Personal Finance Chapter 3 - Taxes in Your Financial Plan

Job-Related Expenses

-Certain work expenses, such as union dues, some travel and education costs, business tools, and job search expenses, may be included as itemized deductions

February

-Check to make sure you received W-2 and 1099 forms from all organizations from which you had income during the previous year; these should have been received by January 31

Types of Tax Forms

-Choice of 3 basic forms when filing your income tax 1. 20% of taxpayers use Form 104EZ or Form 1040A 2. About 60% used the regular Form 1040 -Decision depends on type of income, the amount of income, the number of deductions, and the complexity of tax situation

Moving Expenses

-Costs incurred for a change in residence associated with a new job that is at least 50 miles farther from your former home than your old main job location

Tax Forms and Filing Information

-Current tax forms and instruction booklets and online resources -Reference books on current tax laws and tax-saving techniques -Social Security numbers of household members -Copies of federal tax returns from previous years

Consumer Debt

-Current tax laws allow homeowners to borrow for consumer purchases -Can deduct interest on loans (of up to $100,000) secured by your primary or secondary home up to the actual dollar amount you have invested in it - the difference between the market value of the home and the amount you owe on it -These home equity loans, which are second mortgages, allow you to use that line of credit for various purchases

Coverdell Education Savings Account

-Designed to assist parents in saving for the education of their children -Withdrawals can be used for a variety of educational uses for kindergarten through college-age students -The annual contribution (limited to $2,000) is not tax-deductible and is limited to taxpayers with an adjusted gross income under a certain amount -The earnings accumulate tax-free

December

-Determine if it would be to your advantage to make payments for next year before December 31 -Decide if you can defer income for the current year until the following year

October

-Determine the tax benefits of selling certain investments by year-end -Prepare a preliminary tax form to determine the most advantageous filing status -Tax returns are due October 15 for those who received the automatic 6-month extension

Withholding

-Employer deducts federal income tax from your pay -The withheld amount is based on the number of exemptions and the expected deductions claimed -The difference between the amount withheld and the tax owed is either the additional amount to pay or your refund -Students and low-income individuals may file for exemption from withholding if they paid no federal income tax last year and do not expect to pay any in the current year

January

-Establish a recordkeeping system for your tax information -If you expect a refund, file your tax return for the previous year -Make your final estimated quarterly payment for the previous year for income not covered by withholding

Filing Requirements

-Every citizen or resident of the US and every US citizen who is a resident of Puerto Rico is required to file a federal income tax return if his or her income is above a certain amount -The amount is based on the person's filing status and other factors such as age

Itemized Deduction

-Expenses a taxpayer is allowed to deduct from adjusted gross income -Common itemized deductions include: --Medical and dental expenses --Taxes --Interest --Contributions --Casualty and theft losses --Moving expenses --Job-related and other miscellaneous expenses

Health Care Expenses

-Flexible spending accounts (FSAs), also called health savings accounts and expense reimbursement accounts, allow you to reduce your taxable income when paying for medical expenses or child care costs -Workers are allowed to put pretax dollars into these employer-sponsored programs -These "deposits" result in a lower taxable income -Then, the funds in the FSA may be used to pay for various medical expenses and dependent care costs

Recent Tax Credits

-Foreign tax credit to avoid double taxation on income taxes paid to another country -Savers credit (formerly the retirement tax credit) to encourage investment contributions to individual and employer-sponsored retirement plans by low- and middle- income taxpayers -Adoption tax credit to cover expenses when adopting a child under age 18 -Education credits to help offset college education expenses

Adjusted Gross Income (AGI)

-Gross income after certain reductions have been made -The reductions are called adjustments to income, and include contributions to an IRA or a Keogh retirement plan, penalties for early withdrawal of savings, and alimony payments -Used as the basis for computing various income tax deductions, such as medical expenses

Minimize Tax Owed

-If you expect to have the same or a lower tax rate next year, accelerate deductions into the current year -If you expect to have a lower or the same tax rate next year, delay the receipt of income until next year so the funds will be taxed at a lower rate or later date -If you expect to have a higher tax rate, consider delaying deductions, since they will have a greater benefit -If you expect to have a higher tax rate next year, accelerate the receipt of income to have it taxed at the current lower rate

