEPT CHECKS LO4.1 A progressive tax is one that takes a higher percentage of income as income goes up A regressive tax does the opposite The federal income tax is a progressive tax State sales taxes are often regressive Your marginal tax bracket reflects the tax rate applied to your highest dollar of income Since any additional income you earn becomes your highest dollar of income, it is taxed at that marginal rate Adding the typical middle-income federal income tax bracket rate of 25% (remember, this is higher than one’s average rate) to the Social Security rate of 7.65% and a state income tax rate of 6% and a potential local income tax rate of 2%, you have a possible combined marginal tax rate of 40.65% LO4.2 Five examples of income that must be included in gross income are (1) employment income from wages, salaries, commissions, and tips; (2) gambling winnings; (3) alimony received; (4) interest and dividends from investments (unless in a qualified retirement account); and (5) capital gains from investments sold Short-term capital gains are taxed at your normal marginal tax rate Long-term capital gains are taxed at 0% if you are in the 10% or 15% income-tax brackets and 15% if you are in one of the next four higher tax brackets Those in the 39.6 percent tax bracket pay a 20 percent long-term capital gains rate Five examples of exclusions from gross income are (1) interest income received on most municipal bonds; (2) scholarship and fellowship income spent on course-required tuition, fees, books, and supplies; (3) child support payments received; (4) gifts and inheritances; and (5) life insurance death benefits Alimony paid, contributions to a traditional IRA, and certain college education expenses are examples of adjustments to income A standard deduction is an amount established by the IRS that may be subtracted from your adjusted gross income when arriving at your taxable income The standard deduction reflects an estimate of typical tax-deductible expenses a taxpayer might have Taxpayers who itemize their deductions and come up with a higher figure may use that figure instead of the standard deduction An exemption is an allowable subtraction from adjusted gross income to arrive at your taxable income that reflects the number of people covered by your tax return In a recent year, each exemption was worth $4050 A husband and wife Copyright © 2018 Cengage Learning All rights reserved Chapter 4: Managing Income Taxes 23 with two children would have four exemptions, for example Both the standard deduction and the exemption amounts are adjusted upwards each year to reflect inflation Form 1040X can be used to file these late returns Doing so before being contacted by the IRS may reduce the penalties you might pay Tax credits include the American Opportunity and Lifetime Learning credits for education expenses, a child and dependent care credit, a retirement savings contribution credit for certain lower-income taxpayers, an adoption credit, and the earned income credit LO4.3 One type of tax-sheltered investment return is the earnings accrued each year within a qualified retirement plan These returns not have to be reported each year as they accrue For some plans (plans with “Roth” in the name), these returns are forever tax-free if withdrawn during retirement A second form of tax-sheltered investment returns are the returns from qualified 529 college savings plans They are sheltered in a similar way as retirement account returns are sheltered, and if the funds are used for qualifying educational expenses, they can be withdrawn tax-free The basic premise is to have portions of your income be used in a pretax mechanism and thus not be reported to the IRS Flexible spending accounts, defined contribution retirement plans, and premium-only plans are three examples of these pretax mechanisms The basic (traditional) individual retirement account (IRA) allows you to take any contributions made in a given year as an adjustment to income when you file your tax return As a result, your taxable income and resulting tax owed is reduced Then as the investments made with these contributions earn investment returns over the years, you can defer the taxes on these returns until you withdraw the funds during retirement at which time taxes are owed on the withdrawals Roth IRAs not have the deductible contributions feature They have the tax-deferred feature for the investment returns off the deposited funds The big attraction of the Roth IRA is that withdrawals of any funds from the account during retirement are forever tax-free One strategy is called accelerating deductions This involves making deductible expenditures in such a way that you prepay them in a particular year in order to reach the