Chapter 3 Preparing Your Taxes Chapter Outline Learning Goals I. Understanding Federal Income Tax Principles A. The Economics of Income Taxes B. Your Filing Status C. Your Take-Home Pay 1. Federal Withholding Taxes 2. FICA and Other Withholding Taxes *Concept Check* II. It's Taxable Income That Matters A. Gross Income 1. Three Kinds of Income 2. Capital Gains a. Selling Your Home: A Special Case B. Adjustments to (Gross) Income C. Deductions: Standard or Itemized? 1. Standard Deduction 2. Itemized Deductions 3. Choosing the Better Option D. Exemptions *Concept Check* III. Calculating and Filing Your Taxes A. Tax Rates B. Tax Credits C. Tax Forms and Schedules 1. Variations of Form 1040 D. The 2011 Tax Return of James and Rose Sullivan 1. Finding the Sullivans’ Tax Liability: Form 1040 a. Gross Income b. Adjustments to Gross Income c. Adjusted Gross Income (AGI) d. Itemized Deductions or Standard Deduction? e. The Sullivans’ Taxable Income and Tax Liability f. Do They Get a Tax Refund? *Concept Check* IV. Other Filing Considerations A. Estimates, Extensions, and Amendments 1. Estimated Taxes 2. April 15: Filing Deadline 3. Filing Extensions and Amended Returns B. Audited Returns C. Tax Preparation Services: Getting Help on Your Returns 1. Help from the IRS 2. Private Tax Preparers D. Computer-Based Tax Returns *Concept Check* V. Effective Tax Planning A. Fundamental Objectives of Tax Planning B. Some Popular Tax Strategies 1. Maximizing Deductions 2. Income Shifting 3. Tax-Free and Tax-Deferred Income *Concept Check* Summary Financial Planning Exercises Applying Personal Finance Tax Relief Critical Thinking Cases 3.1 The Kapoors Tackle Their Tax Return 3.2 Cheryl Stern: Waitress or Tax Expert? Money Online! Major Topics The average American family pays about one-third of its gross income in taxes. Therefore, tax planning is a very important element of a personal financial plan. The first objective of tax planning is to maximize the amount of money available for non-tax outlays by minimizing taxes. This is done honestly by understanding the tax laws and taking advantage of favorable provisions. The major topics covered in this chapter include: 1. The economics of income taxes and their effect on take-home pay. 2. Filing status, types of income, and the adjustments and deductions available when determining the amount of taxable income and the associated tax liability. 3. Types of tax returns and a detailed explanation of how to determine taxable income and tax liability using IRS Forms 1040 and 1040EZ. 4. Estimated taxes, procedures for filing taxes, and sources of tax preparation assistance. 5. The role of effective tax planning in reducing taxes by maximizing deductions, shifting, sheltering, avoiding, and deferring taxable income. Key Concepts Because nearly everyone must pay taxes, an understanding of the basic terminology of taxes and tax planning is fundamental to effective personal financial planning. Clearly, everyone who pays taxes needs to know their method of calculation, allowable deductions, and payment timing and procedures. The following phrases represent the key concepts stressed in this chapter. 1. Progressive tax structure 2. Marginal tax rate 3. Average tax rate 4. Filing status 5. Federal withholding taxes 6. Federal Insurance Contributions Act (FICA) or Social Security tax 7. Gross income and adjusted gross income 8. Taxable income 9. Capital gains and losses 10. Deductions and exemptions 11. Joint returns and individual returns 12. Tax calculation procedures 13. Tax credits 14. Estimated taxes 15. Filing your return 16. Tax audits 17. Tax preparation services 18. Good tax planning Answers to Concept Check Questions PLEASE NOTE: Tax laws change rapidly. To keep current with tax laws, find more information, or download forms, try the IRS’s Web site at www.irs.gov. 3-1. With a progressive tax structure, the larger the amount of taxable income, the higher the rate at which it is taxed. The economic rationale underlying the progressive income tax is that taxation should be based not only on income, but also on the ability to pay. In other words, persons who earn more money should be better able to pay taxes. Therefore, as a result of the progressive tax structure, they are required to pay a larger portion of their taxable income in taxes than those who earn less money. 