Estate Tax

-Imposed on the value of a person's property at the time of death -Federal tax that is based on the fair market value of the deceased person's investments, property, and bank accounts less allowable deductions and other taxes

Estimated Payments

-Income from savings, investments, independent contracting, royalties, and pension payments is reported on Form 1099 -People who receive such income may be required to make tax payments during the year (April 15, June 15, September 15, and January 15 as the last payment for the previous tax year) -These payments are based on an estimate of taxes due at year-end -Underpayment or failure to make estimated payments can result in penalties and daily interest charges

Tax-Exempt Income

-Income that is not subject that is not subject to tax

Retirement Plans

-Individual Retirement Account (IRA) -Keogh -401(k)

Tax-Exempt Investments

-Interest income from municipal bonds, which are issued by state and local governments, and other tax-exempt investments is not subject to federal income tax -Although municipal bonds have lower interest rates than other investments, the tax-equivalent income may be higher

Tax-Deferred Investments

-Less beneficial than tax-exempt investments, but they give you the advantage of paying taxes in the future rather than now

November

-Make any last-minute changes in withholding by your employer to avoid penalties for too little withholding -Determine if you qualify for an IRA; if so, consider opening one -If you haven't already, prepare a preliminary tax form to determine the most advantageous filing status

Interest

-Mortgage interest, home equity loan interest, and investment interest expense up to an amount equal to investment income

Deadlines and Penalties

-Most people are required to file a federal income tax return by April 15 -If you are not able to file on time, you can use Form 4868 to obtain an automatic 6 month extension -The extension is for the 1040 form and other documents, but it does not delay your payment liability -You must submit the estimated amount owed along with Form 4868 by April 15 -Underpayment of quarterly estimated taxes may require paying interest on the amount you should have paid -Underpayment due to negligence or fraud can result in penalties of 50-75%

Taxes on Property

-Real estate property tax is a major source of revenue for local governments; based on the value of land and buildings -Some areas impose a personal property tax on the value of automobiles, boats, furniture, and farm equipment

Place of Residence

-Real estate property taxes and interest on the mortgage are deductible (as itemized deductions) and reduce your taxable income -Owning a home is one of the best tax shelters

Expense Records

-Receipts for medical, dependent care, charitable donations, and job-related expenses -Mortgage interest (Form 1098) and other deductible interest -Business, investment, and rental-property expense documents

Keeping Tax Documents

-Required to maintain records to document tax deductions, such as a home filing system -Canceled checks and receipts serve as proof of payment for deductions such as charitable contributions, medical expenses, and business-related expenses -Travel expenses can be documented in a daily log with records of mileage, tolls, parking fees, and away-from-home costs -Generally, you should keep tax records for 3 years from the date you file your return

Office Audit

-Requires you to visit an IRS office to clarify some aspect of your tax return

Passive Income

-Results from business activities in which you do not actively participate, such as a limited partnership

May

-Review your tax return to determine whether any changes in withholding, exemptions, or marital status have not been reported to your employer

Taxes on Purchases

-Sales tax on pretty much everything except food and drugs

Self-Employment

-Self-employed persons may deduct expenses such as health and certain life insurance as business costs -However, business owners have to pay self-employment tax in addition to the regular tax rate

Correspondence Audit

-Simplest and most frequent type of audit -This mail inquiry requires you to clarify or document minor questions

Value-Added Tax (VAT)

-Would add a tax to a product for each stage in the manufacturing process -Believed that higher-income individuals would pay higher taxes since they are typically the larger consumers of goods

Flat Tax

-Would require that all taxpayers, regardless of income level and type, pay the same percentage -Would be an increase in overall tax for a lot of people

Form 1040A

-Would use if: -You have less than $100,000 in taxable income from wages, salaries, tips, unemployment compensation, interest, or dividends and use the standard deduction -Can take deductions for individual retirement account (IRA) contributions and a tax credit for child care and dependent care expenses

