Mastering Tax Planning Strategies for Financial Success

1. Chapter 4 Tax Planning and Strategies

2. Learning Objectives • Identify and understand the major federal income tax features that affect all taxpayers • Describe other taxes that you must pay • Understand taxable income and how taxes are determined

3. Learning Objectives • Choose the tax form that’s right for you, file and survive an audit if necessary • Calculate your income taxes • Minimize your taxes

4. Introduction • Most financial decisions are affected by taxes. • We all need to understand how taxes are imposed. • What strategies are used to reduce taxes and what role does tax planning have in personal financial planning?

5. The Federal IncomeTax Structure • Progressive or graduated tax (example: Federal Income Tax) • The more you earn, the more you pay both as a percentage and as a total amount • Tax brackets – Income ranges in which the same marginal tax rates apply, such as the 15% bracket or the 28% bracket

6. The Federal Income Tax Structure • Personal exemption – a reduction in your income before you calculate taxes. You get one for each member of your family • Deductions – Expenses that reduce taxable income. You choose the one that is greater: • Itemized deductions – calculated using Schedule A. You specify exactly how much you spent in each category • Standard deduction – A set deduction allowed by the IRS regardless of your exact expenses

7. The Federal IncomeTax Structure • Adjusted Gross Income (AGI) - taxable income from all sources minus specific adjustments, but before deducting exemptions or standard or itemized deductions • Taxable income is the income on which you actually owe taxes: • AGI minus exemptions minus deductions

8. Table 4.1 Tax Rates and Brackets

9. Marginal Versus Average Tax Rates • Average Tax Rate —the average amount of your total income taken away in taxes • Marginal Tax Rate (or marginal tax bracket)—the percentage of the last dollar earned that goes to pay taxes • Tax-deferred —income on which the payment of taxes is postponed • Example: retirement accounts such as 401(k)s and IRAs

10. Marginal Vs. Average Tax Rates • Assume you are in the 15% tax bracket and you earn $37,000. Does that mean you pay 15% of your taxable income in taxes? • The last dollar earned is taxed at 15% • This is the marginal rate • Earlier income is taxed at a lower rate

11. Figure 4.1 Historical Top Marginal Income Tax Rate

12. Effective Marginal Tax Rate • The rate you pay when all income taxes are combined (federal, state, city, Social Security taxes, etc.) • It is greater than the marginal tax rate on federal income taxes because other taxes are added in as well

13. Capital Gains and Dividend Income • Capital asset — an asset you own • Capital gain — what you make if you sell a capital asset for a profit • Capital loss — what you lose when you sell a capital asset for a loss • Capital gains tax — tax you pay on your capital gains (usually stocks, bonds, and other securities) • A capital loss can offset capital gains up to a certain limit, resulting in lower taxes

14. Capital Gains and Dividend Income • Dividends are payments to stockholders from the profits of a business • There is a lower tax rate on both long-term capital gains and on dividends, 15% • The long-term capital gains tax is on profits from the sale of stocks and bonds, not gains from sale of collectibles • Capital gains are not claimed or taxed until the asset is sold

15. Long-Term Capital Gains Example • You buy 100 shares of XYZ Corporation at $25/share for a total of $2500 • You sell the stock five years later at $40/share • You made a profit of $15/share or $1500. • This profit is taxed at a lower income tax rate (15%) than ordinary income • The stock must be held for at least one year • Profits on stocks held less than one year are short-term capital gains, and are taxed at the ordinary income tax rate

16. Long-Term CapitalGains on Homes • There is a capital gains tax for homeowners on sale of their homes (but not if they use the money to buy a new home) • Exemption: up to $500,000 for couples filing jointly ($250,000) filing single on the profit on the sale of principal residence • Must have been occupied for 2 of the 5 years prior to the sale • It is available once every 2 years

17. Filing Status • Single (not married on the last day of the year) • Married Filing Jointly and Surviving Spouses (married on the last day of the year, and spouses combine incomes) • Married Filing Separately (married, but each spouse files on his/her own tax return) • Head of Household (not married but have at least one dependent; lower rate)

18. Cost of Living Increases in Tax Brackets, Exemptions, and Deductions • Tax brackets change annually to reflect changes in the cost of living (inflation) • Standard deductions and personal exemptions are increased to reflect inflation • Bracket Creep —tax increase caused by inflation increasing wages

19. Paying Your Income Taxes • Most people are on a pay-as-you-go basis (withholding from wages) • If no withholding is taken, quarterly estimated taxes must be sent to the IRS • Withholdings are also taken from stock dividends, retirement funds, and prize winnings

20. Paying Your Income Taxes • You have some control over how much is deducted for taxes from your wages. • Withholdings are determined by your income level and information on W-4 form • W-4 form (usually filled out with new employer)—marital status, number of exemptions claimed

21. Other Taxes • Income-Based Taxes: • Social Security and Medicare or FICA • State and local income taxes • Non-income-based taxes • Excise taxes (on liquor, cigarettes, travel, jewelry) • Property taxes (on real estate and vehicles) • Gift and estate taxes (no estate taxes on estates worth less than $5 million)

22. Must you file a tax return? Most people do Depends on income, filing status, age, whether you can be claimed as dependent Dependent —a person who relies on the taxpayer for financial support Even if you don’t have to pay, file taxes to get any refund that is available to you Calculating Your Taxes