threshold where it is advantageous to itemize your deductions Another technique is to buy municipal bonds as an investment since the interest off these bonds is free from the federal income tax A third technique is to postpone income into a future year where your marginal tax rate might be lower WHAT DO YOU RECOMMEND NOW? Tax regulations permit money spent on Ace’s tuition and related college expenses to be claimed for a credit of up to $2000 under the regulations of the Lifetime Learning credit Florence’s long-term capital gains tax rate will be 15 percent if she sells the stock At $130 a share, she will realize a profit of $12,000 [($130 – $90) × 300], and after taxes she will net $10,200 [$12,000 – ($12,000 × 0.15)] Copyright © 2018 Cengage All rights reserved 24 Chapter 4: Managing Income Taxes When Florence and Ace buy a home, they can record the interest and property taxes as itemized tax deductions along with many previously nondeductible miscellaneous deductions, plus later on when they sell the home, they can reap the enormous benefit of the capital gains exclusion Neither Florence nor Ace is currently saving much for retirement For every additional $100 of savings, up to their employers’ plan limits (perhaps $5000 or $8000), each would save $25 in income taxes By contributing so few dollars now, they also are probably giving up matching contributions from their employers Therefore, each should check into his or her employer’s retirement plan rules and begin saving for retirement in earnest This will not only save taxes now but will better prepare them for retirement Ace could deduct all his business expenses to offset income from his sideline jewelry business If his business lost money, all or a portion of the losses may be used to offset his salary income LET’S TALK ABOUT IT Student answers will vary Most students will not be in the high tax brackets affected by such changes and, thus, may feel that reduced progressivity is not such a bad thing Some, however, may feel that it is fair that higher income people will pay less in taxes It is correct to assume that the withholding by an employer is enough to cover the taxes owed However, in most such cases there is more than enough deducted and those excess funds can be refunded But this can occur only if the person files a tax return If the employer did not withhold enough, the taxpayer must make up the difference by April 15 If the shortfall is more than 10% of the total amount owed, there will also be a penalty This can be avoided by paying estimated taxes throughout the year so that the combination of the estimated taxes and employer withholdings are sufficient Opinions will vary on this question Some students will see higher-wealth people getting a break Others will see that capital gains accrue over many years, and it may be unfair to tax them as if they all occurred during the year in question They may also see the positive motivation to invest that results from the lower capital gains rates The pro is obvious No taxes will be paid The cons are numerous First, this is an illegal act—tax evasion Second, by not reporting this income, one fails to add to their Social Security earnings history This will mean lower Social Security benefits in the future And third, eventually the IRS may catch up with the person and significant penalties and interest will be owed on top of the taxes themselves Answers will vary among students Many have hobbies that could conceivably be turned into a business The American Opportunity credit and the Lifetime Learning credit are ones for which many college students and/or their parents might qualify Students who are or become parents soon after graduation will qualify for the child credit Answers will vary among students Most commonly cited will likely be reducing their taxable income by enrolling in pretax programs such as flexible spending arrangements and health savings accounts, making tax-sheltered investment through an employer-based Copyright © 2018 Cengage Learning All rights reserved Chapter 4: Managing Income Taxes 25 defined contribution plan or an individual retirement account, setting up a tax-sheltered savings plan for their children’s education, and buying a home so they can take advantage of many different tax deductions Student answers will vary based on their perceptions of the various credits There will likely be some discussion as to why some credits are refundable and the whole idea of having any kind of refundable credit Student answers will vary about which tax reduction strategies they might use in the future Most will probably choose reducing taxes via a tax-sheltered retirement plan Also common will be flexible spending accounts DO THE MATH $50,050 – $6,300 (standard