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Dealing with Your Federal Income Tax
The Definitions
AGI = Adjusted Gross Income
Taxable Income or Net Income =
Income on which tax is computed, or
one’s gross income minus
deductions and exemptions
3-1
Main Components of Gross Income
•
Earned income
–
•
Investment income
–
•
Money received in the form of dividends, interest,
capital gains or rent from investments (1099 INT’s,
1099 DIV’s, 1099 MISC’s, 1099 B’s)
Passive income
–
•
Usually includes wages, salary, commissions, fees,
tips or bonuses (W-2’s) (1099 MISC’s)
Results from business activities in which you do
not directly participate such as a limited
partnership (Usually Sched K-1’s)
Other income
–
Alimony, awards, lottery and gambling winnings,
and prizes
3-2
Total income is affected by:
• Exclusions
• Amounts allowed by law to be excluded from gross
income
• Some items referred to as tax-exempt income; or
income not subject to federal income tax
– Example = interest on most state and city bonds
• Tax-deferred income
• Income that will be taxed at a later date, such as
earnings from an traditional individual retirement account
(IRA)
3-3
Adjusted Gross Income
• Adjustments to income
– Reduce Gross Income to Adjusted Gross Income
– Contributions to a traditional IRA or Keogh
– Alimony payments
– Interest on a Student Loan
– One half of your Self- Employment Tax
• Adjusted gross income (AGI)
– Gross income reduced by these certain reductions
– Becomes the basis for computing various other
deductions on Schedule A
3-4
Calculate Taxable Income
Tax deduction = Amount subtracted from
adjusted gross income (AGI) to arrive at
taxable income before one’s exemptions
Use the Standard deduction (2011) =
Single - $5,800; Joint - $11,600;
Head of Household - $8,500
(Most people use the standard deduction)
3-5
Calculate Taxable Income Itemized Deductions
• Medical & dental expenses (Greater than 7.5%
•
•
•
•
•
•
•
of AGI)
Taxes (State & Local)
Home Interest
Charitable Contributions
Casualty and theft loses (Greater than 10% of
AGI plus $100 for each occurrence)
Moving expenses
Job-related expenses
Other miscellaneous expenses (Most have to be
greater than 2% of AGI; some such as gambling
losses do not.)
3-6
Calculate Taxable Income
Exemptions
• Exemptions  Subtracted from AGI less
deductions
– An exemption = a deduction for yourself,
your spouse and qualified dependents
– The amount of the exemption
for the 2011 tax year is
$3,700 per person
– After deducting exemptions you
have arrived at your taxable income
3-7
Calculate Taxes Owed
– Tax table rates = Marginal rates
• The tax rate paid on the last (or
next) dollar of taxable income.
– Example:
• After deductions and exemptions,
a person in the 25% tax bracket
pays 25 cents in federal income
taxes for every dollar of taxable
income in that bracket.
3-8
2011 IRS Tax Brackets
at December 2011
Rate on
Taxable
Income
Single Taxpayers
Married Taxpayers
Filing Jointly
Head of Household
10%
up to $8,500
up to $17,000
up to $12,150
15%
$8,500 - $34,500
$17,000-$69,000
$12,150-$46,250
25%
$34,500 - $83,600
$69,000-$139,350
$46,250-$119,400
28%
$83,600 - $174,400
$139,350-$212,300
$119,400-$193,350
33%
$174,400 - $379,150
$212,300-$379,150
$193,350-$379,150
35%
Over $379,150
Over $379,150
Over $379,150
3-9
2011 IRS Tax Example
Tax on a single taxpayer’s income of $40,000
Rate on Taxable
Income
Single Taxpayers
Taxable
Amount
Tax Due
10%
up to $8,500
$8,500
$850.00
15%
$8,500-$34,500
$26,000
$3,900.00
25%
$34,500-$83,600
$5,500
$1,375.00
28%
$83,600-$174,400
$40,000
$6,125.00
33%
$174,400-$379,150
35%
Over $379,150
Average Rate
Marginal Rate
15.31%
25.00%
= $6,125 / $40,000
3-10
Calculate Taxes Owed
The average tax rate = the total tax due
divided by taxable income
• Average tax rate < marginal tax rate
Example:
– Taxable income = $40,000
– Total tax bill = $6,125
– Average tax rate = 15.31
or ($6,125 / $40,000)
3-11
Calculate Taxes Owed
• Alternative minimum tax (AMT)
– Paid by taxpayers with high amounts of
certain deductions and various types of
income
– Designed to ensure that those who receive
tax breaks also pay their fair share of taxes
3-12
Calculate Taxes Owed
• Tax credits
– Amount subtracted directly from the
amount of taxes owed
– Examples:
•
•
•
•
•
•
Earned income credits
Foreign tax credits
Child and dependent care credits
Retirement tax credits
Adoption tax credits
Hope Scholarship and Lifetime Learning
credits
3-13
Tax Credit versus Tax Deduction
$100 Tax Credit
Reduces Your Taxes by $100
$100 Tax Deduction
Amount Your Taxes are Reduced
is Based on Your Tax Bracket
3-14
Determining
Your Tax
Liability
3-15
Making Tax Payments
Payroll Withholding
Based on the number of exemptions and the
expected deductions claimed
Estimated Quarterly Payments
Estimated tax payments made throughout
the year based on income made during the
year and reported on various Forms 1099.
