Chapter Using Tax Concepts for Planning Copyright ©2004 Pearson Education, Inc All rights reserved Chapter Objectives • Explain how to determine your tax filing status • Explain how to calculate your gross income • Demonstrate how deductions and exemptions can be used Copyright ©2004 Pearson Education, Inc All rights reserved 4-2 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-3 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 Copyright ©2004 Pearson you pay and affect your wealth Education, Inc All therefore rights reserved 4-4 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 •Copyright This chapter focuses on the federal ©2004 Pearson Education, Inc.tax All rights income process reserved 4-5 Financial Planning Online: Internal Revenue Service • Go to: http://www.irs.gov • This Web site provides information about tax rates, guidelines, and deadlines Copyright ©2004 Pearson Education, Inc All rights reserved 4-6 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 ©2004 provides payments to health care Copyright Pearson Education, Inc Allin rights providers the case of illness reserved 4-7 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 themselves — 15.3% Copyright ©2004taxes Pearson Education, Inc All rights reserved 4-8 Background on Taxes • Personal income taxes: taxes imposed on income earned – If you earn income you must file a Form 1040 to determine your tax liability – Filing deadline is April 15 of each year Copyright ©2004 Pearson Education, Inc All rights reserved 4-9 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©2004 for individual Copyright Pearson taxpayers Education, Inc All rights reserved 4-10 Deductions and Exemptions • Expenses for transportation to and from care • Accident and health insurance premiums – Charitable gifts – Other expenses • Casualties or thefts • Job-related expenses • Compare the total allowable itemized deductions to the standard deduction Copyright ©2004 Pearson and use the larger Education, Inc All rights reserved 4-21 Deductions and Exemptions • 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 Copyright ©2004 Pearson taxable income Education, Inc All rights reserved 4-22 Taxable Income and Taxes • Taxable income: adjusted gross income less deductions and exemptions • Taxes – Depends on taxable income and filing status – Progressive: a term used to characterize a Copyright ©2004 Pearson tax system where a positive relationship Education, Inc All rights exists between an individual’s income level reserved 4-23 and tax rate Taxable Income and Taxes – 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 ©2004 Pearson Education, Inc All rights reserved 4-24 Taxable Income and Taxes Copyright ©2004 Pearson Education, Inc AllTax rights Exhibit 4.6: Individual Rates for the Year 2000 (Panels A and B) reserved 4-25 Taxable Income and Taxes Copyright ©2004 Pearson Exhibit 4.6: Individual Rates for the Year 2000 (Panels C and D) Education, Inc Tax All rights reserved 4-26 Taxable Income and Taxes – 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-27 Taxable Income and Taxes – 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-28 Taxable Income and Taxes – 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-29 Taxable Income and Taxes – 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-30 Focus on Ethics: Reducing Your Taxes • Resist the temptation to under report income • The IRS usually uncovers such behavior • There are many legal ways to reduce taxes •Copyright File on©2004 timePearson Education, Inc All rights reserved 4-31 Financial Planning Online: 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-32 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? Copyright ©2004 Pearson Education, Inc All rights reserved 4-33 Integrating the Key Concepts Copyright ©2004 Pearson Education, Inc All rights reserved 4-34 Integrating the Key Concepts • Part 1: Financial Planning Tools – In Chapter we learned about personal financial statements – In Chapter we learned about time value of money – In Chapter we learned about tax planning • Part 2: Liquidity Management • Part 3: Financing • Part 4: Protecting Your Wealth • Part 5: Investing ©2004 Pearson •Copyright Part 6: Retirement and Estate Planning Education, Inc All rights reserved 4-35 [...]... rights reserved 4-24 Taxable Income and Taxes Copyright ©2004 Pearson Education, Inc AllTax rights Exhibit 4.6: Individual Rates for the Year 2000 (Panels A and B) reserved 4-25 Taxable Income and Taxes Copyright ©2004 Pearson Exhibit 4.6: Individual Rates for the Year 2000 (Panels C and D) Education, Inc Tax All rights reserved 4-26 Taxable Income and Taxes – Marginal tax bracket: the tax rate imposed... taxes •Copyright File on©2004 timePearson Education, Inc All rights reserved 4-31 Financial Planning Online: 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-32 How Tax Planning. .. any additional (marginal) income earned • Tax credits: amounts that offset taxes; the full amount of the tax credit is subtracted from taxes owed Copyright ©2004 Pearson Education, Inc All rights reserved 4-27 Taxable Income and Taxes – 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) •... characterize a Copyright ©2004 Pearson tax system where a positive relationship Education, Inc All rights exists between an individual’s income level reserved 4-23 and tax rate Taxable Income and Taxes – 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... Pearson Education, Inc All rights reserved 4-29 Taxable Income and Taxes – 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-30 Focus on Ethics: Reducing Your Taxes • Resist the temptation to under report... 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 Copyright ©2004 Pearson taxable income Education, Inc All rights reserved 4-22 Taxable Income and Taxes • Taxable income: adjusted gross income less deductions and exemptions • Taxes – Depends on taxable... from employers in that state reserved 4-18 Financial Planning Online: 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 Copyright ©2004 Pearson Education, Inc All rights reserved 4-19 Deductions and Exemptions – Real estate tax: a tax imposed on a home or other real estate in the county... refund to low-income workers who owe no income tax Copyright ©2004 Pearson Education, Inc All rights reserved 4-28 Taxable Income and Taxes – 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... 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? Copyright ©2004 Pearson Education, Inc All rights reserved 4-33 Integrating the Key Concepts Copyright ©2004 Pearson Education, Inc All rights reserved 4-34 Integrating the Key Concepts • Part 1: Financial Planning Tools... Exhibit 4.4: Standard Deduction Amounts for the 2000 Tax Year Copyright ©2004 Pearson Education, Inc All rights reserved 4-17 Deductions and Exemptions • 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 Copyright ©2004states ... Taxable Income and Taxes – 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. .. amount of the tax credit is subtracted from taxes owed Copyright ©2004 Pearson Education, Inc All rights reserved 4-27 Taxable Income and Taxes – Child tax credit: a tax credit allowed for each child... Education, Inc Tax All rights reserved 4-26 Taxable Income and Taxes – Marginal tax bracket: the tax rate imposed on any additional (marginal) income earned • Tax credits: amounts that offset taxes;