3-2. The five filing categories and their definitions are: • Single—an unmarried or legally separated person. • Married filing jointly—married couples who file one tax return that combines their income and deductions. • Married filing separately—each spouse files his or her own return, with only his or her own income, exemptions, and deductions. • Head of household—a single person who provides at least 50% of the household support for him- or herself and a dependent child or relative. • Qualifying widow or widower with dependent child—a person whose spouse has died within two years of the current tax year and who supports a dependent child. Although filing a joint return usually results in lower taxes for couples, under some circumstances separate returns are preferable. This may occur when one person earns much less than his/her spouse and has a large amount of deductions. Taxpayers have the right to minimize their tax burden as much as is legal, so married couples should figure their taxes both ways and choose the option with the lowest tax liability. 3-3. All income (before any deductions) that is subject to federal taxes is considered gross earnings. Note that this amount is not necessarily every cent you bring in, as some types of income are tax exempt and are not included in gross income for federal income tax purposes. Take-home pay is found by deducting the total amount withheld from a person's gross earnings. The amount withheld may consist of the federal withholding tax, the Federal Insurance Contribution Act (FICA) tax (i.e., Social Security), state and local taxes, and other items such as insurance premiums. The employer retains these payments and periodically pays them to the Internal Revenue Service (IRS) or some other appropriate agency. 3-4. The amount of federal withholding taxes deducted from gross earnings each pay period depends on (a) the level of earnings and (b) the number of withholding allowances claimed. Because of the progressive nature of the tax structure, the more a person earns, the greater his or her expected tax liability and the higher the level of withholding. However, the greater the number of exemptions claimed, the lower the amount of taxes withheld. Each exemption claimed in 2011 reduced taxable income by $3,700. 3-5. Gross income is all income (before any adjustments, deductions, and/or exemptions) that is subject to federal taxes. Adjusted gross income (AGI) is found by subtracting adjustments to (gross) income from gross income. Allowable adjustments to gross income (within applicable limits and restrictions) include certain types of employee and personal retirement contributions, interest on student loans, and alimony paid. Examples of tax-exempt income include child support payments, compensation from insurance policies, gifts, veterans’ benefits, etc. These items are not included in gross income. Passive income refers to income derived from certain investments, typically real estate partnerships and other tax shelters, where the investor's primary line of business is not real estate. 3-6. Capital gains and capital losses are profits or losses made on the sale of an asset such as stocks, bonds, or real estate investments. The gain or loss is the difference between the sale price and the cost basis of the asset. (The cost basis is the purchase price plus income produced by the asset on which income taxes were paid year by year.) Long-term capital gains are taxed at lower rates than is active income, while short-term capital gains are taxed at one's ordinary tax rate. Capital losses are subtracted from gains, and if losses exceed gains, the net loss is deducted from active income up to a maximum of $3,000 for the year. Losses in excess of this amount may be carried forward on future years’ tax returns. Note than capital losses will be at the taxpayer’s regular income tax rate and not the lower capital gains rate, as capital losses are used to reduce active income. [For a schedule of the rates, refer to Exhibit 3.3.] 3-7. Major categories of deductions (students are to list five) include: • Medical and dental expenses in excess of 7.5% of AGI • State, local, and foreign income and property taxes • Residential mortgage interest, subject to certain limitations • Charitable contributions, up to a specified percentage of AGI • Casualty and theft losses over 10% of AGI with a $100 deductible per loss • Job and other expenses in excess of 2% of AGI Since 1991, the allowable amount of itemized deductions is reduced for taxpayers with AGI above certain levels. 