Taxes in Your Financial Plan: Strategies for Maximizing Benefits and Reducing Liability

1. Chapter 3 Taxes in Your Financial Plan

2. Taxes in Your Financial PlanChapter Learning Objectives LO3.1Identify the major tax types in our society. LO3.2Calculate taxable income and the amount owed for federal income tax. LO3.3Prepare a federal income tax return. LO3.4Select appropriate tax strategies for various life situations.

3. Planning Your Tax StrategyLO3.1 Tax planning should be an ongoing process: • Know current tax laws as they affect you. • Maintain complete and appropriate tax records. • Make purchase and investment decisions that reduce your tax liability. • Time elapsed from January 1 until mid-April represents the portion of the year people work to pay their taxes. Goal: Paying your fair share but still taking advantage of tax benefits.

4. Types of Taxes • Taxes on Purchases • Sales tax and excise tax • Taxes on Property • Real estate property tax • Personal property tax • Taxes on Wealth • Federal estate tax • A tax imposed on the value of a person’s property at the time of death. • State inheritance tax • A tax levied on the value of property bequeathed by a deceased person. • Taxes on Earnings • Income tax and Social Security

5. The Basics of Federal Income TaxLO3.2 Step 1: Determine Adjusted Gross Income • This process starts with steps to determine taxable income, which is the net amount of income, after allowable deductions, on which income tax is computed. • Types of Income • Earned • Investment • Passive • An exclusion is an amount not included in gross income. • Tax-exempt income is not subject to tax. • Tax-deferred income is income that will be taxed at a later date.

6. Adjustments to Income • Gross income reduced by certain adjustments, described below • Adjustments to income • Reduce AGI • Contributions to a traditional IRA or Keogh • Alimony payments • A tax shelter is an investment that provides immediate tax benefits.

7. Taxable Income Step 2: Computing Taxable Income Tax deduction is an amount subtracted from adjusted gross income (AGI) to arrive at taxable income. • Standard deduction • Itemized deductions

8. Computing Taxable Income Itemized Deductions • Medical and dental expenses (>10% of AGI) • Taxes • Interest • Contributions • Casualty and theft losses • Moving expenses • Job-related and other miscellaneous expenses (>2% of AGI)

9. Computing Taxable Income and Your Tax LiabilityExhibit 3-1

10. Tax Record-Keeping SystemExhibit 3-2

11. Computing Taxable Income Exemptions • Exemptions subtracted from AGI • An exemption is a deduction for yourself, your spouse, or qualified dependents. • The amount of the exemption for the 2017 tax year was $4,050 per person. • After deducting exemptions, you have your taxable income.

12. Calculating Taxes Owed Step 3: Calculating taxes owed • Tax table rates = marginal rates • The tax rate paid on the last (or next) dollar of taxable income • Example: • After deductions and exemptions, a person in the 35% tax bracket pays 35 cents in taxes for every dollar of taxable income in that bracket.

13. 2017 IRS Tax Brackets

14. Average Tax Rates The average taxrate is the total tax due divided by taxable income. • Average tax rate < marginal tax rate • Example: • Taxable income = $50,000 • Total tax bill = $8,240 • Average tax rate = 16.5% • ($8,240 / $50,000)

15. 2017 IRS Tax Example Tax on a Married Taxpayer’s Income of $95,000

16. Alternative Minimum Tax (AMT) • Paid by taxpayers with high amounts of certain deductions and various types of income • Designed to ensure that those who receive tax breaks also pay their fair share of taxes

17. Tax Credits • Amount subtracted directly from the amount of taxes owed • Examples: • Earned income credits • Foreign tax credits • Child and dependent care credits • Savers credit (formerly retirement tax credits) • Adoption tax credits • Education credits to offset college education expenses

18. Making Tax Payments Step 4: Making Tax Payments • Payroll Withholding • Based on the number of exemptions and the expected deductions claimed • Estimated Quarterly Payments • Estimated tax payments made throughout the year based on income made during the year and reported on Form 1099

19. Deadlines and Penalties Step 5: Deadlines and Penalties • Form 4868  automatic six-month extension • Submit estimated tax due with Form 4868 by April 15. • Penalties and Interest • Underpayment of quarterly estimated taxes may require paying interest on the amount owed. • Underpayment due to negligence or fraud can result in penalties of 50 to 75 percent.