23. Step 1: Determining Gross or Total Income • Sum of all taxable income from all sources • Active income —income from wages or a business • Portfolio or investment income —income from securities, such as dividends • Passive income —income from activities in which the taxpayer does not actively participate (rentals and royalties)

24. Step 2: Calculating Adjusted Gross Income (AGI) • AGI = Gross income minus allowable adjustments • Adjustments include: • Tax-deductible contributions • Retirement contributions

25. Step 3: Subtracting Deductions • Take the higher of the standard deduction or itemized deductions, but not both • Itemized deductions — exact list of deductible expenses: some medical expenses, tax expenses, mortgage interest payments, charitable contributions, etc. • Standard deduction — government’s best estimate of what the average person would deduct if itemizing

26. Figure 4.2 Standard Deduction Amounts

27. Step 4: Claiming Your Exemptions • Exemption — reduction of taxable income for each person supported by the income on a tax return • An exemption includes yourself, spouse or dependents • There is one exemption per person • A dependent must have a qualifying family relationship

28. Step 5: Calculating Your Taxable Income, and From That, Calculating Your Base Income Tax • Taxable income —AGI minus deductions and exemptions • Base income tax —comes from the Income Tax Tables • Use tax rate schedules for taxable income greater than $100,000 • Alternative minimum tax (AMT) ensures that wealthy pay enough taxes

29. Figure 4.3Calculating Your Taxes

30. Figure 4.4 Determining Your Taxes Using the 2011 Tax Tables

31. Step 6: Subtract Your Credits andDetermine Your Taxes Due • Tax credits reduce actual taxes paid, dollar for dollar • Tax credits phase out as AGI increases. Examples: • Child Credit (up to $1000 per child) • Education Credits (for undergraduates and lifetime learning) • Child and dependent care credit • Earned income credit (for low incomes, may result in negative taxes paid) • Adoption credit

32. Tax Credits • Especially for low-income families, these tax credits may result in negative taxes paid • These families not only don’t pay taxes, but they get an additional refund from the government

33. Table 4.2 Comparison of Education Credits

34. Other Filing Considerations • Choosing the correct form between 1040EZ, 1040A, or 1040 • Depends on dependents, income, and whether you itemize or not

35. Checklist 4.1 & Checklist 4.2

36. Table 4.3 Common Schedules Used with Form 1040

37. Other Filing Considerations • File by Mail or Electronic Filing (e-file) • Benefits of e-filing include: • Faster refunds with direct deposit • More accurate returns • Quick electronic confirmation • Delete the paperwork—nothing to mail • Both Federal and state e-filing are available

38. Filing Late and Amended Returns • Filing Late – if you file after April 15, you can request an extension for an additional six months to file the return. • You do need to enclose a check for estimated taxes you owe • You may be charged interest and/or a late penalty • Amended Returns – if you make a mistake on your return, but you can’t go back farther than three years

39. Being Audited • Audit —an examination of tax return by IRS • Randomly selected—higher odds if itemized deductions are 44% or more of income. • You may be asked to send additional information in mail or IRS face-to-face interview • Reexamine areas in question, get all data and records, appeal audit outcome if necessary

40. Help in Preparing Taxes • Handle taxes by yourself (tax programs are very helpful) • Use IRS publications, IRS hotlines, & self-help publications and computer programs • Hire a tax specialist

41. Model Taxpayers: The Taylors File Their 2011 Return • Chuck and Dianne Taylor • Using the various steps in calculating taxes for Form 1040

42. Figure 4.5 2011 Federal Income Tax Return for the Taylors, Using Form 1040

43. Figure 4.5 2011 Federal Income Tax Return for the Taylors, Using Form 1040 (cont.)

44. Figure 4.6 Schedule A from the Taylors’ 2011 Federal Income Tax Return

45. Tax Strategies to Lower Your Taxes • Tax planning must be done ahead of time to minimize unnecessary tax payments • Tax strategies should supplement a solid investment strategy • There are five general strategies to lower your taxes

46. 1. Maximize Deductions—Reduce Taxable Income to its Minimum • Use tax-deferred retirement programs: • 401(k)s and IRAs. You don’t pay taxes on the contributions you make now or on interest in these programs until retirement • Use your home as a tax shelter • mortgage interest is deductible and you are sheltered from capital gains taxes • Shifting and bunching deductions—try to shift deductions to years when you will be itemizing

47. 2. Look to Capital Gains and Dividend Income • Long-term capital gains and dividend income are taxed at a maximum of 15%, which is much less than the marginal rate for most taxpayers • You don’t have to claim capital gains until the asset is sold

48. 3. Shift Income to Family Members in Lower Tax Brackets • Can be complex and involve lawyers and establishment of trusts • Simpler way is to make gifts—recipients do not pay taxes on gifts either • Allowed $13,000 per person in total gifts per year • Gift some of your estate while still alive

49. 4. Receive Tax-Exempt Income • Interest from state and local government debt such as bonds is tax-exempt • The higher your marginal tax bracket, the more beneficial tax-free income is.

50. 5. Defer Taxes to the Future • Tax-deferred retirement plans allow you to defer tax payments to the future • Roth IRAs are contributions on after-tax income. None of the interest or increase in value is EVER taxed again • Capital gains taxes are postponed until you sell the asset