Exclusion

-An amount not included in gross income -Affects total income

Tax Deduction

-An amount subtracted from adjusted gross income to arrive at taxable income

Keogh Plan

-If you are self-employed and own your own business -Retirement plan, also called an HR10 plan, may combine a profit-sharing plan and a pension plan of other investments purchased by the employee -People may contribute 25% of their annual income, up to a max of $52,000 (in 2014), to this tax-deferred retirement plan

Excise Tax

-Imposed by the federal and state governments -imposed on specific goods and services, such as gasoline, cigarettes, alcoholic beverages, tires, and air travel

Tax-Deferred Income

-Income that will be taxed at a later date

Tax Shelters

-Investments that provide immediate tax benefits and a reasonable expectation of a future financial return -In recent years, tax court rulings and changes in the tax code have disallowed various types of tax shelters that were considered excessive

Types of Taxes

-Taxes on purchases -Taxes on property -Taxes on wealth -Taxes on earnings

Types of Income

1. Earned Income 2. Investment Income 3. Passive Income -Other types of income subject to federal income tax include alimony, awards, lottery winnings, credit card sign-up bonuses, and prizes

Exemptions

-A deduction from AGI for yourself, your spouse, and qualified dependents -A dependent must not earn more than a set amount unless he or she is under 19 or is a full-time student under 24 -You must provide more than half of the dependent's support; and the dependent must reside in your home or be a specified relative and must meet certain citizenship requirements

Tax Audit

-A detailed examination of your tax return by the IRS -In most audits, the IRS requests more information to support your tax return -Receipts, canceled checks, and other evidence can verify amounts that you claim -About 1% of all tax filers (fewer than 1.5 million) are audited each year -People who claim large or unusual deductions increase their chances of an audit

Standard Deduction

-A set amount on which no taxes are paid -Blind people and individuals 65 and older receive higher standard deductions

Inheritance Tax

-A tax levied on the value of property bequeathed by a deceased person -Paid for the right to acquire the inherited property

Tax Preparation Software

-Application software that is used to guide individuals, families, or small businesses through the process of filing federal taxes

Taxes on Wealth

-Estate tax -Inheritance tax -Gift tax - gift amounts greater than $14,000 may have estate tax implication

March

-Organize your records and tax information in preparation for filing your tax return; if you expect a refund, file as soon as possible

Capital Gains

-Profits from the sale of a capital asset such as stocks, bonds, or real estate -Do not have to pay the tax on these profits until the asset is sold -In recent years, long-term capital gains (on investments held more than a year) have been taxed at a lower rate

Evaluating Tax Services

-What training and experience does the tax professional possess? -How will the free be determined? -Does the preparer suggest various deductions that might be questioned? -Will the preparer represent you if your return is audited? -Is tax preparation the main business activity, or does it serve as a front for selling other financial products and services?

Casualty and Theft Loses

-Financial losses resulting from natural disasters, accidents, or unlawful acts

Completing the Federal Income Tax Return

1. Filing status and exemptions. Your tax rare is determined by your filing status and allowances for yourself, your spouse, and each person you claim as a dependent 2. Income. Earnings from your employment and other income, such as savings and investment income, are reported in this section of Form 1040 3. Adjustments to income. If you qualify, you may deduct contributions (up to a certain amount) to an IRA or other qualified retirement program 4. Tax computation. Your AGI is reduced by your itemized deductions or by the standard deduction for your tax situation. An amount is deducted for each exemption to arrive at your taxable income 5. Tax credits. Any tax credits for which you qualify are subtracted at this point 6. Other taxes. Any special taxes, such as self-employment tax, are included at this point 7. Payments. Your total withholding and other payments are indicated in this section 8. Refund or amount you owe. If your payments exceed the amount of income tax you owe, you are entitled to a refund. If the opposite is true, you must make an additional payment 9. Your signature

Tax Evasion

-The use of illegal actions to reduce one's taxes

Job-Related and Other Miscellaneous Expenses

Unreimbursed job travel, union dues, required continuing education, work clothes or uniforms, investment expenses, tax preparation fees, safe deposit box rental (for storing investment documents), and so on