20. Filing a Federal Income Tax ReturnLO3.3 • Five filing status categories: • Single or legally separated • Married, filing jointly • Married, filing separately • Head of household • Unmarried individual or surviving spouse who has a child or dependent relative • Qualifying widow or widower with a dependent (limited to 2 years after death of spouse) Every citizen or resident of U.S. and every U.S. citizen who is a resident of Puerto Rico is required to file income tax if his or her income is above a certain amount.

21. Which Tax Form Should You Use? • Approximately 800 federal tax forms and schedules exist. • Basically, the choice is between 3 forms. 1040EZ 1040A 1040 - Used by 60% • Which form to use? • Type of income • Amount of income • Number of deductions • Complexity of tax situation Used by 20% of taxpayers

22. Completing the Federal Income Tax Return The major sections of Form 1040 correspond to tax topics previously discussed: • Filing status and exemptions • Income • Adjustments to income • Tax computation • Tax credits • Other taxes (such as from self-employment)

23. Completing the Federal Income Tax Return, continued • Payments (total withholding and other payments) • Refund or amount you owe • Refunds can be directly deposited to your bank account. • Payments may be directly debited from your bank account. • Your signature = Most common filing error

24. How Do I File My State Tax Return? • All but 7 states have a state income tax. • Most states’ tax rates range from 1 to 10 percent. • States usually require income tax returns to be filed when the federal Income tax return is due. • See Exhibit 3-6

25. How Do I File My Taxes Online? • More common than paper filing • IRS reports that over 123 million people file online, which is 90% of filers. • E-filing refunds usually take 3 weeks. • Cost for e-filing is usually between $15 – $40, with no fee in some cases.

26. How Do I File My Taxes Online?, continued • Free File Alliance • Online tax preparation and filing free to many taxpayers, dependent on income • Partnership between the IRS and tax preparation software • The online filing process involves the following steps: • Go to the IRS website and click “Free File” in “Filing and Payment” section. • Determine eligibility and read “How to Use Free File.” • Connect to the chosen company’s website to begin. • Use the company’s online software to prepare return.

27. Tax Preparation Software • Services such as H&R Block At Home and TurboTax allow you to complete returns online and print and mail or file online. • Considerations: • Personal situation • Special tax situation • Features in the software • “Audit check” • Future planning • State tax filing online • Technical aspects • Hardware and operating system requirements • Online support

28. What Tax Assistance Services are Available? • IRS Services • Publications and forms • 1-800-TAX-FORM • IRS Website • Recorded messages • 1-800-829-4477 • Phone hot line • 1-800-829-1040 • Walk-in service at an IRS office • Interactive tax assistant • DVD • IRS2Go App

29. What Tax Assistance Services are Available?, continued • Tax Publications • Offered for sale • Examples: • J.K. Lasser’s Your Income Tax • The Ernst & Young Tax Guide • Your Federal Income Tax (for Individuals) is offered for free from the IRS. • The Internet • Be sure to use reliable websites and print information for your records.

30. Tax Preparation Services In the event you do not wish to complete your own return, professional services can be utilized. • Range from one-person, local offices to large firms such as H&R Block • Enrolled agents = Government-approved tax experts • CPA Tax Accountants • Attorneys

31. Evaluating Tax Services Factors to consider: • Training and experience of the tax professional • Fee for preparing taxes and how determined • Questionable deductions suggested? • If return is audited, will the preparer represent the client? • Is tax preparation the main business activity, or is it a front for other financial products? *Additional information may be obtained at the websites for the National Association of Enrolled Agents and the National Association of Tax Professionals.

32. Tax Service Warnings • Ultimately you are responsible for providing complete and accurate information. • If your professional tax preparer makes a mistake, you are still responsible for paying the correct amount, plus any interest and penalties. • Hiring a tax preparer does not guarantee that you will pay the correct amount. • Beware of tax preparers that offer refunds in advance. • “Refund anticipation loans” can charge interest rates in excess of 300%.

33. What If Your Return Is Audited? A tax audit is a detailed examination of your tax return by the IRS. • In most audits, the IRS requests additional information to support your return. • Keep accurate records. • Receipts, canceled checks, and other evidence can verify amounts that you claim. • See Exhibit 3-7

34. Who Gets Audited? Approximately 1.0% of all returns are audited • If you claim large or unusual deductions you are more likely to be audited. • Three types of audits: • Correspondence audit for minor questions • Office audit takes place at an IRS office. • Field audit is the most complex, with an IRS agent visiting you at your home, your business or your accountant’s office.