deduction) – $4,050 (single exemption) = $39,700 Using Table 4.3, the tax on $39,700 is $5,703 (a) 15%, (b) 25%, (c) 25%, (d) 28% This is a potential “Do It In Class” exercise related to page 129 in the text (a) $14,099, (b) $10,199, (c) $3718, (d) $9879 This is a potential “Do It In Class” exercise related to page 125 in the text Jared Goff’s tax liability: Gross income is $162,000 = $160,000 + $2000 Adjustments to income are $5,000 for the IRA contribution Adjusted gross income is $157,000 = $162,000 - $5,000 Jared can take $8,000 in itemized deductions as they exceed the standard deduction Jared can take one exemption for $4,050 Jared’s taxable income is $144,950 = $157,000 - $8,000 - $4,050 Jared’s tax liability is $33,622.75 = $18,558.75 + [0.28 x ($144,950 – 91,150)] This is a potential “Do It In Class” exercise related to page 125 in the text Carson Wentz’s tax liability: Gross income is $146,000 = $144,000 + $2000 Adjustments to income are $6,000 for the retirement plan contribution Adjusted gross income is $140,000 = $146,000 - $6,000 Carson can take $10,000 in itemized deductions as they exceed the standard deduction Carson can take one exemption for $4,050 Carson’s taxable income is $125,950 = $140,000 - $10,000 - $4,050 Copyright © 2018 Cengage All rights reserved 26 Chapter 4: Managing Income Taxes Carson’s tax liability is $28,302.75 = $18,558.75 + [0.28 x ($125,950 – 91,150)] This is a potential “Do It In Class” exercise related to page 117 in the text Victoria begins with a $60,000 gross income from which she can subtract adjustments, deductions and personal exemptions She has no adjustments but after subtracting her standard deduction and personal exemption, she has a taxable income of $49,650 meaning that $10,350 is not taxed The first $9275 of her remaining taxable income is taxed at 10 percent The next $28,375 is taxed at 15 percent This leaves $12,000 of income to be taxed at 25 percent Thus, she paid $8,183.75 in taxes on a gross income of $60,000 for an average tax rate of 13.64 percent ($8,183.75/$60,000) with a marginal tax rate of 25 percent FINANCIAL PLANNING CASES CASE 1: The Johnsons Calculate Their Income Taxes a The Johnsons’ income is $73,000 for Harry plus $94,000 in salary for Belinda and $3400 in interest, for a total reportable gross income of $ $170,400 b The Johnson’s AGI is $164,400 ($170,400 - $3000 - $3000) c The Johnsons’ joint return entitles them to two exemptions totaling $8100 d The Johnsons’ tax status is that of a married couple filing jointly They are entitled to a $12,600 standard deduction e Since they have $46,800 in itemized deductions, the Johnsons should take the itemized deduction of $46,800 This leaves a taxable income of $109,500 ($164,400 – $8,100 – $46,800) Using Table 4.2 they calculated a tax liability of $23,696.75 f Since they had $24,000 in federal taxes withheld, the Johnsons’ refund will be $303.25 g The Johnsons’ marginal tax rate is 28 percent h The Johnsons could reduce their tax liability next year by depositing more money in qualified retirement contribution plans, making charitable contributions, deducting their state and local income taxes, and participating in employer-sponsored programs such as premium conversions and flexible spending arrangements CASE 2: This is a potential “Do It In Class” exercise related to page 125 in the text Victor and Maria Reduce Their Income Tax Liability c Hernandez’s tax liability: Gross income is $138,650 = $85,000 + $52,000 + $400 + $250 + $1,000 Adjustments to income are $5,500 for the IRA contribution Copyright © 2018 Cengage Learning All rights reserved Chapter 4: Managing Income Taxes 27 Adjusted gross income is $133,150 = $138,650 - $5,500 Victor and Maria can take $13,400 ($4,600 + $6,300 + $2,500) in itemized deductions as they exceed the standard deduction Victor and Maria can take four exemptions for $16,200 ($4050 x 4) Their taxable income is $103,550 = $133,150 - $13,400 - $16,200 Victor and Maria’s tax liability is $17,430 = $10,367.50 + [0.25 x ($103,550 – 75,300)] d Other strategies that the Hernandezes could try that would reduce their tax liability include increasing their contributions to qualified retirement plans; participating in employer-sponsored programs such as premium conversions and flexible spending arrangements; increasing their charitable contributions; deducting certain medical and dental expenses not covered by insurance, in excess of 10 percent of their AGI; deducting taxes on personal property; deducting any local, and foreign income taxes; deducting qualified job expenses and miscellaneous deductions, in excess of percent of their AGI; taking any tax credits for which they may qualify (American Opportunity credit, child tax