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Chapter 3 Preparing Your Taxes How Will This Affect Me? There’s an old joke that people who complain about taxes can be divided into two groups: men and women. This chapter helps you pursue the tax-planning goal of maximizing the money that you get to keep by legally minimizing the taxes you have to pay. Income, various adjustments to income, deductions, and credits are considered in computing taxes. The chapter walks through the steps in completing representative tax returns. The impact of Social Security taxes and tax shelters are considered. And a framework for choosing a professional tax preparer or tax preparation software is provided. After reading this chapter you should be able to prepare your own taxes or to better understand and evaluate how your taxes are prepared by software or a tax professional. The one continuing characteristic of the federal income tax is change. Congress feels compelled to “improve” the tax law, frequently doing so in December of the tax year at issue. Thus, any summary of the tax law will be out of date whenever it is written. This chapter is based upon the law in effect November, 2018. The tax rates and other numeric items for 2019 are included for your information. The tax forms used are drafts of 2018 forms that were available in October, 2018. The final forms for 2018 were not available in time to include in these materials. The forms will be available at irs.gov, forms and publications. The student who is serious about personal financial planning needs to take an individual tax course. While only about half of all people pay income tax [that half pays a lot of FICA taxes and state sales taxes] the people who ask for help with their financial planning are in the top 20% and they do pay income taxes. Minimizing that tax is a concern to the clients of financial planners. There are several dollar limits or deductions that are annually adjusted for inflation. The numbers in the text are the numbers for 2018. The adjusted numbers are published in a revenue procedure issued by the IRS in mid-November of each year. The adjusted numbers for 2019 are included here for information. For planning purposes, the exact adjusted number is not necessary. Whether the standard deduction for a joint return is $24,000 [the amount for 2018] or $24,400 [the amount for 2019], the impact on financial planning is the same. Learning Goals LG1 Discuss the basic principles of income taxes and determine your filing status. All taxes have a tax base and a tax rate, thus tax = base * rate. The name of the tax indicates the tax base, thus, the tax base for the income tax is income; for the sales tax, the base is sales; and so on. Income in general is similar for accounting purposes and for tax purposes, with several differences designed to achieve some public policy goal. The concept of standard deduction and itemized deductions are not a part of accounting income, but they serve various public purposes. Most criminals do not pay taxes on their illegal income. This chapter does not discuss how to illegally pay taxes or how to otherwise be a criminal. The goal is to pay only the tax required by the law, no more nor no less. So much of the chapter discusses how to reduce the tax base and how to reduce the tax rate. Key concepts are exclusions [for example, proceeds from life insurance received by reason of the death of the insured are excluded from gross income], deductions [investment interest may be deducted up to the amount of investment income], credits [child tax credit reduces tax-not taxable income- by $2,000 per child], and rates [gains from sale of long-term capital gains are taxed at a lower rate than salary or interest income]. The tax rates are progressive, that is the marginal tax rates increases as income increases in steps or brackets. For a single taxpayer, the first $9,525 of taxable income [gross income less all deductions] is taxed at a marginal rate of 10%. The first dollar over $9,525 is taxes at 12%, and so on to the top tax rate of 37%. There are four sets of rates – Single, Joint, Married filing separately, and Head of households. The 2018 rates are in the textbook. The 2019 rates are below. The chapter has several examples of computing the tax. You can build the tax by computing the tax on each bracket of income or use the rate schedule that computes the tax on income up to the first number in the bracket and then you add the additional tax using the appropriate marginal tax rate. Using the 2018 single tax rate, the tax on $38,700 is $4,345.50 computed as [10% * $9,525] + [12% * (37,800 – 9,525 = $28,275)] = $4,345.50 The filing status determines which rates you can use. There are five filing status: Single, Married filing jointly, Married filing separately, Surviving spouse, and Head of household. The surviving spouse status is for the two years after a spouse dies if the surviving spouse has a dependent child living with him/her. Qualifying surviving spouse uses the Joint rates. 2019 Tax Rates Married filing separate is the same as single until the 35 percent bracket. The 35 percent rate applies to taxable income over $204,301 but under $306,175, and the 37 percent rate applies to taxable income over $305,175. Standard deductions for 2019: $12,200 single; $24,400 joint Limits on contributions to 401(k), 403(b), and 457 is $19,000 with an additional $6,000 for over 50 years old. Contributions to an IRA is limited to $6,000 in 2019, up from $5,500. The credit for the transfer tax [See chapter 15) is based on $11,400,000. The annual exclusion for gift tax is $15,000. Most of the phase out amounts are increased. LG2 Describe the sources of gross income and adjustments to income, differentiate between standard and itemized deductions and exemptions, and calculate taxable income. Exhibit 3.1 gives the steps to compute taxable income and the related tax liability. It will be good to go over these steps. The three types of income discussed are important because of the limits the type of income imposes. Portfolio income limits