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Chapter 4

Chapter 4. Tax Planning and Strategies. How It All Began. In 1913, the 16th Amendment gave Congress the right to impose the first income tax Initial tax rates ranged from 1 to 8%. Importance of Tax Planning. Taxes are your largest annual expense

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Chapter 4

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  1. Chapter 4 Tax Planning and Strategies

  2. How It All Began • In 1913, the 16th Amendment gave Congress the right to impose the first income tax • Initial tax rates ranged from 1 to 8%

  3. Importance of Tax Planning • Taxes are your largest annual expense • The average American works more than 4 months just to pay his/hers taxes

  4. Income Tax Structure • Income tax -- progressive tax meaning that the more you earn the more you pay • Tax brackets -- income ranges for which the same marginal tax rate applies • Marginal tax rate -- percentage of the last dollar that you earned that will go toward federal income taxes

  5. Income Tax Structure (cont’d) • Average tax rate -- average amount of every dollar you earned that was paid for federal income taxes • Effective marginal tax rate -- average amount of every dollar you earned that paid for all local, state, and federal income taxes

  6. Capital Gains Taxes and the Taxpayer Relief Act of 1997 • Capital gains tax -- can be postponed until you sell an asset for a profit • Short-term capital gains -- gains made from assets held less than 12 months • Long-term capital gains -- gains made from assets held for 12 months or longer

  7. Tax Rates Associated With Capital Gains • These rates are dependent on how long the asset is held as well as the marginal tax bracket of the owner. • Short-term rate – 28% • Long-term rate – 20%, unless you’re in the 15% tax bracket and then it is 10%

  8. Tax Rates Associated With Capital Gains After 2000 • Applies to assets purchased in or after 2001and held for 5 years • Long-term rate of 18%, unless you’re in the 15% tax bracket and then it is 8%

  9. What Does This Mean For You? • Avoid frequent trading • Buy low-turnover, “tax managed” mutual funds • Buy individual stocks and make your own mutual fund

  10. Capital Gains Taxes On Homes • Gains up to $500,000 for couples and $250,000 for individuals exempt from taxes • Home must be your principal residence • Must have lived there 2 of the last 5 years • No need to “rollover gain” as before the Taxpayer Relief Act of 1997

  11. Filing Status Classifications • Single • Married filing jointly • Married filing separately • Head of household

  12. Cost of Living Increases in the Tax Brackets • The tax brackets change annually to insure that no one pays more income tax just because earnings increased with inflation. • Bracket creep -- a tax liability increase caused by inflation. • Example -- the income minimum for the 28% tax bracket for joint filers increased from $42,350 to $43,050 in 1999.

  13. Paying Your Income Taxes • Withholdings -- tax payment from each paycheck, determined on the basis if income and W-4 form • Quarterly estimated payments • Payments with the tax return (the dreaded April 15th) • Withholdings from stock, retirement funds, and prize or gambling winnings

  14. Social Security or FICA • Social Security -- a mandatory insurance program administered by the federal government that provides support in the event of death, disability, health problems, or retirement. • Tax rate of 6.20% of gross salary • Social Security cap, adjusted annually for inflation, was $72,600 in 1999. Income over this amount is not taxed.

  15. Social Security or FICA (cont’d) • Medicare -- a health care insurance program for elderly and disabled. • Tax rate of 1.45% of gross salary, with no annual cap. • Total FICA tax rate -- 15.3% (12.4% Social Security + 2.9% Medicare). • You are only responsible for half of the tax unless you’re self-employed.

  16. State and Local Income Taxes • Most states impose an income tax; however, some, like Texas, do not. • Local income taxes are uncommon; but some larger cities, for example, New York City, impose such a tax.

  17. Other Non-Income-Based Taxes That You Face • Excise “sin taxes” and state sales taxes -- imposed when goods are purchased • Real estate and property taxes -- imposed annually or semi-annually on assets owned • Gift and estate taxes -- imposed when assets are transferred from one owner to another

  18. Calculating Your Taxes • Who has to file an income tax return? • Determining gross or total income • Calculating adjusted gross income (AGI) • Subtracting deductions • Claiming your exemptions • Calculating your base income tax • Determining your credits • Determining your final tax liability

  19. Who Has to File an Income Tax Return? • Everyone who earns more than $14,400 must file an income tax return. • Some people who earn less, depending on age, filing status, and dependency status must file a return. • People who have more than $700 of unearned income must file. • Note: All thresholds are for 1999 and are adjusted annually for inflation.

