Chapter 4

Tax Planning and Strategies

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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.

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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.

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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?

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The Federal Income Tax Structure

Progressive or graduate tax Tax rates and tax brackets Personal exemption Itemized or standard deductions Taxable income

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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

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Table 4.1 Tax Rates and Brackets

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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.

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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

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Figure 4.1 Historical Top Marginal Income Tax Rate

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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.

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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

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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.

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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

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

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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

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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

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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

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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

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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
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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

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Step 2: Calculating Adjusted Gross Income (AGI)

Gross income less allowable adjustments Adjustments include:
Tax-deductible contributions Retirement contributions

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Step 3: Subtracting Deductions

Choose between standard deduction or itemizing 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

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Figure 4.2 Standard Deduction Amounts

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Step 3: Subtracting Deductions

Take greater deduction between standard and itemized deduction Difficult to choose when they are close in value

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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

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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 Use tax rate schedules for taxable income greater than $100,000 Alternative minimum tax (AMT) ensures that wealthy pay enough taxes
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Figure 4.3 Calculating Your Taxes

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Figure 4.4 Determining Your Taxes Using the 2011 Tax Tables

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Step 6: Subtract Your Credits and Determine Your Taxes Due

Tax credits reduce actual taxes paid Tax credits phase out as AGI increases Child Credit Education Credits Child and dependent care credit Earned income credit Adoption credit

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Table 4.2 Comparison of Education Credits

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Other Filing Considerations

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

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Checklist 4.1 & Checklist 4.2

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Table 4.3 Common Schedules Used with Form 1040

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Other Filing Considerations

File by Mail or Electronic Filing (e-file) Benefits of e-filing include:
Faster refunds More accurate returns Quick electronic confirmation Delete the paperworknothing to mail Federal/state e-filing

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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

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Being Audited
Auditan examination of tax return by IRS

Randomly selectedhigher odds if itemized deductions are 44% of income.

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.

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Help in Preparing Taxes

Handle taxes by yourself. Use IRS publications, IRS hotlines, & selfhelp publications and computer programs.

Hire a tax specialist.

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Model Taxpayers: The Taylors File Their 2011 Return

Chuck and Dianne Taylor Using the various steps in calculating taxes for Form 1040

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Figure 4.5 2011 Federal Income Tax Return for the Taylors, Using Form 1040

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Figure 4.5 2011 Federal Income Tax Return for the Taylors, Using Form 1040 (cont.)

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Tax Strategies to Lower Your Taxes

Tax planning must be done ahead of time to minimize unnecessary tax payments. Tax strategies should supplement a solid investment strategy. There are five general tax strategies.

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Maximize Deductionsreduce taxable income to its minimum

1. Use tax-deferred retirement programs. 2. Use your home as a tax shelter. 3. Shift and bunch deductions

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Look to Capital Gains and Dividend Income

15 percent is the maximum tax rate for long-term capital gains for taxpayers in tax brackets that exceed 15 percent. 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.
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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 $13,000 in total gifts per year. Gift some of your estate while still alive.

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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.

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Defer Taxes to the Future

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

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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.
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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.

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Figure 4.6 Schedule A from the Taylors 2011 Federal Income Tax Return

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