the amount of investment interest that may be deducted. Passive income limits the loss deduction from businesses in which the investor has a passive interest [that is the investor does not work in the business). All real estate investments are passive interests with a small exception for middle income taxpayers that allows a loss deduction of $25,000 if the investor participates in the managing of the real estate investment. Active income is everything else. Exhibit 3.2 reports the various alternative rates for capital gains. Key point is that the reduced rates applies only to gains on sales of assets held more than 12 months, so called “long-term gains”. The top capital rate is 20% and applies if the ordinary income tax rate is 37%. There are two additional alternatives rates that apply in limited cases: 25% on part of gain from sale of depreciable real estate, and 28% on gains from sale of collectibles such as artwork, ceramics, stamps, etc. Note that these are alternative rates: if the ordinary tax rates are lower, use them. The standard deduction varies by taxpayer’s age and filing status. Most common are the single status which has a standard deduction of $12,000 in 2018 and $12,200 in 2019, and the married filing joint status which has a standard deduction of $24,000 in 2018 and $24,400 in 2019. They change every year as the Consumer Price Index changes. If the taxpayer’s itemized deductions are greater, the Schedule A is filed and the itemized deductions deducted. The itemized deductions tend to be greater if the taxpayer has state income and property taxes [although limited to $10,000 and mortgage interest on up to two personal residences. The personal exemption does not apply for years 2018 - 2025. It has in effect been incorporated into the standard deduction. Whether it will return in 2026 or not remains to be seen. LG3 Prepare a basic tax return using the appropriate tax forms and rate schedules. All taxpayers file Form 1040. Previously there were less complicated versions of the Form 1040 but for 2018 these have been eliminated. There are special versions for the 1040 for non-residents aliens [1040NR] and for amended returns [1040X]. Exhibit 3.3 displays the 2018 tax rates in the form that is normally reported by the IRS. The 2019 rates are above. Tax Credits and tax deductions have different effects. The value of a tax deduction is the amount of the deduction times the marginal tax rate. Thus, the value of standard deduction to a single taxpayer in the 22% marginal rate is 22% * $12,000 or $2,640. The value of a tax credit is the amount of the credit, thus the value of a $2,000 child tax credit to a 22% marginal rate taxpayer is $2,000. Worksheet 3.1 is an example of a form 2014. LG4 Explain who needs to pay estimated taxes, when to file or amend your return, and how to handle an audit. People frequently will say that they did not pay taxes because they got a refund. A refund only means that you have overpaid the taxes you owe. In effect you have loaned money to the federal government at zero interest. Better to have a small balance due, an amount that you can easily pay. You pay taxes via your employer withholding the tax from you wages which reduces your take home pay. If you are self-employed, you are required to pay estimated taxes four times a year [April 15, June 15, October 15, and January 15]. If you have other income that is not withheld upon, such as retirement annuities or withdrawals from retirement funds, you will also have to pay estimated taxes. The IRS has a program that uses a discriminate function to grade returns as to the probability of an error on the return. Those with the highest score are then audited to determine the source of the error, if any. The taxpayer is then notified of the error and the additional tax due. If the taxpayer is due a refund because of the error, that amount is sent to the taxpayer. All returns are checked for arithmetical errors. With the current budget level of the IRS, only the most obvious erroneous returns will actually get audited. LG5 Know where to get help with your taxes and how software can make tax return preparation easier. Most taxpayers can prepared their own tax returns as well as change the oil in their car. However, many people chose to hire someone to do both. Certainly when you prepare only one tax return a year, it can take a long time to get it done. A professional tax return preparer can do it faster. The chapter lists the most frequently used tax preparers. User friendly tax preparation software is widely available. There are real advantages to using such software and to use the same software each year. There is a learning curve to using the software and there is a great deal of carryover data required in preparing a tax return. Using the same software each year helps reduce the time required to get it done. LG6 Implement an effective tax planning strategy. There are two strategies to tax planning: Income shifting – Shift income to a taxpayer in a lower tax bracket or between years, from a high tax year to a low tax year. Perhaps you can bunch your itemized deductions. For example pay your property tax in January for last year and December for this year, thus you can deduct two years of property tax in one year. Income Conversion – Convert ordinary income to capital gain income, or to tax exempt income. For example sell your bonds and purchase preferred stock. Dividends from stock are taxed at capital gain rates, while interest income is taxed at the higher ordinary rates. Or sell corporate bonds and purchase bonds from state and local governments – that interest is tax exempt. It would be useful to review the table Planning Over a Lifetime with the students. That table emphasizes the role of taxes in investment decisions and retirement decisions. Financial Facts or Fantasies? These may be used as “teasers” to get the students on the right page with you. Also, they may be used as quizzes after you covered the material or as “pre-test questions” to get their attention. Are the following statements Financial Facts (true) or