Children's Investments

-A child under 18, or a full-time student under 24, with investment income of more than $2,000 is taxed at the parent's top rate -For investment income under $2,000, the child receives a deduction of $1,000 and the next $1,000 is taxed at his or her own rate, which is probably lower than the parent's rate

Roth IRA

-Also allows a $5,500 (in 2014) annual contribution, which is not tax-deductible; however, the earnings on the account are tax-free after 5 years -The funds from the Roth IRA may be withdrawn before age 59.5 if the account owner is disabled, or for the purchase of a first home ($10,000 max) -Limited to people with an adjusted gross income under a certain amount -Does not have immediate benefits, but the investment grows in value on a tax-free basis -Withdrawals from the Roth IRA are exempt from federal and state taxes

Field Audit

-An IRS agent visits you at your home, business, or the office of your accountant to have access to your records -May be done to verify whether an individual has a home office if this is claimed

Tax Credit

-An amount subtracted directly from the amount of taxes owed -Ex: the credit given for child care and dependent care expenses -Earned-income credit (EIC)- for working parents with taxable income under a certain amount; families that do not earn enough to owe federal income taxes are also eligible for the EIC and receive a check for the amount of their credit -Tax credit has a full dollar effect in lowering taxes, whereas a deduction reduces the taxable income on which the tax liability is computer

529 Plan

-An education savings plan that helps parents save for the college education of their children -There is no federal tax deduction, but the earnings grow tax-free and there are no taxes when the money is taken out of the account for qualified education expenses -Many states allow their residents to deduct contributions to their state plans up to a specified maximum

Form 1040

-An expanded form of Form 1040A that includes sections for all types of income -Required to use if: -Your income is over $100,000 or if you can be claimed as a dependent on your parents' return and you had interest or dividends over a set limit -Allows you to itemize your deductions -Can list various allowable expenses (medical costs, home mortgage interest, real estate property taxes) that will reduce taxable income and the amount you owe the government

April

-April 15 is the deadline for filing your federal tax return; if it falls on a weekend, you have until the next business day -If necessary, file for an automatic extensions for filing your tax forms

401(k) Plan

-Authorizes a tax-deferred retirement plan sponsored by an employer -Allows you to contribute a greater tax amount ($17,500 in 2014) than you can contribute to an IRA -Older workers (50+) may be allowed to contribute an additional $5,500 if their employer allows -However, most companies set a limit on your contributions, such as 15% of salary -Some employers provide a matching contribution in their 401(k) plans -Tax planners advise people to contribute as much as possible to a Keogh or 401(k) plan since (1) the increased value or the investment accumulates on a tax-free basis until the funds are withdrawn and (2) contributions reduce your adjusted gross income for computing your current tax liability

Form 1040EZ

-Can use if: -You are single or married filing a joint return, under age 65, and claim no dependents -Your income consisted only of wages, salaries, and tips and not more than $1,500 of taxable interest -Your taxable income is less than $100,000 -You do not itemize deductions or claim any adjustments to income or any tax credit

Contributions

-Cash or property donated to qualified charitable organizations -Contribution totals greater than 20% of AGI are subject to limitations

Five Filing Status Categories

-Single - never married, never divorced, or legally separated individuals with no dependents -Married, filing joint return - combines the spouses' incomes -Married, filing separate returns - each spouse is responsible for his or her own tax; under certain conditions, a married couple can benefit from this filing status -Head of household - an unmarried individual or a surviving spouse who maintains a household (paying for more than half of the costs) for a child or dependent relative -Qualifying widow or widower - an individual whose spouse died within the past 2 years and who has a dependent; this status is limited to 2 years after the death of the spouse

Investment Income

-Sometimes referred to as portfolio income -Money received in the form of dividends, interest, or rent from investments

Tax Planning

-Starts with knowing current tax laws, next maintaining complete and appropriate tax records, then making purchase and investment decisions that can reduce your tax liability -Primary goal should be to pay your fair share of taxes while taking advantage of appropriate tax benefits