3-8. It would be well to refer to the 1040 instruction booklet (found at the IRS web site www.irs.gov) for a brief description of the 5 tests which must be met in order for a person to qualify as a dependent. If Jeff and Laura use the filing status “married filing jointly,” they will claim two exemptions. If Laura’s parents provided over half her support for the year, then it’s possible they could claim her for an exemption. If they do claim her, then she cannot be claimed as an exemption on a joint return with her husband. In fact, only if she is filing to get a refund and if no tax liability exists for either spouse would Laura be able to file a joint return with her husband and still be claimed as a dependent on her parents' return. To be eligible to claim Laura, her parents must meet all 5 tests: 1) relationship (yes, she’s their daughter); 2) joint return (already mentioned—she probably will not be able to file a joint return with her husband if her parents claim her); 3) U.S. citizen (assume yes); 4) support test (yes, parents provided over half her support for the year); and 5) income. The income test would limit Laura’s gross income to less than $3,700 (in 2011), so this test would not be met ($625/mo. × 12 months = $7,500). However, since she made more, they could still claim her if she was under 19 or if she was a full-time student under age 24. So in this case, Laura’s parents may be able to claim her. If they do, then she cannot claim herself or be claimed on her husband’s return and probably cannot file a joint return with him. If this situation applies to you, you probably would want to call the IRS and ask them. 3-9. The average tax rate is the rate at which each dollar of taxable income is taxed and is calculated by dividing the total tax liability by taxable income. The marginal tax rate is the rate applied to the next dollar of taxable income (the highest applicable tax bracket). It is applied only to the portion of taxable income which falls in the last applicable tax bracket. A tax credit directly reduces one's tax liability, while a deduction from income reduces one's taxable income before taxes are calculated. Dollar for dollar, a tax credit is more valuable than a deduction. 3-10. a. Form 1040 is the main form used in filing federal income taxes. All individuals filing the long form use Form 1040 accompanied by appropriate schedules as needed to file their tax return. The form's two pages summarize all items of income, the deductions detailed on the accompanying schedules, and note the taxable income and associated tax liability. b. A variety of schedules may accompany Form 1040, with Schedules A, B, C and D being some of the frequently used ones. The schedules provide detailed guidelines for calculating certain entries on the first two pages of Form 1040, and their use varies among taxpayers, depending upon the relevance of these entries to their individual financial situations. c. Tax rate schedules provide the information for calculating the tax due after all deductions and exemptions have been taken to arrive at taxable income. The tables cover tax rates for the various filing categories. 3-11. Estimated taxes are tax payments that must be made by persons earning income from sources that are not subject to withholding taxes. In order to assure that taxes are received on a "pay-as-you-go" basis, the IRS requires that taxpayers who earn income against which taxes are not withheld make quarterly estimated tax payments. The taxes are based upon the amount of this type of income expected during the year. IRS Form 1040ES is used to declare this income and tax estimate. Taxpayers with AGI over certain amounts are subject to additional estimated tax rules. Refer to Form 1040ES for a worksheet which will help you determine if you need to make estimated tax payments. For more details, see Publication 505. 3-12. A tax audit is a review of a tax return to prove its accuracy with regard to proper reporting of income and deductions. Some taxpayers are chosen randomly for audits, while others are audited because certain income or deduction items fall outside of normal ranges. The best way to be prepared for an audit is to keep thorough records of cash receipts and expenditures and receipts from other deductible items. Especially when you have deductions that fall outside the IRS norms, be sure to have proper documentation and attach an explanation of such deductions to your return. 3-13. The IRS provides various types of assistance to taxpayers. The agency makes available forms and publications which can be accessed by going online, by requesting a fax, by requesting a printed copy, or by picking them up at numerous locations around town. The IRS also provides direct assistance to taxpayers through a toll-free telephone number. In certain instances, the IRS will even figure your income tax liability for you. Refer to Publication No. 967. 