Fantasies (false)? Consider the answers to the questions below as you read through this chapter. Every individual or married couple is required to file a federal income tax return regardless of the amount of income earned. Fantasy: Only those individuals or married couples who earn a specified minimum level of income [the amount of the applicable standard deduction] or wish to receive a refund or withheld taxes are required to file a tax return. The amount of federal income tax withheld depends on both your level of earnings and the number of withholding allowances claimed. Fact: The more you make and the fewer withholding allowances you claim, the more will be withheld from your paycheck. Federal income taxes are levied against the total amount of money earned. Fantasy: Federal income taxes are levied against your taxable income, which is the amount remaining after adjustments and deductions have been subtracted from gross income. Gains on the sale of investments such as stocks, bonds, and real estate are taxed at the lower capital gains tax rate. Fantasy: Only capital gains on investments held for longer than 12 months (long-term) qualify for tax rates lower than those on ordinary income. Short-term capital gains are taxed as ordinary income rates. Tax credits, and deductions reduce your taxable income by comparable amounts. Fantasy: Tax credits are far more valuable than comparable dollar amounts of deductions because they directly reduce, dollar for dollar, the amount of taxes due. An easy way to earn tax-deferred income is to invest in Series EE savings bonds. Fact: The interest income from a Series EE savings bond can be tax deferred. The holder can elect to delay payment of taxes until the earlier of the year the bonds are redeemed for cash or the year in which they finally mature. Financial Facts or Fantasies? These may be used as a quiz or as a pre-test to get the students interested. 1. True False Every individual or married couple is required to file a federal income tax return regardless of the amount of income earned. 2. True False The amount of federal income tax withheld depends on both your level of earnings and the number of withholding allowances claimed. 3. True False Federal income taxes are levied against the total amount of money earned. 4. True False Gains on the sale of investments such as stocks, bonds, and real estate are taxed at the lower capital gains tax rate. 5. True False Tax credits and deductions reduce your taxable income by comparable amounts. 6. True False An easy way to earn tax-deferred income is to invest in Series EE savings bonds. Answers: 1. False 2. True 3. False 4. False 5. False 6. True YOU CAN DO IT NOW The “You Can Do It Now” cases may be assigned to the students as short cases or problems. They will help make the topic more real or relevant to the students. In most cases, it will only take about ten minutes to do, that is, until the student starts looking around at the web site. But they will learn by doing so. Tax Planning Consider whether you expect your tax rate to be lower, the same, or higher next year. Then do some simple but effective tax planning: • If your tax rate is expected to be lower or the same next year, if you can, delay receiving income until next year so it will be taxed at the lower rate - or just later at the same rate. • If your tax rate is expected to be higher next year, try to speed up the receipt of income so it will be taxed at the currently lower rate. And consider waiting to take some deductions until next year when the higher rate will shield you better from the higher rate. Solutions to Financial Planning Exercises 1. Calculating marginal tax rates. Lacey Hansen is single and received the following items and amounts of income during 2018, as shown below. Determine the marginal tax rate applicable to each item. Note that if the item is not taxable, the marginal rate is 0. Loan from bank, $2,000, is not income, thus it is not a part of the tax computation. 2. Estimating taxable income, tax liability, and potential refund. Anabella Cunningham is 24 years old and single, lives in an apartment, and has no dependents. Last year she earned $55,000 as a sales representative for Planning Associates; $3,910 of her wages were withheld for federal income taxes. In addition, she had interest income of $142. She takes the standard deduction. Calculate her taxable income, tax liability, and tax refund or tax owed for 2018. 3. Calculating Taxes on security transactions. If Julia Diaz is single and in the 24 percent tax bracket, calculate the tax associated with each of the following transactions. (Use the IRS regulations for capital gains in effect in 2018.) Treat each of the following cases as independent of the others. a. She sold stock for $1,200 that she purchased for $1,000 5 months earlier. She has a capital gain of 1,200 – 1,000 = $200. It is a short-term capital gain and will be taxed at 24%, tax is $48. b. She sold bonds for $4,000 that she purchased for $3,000 3 years earlier. She has a capital gain of 4,000 – 3,000 = $1,000. It is a long-term capital gain and will be taxed at 15%, tax is $150. The rate is 15% because the ordinary income tax rate is 24%. c. She sold stock for $1,000 that she purchased for $1,500 15 months earlier. She has a capital loss of 1,000 – 1,500 = $500. It is a long-term capital loss and will reduce any other long-term capital gain. If she does not have any other capital gain, the $500 loss will reduce her ordinary taxable income, thereby saving her $120 [24% * $500] 4. Education Tax Credits. Mason is married and has two sons. The older son, Harrison, is a graduate student working on his MBA. He paid $15,000 in tuition, $2,000 for textbooks and supplies, and incurred $20,000 in living expenses for the year. The younger son, Alexander, is a sophomore in college. Alexander’s tuition was $12,000, textbooks and supplies were $1,500, and Alexander’s living expenses were $18,000. While Mason’s younger son, Alexander, is claimed as a dependent on his return, his older son, Harrison, is not claimed as a