3-16
Watching Deadlines
Avoiding Penalties
• Form 4868  automatic six-month extension
– Submit estimated tax due with Form 4868 by April 15
• Penalties & Interest
– Underpayment of quarterly estimated taxes may
require paying interest on the amount owed
– Underpayment due to negligence can result in
penalties of 50 to 75 percent
3-17
Prepare a Federal Income Tax Return
Every citizen or resident of U.S. and every U.S.
citizen who is a resident of Puerto Rico is required
to file income tax.
•
Five filing status categories:
–
–
–
–
–
Single or legally separated
Married, filing jointly
Married, filing separately
Head of household
• Unmarried individual or surviving spouse who with
a child or dependent relative
Qualifying widow or widower (Year of the
spouse’s death plus two additional years)
3-18
Which Tax Form Should You Use?
•
≈ 400 federal tax forms and schedules
•
Basically the choice is between 3 forms
1040EZ
1040A
1040
•
Which form to use?
–
Type of income
– Amount of income
– Number of deductions
– Complexity of tax situation
3-19
Completing the Federal Income Tax
Return








Filing status and exemptions
Income
Adjustments to income
Tax computation
Tax credits
Other taxes (such as from self-employment)
Payments (total withholding and other payments)
Refund or amount you owe
•
•
Refunds can be directly deposited to your bank account.
Payments may be directly debited from your bank account.
 Your signature = Most common filing error
3-20
Mississippi State Income Tax
• All but 7 states have a state income tax
• Mississippi (2010)
1st $5,000 or part of taxable income is
taxed at 3%
Next $5,000 or part of taxable income is
taxed at 4%
Remaining Balance of taxable income is
taxed at 5%
• States usually require income tax returns to be filed
when the federal income tax return is due
3-21
How Do I File My Taxes Online?
• Tax preparation software
–
TurboTax and H & R Block At Home are two of
the most popular tax preparation software
packages
• Using software can save 10 or more hours
– Tax software allows you to complete needed tax
forms
• Print and mail the forms or file online
– e-filing refunds usually take 3 weeks
– Cost for e-filing = $5 - $40
3-22
How Do I File My Taxes Online?
• Free File Alliance
– Online tax preparation and filing free to many
taxpayers
– http://www.irs.gov - go to “Free File”
– Various qualification criteria to file free; use
“Guide Me to a Service”
– Connect to selected firm’s website
– Use form’s online software to prepare and
file tax return
3-23
Available Tax Assistance Sources
•
IRS Services
– Publications and forms
• 1-800-TAX-FORM
• www.irs.gov
– Recorded messages
• 1-800-829-4477
– Phone hot line
• 1-800-829-1040
– Walk-in service at an IRS office
3-24
Available Tax Assistance Sources
•
Tax publications
–
•
The Internet
–
•
e.g. Ernst and Young Tax Guide and J.K.
Lasser’s Your Income Tax
Tax preparation software companies
Tax Preparation Services
–
–
Tax preparers charge between $40 and $2,000
depending on the complexity of the return
Over 40 million U.S. taxpayers pay someone
else to do their taxes
3-25
Types of Tax Preparation Services
• One-person, local offices to large
firms such as H & R Block
• “Enrolled agents” = Government-
approved tax preparers
• CPA’s
• Attorneys
3-26
Evaluating Tax Services
Factors to consider:
•
•
•
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Training and experience of the tax professional?
Fee for preparing taxes and how determined?
Questionable deductions suggested?
If return is audited will the preparer represent the
client?
