3-1 copyright 2002 by harcourt, inc. all rights reserved. chapter 3: managing your taxes clip art ...

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Copyright 2002 by Harcourt, Inc. All rights reserved.

CHAPTER 3:

MANAGING YOUR TAXES

Clip Art 2001 Microsoft Corporation. All rights reserved.

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Principles of Federal Income Taxes

Typical American family pays about a third of its gross income in various types of taxes.

Internal Revenue Service (IRS) is responsible for the administration and enforcement of federal tax laws.

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Economics of Income Taxes: Federal income taxes are assessed

according to a progressive tax structure;

i.e., the larger the taxable income, the higher the tax rate.

The next higher rate applies only to the additional income in that bracket, not to your entire income.

Tax brackets, standard deductions, and personal exemptions are indexed to inflation to prevent bracket creep.

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2000 Tax Rate Schedule(single taxpayers)

Taxable Income Tax Rate

$0 – $26,250 15%

$26,251 – $63,550 28%

$63,551 – $132,600 31%

$132,601 – $288,350 36%

Over $288,350 39.6%

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Example:

If you have $80,000 in taxable income, what will your federal

income tax liability be?


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$26,250 x 15% = $ 3,937.50

+

($63,550 – $26,250) x 28% = $10,444.00

+

($80,000 – $63,550) x 31% = $ 5,099.50

Work through the tax brackets:

Tax Liability $19,481.00

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Your average tax rate is 24.4%, which is calculated by dividing the amount of taxes paid by your taxable income:

$19,481 $80,000 = 24.4%

Your marginal, or stated, tax rate is 31%, the rate of your highest bracket.

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More Principles of Taxation: Filing Status has to do with your marital

status and family situation; factor in determining amount of income tax paid.

Taxes are due on a pay-as-you-go basis; at time of filing you receive credit for amount already withheld and settle up for the past year.

Your income is subject to federal, state and local income taxes and Social Security taxes.

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It's Taxable Income that Matters!

Taxable Income

is the amount of our income on which we actually pay taxes.


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Determining Taxable Income:

Gross income [1]

– Adjustments [2]

= Adjusted Gross Income (AGI) [3]

– Deductions [4]

– Exemptions [5]

= Taxable Income [6]

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[1] Gross Income:

All income that is subject to federal income taxes.

3 classifications of income which must be kept separate for deduction purposes:

Earned or Active Income

Wages & Salaries

Alimony received

Business & farm income

Prizes, awards, gambling winnings

Unearned or Portfolio Income

Interest

Dividends

Capital gains

Most types of investment earnings

Passive Income

Income from real estate (unless real estate is your primary business)

Limited partnerships & Tax shelters

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Tax-Exempt Income:

Either totally or partially excluded from gross income for income tax purposes:

Child support received

Insurance reimbursements

Gifts (limits apply)

Scholarships (some limits)

Tax refunds

Return of original investment capital

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– Short-term capital gain occurs when an item is held for 1 year or less; taxed at ordinary income tax rates.

– Long-term capital gain occurs when an item is held longer than 1 year; currently taxed at 20% or less. (See Exhibit 3.5)

Generally, the sale of a home is now excluded from capital gains taxation (some limits and exceptions).

Capital gain (loss) occurs when an asset is sold for more (less) than its original cost.

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[2] Adjustments to Gross Income:

Items which can be subtracted from gross income.

Adjustments include:

– Traditional IRA contributions (some limits)

– Self-employment tax—50% of amount paid

– Alimony paid

– Penalty on early withdrawal of savings

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[3] Adjusted Gross Income (AGI):

Subtotal obtained when adjustments are subtracted from gross income.

Certain itemized deductions and other calculations are limited by this amount.

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[4] Deductions:

The standard deduction is the blanket amount allotted for various deductible expenses taxpayers normally incur.

If your deductible expenses are greater than the standard deduction, you may choose to itemize your deductions.

You should choose the most advantageous method; itemized deductions must be documented.

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– Medical and dental expenses (only amount in excess of 7.5% of AGI)

– State and local income taxes and property taxes

– Home mortgage interest

– Charitable contributions

– Casualty and theft losses (very limited)

– Job and misc. expenses (only amount in excess of 2% of AGI)

Itemized deductions are listed on Schedule A and include the following:

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[5] Exemptions: Amount subtracted based upon

the number of people supported by the taxpayer’s income.

You are an exemption on your own return unless you can be claimed by someone else.

Children, spouses, elderly parents are other examples of exemptions.

Each person can be claimed on only 1 tax return!


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Calculating and Filing Your Taxes

Your federal income tax liability is calculated on your taxable income [6].

Taxes owed are found in the tax rate tables or calculated using schedules.

Alternative Minimum Tax is calculated differently; for higher-income taxpayers.

Exemption & deduction amounts are limited at higher income levels.

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Tax Credits versus Tax Deductions:

Credits are subtracted from the amount of taxes you owe.

Deductions are subtracted from your AGI and reduce your taxable income.

Which results in lower taxes?

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Extra $1000 $1000 Deduction Tax

CreditGross Income $38,000 $38,000

Other deductions/ exemptions – 6,000 – 6,000

Extra $1000 Deduction– 1,000 – 0

Taxable Income $31,000 $32,000

Tax Liability $ 5,268 $ 5,548

$1000 Tax Credit – 0 – 1,000

Taxes Due $ 5,268 $ 4,548

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Tax Forms and Schedules: All taxpayers file their returns on some

variation of Form 1040.

If more detail is needed, taxpayers will also have to file other forms and schedules.

Frequently used schedules include:– Schedule A (itemized deductions)– Schedule B (interest/dividend income)– Schedule C (personal business income)– Schedule D (capital gains/losses)

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Other Filing Considerations

Quarterly payment of estimated taxes

April 15 filing deadline

Filing extensions

Amended returns (1040X)

Audited returns

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Preparing Your Tax Return

Do it yourself! Get help from the IRS Use professional services

– Tax services– Enrolled agents– Certified public accountants– Tax attorneys

Use tax software Taxpayer is responsible for accuracy!

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Effective Tax Planning

Tax avoidance is legal. Tax evasion is not! Reduce taxes

– Use all appropriate deductions or credits. – Use techniques that receive preferential tax

treatment, such as depreciation on real estate and tax-exempt income on municipal bonds.

Shift taxes– Use gifts or trusts to shift some of your

income to others in lower tax bracket.

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Defer taxes– Postpone taxes to the future when you may be in a lower tax bracket.– Use retirement plans, IRAs, annuities, life insurance policies, and EE

savings bonds.

Use tax shelters (not many are left!)– Some real estate and natural resource investments provide tax write-

offs.– Generally considered passive investments, and amount of write-off is

limited.

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Still More Taxes! Federal taxes

– Social Security– Excise (ex: gasoline)– Gift and Estate– Others, such as duties on imports

State and local taxes– Sales– Income – Property taxes, licensing fees, etc.

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THE END!

3-1 copyright 2002 by harcourt, inc. all rights reserved. chapter 3: managing your taxes clip art ...

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