dependent. Determine the amount of education credits or deductions Mason can take on his tax return for these education expenses. The available educations credits and deductions are: The American Opportunity Credit is worth 100% of the first $2,000 in qualifying educational expenses and 25% of the next $2,000, for a maximum tax credit amount of $2,500. Lifetime Learning Credit applies to undergraduate and graduate education and is 20% of $10,000 of tuition and required supplies, for a total of $2,000. The credit applies per return, not per student. The credit is subject to a phase out if modified adjusted gross income is over $58,000 ($116,000 for a joint return) The tuition and fees deduction allow you to exclude up to $4,000 of qualifying expenses from your income. The deduction is from gross income, a so called “above the line” deduction. Interest on Education Loans. For taxable years beginning in 2019, the $2,500 maximum deduction for interest paid on qualified education loans under § 221 begins to phase out under § 221(b)(2)(B) for taxpayers with modified adjusted gross income in excess of $70,000 ($140,000 for joint returns), and is completely phased out for taxpayers with modified adjusted gross income of $85,000 or more ($170,000 or more for joint returns). Mason may claim the following: For older son, Harrison, Mason may claim a Lifetime Learning Credit of 20% of tuition ($15,000) plus required supplies ($2,000) with a limit of 20% of $10,000 for a credit of $2,000. For younger son, Alexander, Mason may claim an American Opportunity Credit of $2,500 [his tuition is a total of $12,000 and required supplies $1,500, $4,000 is used for the credit] The tuition not subject to a credit may be taken as a deduction up to $4,000. From Alexander, he paid $12,000 plus $1,500, total $13,500 of which $4,000 used for American Opportunity Credit. The remainder, 13,500 – 4,000 = 9,500 is subject to being deductible but with a limit of $4,000. So, Mason may deduct $4,000 tuition and fees. In summary, total credits of $4,500 and a $4,000 deduction for tuition and fees. 5. Calculating taxable income for a married couple filing jointly. Freya and Sebastian Hunter are married and have one child. Sebastian is putting together some figures so that he can prepare the Hunter’s joint 2018 tax return. So far, he’s been able to determine the following concerning income and possible deductions: Given this information, determine the amount of the available itemized deductions. How much taxable income will the Compton’s have in 2018? (Note: Assume that Sebastian is not covered by a pension plan where he works, his child qualifies for the child tax credit, and the standard deduction of $24,000 for married filing jointly applies.
Income
Gross wages $50,770
Income from Limited Partnership 200
Capital gains-short term $1,450
Capital Losses (3,475)
Net capital loss (2,025)
Qualified Dividends 610
Total income $49,555
Adjustments to income
IRA Contribution $5,000
Adjusted Gross Income $44,555
Less: Standard Deduction $24,000
Taxable Income $20,555
Less Qualified dividends (610)
Ordinary taxable income $19,945
Ordinary income tax 1,905 + [(19,945 – 19,050) * 12%] $2, 012.40
Tax on qualified dividends @0% 0
Less Child Tax Credit (2,000.00)
Income Tax Liability $12.40
Notes: The qualified dividends are subject to the alternative tax of 0% since the ordinary tax rate is 12%. Total Itemized Deductions: The total of the itemized deductions is $9,570, which is less than the standard deduction of $24,000. Thus, the standard deduction is used. The itemized deductions are:
Total unreimbursed medical expenses incurred $ 1,155 less 7.5% of AGI, thus 0 deductible (10% in 2019 and beyond)
Mortgage interest paid 5,200
Sales taxes paid 2,470 [Since Sales tax is greater than state income tax paid (1,700), deduct sales tax]
Property taxes paid 700
Charitable contributions made 1,200
Total itemized deductions $9,570
Nondeductible items: Interest paid on credit cards, Interest paid on a car loan, and Social Security taxes paid are personal items and are not deductible. The Hunters would qualify for the earned income credit. The credit would be $101 for adjusted gross income for $44,555 with one child. This computation is beyond the scope of the text and is given only for your information. 6. Choosing and Preparing an individual tax form. Liam McKenzie is single, graduated from college in 2018 and began work as a systems analyst in July of that year. He is preparing to file his income tax return for 2018 and has collected the following financial information for that calendar year. A blank Form 1040 and Schedule 1 may be obtained at www.irs.gov. a. Prepare Liam’s 2018 tax return, using a $12,000 standard deduction and the tax rates given in Exhibit 3.3. The Form 1040 is used for most taxpayers. The Tuition scholarship is not subject to tax, it is an exclusion. The room and board scholarship is taxable. The itemized deduction are less than the standard deduction and would not impact the return. Adjusted gross income is $1,850 + 55,000 + 185 = $57,035 Taxable income = 57,035 – 12,000 = $45,035 Tax liability = 4,453.50 + [(45,035 – 38,700) * 22%] = $6,045.20 Tax due = $6,045.20 - $2,600 = $3,445.20 b. Prepare Liam’s 2018 tax return using the data in part a, along with the following information: Tax on ordinary taxable income = $4,453.50 + 22%*(40,035 – 37,800) = $4,945.20. Tax on dividend is 15% * $150 = $22.50. The final tax liability is $4,945.20 + 22.50 = 4,967.70 and the tax due $4,967.70 – 2,600 = $2,367.70. 7. Effect of tax credit v tax deduction. Explain and calculate the differences resulting from a $1,000 tax credit versus a $1,000 tax deduction for a single taxpayer with $40,000 of pre-tax income. Tax credits directly reduces the tax; the value of a $1,000 tax credit is $1,000. Tax deductions reduce taxable income thus the value of a deduction is the marginal tax rate times the deduction. Pre-tax income of $40,000 less standard deduction of $12,000 gives taxable income of $28,000. The marginal tax rate for taxable income of $28,000 is 12%. A $1,000 deduction for this taxpayer will reduce the tax by $120 (12% * $1,000). A $1,000 tax credit is worth $880 more than a $1,000 deduction for a taxpayer in the marginal tax bracket of 12%. 