Taxes

-State and local income tax, real estate property tax, and state or local personal property tax

Section 529 Savings Plans

-State-run, tax-deferred plans to set aside money for a child's education -Savings plan to help families set aside funds for future college costs -The 529 plans differ from state to state

August

-Tax returns are due August 15 for those who received the automatic 4-month extension -Determine if you qualify for an IRA; if so, consider opening one

Types of Tax Services

-Tax services range from local, one-person operations to national firms with thousands of offices, such as H&R Block -Enrolled agents - government-approved tax experts - prepare returns and provide tax advice -Many accountants offer tax assistance along with other business services. A CPA with special training in taxes can help with tax planning and the preparation of your annual tax return -Attorneys usually do not complete tax returns; however, you can use an attorney's services when you are involved in a tax-related transaction or when you have a difference of opinion with the IRS

Alternative Minimum Tax

-Taxpayers with high amounts of certain deductions and various types of income may be subject to an additional tax -AMT is designed to ensure that those who receive tax breaks also pay their fair share of taxes -Originally designed to prevent those with high incomes from using special tax breaks to pay little in taxes -Some of the tax situations that can result in a person paying the AMT include high levels of deductions for state and local taxes, interest on second mortgages, medical expenses, and other deductions -Income items that can trigger the AMT are incentive stock options, long-term capital gains, and tax-exempt interest

Medical and Dental Expenses

-The amount of this deduction is the medical and dental expenses that exceed 10% of AGI -For taxpayers over 65, it will remain at 7.5% of AGI through 2016

Taxable Income

-The net amount of income, after allowable deductions, on which income tax is computer

Electronic Filing

-The process of filing tax and information returns directly from one computer to another

Marginal Tax Rate

-The rate used to calculate tax on the last (and next) dollar of taxable income

Traditional IRA

-The regular IRA deduction is available only to people who do not participate in employer-sponsored retirement plans or who have an adjusted gross income under a certain amount -As of 2014, the IRA contribution limit was $5,500 -Older workers, age 50 and over, were allowed to contribute up to $6,500 as a "catch up" to make up for lost time saving for retirement -In general, amounts withdrawn from deductible IRAs are included in gross income -An additional 10% penalty is usually imposed on withdrawals made before age 59.5 unless the withdrawn funds are on account of death or disability, for medical expenses, or for qualified higher education expenses

Capital Loss

-The sale of an investment for less than its purchase price -Can be used to offset capital gains and up to $3,000 of ordinary income -Unused capital losses may be carried forward into future years to offset capital gains or ordinary income up to $3,000 per year

June

-The second installment for estimated tax is due June 15 for income not covered by withholding

September

-The third installment for estimated tax is due September 15 for income not covered by withholding

Tax Avoidance

-The use of legitimate methods to reduce one's taxes

Average Tax Rate

-Total tax divided by taxable income -Based on the total tax divided by taxable income

Taxes on Earnings

-Two main taxes on wages and salaries are Social Security and income taxes -FICA created SS tax to fund the old-age, survivors, and disability insurance portion of the SS system and the hospital insurance portion (Medicare) -Throughout the year, your employer will withhold income tax payments from your paycheck, or you may be required to make estimated tax payments if you own your own business

Tax Rates

-Use your taxable income in conjunction with the appropriate tax table or tax schedule

Form 1040X

-Used to amend a previously filed tax return -If you discover income that was not reported, or if you find additional deductions, you should file Form 1040X to pay the additional tax or obtain a refund

Earned Income

-Usually in the form of wages, salary, commission, fees, tips, or bonuses

Tax-Deferred Annuities

-Usually issued by insurance companies

Income Records

-W-2 forms reporting salary, wages, and taxes withheld -W-2P forms reporting pension income -1099 forms reporting interest, dividends, and capital gains and losses from savings and investments -1099 forms for self-employment income, royalty income, and lump-sum payments from pension or retirement plans

July

-With the year half over, consider or implement plans for a personal retirement program such as an IRA or a Keogh plan