credit, etc.); and taking advantage of tax-sheltered investments such as municipal bonds CASE 3: Julia Price Thinks About Reducing Her Income Taxes While Julia has ruled out buying a home to reduce income taxes she may want to revisit her thinking when the real estate have hit bottom in her community because there will be some excellent prices at that time Opening a sideline business should give her lots of new deductions against her business To succeed in reducing income taxes she should keep excellent business records Stretching out a job-hunting trip is a legitimate deduction at least once a year Getting a master’s degree is excellent and Julia should review the tax rules to make certain her schooling expenses will be deductible In addition to her retirement plan at work, contributing to a Roth IRA is a good idea even though it does not reduce income taxes CASE 4: A New Family Calculates Income and Tax Liability e Kate and Richard’s income that must be included as total income for the IRS is the $90,000 for Richard’s salary, $60,000 for Kate’s royalties, $140 interest on savings, and $4380 alimony Kate and Richard’s total reportable gross income is $154,520 f Accounting for their $5600 contribution to a qualified pension plan, their adjusted gross income is $148,920 g They can claim four exemptions, one for each of themselves and one each for Kate’s children The exemption is $4050 per person for a total of $16,200 h Assuming they will file jointly, their standard deduction is $12,600 i The Beckett-Castle family has itemized deductions of $13,100 They should take the higher itemized deduction instead of the standard deduction of $12,600 The larger itemized deduction reduces their taxable income more than the smaller standard deduction Copyright © 2018 Cengage All rights reserved 28 Chapter 4: Managing Income Taxes j The Beckett-Castle’s gross income is $154,520 and adjusted gross income (AGI) is $148,920 The AGI minus exemptions, $16,200, and the itemized deduction, $13,100, yields a taxable income of $119,620 k Using Table 4.2 yields a tax liability of $21,447.50 = $10,367.50 + [.025 x ($119,620 - $75,300)] on a taxable income of $119,620 l If Richard’s employers withheld $25,000 from his paychecks for income taxes and their tax liability is $21,447.50, they will receive a refund of $3,552.50 This is a potential “Do It In Class” exercise related to page 140 in the text CASE 5: Taxable versus Tax-Exempt Bonds The after-tax yield on each of Paxton’s investments is reduced by 30% from its taxable yield As a result, the ABC Bond pays 4.13% [5.9% x (1 - 30)], the DEF Bond pays 3.85% [5.5% % x (1 -.30)], the GHI Bond pays 4.06% [5.8% x (1 - 30)] and the JKL Bond pays 3.78% [5.4% x (1 - 30)] This is a potential “Do It In Class” exercise related to page 122 in the text CASE 6: Taxable Versus Nontaxable Income Brian’s earnings of $75,000 Brian’s $10,000 bonus Morgan’s commissions of $70,000 Child support of $800 per month Brian’s alimony income of $600 per month Brian’s $6000 retirement contribution Morgan’s inherited car worth $13,000 Morgan’s $1500 gift to her aunt’s church The $5000 gift from Brian’s mother taxable income taxable income taxable income exclusion taxable income Adjustment to income exclusion itemized deduction exclusion ACTION INVOLVEMENT PROJECTS Students should provide a brief summary of the question they posed to the IRS spokesperson and the response given by the spokesperson Students should provide a brief summary of their findings as well as a statement indicating what type of reform the student might prefer Students should provide a written summary of their findings in regards to who in America pays federal income taxes Students should provide a brief summary of their findings on the USA Today article as well as a summary of any additional Web reports they found on the same topic Response should be a brief summary of their findings and his/her impressions of the Copyright © 2018 Cengage Learning All rights reserved Chapter 4: Managing Income Taxes results Students’ responses should be a brief summary of their findings Copyright © 2018 Cengage All rights reserved 29 ... $73,000 for Harry plus $94,000 in salary for Belinda and $3400 in interest, for a total reportable gross income of $ $170,400 b The Johnson? ??s AGI is $164,400 ($170,400 - $3000 - $3000) c The Johnsons’... Income and Tax Liability e Kate and Richard’s income that must be included as total income for the IRS is the $90,000 for Richard’s salary, $60,000 for Kate’s royalties, $140 interest on savings, and. .. four exemptions, one for each of themselves and one each for Kate’s children The exemption is $4050 per person for a total of $16,200 h Assuming they will file jointly, their standard deduction is