  20. Sources of Taxable Income • Wages, salaries, and tips • Capital gains, dividends, and interest • Alimony • Pension funds and IRA distributions • Business and farm income • Rental and royalty income • Social Security and unemployment benefits

  21. Sources of Tax-Exempt Income • Roth IRA earnings • State and local municipal bond interest • Gifts and inheritances • Child support payments • Federal income tax refunds • Veterans’ and welfare benefits

  22. Subtracting Adjustments to Calculate AGI • Alimony payments • Selected moving expenses • Selected IRA and other retirement contributions • 50% for Social Security and Medicare (self-employed only) • Penalties for early withdrawal • Student loan interest, with limitations

  23. Subtracting Deductions from AGI • Itemized deductions (Normally, you must first own a home.) • Standard deductions

  24. IRS Limits on Itemized Deductions • Medical and dental expenses -- must exceed 7.5% of AGI • Selected tax expenses • Home mortgage and investment interest payments • Gifts to charity -- Keep good records, but must have receipt if the gift is more than $250

  25. IRS Limits on Itemized Deductions (cont’d) • Casualty and theft loss -- first $100 of loss is excluded, and remaining losses are deductible only to the extent they exceed 10% of AGI. • Miscellaneous deductibles -- must exceed 2% of AGI. • Percentage of itemized deductions lost for filers above a certain income level.

  26. Standard Deductions • Single -- $4,300 (1999) • Married filling jointly -- $7,200 (1999) • Head of household -- $6,350 (1999) • Married filing separately -- $3,600 (1999) • Note: thresholds are indexed to inflation

  27. Using Standard or Itemized?? • Take the larger of the two amounts • If close, consider bunching deductions • Don’t let laziness or poor recordkeeping cost you money!

  28. Additional Deductions for Elderly or Blind Taxpayers • Unmarried taxpayer -- $1,050 ($2,100 if both elderly and blind). • Married taxpayer -- $850 ($1,700 if both elderly and blind). • Amounts shown are for 1999 and are adjusted annually for inflation.

  29. Claiming Your Exemptions • Exemptions are meant to provide everyone with some untaxed income, provided you don’t earn too much. • Personal exemptions -- $2,750 (1999). • Dependency exemptions • Three-step dependency test • Exemption phaseout.

  30. Calculating Your Base Income Tax on Taxable Income • Tax tables in the booklet. • Tax rate schedules -- must be used if income exceeds $100,000. • Alternative minimum tax -- to prevent the very wealthy from using the tax breaks to pay little or no tax.

  31. Determining Your Credits • Child credit • Hope Scholarship credit • Lifetime Learning credit • Child and dependent care credit • Earned income credit (EIC) • Adoption credit • Other credits, such as elderly and disabled taxpayer credits

  32. Other Filing Considerations • Picking the right form • Determining how to file • Filing late or amended returns • Where to get help

  33. Choosing a Tax Form • 1040EZ • taxable income less than $50,000 • can’t itemize or claim dependents • 1040A • taxable income less than $50,000 • allows for more sources of income

  34. Choosing a Tax Form (cont’d) • 1040 “long form” • allows the use of schedules • only form that allows you to itemize deductions • Know the schedules

  35. How To File? • Electronic Filing • Refund within 3 weeks • Less chance of processing error • Cost? • Filing by mail

  36. Filing Late and Amended Returns • Filing late • Form 4868 • Penalties -- 10% of tax bill • Amended returns • Form 1040X • Limitations -- 3 years after the original tax due date

  37. Reasons for Being Audited • Random • Previous errors • High income level • Filing a Schedule C • Audits allow the IRS to conduct spot checks of returns to ensure compliance to the tax laws and regulations

  38. Preparing for an Audit • Reexamine the areas in question • Gather all supporting data • Anticipate any probable questions • Hire a tax accountant or attorney (if necessary) • Note: the best way to win an audit is to keep excellent records

  39. Appealing an Audit Outcome • Appeal with the auditor • Appeal with the auditor’s manager • File a formal appeal • Go to tax court

  40. Help in Preparing Your Taxes • IRS Publication 17 • IRS hotline • Self-help tax publications • Computer programs • Videos • Tax specialists--be sure to start early

  41. Tax Planning to Minimize Payments • Maximize your deductions. • Look to capital gains income in particular if you are in the top tax brackets. • Receive tax-exempt income such as income for municipal bonds. • Defer taxes to the future.

  42. Maximizing Your Deductions • Using tax-deferred retirement programs to reduce taxes. • Using your home as a tax shelter. • Shifting and bunching your deductions.

  43. Look to Capital Gains Income • Long-term capital gains rates are taxed less than your earned income. In some cases as much as 19.6% less. • Taxes are postponed until the assets are sold.

  44. Shift Income to Family in Lower Tax Brackets • Gifts -- $10,000 per person ($20,000 per couple) per year tax-free. • Trusts -- hold property for another.

  45. Receive Tax-Exempt Income • Municipal bond interest from state and local government debt. • The higher your marginal tax bracket, the more beneficial tax-free income is.

  46. Defer Taxes to the Future • Traditional IRAs,401(k) plans, and Keogh plans defer taxes to the future. • Roth IRA earnings are never taxed. • Long-term capital gains taxes are not paid until the asset is sold.

  47. Summary • Know the U.S. tax code and your marginal tax bracket -- use both for tax planning to minimize tax payments. • Use adjustments, exemptions, and deductions to calculate your taxable income. • Use credits to reduce your tax liability.

  48. Summary (cont’d) • Know who must file, how, and when. • Know how and where to get help filing. • Know how to prepare for an audit.

  49. Summary (cont’d) • Know how to use tax strategies to reduce your tax liability • maximize deductions • look to capital gains income • shift income • look to tax-exempt income • defer taxes

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