Chapter 4

Tax Planning and

Strategies

Learning Objectives
1. Identify and understand the major federal
income tax features that affect all
taxpayers.
2. Describe other taxes that must pay.
3. Understand what is taxable income and
how taxes are determined.

4-2

2016 Pearson Education, Inc. All rights reserved.

Learning Objectives
4. Choose the tax form thats right for you,
file and survive an audit if necessary.
5. Calculate your income taxes.
6. Minimize your taxes.

4-3

2016 Pearson Education, Inc. All rights reserved.

Introduction
Most financial decisions are affected by
taxes.
Need to understand how taxes are imposed.
What strategies are used to reduce taxes
and what role does tax planning have in
personal financial planning?

4-4

2016 Pearson Education, Inc. All rights reserved.

The Federal Income Tax

Structure
Progressive or graduate tax
Tax rates and tax brackets
Personal exemption
Itemized or standard deductions
Taxable income
4-5

2016 Pearson Education, Inc. All rights reserved.

The Federal Income Tax

Structure
Taxable income is a function of adjusted
gross income (AGI), deductions, and
exemptions.
AGI = taxable income from all sources
minus specific adjustments but before
deducting standard or itemized deductions

4-6

2016 Pearson Education, Inc. All rights reserved.

4-7

2016 Pearson Education, Inc. All rights reserved.

The Federal Income Tax

Structure
Assume you are in the 15% tax bracket.
Does that mean you pay 15% of your
taxable income in taxes?
The last dollar earned is taxed at 15%.
Earlier income is taxed at the lower rate.

4-8

2016 Pearson Education, Inc. All rights reserved.

Marginal Versus Average Taxes

Average Tax Ratethe average amount of
your total income taken away in taxes
Marginal Tax Rate (or marginal tax bracket)
the percentage of the last dollar earned
that goes to pay taxes
Tax-deferredincome on which the payment
of taxes is postponed

4-9

2016 Pearson Education, Inc. All rights reserved.

4-10

2016 Pearson Education, Inc. All rights reserved.

Effective Marginal Tax Rate

The rate you pay when all income taxes are
combined (federal, state, city, Social
Security taxes, etc.).
Is greater than the marginal tax rate on
federal income taxes.

4-11

2016 Pearson Education, Inc. All rights reserved.

Capital Gains and

Dividend Income
Capital assetan asset your own
Capital gainwhat you make if you sell a
capital asset for a profit
Capital losswhat you lose when you sell a
capital asset for a loss
Capital gains taxtax you pay on your
capital gains
4-12

2016 Pearson Education, Inc. All rights reserved.

Capital Gains and

Dividend Income
Lower tax rate on both the long-term capital
gains and on dividends.
Long-term capital gains tax on profits from
the sale of stocks and bonds, not gains from
sale of collectibles.
Capital gains are not claimed or taxed until
the asset is sold.

4-13

2016 Pearson Education, Inc. All rights reserved.

Long-Term Capital
Gains on Homes
Capital gains taxes for most homeowners on
sale of their homes
Exemption up to $500,000 for couples filing
jointly ($250,000) filing single on sale of
principal residence
Must have been occupied for 2 of the 5
years prior sale

4-14

2016 Pearson Education, Inc. All rights reserved.

Filing Status
Single
Married Filing Jointly and Surviving Spouses
Married Filing Separately
Head of Household

4-15

2016 Pearson Education, Inc. All rights reserved.

Cost of Living Increases in Tax

Brackets, Exemptions, and Deductions
Tax brackets change annually to reflect
changes in the cost of living (inflation)
Standard deductions and personal
exemptions are increased to reflect inflation
Bracket Creeptax increase caused by
inflation increasing wages

4-16

2016 Pearson Education, Inc. All rights reserved.

Paying Your Income Taxes

Pay-as-you-go basis
Withholding from wages
Quarterly estimated taxes sent to the IRS
Payments with tax return
Withholdings from stock dividends, retirement
funds, and prize winnings
4-17

2016 Pearson Education, Inc. All rights reserved.

Paying Your Income Taxes

You have some control over how much is
deducted for taxes from your wages.
Withholdings are determined by income
level and information on W-4 form.
W-4 form (usually filled out with new
employer)marital status, number of
exemptions claimed

4-18

2016 Pearson Education, Inc. All rights reserved.

Other Taxes
Income-Based Taxes:
Social Security or FICA
State and local income taxes

Non-income-based taxes
Excise taxes
Property taxes
Gift and estate taxes

4-19

2016 Pearson Education, Inc. All rights reserved.

Calculating Your Taxes

Must you file a tax return?
Depends on income, filing status, age,
whether you can be claimed as dependent
Dependentperson you support financially
Calculate taxes anyway to get any refund
due to you

4-20

2016 Pearson Education, Inc. All rights reserved.

Step 1: Determining Gross or

Total Income
Sum of all taxable income from all sources
Active incomeincome from wages or a
business
Portfolio or investment incomesecurities
Passive incomeactivities in which the
taxpayer does not actively participate
4-21

2016 Pearson Education, Inc. All rights reserved.

Step 2: Calculating Adjusted

Gross Income (AGI)
Gross income less allowable adjustments
Adjustments include:

4-22

Retirement contributions
Student loan interest paid
Moving expenses
Health Savings Account contributions
Unreimbursed educator expenses

2016 Pearson Education, Inc. All rights reserved.

Step 3: Subtracting Deductions

Take greater deduction between standard
and itemized deduction
Itemize deductionslist of deductible
expenses: medical expenses, tax expenses,
mortgage interest payments, etc.
Standard deductiongovernments best
estimate of what the average person would
deduct if itemizing
4-23

