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© 2008 Thomson South-Western
CHAPTER 3
MANAGING YOUR TAXES
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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
– 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 the entire income.
Tax brackets, standard deductions, and personal exemptions are indexed to inflation.
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Economics of Income Taxes
Tax rate for each bracket is called the marginal tax rate
Relating the tax liability to the level of taxable income earned, tax rate is called the average tax rate– It is lower than the marginal rate
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2005 Tax Rate Schedule(single taxpayers)
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Examples: Jason and David
Jason’s marginal tax rate = 25%
Jason’s average tax rate = 16.7%
David’s marginal tax rate = 28%
David’s average tax rate = 21.1%
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More Principles of Taxation
Filing Status a factor in determining amount of income tax paid.– Single– Married filing jointly– Married filing separately– Head of household– Qualifying widow/widower with dependent child
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More Principles of Taxation
Taxes are due on a pay-as-you-go basis– Employer withholds taxes all year– Self-employed deduct and pay taxes
Taxes paid are:– Federal income taxes– State income taxes– Local income taxes – Social Security taxes
• Medicare component
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It's Taxable Income that Matters
Taxable Income
is the amount of our income on which we calculate taxes owed.
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All income subject to federal income taxes3 classifications of income that must be kept separate for deduction purposes
Active Income
Wages & salaries
Alimony received
Business & farm income
Prizes, awards, gambling winnings
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
Gross Income
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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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Adjustments to Gross Income (AGI)
Items that can be subtracted from gross income.
Some items included:
– Traditional IRA contributions (some limits)
– Self-employment tax—50% of amount paid
– Alimony paid– Penalty on early withdrawal of savings
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The subtotal obtained when adjustments are subtracted from gross income.
Used to limit certain itemized deductions and other calculations
Adjusted Gross Income (AGI)
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Deductions
Standard deduction – the blanket amount allotted for various deductible expenses taxpayers normally incur
Itemized Deductions – if deductible expenses are greater than the standard deduction, deductions may be itemized instead.
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– Medical and dental expenses
– State and local income taxes
– Property taxes
– Home mortgage interest
– Charitable contributions
– Casualty and theft losses
Itemized Deductions
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Exemptions
Self and dependents 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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Tax Credits versus Tax Deductions
Credits directly reduce 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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Tax Credits versus Tax Deductions
A $1000 tax credit reduces tax by much more than a deduction.
* Tax liability is figured as follows: the first $7,300 of taxable income is taxed at 10 percent, the balance at 15 percent.
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Tax Forms and Schedules
Variations of Form 1040
If more detail required, taxpayers also must file other forms and schedules.
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Common Tax Forms and Schedules
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Example: 2005 Tax Return of the Beckers
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Example: 2005 Tax Return of the Beckers
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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 – Certified public accountants (CPAs)– Enrolled agents (EAs)– Tax attorneys
Use tax software Computer-based tax returns Taxpayer is responsible for accuracy!
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Effective Tax Planning
Tax avoidance is legal. Tax evasion is not!
Reduce taxes– Maximize deductions and/or credits – Income shifting– Tax deferral– Tax-free income