Chapter 4Lecture 3 Tax Planning and Strategies
Individual Income Tax Formula Total Income (everything received) - Exclusions/Tax-exempt Income_______________ = Gross income (GI) - Adjustments______________________________ = Adjusted Gross Income (AGI) - Greater of Standard or Itemized deductions - Personal and dependency Exemptions ($3050 in 2003)__________________________________ = Taxable income (TI) * Tax rates: 10%-35%______________________ = Tax liability - Tax credits - Tax prepayments___________________________ = Tax due or refund
Calculating Adjusted Gross Income (AGI) • Adjustments for AGI include: • Alimony payments. • Moving expenses. • 50% of FICA taxes (social security and Medicare) if self- employed. • 100% of health insurance costs if self-employed. • Payments to a Keogh or SEP retirement plan. • Payments to a Traditional IRA. • Student loan interest. • Tuition and fees.
IRAs • Traditional IRA: • Contributions are deductible (limited to $4,000 per year). • Contributions and earnings are taxed when money is withdrawn. • Limits if covered by an employer-sponsored plan or if income exceeds a certain amount.
IRAs • Roth IRA: • Contributions are not deductible. • Can contribute up to $4,000 per year. • Individuals whose income exceeds specified limits are not eligible for a Roth IRA. • Contributions and earnings are not taxed when money is withdrawn.
Student Loan Interest • Student loan interest paid is an adjustment to gross income. • Can deduct up to $2,500 per year. • There is a phase-out of the amount of the adjustment based on income levels.
Tuition and Fees • Adjustment for qualified tuition and fees paid. • Limit is $4,000 per year. • Cannot take adjustment in same year claiming a Hope or lifetime learning credit.
Subtracting Deductions from AGI • Take the greater of: • The standard deduction or the total itemized deductions.
Standard Deduction for 2005 • Single -- $5,000. • Married filling jointly -- $10,000. • Married filing separately -- $5,000. • Head of household -- $7,300. • Note: thresholds are indexed for inflation
Itemized Deductions • Medical and dental expenses paid (must exceed 7.5% of AGI). • Taxes paid (state income, real estate, and personal property taxes such as vehicle ownership tax). • Interest paid (e.g., home mortgage interest). • Charitable contributions (cash and noncash). • Miscellaneous itemized (must exceed 2% of AGI). • Tax preparation fees and safe deposit expense.
Phase-Out of Itemized Deductions • Taxpayers in higher income brackets do not get credit for all their itemized deductions. • 2005 married filing jointly – AGI of $145,950. • Lose deductions equal to 3% of the amount by which your AGI exceeds this amount. • Always can take the standard deduction. • The phase-out of itemized deductions will begin to be eliminated in 2006, disappearing entirely by 2010.
Classification of Deductible Items • Adjustments are “above the line.” • See page 1 of Form 1040. • Deductions (standard or itemized) are “below the line.” • See page 2 and Schedule A of Form 1040.
Claiming Your Exemptions • Exemptions are given so that everyone will have a little bit of untaxed money to spend on necessities. • Is a deduction for each person supported by the income on your tax return.
Exemptions • Two types: • Personal exemption (yourself) – $3,200. • Dependency exemption - $3,200 each. • Must pass a relationship or household member test. • You must provide more than half of the dependent’s support. • Are subject to phase-outs (exemptions can be reduced to $0).
Phase-out of Exemptions • Once AGI reaches a certain level, the value of the exemptions taken is reduced • 2005 – married filing jointly $218,950 (reduction when AGI exceeds this amount). • For every $2,500 your AGI exceeds this amount, you lose 2% of your exemptions.
Calculating Your Income Tax Liability • Tax Table. • Tax Rate Schedules -- must be used if taxable income exceeds $100,000. • Alternative Minimum Tax (AMT) -- parallel tax system designed to prevent the very wealthy from using the tax breaks to pay little or no tax.