8. Preparing for a tax audit. Paige and Landon Diamond have been notified that they are being audited. What should they do to prepare for the audit? Keep calm, it is only an audit. Gather records and supporting documents. If the notice is from the criminal division of the IRS, you will need to contact a lawyer. If they had hired a professional tax return preparer, that preparer should be contacted and you may want that person to accompany you to the IRS. Assuming you have your supporting documents and you tried your best to be correct, it will be a simple audit. If you made an error, there will be an adjustment including penalties and interest. But you will not go to jail. 9. Getting help with tax form preparation. Noah King’s job doesn’t leave him much spare time. Consequently, he would like some help preparing his federal tax forms. What advice would you give Noah? If Noah only needs help preparing the return and does not have any complicated transactions, he should use a national tax preparation office such as H&R Block, or a local tax preparer that has been in business for more than three years and that is recommended by a friend. If Noah has complicated transactions or has questions about his investments or transactions, he should go to a CPA or an enrolled agent. These professionals are better able to provide tax planning advice. A tax attorney should be consulted if the transaction involves a real estate transaction or forming a business such as an LLC or a corporation. Of course, if Noah has engaged in criminal activities, he should consult with a criminal lawyer to get the best advice. 10. Effective Tax Planning. Explain the key elements of effective tax planning. What are some of the most popular tax management strategies? The income tax is computed as taxable income times tax rate. So, to reduce the income tax, you may reduce taxable income or reduce the tax rate. Taxable income may be reduced that shifting income from the current year to the next year or by shifting income from a high-income taxpayer to a lower income taxpayer such as a parent [think grandparent] or a child. Taxable income may also be reduced by increasing deductions such as discretionary itemized deductions like charitable contributions. In prior years state and local taxes could be paid before end of year in order to increase itemized deductions. However, with the $10,000 limit on state and local taxes, that technique is not likely to be effective in increasing itemized deductions. You may also reduce taxes by reducing the tax rate. The primary action is to covert ordinary income into income subject to the capital gains tax rate. Recall that interest income is subject to ordinary tax rates [37% at maximum] while dividends and gains on sale of capital assets like stock are subject to the capital gains tax [maximum 20%]. Also recall that interest from state and local bonds is excluded from income, that is a 0% tax rate. There are also ways to increase deductions from your business activities. Also, the way you organize your business can impact your taxable income. These are beyond the scope of this text. 11. Effective Tax Planning. Denise Hughes reports the following data from her 2018 tax return. Analyze the data and suggest tax planning ideas that she should consider. Note: The interest income is from a bank savings account earning 1%. The dividends are from a stock paying 3 percent dividends. OK it is obvious here that some or a lot of the bank savings account [$3,000,000] should be converted to investment in stock. The bank is paying 1%; the stock is paying 3%. Also, the dividends are taxed at capital gains rate [15% here, but with changes rate may go to 20%] rather than ordinary income rate of 32% or 35%. This is an example of the type of information you can obtain by reviewing a tax return. “Test Yourself” Questions are taken from previous editions of the text. You may use them as quiz questions or as additional homework. 3-1. What is a progressive tax structure and the economic rationale for it? The progressive tax structure uses a progressive tax rate where the rate increases [ from 10% to 37% as taxable income increases. The economic concepts supporting the progressive tax are ability-to-pay and marginal utility of income. Those will higher income have the ability to pay a higher tax, thus a progressive rate. Also, the higher income, the less pain associated with the loss of a dollar, thus the diminishing marginal utility of income. 3-2. Briefly define the five filing categories available to taxpayers. When might married taxpayers choose to file separately? The five filing statuses are: Single—taxpayer is not married on last day of year Married filing jointly—both parties to the marriage agree and take responsibility for the tax return. They must be married on the last day of the year. Married filing separate—there are two returns filed by the married couple. Each spouse is responsible for reporting his or her own income and tax. Surviving Spouse [Qualifying widow(er)]—For the two years after death of a spouse, the surviving spouse may use the joint rates as long as they have a dependent child living with them. Head of Household—Unmarried taxpayer who provides a household for a qualified person living with them. There is an exception for abandoned spouses and for parents living in a retirement home paid for by taxpayer. It will be a rare case where a couple will decide to file married filing separately. Examples are where one spouse does not want to be liable for the other’s unpaid taxes. In very unusual cases, one spouse may be able to deduct higher itemized deductions by filing separately. 3-3. Distinguish between gross earnings and take-home pay. What does the employer do with the difference? Take-home pay is the gross earnings less required income tax withholding, FICA taxes [Social Security and Medicare taxes], and less any fringe benefits paid for by taxpayer such as group life insurance or employee business expenses paid by taxpayer, such as a uniform. The employer remits the withholding to the IRS for crediting to the taxpayer’s account. 