35. Your Audit Rights You may, if audited: • Request time to prepare • Clarification of items being questioned • Right to appeal audit results When Audited: • Decide whether to bring your tax preparer, accountant, or lawyer. • Be on time and bring only relevant documents. • Present evidence in a logical, calm, and confident manner; maintain a positive attitude. • Make sure your information is consistent with tax law. • Keep your answers aimed at the auditor’s questions.

36. Tax Planning StrategiesLO3.4 • Practice tax avoidance • Legitimate methods to reduce your tax obligation to your fair share but no more • Financial decisions related to purchasing, investing, and retirement planning are the most heavily affected by tax laws. • Tax Evasion • Illegally not paying all the taxes you owe, such as not reporting all income

37. Tax Planning StrategiesMinimizing Taxes Owed

38. Education Deduction or Tax Credit? • If you paid higher education costs this year, decide between: • Tuition and Fees deduction • One of two Education credits • Tuition and Fees deduction reduces AGI by as much as $4,000. • The American Opportunity Credit • Allows credit up to $2,500 • Limited to the first four years of postsecondary education • Must be enrolled at least half-time • The Lifetime Learning Credit • Limited to $2,000 • Can be used for part-time education and graduate school funds

39. Consumer Purchasing • Place of Residence • One of the best tax shelters is owning a home. • Deduct mortgage loan interest and property taxes. • Reduces your taxable income • Consumer Debt • Use home equity line of credit (second mortgage) to buy a car or consolidate debt. • Interest deductible

40. Consumer Purchasing, continued • Job-related expenses may be allowed as itemized deductions. • Union dues • Business tools • Job search costs • Health care expenses like FSA’s (Flexible Spending Accounts) allow you to reduce your taxable income when paying for health related expenses.

41. Investment Decisions Tax Exempt Investments • Interest income from municipal bonds are exempt from federal and some state taxes. Tax Deferred Investments • Tax deferred annuities • Health Savings Accounts • Retirement Plans – IRA, Keogh or 401(k) • A type of tax shelter

42. Investment Decisions, continued Capital Gains • Profits from the sale of stocks, bonds, or real estate • Long-term capital gains (held more than one year) taxed at a lower rate. Self Employment • Advantage:Owning your own business can have tax advantages. • Disadvantage: Business owners have to pay additional taxes. Children’s Investments • Children under 18 or a full-time student under 24 with investment income of more than $2,000 is taxed at parents’ top rate. • Under $2,000 qualifies for a $1,000 deduction, with remainder taxed at child’s rate.

43. Retirement and Education Plans • Traditional IRA • Available to people who are not participating in an employer sponsored program • Amounts withdrawn are included in gross income. • Roth IRA • Contributions not tax deductible. • Amounts withdrawn are not included in gross income.

44. Education Plans and Retirement Plans • Keogh Plan • Self-employed retirement plan • 401(K) Plan • Tax-deferred retirement plan • Coverdell Education Savings Account • Educational uses for kindergarten through college-age • 529 Plan • Qualified educational expenses

45. Changing Tax Strategies • Recent Tax Changes include: • Advanced tax credits are available. • Penalties are being assessed for those who do not have health insurance. • Employers now allow employees with health care flexible spending accounts to carry over up to $500 of unused funds. • Streamlined options are available for the home office deduction for small businesses.

46. Flat or VAT Tax? • Flat tax • All taxpayers pay the same rate. • Would increase taxes for many • VAT = Value-Added Tax • Taxes a product at each stage in the manufacturing process • Tends to start small and rise over time

47. Chapter SummaryLO3.1: Identify the major tax types in our society. • Tax planning can influence spending, saving, borrowing, and investing decisions. • An awareness of income taxes, sales taxes, excise taxes, property taxes, estate taxes, inheritance taxes, gift taxes, and Social Security taxes is vital for successful financial planning.

48. Chapter SummaryLO3.2: Calculate taxable income and the amount owed for federal income tax. • Taxable income is determined by subtracting adjustments to income, deductions, and allowances for exemptions from gross income. • Your total tax liability is based on the published tax tables or tax schedules, less any tax credits.

49. Chapter SummaryLO3.3: Prepare a federal income tax return. • The major sections of Form 1040 provide the basic framework for filing your federal income tax return. • Main sources of tax assistance: • IRS services and publications • Other publications • The Internet • Computer software • Professional tax preparers such as commercial tax services, enrolled agents, accountants, and attorneys

50. Chapter SummaryLO3.4: Select appropriate tax strategies for various life situations. • Reduce your tax burden through careful planning and making financial decisions related to consumer purchasing and the use of debt, investments, and retirement planning.