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Tax Planning and Strategies for Individual Income: Understanding Tax Formula and Exemptions

Learn about the tax formula, adjustments, deductions, tax credits, and strategies for lowering taxes. Understand taxable income, deductions vs. credits, W-4 form, and more.

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Tax Planning and Strategies for Individual Income: Understanding Tax Formula and Exemptions

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  1. Chapter 4Lecture 4 Tax Planning and Strategies

  2. 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 _________________________________ = Taxable income (TI) * Tax rates: 10%-35%______________________ = Tax liability - Tax credits - Tax prepayments___________________________ = Tax due or refund

  3. Tax Credits • Tax credits are subtracted directly from taxes due on a dollar-for-dollar basis.

  4. Deduction vs. Tax Credit • A deduction reduces the amount of income that is taxed. • Deductions are subtracted from AGI before you calculate income taxes due. • A credit reduces the tax. • The amount of the credit is subtracted from income taxes due.

  5. Types of Tax Credits • Child Credit. • Hope Scholarship Tax Credit. • Lifetime Learning Credit. • Child and dependent care credit. • Earned income credit. • Adoption credit.

  6. Paying Your Income Taxes • W-4 Form -- provides your employer information about your marital status and number of exemptions you wish to claim. • Withholding -- is the amount of tax that is paid each time you receive a paycheck. This is why there is a difference between your gross pay and your “take-home” pay. • Estimated tax payments.

  7. Tax Formula Example Bob Stone needs help with his tax return. In 2005, he received a $38,000 salary, $200 in bank interest, and $1,500 in lottery winnings. He paid $1,500 in medical expenses, $3,000 to a Traditional IRA, $7,000 in mortgage interest, $3,000 in federal income taxes withheld, $1,500 in state income taxes, and $500 in charitable contributions. He also a has a $200 federal income tax credit. He files as single with no qualifying dependents. What is Bob’s taxable income, gross tax and tax due for 2005?

  8. SOLUTION

  9. Late and Amended Returns • Filing late. • Must request an extension of time (Form 4868) from the IRS. • 4-month extension is automatic. • You must pay the estimated tax due by April 15th (or will be charged interest and penalties). • Amending your return. • File Form 1040X. • Limitation - 3 years. • Amend state and local returns.

  10. 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.

  11. Preparing for an Audit • Reexamine the areas in question. • Gather all supporting data. • Anticipate questions. • Hire a tax accountant or attorney (if necessary). • The best way to win an audit is to keep excellent records and take supported tax positions.

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

  13. Tax Strategies to Lower Taxes • Maximize deductions. • Use tax-deferred retirement programs. • Use your home as a tax shelter. • Look to capital gains and dividend income. • Shift income to family members in lower tax brackets. • Receive tax-exempt income. • Defer taxes to the future.

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