3-4. What two factors determine the amount of federal withholding. Tax withholding will vary by filing status, number of withholding exemptions claimed, and amount of income. The taxpayer may have more tax withheld by reducing the number of exemptions or have less withheld by increasing the number of exemptions. 3-5. Define and differentiate between gross income and AGI. Name several types of tax-exempt income. What is passive income? Goss income is income from whatever source derived unless excluded by Congress. Examples of excluded income are interest on state and local bonds, proceeds from various insurances, and gifts. Adjusted gross income is gross income less business expenses and other adjustments allowed by law. Examples of other adjustments include contributions to IRAs, alimony paid, self-employed health insurance premiums, expenses relating to serving in the National Guard or Reserves, and interest on education loans. Passive income is income from businesses and investments in which the taxpayer is a passive owner that is the taxpayer does not materially participant in the operation of the business. A general rule is if you spend 500 hours per year working in the business, it will be an active activity, not passive. 3-6. What is a capital gain, and how is it treated for tax purposes? Capital gain is gain from the sale of capital assets. Capital assets is defined in the negative, that is it is anything except receivables, inventory, real property used in a trade or business, personal property used in a trade or business, and so on. What is not not a capital asset? Investments in stocks, bonds, raw land, real estate [not used in a business], personal assets, and so on. Gains from the sale of capital assets held more than 12 months are subject to an alternative rate based upon the ordinary tax rate—the rate that applies to wages and other ordinary income. The following table reports these rates:
Ordinary tax rates Alternative tax rates
10% or 12% 0%
22, 24%, 32%, 35% 15%
37% 20%
In addition, gains from the sale of collectibles are subject to an alternative rate of 28% and gain equal to depreciation allowed on real property is taxed at 25%. If the capital asset has not been held more than 12 months, the alternative rate does not apply, and the gain is taxed as ordinary income. Losses are not treated favorably. Net capital losses, capital gains fewer capital losses, are limited to $3,000 per year when deducted against ordinary income. 3-7. If you itemize your deductions, you may include certain expenses as part of your itemized deductions. Discuss five types of itemized deductions and the general rules that apply to them. Medical expenses—deductible if they exceed 10% of adjusted gross income State and local taxes—Only income taxes and property taxes where the property tax is based upon value of the property. These tax deductions are limited to $10,000. Interest paid—only applies to interest on mortgages for up to two homes and limited to $750,000 of principal. Charitable Contributions—Only contributions given to a 501(c)-3 organization. Overall limit is 60% of adjusted gross income. Any in kind contribution with a value over $5,000 must be based upon an appraisal. Also, any single contribution over $250 must have a letter from organization that states amount and that the donor received no tangible benefit from the contribution. Miscellaneous NOT DEDUCTIBLE for 2018-2025—includes expenses of preparing tax returns, employee business expenses, and investment interest paid limited to the amount of investment income. These deductions are limited to the total amount that exceeds 2% of adjusted gross income. Casualty and theft losses—limited to amount in excess of 10% of adjusted gross income. Loss must be reduced by $100 before applying the 10% of AGI limit. Only casualty losses attributed to a federally declared disaster area are deductible. 3-8. NO Personal Exemptions from 2018-2025 Dan Caldwell was married on January 15, 2018. His wife, Catherine, is a full-time student at the university and earns $625 a month working in the library. How many personal exemptions will Dan and Catherine be able to claim on their joint return? Would it make any difference if Catherine’s parents paid for more than 50 percent of her support? Explain. Dan and Catherine may each claim a personal exemption on their return. If they file a joint return, they would claim two exemptions. One general requirement to claim a dependent is that the dependent may not file a joint return. Thus, if Dan and Catherine file a joint return, Catherine’s parents may not claim her as a dependent regardless of amount of support they provide. If Catherine and Dan elected to file as married filing separately, then Catherine’s parents would be able to claim her as a “qualified child” dependent as long as she is under 23 years old. If she is over 23 than she would not qualify as “qualified child”. She could not qualify as a “qualified relative” since her gross income is over the amount of a personal exemption [$3,950 in 2014]. 3-9. Define and differentiate between the average tax rate and the marginal tax rate. How does a tax credit differ from an itemized deduction? Average tax rate is the tax due divided by the taxable income. The marginal tax rate is the rate on the next dollar of income which is determined by the bracket their income falls in. With a progressive tax rate, the marginal tax rate is always greater than the average tax rate when income is over the 10% bracket amount. A tax credit is a dollar for dollar reduction in the tax due. A tax deduction reduces taxable income and is worth the marginal tax rate times the amount of the deduction to the taxpayer. A $2,000 child tax credit is worth $2,000 to a 22% taxpayer while a deduction of $2,000 is only worth $440 to a 22% taxpayer. 