3-14. Tax preparation computer software, such as Tax Cut, TurboTax, and similar programs, allows those with PCs to do their own tax returns. Such programs can save hours of figuring and refiguring the many forms and schedules involved in filing tax returns. However, they are not a substitute for personal knowledge of tax laws and the skill and expertise of a tax accountant or attorney, especially when the tax return is complex. 3-15. Tax avoidance is the practice of using various legal strategies to reduce one's tax liability. Tax evasion, on the other hand, refers to illegal means of reducing taxes, such as underreporting income or overstating deductions. 3-16. a. Taxpayers can maximize deductions by accelerating or bunching their deductions into one tax year. Examples include paying next year's property taxes early in order to be able to count both, this year's and next year's taxes on this year's return, and bunching no reimbursable elective medical procedures into one year. Such actions may make it advantageous for a taxpayer to itemize deductions for at least one year versus having to take the standard each year. b. Income shifting is a technique for reducing taxes by shifting some income to a family member in a lower tax bracket. This is done by creating trusts or custodial accounts or making outright gifts of income-producing property to family members. (Note: The age of the family member will affect the tax benefits of this strategy.) c. Tax-free income is income which is free from federal income taxation. For example, qualified municipal bonds pay interest income which is free from federal income taxes. However, if you live where there is a state and/or local income tax, qualified municipal bonds from other states will be subject to your state and local income taxes. Be aware that not all municipal bonds qualify for the tax-exempt status and that capital gains on the sale of municipal bonds are not tax free! d. Tax-deferred income allows you to reduce or eliminate taxes today by postponing them to sometime into the future after retirement. The appeal of tax-deferred vehicles, such as IRAs and 401(k) plans, is their ability to allow the investor to accumulate earnings in a tax-free fashion. This will allow the investment to grow to a larger amount before it is subject to taxation, and the idea with this is that many people will be in a lower income tax bracket after retirement. Then, when income is taxed after retirement, not as much will be lost to taxes. However, many retired people are in the same or sometimes higher tax bracket than they were before retirement. Financial Planning Exercises 1. Mary Watson's tax calculations are as follows (assuming a 2011 tax year). Look on page 2 of the sample Form 1040 shown in the text. The standard deduction amounts are shown in the top left margin, and the exemption amount is given on line 42. Mary is single and will claim herself as an exemption. Use the tax rate schedules given in Exhibit 3.3 to determine her tax liability. Note that Mary will owe additional taxes for 2011. If she has underpaid by too great an amount, she may also be subject to an underpayment penalty regardless of whether she files her return by April 15 or not. Refer to IRS Publication 505. 2. 3. Amy would pay the following capital gains taxes according to the regulations for capital gains in effect in 2011. Please note that no mention is made of interest or dividends earned during the time these securities were held, and we will disregard these items for this problem. Interest or dividends earned increase a security's basis, or the starting amount for the capital gains calculation. This would serve to lower the capital gains realized, and thus lower the capital gains taxes due on the security. *If the stock in part c was Amy’s only capital gain or loss for the year, this loss would reduce her active income by $500. At the 28% tax rate, she would pay $140 less in taxes than would have been the case without the $500 capital loss. If she has other capital gains or losses, the long-term capital gains would be netted with one another, the short-term capital gains would be netted with one another, and finally the overall short-term gain or loss netted with the overall long-term gain or loss. 4. Assuming “pre-tax income” to mean “taxable income,” the impact of an extra $1,000 deduction vs. a $1,000 tax credit for a single taxpayer in the 25% tax bracket (as of 2011) is as follows: As can be readily observed, a tax credit reduces the taxes due (line 2) more than does a deduction, thus causing the after-tax income (line 3) to be greater with the $1,000 credit than with the $1,000 deduction. A tax deduction reduces taxable income (a larger number) whereas a tax credit reduces the tax due (a much smaller number), so dollar for dollar, the tax credit has a greater impact. 