paying taxes © 2010 pearson education, inc. all rights reserved chapter 6
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Paying Taxes
© 2010 Pearson Education, Inc.All rights reserved
Chapter 6
Learning Objectives
• Describe the basic principles of taxation and the major categories of taxes.
• Explain payroll taxes
• Describe the purpose and process of filing tax returns
• Explain how taxes affect your financial plan
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Tax Basics
• Tax is money collected by a government from its citizens for the purpose of operating the government
• Gross pay is the total amount of money you earn• Take-home pay is the amount of money you get to
keep and use• Net Pay is the amount of money you take home
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Tax Basics
• Everyone pays taxes • Taxes pay the cost of government• The government levies taxes on different things• States can have different taxes too• There are all different types of taxes, such as:
– Sales Taxes
– Real Estate Taxes
– Payroll Taxes
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Math for Personal Finance
• Ryan’s take-home or net pay was $147.76 and his gross pay was $160.00. Assume the FICA withholdings are 7.65. How much did Ryan pay in FICA from this check?
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Math for Personal Finance
• Solution: Solution: Ryan paid 7.65 percent of the $60 or $12.24 in FICA from this check.
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Sales Tax
• Sales tax is tax on purchases at a store
• Some of the price we pay for an item is a tax
• The merchant collects this money and sends it to the government
• The federal government does not impose a sales tax
• Many state governments do impose a sales tax
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Real Estate Tax
• Governments calculate real estate taxes based on the value of the property
• The government sends the property owner a bill for this tax
• These taxes are primarily used to fund local schools
• They also vary significantly from state to state and county to county.
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Payroll Taxes
• Payroll Taxes are taxes on your paycheck
• Many people pay taxes every time they get paid
• These taxes can include federal and state income taxes and social security (or FICA) withholdings.
• People who are self employed do not have taxes withheld from their earnings.
• See figure 6.1 for an example of a pay stub
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Figure 6.1
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The Internal Revenue Service
• Internal revenue service (IRS) is the government body that carries out the federal tax system
• The IRS is a branch of the United States Treasury Department
• They enforce the tax laws and collect taxes
• Each year in which you earn an income over a certain amount, you need to file a federal tax return with the IRS
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The Internal Revenue Service
• Tax returns report to the IRS all the information relative to your income taxes
• A tax return consists of a form called 1040 or 1040EZ (see Figure 6.2 a &b)
• On this form you need to include how much income you earned and how much you paid to the IRS
• You will either receive a refund or pay the difference to the government if you owe money
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Figure 6.2a
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Figure 6.2b
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The Internal Revenue Service
• Taxes are figured based on your earnings from January to December
• When the year is over, you have until April 15th to file your return
• Many careers involve helping people take advantage of tax laws to pay the lowest possible tax
• Attorneys and accountants make good incomes by helping people with tax issues
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Check Your Financial IQ
• What is the major purpose of taxes?
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Check Your Financial IQ
• Taxes pay the cost of government
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Understanding Payroll Taxes
• Personal Income Taxes are federal income taxes and state income taxes (the states that have them)
• Social Security provides payments to eligible retirees and disabled people
• Medicare provides health care coverage to mostly older Americans and some younger disabled people
• Payroll taxes include:
– Social Security and Medicare taxes
– Personal income taxes (state and federal)
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Social Security and Medicare
• For most Americans, earned income is subject to FICA taxes
• FICA taxes are withheld from your paychecks and sent to the government
• These withholdings fund Social Security and Medicare
• For both Social Security and Medicare, your employer matches your contributions and sends the total amount to the government
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Social Security and Medicare
• Your portion of the Social security tax is equal to 6.20 percent of your salary—up to a specific income level
• This amount is linked to inflation and increases slightly every year
• There is no cap on the amount of earnings subject to the Medicare tax
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Math for Personal Finance
• Brogan’s grandfather made $112,000 in 2007, and the Social Security cap in 2007 was $97,5000.
• How much Social Security was withheld from his pay and how much Medicare was withheld from his pay?
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Math for Personal Finance
• Solution: Brogran’s grandfather had 6.2% withheld from his pay for the first $97,500 he made during 2007 for a total of $6,045 or (.062 x $97,500). However, Medicare was withheld on the entire amount so Medicare withholdings were $112,000 x .0145 = $1,624.
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Personal Income Taxes
• Personal income taxes is the income reported on your tax return
• Many people use a tax professional or tax preparation software for returns.
