Chapter 4

1. Chapter 4 Managing Income Taxes

2. Objectives • Explain the nature of progressive income taxes and the marginal tax rate. • Differentiate among the eight steps involved in calculating your federal income taxes • Use appropriate strategies to avoid overpayment of income taxes.

3. Introduction • Tax Planning: Seeking legal ways to reduce, eliminate, or defer income taxes. • Taxable Income: the income upon which income taxes are levied.

4. Taxes • Progressive income taxes and the marginal tax rate • Taxes– amount owed as % income. Taxes are compulsory charges imposed by government on its citizens and their property. • Internal Revenue Service (or IRS) • Internal Revenue Code • The progressive nature of the federal income tax • Progressive tax – is one that requires a higher tax rate as income increases. • Regressive tax – is one that demands a decreasing proportion of one’s income.

5. Progressive Nature of the Federal Income Tax Taxable Income Rate First $8700 10% Over $8700 but not over $35,350 15% Over $35,350 but not over $85,650 25% Over $85,650 but not over $178,650 28% Over $178,650 but not over $388,350 33% Over $388,350 35%

6. Marginal Tax Rateand Financial Decisions • Marginal tax rate is the rate at which your last dollar of income is taxed. • Your effective marginal tax ratecan be 43% and includes Medicare, Social Security, Federal, State and City • Your average tax rate is lower. • Average tax rate: Proportion of total gross income paid in income taxes.

7. How Your Income Is Really Taxed

8. 8 Steps in CalculatingYour Income Taxes • Determine your total income. • Determine and report gross income after subtracting exclusions such as gifts, inheritance, tax refunds, etc. • Subtract adjustments to income such as moving expenses, tuition and fees, student loan interest expense, etc. to determine the adjusted gross income (AGI). • Subtract either the IRS’s Standard Deduction for your tax status or itemize your deductions.

9. 8 Steps in CalculatingYour Income Taxes • Subtract the value of your personal exemptions. ($3,800 Each Dependent) • Determine your preliminary tax liability based upon your taxable income. • Subtract tax credits for which you qualify. 8. Calculate the balance due the IRS or the amount of your refund.

10. The Processof Income Tax Calculation

11. Total Income • Income to include: • Wages and Salaries • Commissions • Bonuses • Tips Earned • Interest and Investment Income • Retirement Income • Unemployment benefits • Gambling and Lottery Winnings • Include capital gains and losses in Total Income. Long term gains or losses are taxed at 10% - 15% and short term gains or losses are taxed at your marginal tax rate.

12. Gross Income • Income to exclude from taxes: • Gifts • Inherited money or property • Income from a carpool • Federal income tax refunds • Employee contributions to flexible spending accounts • Reimbursements from flexible spending accounts • Child support payments received

13. W-2 Form

14. Deductions • Subtract either the IRS’s standard deduction for your tax status or your itemized deductions. • Standard deduction depends on filing status. • $5,950 for single individuals – 2012 tax year • $11,900 for married couples – 2012 tax year

15. Deductions • Itemized deductions: Medical and dental expenses • Amount must exceed 7.5% of total adjusted gross income for 2012.

16. Deductions • Itemized deductions: Taxes you paid • Real Estate Property Taxes (home or land) • Personal Property Taxes – vehicle registration, license fees • State, Local, and Foreign Income Taxes • State and Local Sales Taxes (instead of state and local income taxes)

17. Deductions • Itemized deductions: Taxes you paid • Interest Paid on Home Mortgage Loans • “Points” • Interest Paid on Home-Equity Loans • Interest paid on loans used for investments • Mortgage insurance premiums on new loans after January 1, 2007 • Gifts to charity • Casualty and theft losses that is uninsured and exceed 10% of your AGI

18. Deductions • Miscellaneous deductions in excess of 2% of adjusted gross income • Job search expenses • Moving expenses • Other miscellaneous deductions allowed at 100%: • Gambling losses • Business expenses for workers with disabilities

19. Exemptions • Exemption (or Personal Exemption) • Subtract the value of your personal exemptions. • Each exemption reduces taxable income by $3,800 for 2012 • Claiming another person as an exemption requires that you provide more than one-half of their support. • What if you are claimed as an exemption? • If someone else claims you, you cannot claim yourself. • The opposite is also true.

20. Tax Liability • Determine your preliminary tax liability based on your taxable income using the tax-rate schedule or tax table. • Taxable income is the amount remaining after subtracting adjustments, deductions and exemptions from your gross income. • Subtract tax credits for which you qualify. • Tax Credit: Dollar-for-dollar decrease in tax liability. • American Opportunity Credit – up to $2,500 tax credit per student • Lifetime Learning Credit – up to $2,000 tax credit per return • Earned Income Credit – Eligible if income less than $13,980 single or $19,190 married (no child) • Child Tax Credit - $1,000 per child

21. Tax Credits • American Opportunity Credit • Lifetime Learning Credit • Earned Income Credit • Child Tax Credit • Child and Dependent Care Credit • Retirement Savings Contribution Credit • Adoption Credit • Energy Saving Vehicle Credit

22. Tax Liability • After subtracting your credits from your preliminary tax liability you arrive at your final tax liability. • Add up all prior payments from tax withholding or estimated tax payments. • Calculate the balance due the IRS or the amount of your refund.

23. Avoid Taxes ThroughProper Planning • Practice legal tax avoidance, not tax evasion. • A dollar saved from taxes is really two dollars - or more. Remember the time value of money ? • Opportunity cost • Earning another dollar to replace one given to the IRS • Earnings on a dollar not given to the IRS

24. Reduce Taxable IncomeVia Your Employer • Premium only plan (health care) • Flexible Spending Account - $2,500 Max. after December 31, 2012(or FSA or Expense Reimbursement Account) • Defined Contribution Retirement Plan: • Tax Sheltered Investments • Matching Contributions • 401(k) - $17,000 Max Limit • IRA - $5,000 Max Limit • Roth IRA - $5,000 Max

25. Reducing Taxable Income: Other Strategies • Coverdell Education Savings Account • Qualified Tuition (Section 529) programs • Govt. savings bonds – Interest income deferred • Municipal bonds – Interest earned tax exempt • Postpone income such as bonus payments • Bunch deductions into one year • Take all of your legal tax deductions.

26. Comparing Taxable and After-Tax Yields After-tax yield using taxable yield formula: After-tax yield equals the taxable yield times (1 - federal marginal tax rate) Lets compare the yield of a 5.7% corporate bond vs. 4% tax-exempt municipal bond If someone has a 35% Marginal Tax Rate: 5.7% taxable interest x (1.00 - 0.35) 5.7% x 0.65 The answer is a 3.71 after-tax yield corporate bond A municipal bond with 4% is preferred since interest is tax exempt

27. Top 3 Financial Missteps in Managing Income Taxes People risk incurring more tax liability when they do the following: • Turn all you income tax planning over to someone else. • Over-withhold too much income to receive a refund next year. • Ignore the impact of income taxes in you personal financial planning.

28. Good Money Habits inManaging Income Taxes • Reduce you income taxes by signing up for tax-advantaged employee benefits at your workplace. • Contribute to you employer-sponsored 401(k) retirement plan at least up to the amount of the employer’s matching contribution. • When practical, consider purchasing a home to reduce income taxes. • Do your own tax return so you can learn how to reduce your income tax liability. • Maintain good tax records.

29. Questions ?