3-10. Explain how the following are used in filing a tax return: (a) Form 1040, (b) various schedules that accompany Form 1040, and (c) tax rate schedules. a. Form 1040 is the main form used in filing federal income taxes. All individuals filing may 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 1, 2, 3, 4, 5, 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. Define estimated taxes and explain under what conditions such tax payments are required. Taxpayers who do not work for an employer, must pay their own taxes four times a year: April 15, June 15, October 15, and January 15 of following year. Any income in excess of $600 on which taxes have not been withheld received by the taxpayer will require the taxpayer to pay estimated taxes. 3-12. What is the purpose of a tax audit? Describe some things you can do to be prepared if your return is audited. 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. And stay calm; it is only an audit. 3-13. What types of assistance and tax preparation services does the IRS provide? The IRS attempts to provide tax assistance on a walk-in basis at its various offices in the larger cities. The IRS also attempts to provide telephone assistance via toll free numbers. Also at irs.gov there are a large number of publications and instructions designed to help taxpayers and tax professionals prepare returns. With the budget cuts, the tax filing season in recent years has seen a sharp decline in service from the IRS. 3-14. What are the advantages of using tax preparation software? Tax software provides guidance, computation, and form preparation based upon taxpayer inputs. It works and is not expensive. 3-15. Differentiate between tax evasion and tax avoidance. 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. Explain each of the following strategies for reducing current taxes: (a) maximizing deductions, (b) income shifting, (c) tax-free income, and (d) tax-deferred income. 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 non-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. 3.1 The Andersons Tackle Their Tax Return Noah and Olivia Anderson are a married couple in their early 20s living in Dallas. Noah Anderson earned $73,000 in 2018 from his job as a sales assistant. During the year, his employer withheld $4,975 for income tax purposes. In addition, the Andersons received interest of $350 on a joint savings account, $750 interest on tax-exempt municipal bonds, and dividends of $400 on common stocks. At the end of 2018, the Andersons sold two stocks, A and B. Stock A was sold for $700 and had been purchased four months earlier for $800. Stock B was sold for $1,500 and had been purchased three years earlier for $1,100. Their only child, Logan, age 2, received (as his sole source of income) dividends of $200 from Hershey stock. Although Noah is covered by his company’s pension plan, he plans to contribute $5,000 to a traditional deductible IRA for 2018. Here are the amounts of money paid out during the year by the Andersons: Medical and dental expenses (unreimbursed) $ 200 State and local property taxes 831 Interest paid on home mortgage 4,148 Charitable contributions 1,360 Total $6,539 In addition, Noah incurred some unreimbursed travel costs for an out-of-town business trip: Airline ticket $250 Taxis 20 Lodging 60 Meals (as adjusted to 50 percent of cost) 36 Total $366 Critical Thinking Questions 1. Using the Andersons’ information, determine the total amount of their itemized deductions. Assume that they’ll use the filing status of married filing jointly, the standard deduction for that status is $24,000. Should they itemize or take the standard deduction?
Medical and dental expenses (unreimbursed) $200 less 10% of AGI, thus 0 deductible
State and local property taxes 831
Interest paid on home mortgage 4,148
Charitable contributions 1,360
Employee business expense Travel costs 366 less 2% of AGI, thus 0 deductible In 2018-2015, no deduction for miscellaneous deductions subject to thee 2% reduction
Total Itemized Deductions $6,339 – Standard is higher
Prepare a joint tax return for Noah and Olivia Anderson for the year ended December 31, 2018, that gives them the smallest tax liability. Use the appropriate tax rate schedule provided in Exhibit 3.3 to calculate their taxes owed. 2. How much have you saved the Andersons through your treatment of their deductions? 3. Discuss whether the Andersons need to file a tax return for their son. A taxpayer claimed as a dependent on another’s tax return and receiving unearned income has a standard deduction of $1,000. Since Logan’s income is only $200, he is not required to file. Furthermore he has had no tax withheld, so he does not need to file for a refund. Logan does not file a tax return. 4. Suggest some tax strategies that the Andersons might use to reduce their tax liability for next year. 1. They can increase the amount of their IRA deduction. Noah Can contribution another $500 [total of $5,500 in 2018]. In addition, Olivia may make a contribution to an IRA of $5,500. 2. They should review all of their transactions to discover any other deductions that they might have missed. 3.2 Cheryl Stern: Waitress or Tax Expert? Cheryl Stern, who is single, goes to graduate school part-time and works as a waitress at the Sunset Grill in Seattle. During the past year (2018), her gross income was $18,700 in wages and tips. She has decided to prepare her own tax return because she cannot afford the services of a tax expert. After preparing her return, she comes to you for advice. Here’s a summary of the figures that she has prepared thus far: Gross income: Wages $10,500 Tips − 8,200 Adjusted gross income (AGI) $18,700 Less: Itemized deductions −2,300 $16,400 Less: Standard deduction −6,200 Taxable income $10,200 Cheryl believes that if an individual’s income falls below $20,350, the federal government considers him or her “poor” and allows both itemized deductions and a standard deduction. Critical Thinking Questions 1. Calculate Cheryl Stern’s taxable income, being sure to consider her exemption. Assume that the standard deduction for a single taxpayer is $12,000.
