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Chapter 12: Planning Your Tax Strategy

Section 12.1 Income Tax Fundamentals

Today’s Agenda:1. The importance of tax planning

2. How to identify your taxable income

3. The difference between deductions and credits

4. The W-4 form

Goal:Learn basic income tax terminology

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“Tax Freedom Day”

Tax strategies help with financial planning

1. Learn how current tax laws affect you

2. Keep accurate tax records

3. Learn how to make decisions that reduce

your tax liability

Taxes are an everyday occurrence!

What do taxes pay for?

Pay your FAIR SHARE and NO MORE!

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I. TYPES OF TAXES

A. Taxes on Purchases (Sales Tax)

B. Taxes on Property / Home

Real estate property tax: based on value of land and buildings

C. Taxes on Wealth

Federal Estate Tax: based on entire value of property at death

State Inheritance Tax: based on value of property willed to a specific heir

Federal Gift Tax: money or property valued at $13,000 or more (2010)… who pays?

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D. Taxes on Earnings

Income tax: a tax on our earnings

The IRS: federal agency that collects these taxes

The Basics of How it Works:

Employer withholds (takes out) income taxes and Social Security taxes from paychecks, sends to IRS

Year-end: use a tax form to calculate what you SHOULD HAVE PAID (your tax liability)

determine if you have over/under paid

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Remember…You are calculating your

TAXABLE INCOME to find your

TAX LIABILITY (the amount you should have paid)

TAXABLE INCOME is based on your income, plus many other factors.

You start with your income, and work it DOWN, DOWN, DOWN to find your

TAXABLE INCOME.

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1. Add up Gross Income

Earned income from your job

Interest income from savings

Dividend income from investments

(Some types of income are not taxed) Exclusions = tax-exempt income

Tax-deferred income = income taxed at later date

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2. Adjustments to Income

Gross Income – Adjustments =Adjusted Gross Income

(AGI)

Certain items are allowed to be subtracted from your income

3. Tax Deductions

Certain expenses that you can subtract from your AGI

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Standard vs. Itemized Tax Deductions

Every taxpayer can subtract at least the standard deduction

Are you eligible for more deductions, above the standard amount?

“Itemize” your deductions if the amount is more than the standard deduction

• Medical and dental expenses that exceed 7.5% of your AGI

• Real estate property taxes

• Mortgage interest

• Charitable contributions

• Certain expenses incurred from your job

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4. ExemptionsAllows a specific reduction in AGI per person (you, spouse, each dependent)

What is a qualified dependent? Pg. 385

5. Calculating Your Tax Liability:

AGI – Deductions – Exemptions =Taxable Income

Your taxable income is used to determine your tax liability

Use a Tax Table (based on six tax rates)

Figure 12.1

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6. Tax Credits

If eligible, allows further reductions in your taxes!

Subtract directly from your tax liability (different than tax deduction)

Dollar-for-dollar savings

Examples:

EIC = earned income credit for lower-income workers

Child Tax credit = credit for people with children

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6. Your Total Tax Liability

After CREDITS are SUBTRACTED, you arrive at Total Tax Liability

Compare this amount to what you paid in taxes the prior year

Did you pay enough?

Did you pay too much?

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Payroll Withholding

The number of allowances claimed on the W-4 form determines the amount of federal income tax withheld

Use the Personal Allowances Worksheet to figure out how many allowances to claim

Claim “0” => higher amount withheld

Claim “exempt” => no taxes withheld

How to fill out a W-4 form Figure 12.2

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Claiming AllowancesSome people like to claim “0” allowances, making withholding amounts greater

What is their reasoning?

How is this a forced form of savings?

Disadvantage of this?

What is a better alternative?

How will my allowances affect my paycheck? http://www.paycheckcity.com/netpaycalc/netpaycalculator.asp

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What is a Dependent?Someone is considered a “dependent” if:

Son, daughter, stepchild, foster childUnder age 19 OR If full-time student, under age 24 Lived with you more than half the yearNot provided more than half of own support

Dependents must file a tax return if their income is over $5700

Dependents cannot claim themselves as an exemption

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The 1040EZ

The simplest income tax return

Who can file?Can be single or marriedMust be under age 65No dependentsUnder $100,000 income

If eligible to file the EZ form, why might some people file a longer form?

http://www.bankrate.com/finance/money-guides/which-tax-return-form-should-you-use--1.aspx