• These programs guide you through preparing your tax returns and include all the necessary forms
• Refer to Figure 6.3 for the IRS table of individual tax rates
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Figure 6.3
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Other Income Taxes
• Many people pay a state income tax, depending on where they live
• Some cities also collect income taxes
• Take a look at figure 6.4 for a listing of states with the highest and lowest tax rates
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Figure 6.4
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Check Your Financial IQ
• What are the payroll taxes?
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Check Your Financial IQ
• Federal and state income taxes, Social Security, and Medicare are payroll taxes
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Filing Taxes
• A tax return form allows you to record several different categories of information, including:– Filing Status– Exemptions– Gross Income– Adjusted gross income– Tax and credits
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Filing Status
• Taxpayers need to specify a filing status when they submit their income tax return
• They must choose one of the following options: – Single– Married filing jointly– Married filing separately– Head of household– Qualifying widow(er) with dependent child
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Filing Status
• Tax rules and rates differ depending on which status you choose
• Until the age of 18, most of you will be considered dependents by the IRS
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Gross Income or Total Income
• Gross income is the total income consisting of the total amount of a person’s income from (almost) any source
• The first step in calculating the federal tax you owe is to determine your gross income
• Your employer will send you a W-2 form that details how much money you made
• See Figure 6.5 for a sample W-2 form
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Figure 6.5
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Gross Income or Total Income
• Capital gains occur when you sell an asset for more than what you paid for it
• Other forms of income include interest income, dividend income, and capital gains
• Gross income also includes income from tips, rental properties, and business income.
• Some types of income are not included in gross income and therefore are not taxes, such as: – Insurance reimbursements– Child support payments– Veteran’s welfare benefits
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Adjusted Gross Income
• Adjusted gross income is figured by taking the total income and subtracting certain allowable amounts
• The next step in filing a tax return is to figure your adjusted gross income, or AGI.
• The allowable amounts include :– contributions to certain retirement
accounts
– alimony payments
– interest paid on student loans
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Math for Personal Finance
• Last year Colt’s salary was $32,000 but he also received $1,200 in dividend income and lost $400 on the sale of one stock and gained $650 on the sale of another stock.
• What was Colt’s gross income?
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Math for Personal Finance
• Solution: Colt’s gross income was $32,000 + $1,200 - $400 +$650 = $33,450
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Deductions and Exemptions
• Standard deduction is a fixed amount all people are allowed to deduct from their AGI to reduce their tax liability
• Itemized deductions are specific expenses that, under tax law, can be deducted from income to reduce the amount of income subject to income tax
• You may be able to claim various deductions and exemptions that will reduce the amount of your AGI that is subject to your income taxes.
• These deductions include:– Standard deduction– Itemized deduction
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Deductions and Exemptions
• Congress has approved certain items as tax deductible in order to encourage certain behaviors
• For example, Congress encourages home ownership
• Homeowners can deduct the interest paid on a mortgage loan and the real estate taxes they pay
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Refund or Payment
• Accurate completion of your tax return will show you if you need to pay additional income taxes or if you will receive a refund
• In most cases, you will not receive a refund unless you pay taxes during the year
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Check Your Financial IQ
• When does a person file his or her taxes?
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Check Your Financial IQ
• A person fills out a tax return by April 15 of each year
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Taxes and Your Financial Plan
• People want to lower their tax liability to the lowest possible level for their income
• They will keep more of their own money rather than paying it to the government in taxes
• Tax planning influences both your short-term and long-term future
• Consider the tax implications of your financial life at all stages
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Check Your Financial IQ
• Why are taxes an important part of your financial plan?
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Check Your Financial IQ
• You must consider the tax consequences of all your financial decisions because the tax impact may make one course of action better than another
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Summary
• Taxes are monies the government collects from citizens for the purpose of operation the government
• The government collects taxes in a variety of ways and forms:– Sales taxes– Real estate taxes– Payroll taxes
• The IRS is the governmental body that carries out the federal tax system
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Summary
• Payroll taxes include personal income taxes (state and federal) and Social Security and Medicare taxes
• Social Security and Medicare taxes are also known as FICA
• Filing taxes involves reporting your earnings for the year on a tax return.
• This is sent to the IRS and to any appropriate state or local tax collection agency
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Summary
• Tax planning is another important step in your financial plan
• Taking full advantage of the ways to reduce your taxable income takes planning
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Key Terms and Vocabulary
• Adjusted gross income
• Capital gain
• Gross income
• Gross pay
• Internal Revenue Service (IRS)
• Itemized deduction
• Medicare
• Net pay
• Payroll tax
• Personal income tax
• Sales tax
• Social security
• Standard deduction
• Take-home pay
• Tax
• Tax return
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Websites
• www.irs.gov
• www.taxadmin.org/fta/rate/ind_inc.html
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