2016 Pearson Education, Inc. All rights reserved.

4-24

2016 Pearson Education, Inc. All rights reserved.

Step 4: Claiming Your

Exemptions
Exemptiondeduction for each person
supported by the income on a tax return
An exemption includes yourself, spouse, or
dependents
Dependent must qualify as child or
dependent

4-25

2016 Pearson Education, Inc. All rights reserved.

Step 5: Calculating Your Taxable Income,

and From That, Calculating Your Base
Income Tax

Taxable incomesubtract deductions and

exemptions from AGI
Base income taxintersection of filing
status and taxable income in the federal
income tax tables
Alternative minimum tax (AMT) ensures
that wealthy pay enough taxes
4-26

2016 Pearson Education, Inc. All rights reserved.

4-27

2016 Pearson Education, Inc. All rights reserved.

4-28

2016 Pearson Education, Inc. All rights reserved.

Step 6: Subtract Your Credits and

Determine Your Taxes Due
Tax credits reduce actual taxes paid
Tax credits phase out as AGI increases

4-29

Child credit
Education credits
Child and dependent care credit
Earned income credit
Health care premium credit
Adoption credit
2016 Pearson Education, Inc. All rights reserved.

Other Filing Considerations

Choosing the right form between 1040EZ,
1040A, or 1040
Depends on dependents, income, itemizing

4-30

2016 Pearson Education, Inc. All rights reserved.

4-31

2016 Pearson Education, Inc. All rights reserved.

4-32

2016 Pearson Education, Inc. All rights reserved.

Other Filing Considerations

File by Mail or Electronic Filing (e-file)
Benefits of e-filing include:

4-33

Faster refunds
More accurate returns
Quick electronic confirmation
Delete the paperworknothing to mail
Federal/state e-filing

2016 Pearson Education, Inc. All rights reserved.

Filing Late and Amended Returns

File LateForm 4868request an extension
if unable to file by April 15th and include
estimated tax payment
Amended ReturnForm 1040Xfile within 3
years of original tax date
Amend the state and local forms as well

4-34

2016 Pearson Education, Inc. All rights reserved.

Being Audited
Auditan examination of tax return by IRS
Randomly selectedhigher odds if you have
been audited in the past
Asked to send additional information in mail
or IRS face-to-face interview.
Reexamine areas in question, get all data and
records, appeal audit outcome if necessary.
4-35

2016 Pearson Education, Inc. All rights reserved.

Help in Preparing Taxes

Handle taxes by yourself.
Use IRS publications, IRS hotlines, & selfhelp publications and computer programs.
Hire a tax specialist.

4-36

2016 Pearson Education, Inc. All rights reserved.

Model Taxpayers: The Taylors

File Their Federal Tax Return
Chuck and Dianne Taylor
Using the various steps in calculating taxes
for Form 1040

4-37

2016 Pearson Education, Inc. All rights reserved.

4-38

2016 Pearson Education, Inc. All rights reserved.

4-39

2016 Pearson Education, Inc. All rights reserved.

Tax Strategies to Lower Your

Taxes
1. Maximize deductions.
2. Look to capital gains and dividend income.
3. Shift income to family member in lower tax
brackets.
4. Receive tax-exempt income.
5. Defer taxes to the future.

4-40

2016 Pearson Education, Inc. All rights reserved.

Maximize Deductionsreduce
taxable income to its minimum
Use tax-deferred retirement programs.
Use your home as a tax shelter.
Shift and bunch deductions

4-41

2016 Pearson Education, Inc. All rights reserved.

Look to Capital Gains and

Dividend Income
Long-term capital gains rate is lower than ordinary
income tax rate
No tax for those in the 10 and 15 percent tax brackets
15 percent tax for those in the 25 to 35 percent tax
brackets
20 percent tax for those in the 36.9 percent tax bracket

Dont have to claim capital gains until asset is sold.

Qualified dividends from corporations are taxed at
same low rates as long-term capital gains.

4-42

2016 Pearson Education, Inc. All rights reserved.

Shift Income to Family Members

in Lower Tax Brackets
Can be complex and involve lawyers and
establishment of trusts.
Simpler way is to make giftsrecipients do
not pay taxes on gifts either.
Allowed to give $14,000 tax free per year to
as many recipients as donor wishes.
Gift some of your estate while still alive.
4-43

2016 Pearson Education, Inc. All rights reserved.

Receive Tax-Exempt Income

Interest from state and local government
debt such as bonds is tax-exempt
The higher your marginal tax bracket, the
more beneficial tax-free income is.
Calculate the equivalent taxable yield to
determine which is the better investment

4-44

2016 Pearson Education, Inc. All rights reserved.

Defer Taxes to the Future

Tax-deferred retirement plans allow you to
defer tax payments to the future.
Roth IRAs allow taxes to be paid on
contributions and never again.
Capital gains taxes are postponed until you
sell the asset.

4-45

2016 Pearson Education, Inc. All rights reserved.

Summary
Taxable income is a function of AGI, deductions
and exemptions.
Apart from federal income tax, there are Social
Security and Medicare taxes, state and local
taxes, excise, sales, property, and gift and
estate taxes.
To calculate taxes, determine total income,
adjusted gross income, taxable income, then
the taxes your owe.
4-46

2016 Pearson Education, Inc. All rights reserved.

Summary
It is important to know if you must file a
return, when to file, use the right form, and
the information needed for the return.
Obtain the help you need for filing returns
from the IRS, self-help tax books, and
computer programs and tax specialists.
There are five general strategies that can be
used to reduce taxes to a minimum.
4-47

2016 Pearson Education, Inc. All rights reserved.