5. a. Qiang can use Form 1040EZ because his income is only from eligible sources and he has less than $1,500 in interest income. (Generally, tuition scholarships and grants are generally considered tax exempt, while those that go for room and board are not.) b. In order to deduct his contribution for a traditional IRA, Qiang would have to use Form 1040A or the standard 1040 long form. The Roth IRA (available beginning 1998) is not tax deductible, so the illustration for part b assumes a contribution to a traditional IRA. Qiang’s tax calculations on the appropriate forms are shown on the following pages. 5a.1040EZ 5b. 1040 5b.1040 Qiang should use the standard 1040 form because he will receive a refund rather than having to pay more tax as with the 1040EZ format. 6. Taxable income for 2011 is calculated as follows: Exclusions: • Medical expenses of $1,155 are less than the 7.5 % minimum of AGI ($38,555 × 0.075 = $2,892) allowed by law before deductions can be taken. • Sales tax and personal interest expenses are not allowed. Social Security taxes are not deductible. • Job and other qualified miscellaneous expenses are limited to the amount which is over 2% of AGI. • Interest paid on car loans and credit cards are generally not tax deductible. The standard deduction of $11,600 was used because it was greater than this family's itemized deductions of $8,904. The IRA contribution was assumed to be to a traditional deductible IRA, as contributions to Roth IRAs are not deductible. 7. Typically, tax audits question whether all income received has been properly reported and if the deductions claimed are legitimate and for the correct amounts. Therefore, in preparation for the audit Shauna and Conan should get all their documentation in order for these items, particularly those for cash receipts and cash payments. They should contact their CPA or other tax preparer if they have to seek both their advice and guidance through the audit. If they did not have a professional prepare their return, they would still do well to consult with one before the audit. In fact, they might want to seek the counsel of a tax attorney. If the O’Farrells do not agree with the IRS examiner on disputed items, the taxpayer can meet with the examiner's supervisor to discuss the case further. If there is still disagreement, they can appeal through the IRS Appeals Office. If they do not wish to use the Appeals Office or if they disagree with its findings, they may be able to take their case to the U.S. Tax Court, U.S. Court of Federal Claims, or the U.S. District Court where they live. [For more information, IRS Publication 1 deals with "Your Rights as a Taxpayer" which can be printed off from the IRS Web site, www.irs.gov.] Solutions to Critical Thinking Cases 3.1 The Kapoors Tackle Their Tax Return 1. The Kapoors’ tax return on Form 1040 is included on the following pages. Please note that the tax return shown was prepared using tax preparation software, so the tax calculation may be slightly different from what it would be if figured using the tax rate schedule. Also note that in addition to the forms shown, other forms would have to be filed with this family's tax return for credit for qualified retirement savings contributions, additional child tax credit, and earned income credit. This family's itemized deductions total $6,339 ($831 + $4,148 + $1,360), which is less than the standard deduction. Therefore, they will take the standard deduction, because it will lower their taxable income and hence their tax liability more than would itemizing deductions. Note that their $200 of unreimbursed medical and dental expenses is less than 7.5% of their adjusted gross income, so this amount would not be considered toward their itemized deductions. A completed Schedule A is included in the tax forms which follow to illustrate how deductions are listed. This family would NOT file this form, because they would take the standard deduction instead. Note Murali’s $366 in unreimbursed job expenses are too low to have any effect on their itemized deductions, as these expenses do not exceed 2% of their AGI. Also, medical and dental expenses are far below the 7.5% of AGI required for deductibility. 2. The Kapoors would have to pay additional tax of $916.65 if they itemize deductions versus pay only additional tax of $127.50 if they take the standard deduction, a difference of $789.15. They would definitely choose to take the standard. 