• Is tax preparation the main business activity or is it a
front for other financial (or non-financial) products? (I
have seen signs advertising tax services at barber
shops and men’s wear stores.)
3-27
Tax Service Warnings
• Ultimately you are responsible for providing complete
and accurate information
– If your professional tax preparer makes a mistake,
you are still responsible for paying the correct
amount, plus any interest and penalties. A good
preparer will reimburse any penalties and interest
you pay. (I paid one in 2010!)
• Hiring a tax preparer does not guarantee that you will
pay the correct amount
• Beware of tax preparers that offer refunds in advance
• “Refund anticipation loans” can charge interest rates in
excess of 300%
3-28
What Tax Records to Keep
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•
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•
•
•
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Current tax forms and instruction booklets
Social security numbers
Copy of previous year’s returns
W-2 forms from employers
1099 forms (interest, self employment)
1098 (mortgage interest paid)
Receipts and documentation for expenses
Investment & business expense documents
3-29
What if Your Return is Audited?
≈ 0.6% of all returns are audited
•
If you claim large or unusual deductions you
are more likely to be audited.
• Three types of audits:
– Correspondence audit for minor questions
– Office audit takes place at an IRS office
– Field audit is the most complex, with an
IRS agent visiting you at your home, your
business or your accountant’s office
3-30
What if Your Return is Audited?
• Audit Rights
– Request time to prepare
– Clarification of items being questioned
– Right to appeal audit results
• When Audited:
– Decide whether to bring you tax preparer,
accountant or lawyer
– Be on time for you’re appointment; bring only
relevant documents
– Present evidence in a logical, calm and confident
manner; maintain a positive attitude
– Make sure your information is consistent with tax
law
– Keep your answers aimed at the auditor’s questions
3-31
Objective 4
Select Appropriate Tax Strategies
Tax Planning Strategies
• Practice tax avoidance
– Legitimate methods to reduce your tax
obligation to your fair share but no more
– Financial decisions related to purchasing,
investing, and retirement planning are the
most heavily affected by tax laws
•
Tax Evasion
– Illegally not paying all the taxes you owe,
by purposely not reporting all income
3-32
Tax Planning Strategies
Minimizing Taxes
If you expect
Then you should
Because
The same or a
Accelerate
Greater benefit to
lower tax rate
deductions into
higher rate
next year
this year
The same tax rate Delay income into Delay paying taxes
next year
next year
Delay deductions
Greater benefit
A higher tax rate
Accelerate income Taxed at lower rate
next year
3-33
Tax-Planning Strategies
Consumer Purchasing
•
•
Home ownership
–
One of the best tax shelters
–
Deduct mortgage loan interest
property taxes
–
Reduces your taxable income
and
Use home equity line of credit to buy a
car or consolidate debt
–
Interest deductible
–
Be careful; the loan has to be
paid back one of these days
3-34
Tax-Planning Strategies
Consumer Purchasing
•
Job-related expenses may be allowed as
itemized deductions
–
–
–
•
Union dues
Business tools
Job search costs
Health care expenses
FSA’s (Flexible Spending Accounts) allow you to
reduce your taxable income when paying for health
related expenses
3-35
Tax-Planning Strategies
Investment Decisions
Tax Exempt Investments
– Interest income from municipal bonds are
exempt from federal and some state taxes
Tax Deferred Investments
– Tax deferred annuities
– Section 529 education savings plans
– Retirement Plans -IRA, Keogh or 401(k)
• A type of tax shelter
3-36
Tax-Planning Strategies
Investment Decisions
Capital Gains
–
–
Profits from the sale of stocks, bonds or real estate
Long-term capital gains (held more than one year)
taxed at a lower rate
Self Employment
Advantage: Owning your own business can have tax
advantages
Disadvantage: Business owners have to pay
additional taxes
3-37
Tax-Planning Strategies
Investment Decisions
Children’s Investments
Children with investment income of more than $1500
are taxed at parent’s top rate
Retirement Plans (These have different contribution limits
depending on the situation. One should consult their financial
advisor.)
–
Traditional IRA
–
Roth IRA
–
Education IRA
–
Keogh Plan
–
401 (K) Plan
3-38
Changing Tax Strategies
• IRS Changes:
– IRS modifies tax filing procedures each year
– Congress passes legislation to change the tax
code each year.
– Take advantage of these changes for personal
financial planning
• Personal Changes:
– Consider changes in your personal situation and
income
– Monitor your tax strategies to best serve your
daily needs and long-term financial goals
3-39

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