Use for part 1 and 3 Cheryl John Brooks Joint
1. Adjusted Gross Income $18,700 $18,700 $37,400
2. Standard Deduction 12.000 12,000 24,000
3. Personal Exemption 0 0 0
Taxable Income 1-2-3 6,700 6,700 13,400
Tax Liability $670 $670 $1,340
2. Discuss Cheryl’s errors in interpreting the tax laws, and explain the difference between itemized deductions and the standard deduction. We all wish the tax law say something it does not. Taxpayer may deduct either standard deduction or itemized deductions, not both. A point could be made to remind all that if the tips are not reported to the employer, the wait staff must report the tips and compute both the income tax and the self-employment tax [15.3%]. I assume that the tips have been reported to the employer and the appropriate FICA tax has been withheld. 3. Cheryl has been dating John Brooks for nearly four years, and they are seriously thinking about getting married. John has income and itemized deductions that are identical to Cheryl’s. How much tax would they pay as a married couple (using the filing status of married filing jointly and a standard deduction of $24,000) versus the total amount the two would pay as single persons (each using the filing status of single)? Strictly from a tax perspective, does it make any difference whether Cheryl and John stay single or get married? Explain. When the same income level is the same, the tax is the same whether single or joint. If the income differs, the joint rates will produce a lower tax. Terms Found in the Chapter
adjusted gross income (AGI) The amount of income remaining after subtracting all allowable adjustments to income from gross income.
adjustments to (gross) income Allowable deductions from gross income, including certain employee, personal retirement, insurance, and support expenses.
amended return A tax return filed to adjust for information received after the filing date of the taxpayer’s original return or to correct errors.
average tax rate The rate at which each dollar of taxable income is taxed on average; calculated by dividing the tax liability by taxable income.
estimated taxes Tax payments required on income not subject to withholding that are paid in four installments.
exemptions Deductions from AGI based on the number of persons supported by the taxpayer’s income.
Federal Insurance Contributions Act (FICA), or Social Security tax The law establishing the combined Old-Age, Survivor’s, Disability, and Hospital Insurance tax levied on both employer and employee.
federal withholding taxes Taxes—based on the level of earnings and the number of withholding allowances claimed—that an employer deducts from the employee’s gross earnings each pay period.
gross income The total of all of a taxpayer’s income (before any adjustments, deductions, or exemptions) subject to federal taxes; it includes active, portfolio, and passive income.
income shifting A technique used to reduce taxes in which a taxpayer shifts a portion of income to relatives in lower tax brackets.
income taxes A type of tax levied on taxable income by the federal government and by many state and local governments.
itemized deductions Personal expenditures that can be deducted from AGI when determining taxable income
marginal tax rate The tax rate that you pay on the next dollar of taxable income.
progressive tax structure A tax structure in which the larger the amount of taxable income, the higher the rate at which it is taxed.
standard deduction A blanket deduction that depends on the taxpayer’s filing status, age, and vision and can be taken by a taxpayer whose total itemized deductions are too small.
tax audit An examination by the IRS to validate the accuracy of a given tax return.
tax avoidance The act of reducing taxes in ways that are legal and compatible with the intent of Congress.
tax credits Deductions from a taxpayer’s tax liability that directly reduce his or her taxes due rather than taxable income.
tax deferred Income that is not subject to taxes immediately but that will be subject to taxes later.
tax evasion The illegal act of failing to report income or deductions accurately and, in extreme cases, failing to pay taxes altogether.
taxable income The amount of income subject to taxes; it is calculated by subtracting adjustments, the larger of itemized or standard deductions, and exemptions from gross income.
taxes The dues paid for membership in our society; the cost of living in this country.
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 Federal Withholding Taxes FICA and Other Withholding Taxes II. It's Taxable Income That Matters A. Gross Income Three Kinds of Income 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 III. Calculating and Filing Your Taxes A. Tax Rates B. Tax Credits C. Tax Forms and Schedules D. The 2018 Tax Return of David and Violet Duncan Finding the Duncan’s 2018 Tax Liability: Form 1040 Gross Income Adjustments to Gross Income Adjusted Gross Income (AGI) Qualified Business Income Deduction Itemized Deductions or Standard Deduction? The Duncan’s Taxable Income and Tax Liability Do They Get a Tax Refund? E. Issues for High Income Taxpayers IV. Other Filing Considerations A. Estimates, Extensions, and Amendments Estimated Taxes April 15th: Filing Deadline Filing Extensions and Amended Returns Audited Returns Tax Preparation Services: Getting Help on Your Returns Help from the IRS Private Tax Preparers Computer-Based Tax Returns V. Effective Tax Planning A. Fundamental Objectives of Tax Planning B. Some Popular Tax Strategies Maximizing Deductions Income Shifting Tax-Free and Tax-Deferred Income C. The Tax Return and the Financial Planning Process
Solution Manual for Personal Finance Michael Joehnk , Randall Billingsley , Lawrence Gitman 9780357033609