3. Their son's income of $200 from dividends is considered unearned income and is below the minimum for which a single return has to be filed ($950 is unearned income for 2011). The only reason why they would file with income below this level is to receive a refund of any taxes withheld, which is not necessary in this case. 4. Due to current tax laws, the Kapoors’ refund was greater than the amount of taxes they owed. However, if they make more money in the future and actually owe taxes, some possible tax planning strategies for them might include: • Purchase Series EE savings bonds to use for Nalin’s education (interest is not taxed so long as the parents' taxable income falls within specified limits when redeemed for Nalin’s education). However, since Nalin is very young, the family might better provide for his education with more aggressive taxable investments than with savings bonds. Also, the family's income might be above the allowable limits for tax exemption when it is time to cash in the bonds. • Shift some interest-earning investments into tax-free municipal bonds or bond funds. Caution: since this family is only in the 15% tax bracket, the yield on municipals may be lower than the after-tax yield on comparable corporate bonds. If this were the case, then municipals would not be a good choice for this family. In fact, this family needs to examine their investment objectives and time horizon to determine if bonds are an appropriate investment for them. • Start a Coverdell Education Savings Account for Nalin. These accounts are allowed to grow tax-free, and the distributions are not taxed if Nalin’s higher education expenses in the year of withdrawal are at least as much as the withdrawal. If Nalin doesn't use all the money in the account for his higher education, this money can be passed on to other family members for their higher education expenses. The family might also want to consider a Section 529 Plan for Nalin’s education. See IRS Publication 970, Tax Benefits for Education. • Continue to fund an IRA and add the allowed spousal contribution. As long as the family’s income is below the phase-out level, they can continue to make contributions to a traditional IRA even with a company-sponsored retirement plan. However, they may decide to go with Roth IRAs in the future, as withdrawals from Roths in retirement are not subject to taxes (if all conditions have been met). Even though taxes will have to be paid now on any money contributed to a Roth IRA, this family is in the lowest tax bracket, so taxes paid now on this amount would be small. The family’s earnings can rise much higher before reaching the phase-out level for a Roth IRA than for a traditional IRA. • Investigate whether his company offers a flexible spending account for medical expenses that would reduce taxable income. • Watch the timing of medical and miscellaneous expenses to see if they can be grouped in the same tax year to qualify to be deducted. • If their taxable income rises enough to move them into a higher bracket, consider shifting some investments to their son (but keep the income within the required limits) so that more income is taxed at his lower level. Case 3.1, Problem 1—Form 1040, p. 1 Case 3.1, Problem 1—Form 1040, p. 2 (Note: forms for child tax credit are not included here, but may be downloaded from www.irs.gov, and completed if desired.) Case 3.1, Problem 1—Schedule A Note: This form would NOT be filed with the Kapoors’ tax return, as taking the standard deduction is more advantageous for them. This form is included to illustrate how itemized deductions are listed and calculated. Case 3.1, Problem 1—Schedule D, page 1 Case 3.1, Problem 1—Schedule D, page 2 3.2 Cheryl Stern: Waitress or Tax Expert? 2. Cheryl is incorrect in her assumption that she is allowed to both itemize deductions and take the standard deduction if her income is below a certain level. She appears to be confusing the standard deduction with the personal exemption, which she did not include in her calculations. Itemized deductions are allowable personal and job-related expenses that can be used to reduce adjusted gross income in order to arrive at taxable income. The standard deduction is a blanket deduction that serves as an alternative to itemizing deductions. Those who itemize cannot take the standard deduction as well, and vice versa. 3. At a taxable income of $9,200, Cheryl and John would each pay $955 in taxes filing as single taxpayers [$850 + .15($9,200 − $8,500)]. That totals $1,910 for the two of them. The taxes they would pay if married filing jointly are as follows: Their tax would be $1,910, the same as it would be for two single people filing individually [$1,700 + .15($18,400 − $17,000)]. Solution Manual for PFIN Personal Finance Lawrence J. Gitman, Michael D. Joehnk, Randall S. Billingsley 9781285082578
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