Personal Finance Chapter 4
How do you calculate taxable income?
1. Start with Income from all sources less exclusions=total income. 2. Minus adjustments to total income=Adjusted Gross Income. 3. Minus Standard Deduction or itemized deductions. 4. Minus Exemptions=Taxable Income. 5. Look up your tax on Tax Table=Tentative Tax. 6. Minus Credits=Total Tax Owed. 7. Minus taxes already paid (payroll withholding and estimated taxes)=Balance Due or Amount of Refund.
How do you file your taxes?
1. Through the mail 2. Electronically 3. Over the phone
When did income tax start in the U.S?
1923 when the 16th Amendment to the U.S. Constitution was passed. Necessary to pay for WWI
When did they implement the 10% tax bracket?
2001 as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. Prior to that it was 15%. Was effective in 2003.
Internal Revenue Code
A compilation of all statues, regulations, and court decisions relating to U.S. income tax.
FICA
A payroll tax levied on earned income by the U.S. government to fund Social Security and Medicare.
tax credit
A reduction applied directly to taxes owed rather than to income subject to taxes.
flat tax
A single tax rate imposed on every dollar of income for every taxpayer.
IRS e-file
A system allowing electronic filing of federal tax returns. Less than 1% of all electronic tax returns included errors in 2002.
regressive tax
A tax that places a disproportionate financial burden on low-income taxpayers. examples: payroll, consumption, and sales taxes, Social Security and Medicare, and FICA
progressive tax
A tax that requires higher-income taxpayers to pay proportionately more in taxes, through either higher tax rates or other rules.
flexible spending account
An account maintained by an employer in which the pretax earnings of an employee are set aside and can be used for reimbursement of qualified medical and child-care expenses.
itemized deduction
An alternative to the standard deduction in which the taxpayer reports and deducts actual expenses in certain allowed categories to arrive at taxable income.
tax evasion
Deliberate nonpayment of taxes legally owed.
Telefile
Doing taxes over the phone.
standard deduction
Dollar amount based on filing status that is subtracted from adjusted gross income in calculating taxable income. In 2003 was $4,750 for single and $9,500 for married couples and head of household could deduct $7,000. Higher for people age 65 or older and for people who are blind.
exemption
Dollar amount per household member that is subtracted from adjusted gross income in calculating taxable income. Allowed $3,050 (in 2003, indexed for inflation) for each qualifying person in your household. Phased out for very-high-income households.
Married filing separately
Each spouse files an individual tax return, reporting his or her own income and allowed deductions from income.
adjusted gross income (AGI)
Earned income and unearned income minus certain allowed adjustments to income.
Amended Tax Return
If you discover that you made a mistake on a prior year's taxes, you are allowed to file Form 1040X up to three years after the original tax year. IRS receives about 4 million a year.
Form 1040A
If you make less than $50,000 a year and do not plan on itemizing but either have a dependent, adjustments to income or credits for IRA contributions or student loan interest
Do not need to file a tax return if...
In 2003, $3,050 (exemption) + $4,750 (standard deduction)=$7,800 for single and $6,100 (exemption)+$9,500 (standard deduction)=$15,600 for married.
% that files electronically
In 2003, 40%. In 2009, 60%. In 2012, 80%. Get refund in 3 weeks instead of 6 weeks.
Gross Income
Income from all sources, including earned income, investment income, alimony, unemployment, compensation, and retirement benefits.
unearned income
Income from investments, interest, dividends, capital gains, net business income, rents, and royalties.
earned income
Income from salaries, wages, tips, bonuses, commissions, and other sources.
How do you determine your tax liability?
It is calculated by your taxable income. Taxable income is your total income from all sources less allowed exclusions, adjustments, exemptions, and deductions. After calculating the tentative tax owed based on taxable income, you may be able to reduce the amount owed by claiming certain tax credits.
Married filing jointly
Married couple filing a single tax return, even if only one spouse had income.
dependent
Member of a household who receives at least half of his or her support from the head of the household.
payroll withholding
Money regularly withheld from employees' pay by employers for payment of the employees' taxes.
Qualifying widow(er) with dependent child
Person whose spouse died with two years of the tax year and who lives with and pays more than half of the support for a dependent child.
audit
Process by which the IRS more carefully examines particular tax returns for errors and omissions.
Capital Gain
Profit on the sale of an investment; subject to a lower tax rate if the investment has been held for more than one year.
How to legally minimize the taxes you pay.
Reducing your current taxable income, deferring taxable income to future years, maximizing deductions, receiving capital gains income, which is subject to a lower marginal tax rate, and taking advantage of allowed tax credits.
marginal tax rate
Tax rate imposed on the taxpayer's next dollar of income. Range from 10-35%
How is tax system enforced?
The IRS and the use of audits
Internal Revenue Service (IRS)
The U.S. government agency responsible for collecting federal income taxes and enforcing tax laws and regulations.
taxable income
The amount of income that is subject to taxes under the law.
marginal tax effect
The change in taxes owed as a result of a financial decision.
Medicare
The federal system for retiree healthcare. Rate is 1.45% for everyone.
Social Security
The federal system for retirement income. Rate is 12.4% for everyone up to $117,000 (2014) (87,900 in 2004). Employees pay 6.2% of their wage earnings. Employers pay 6.2% of their employee's wage earnings.
average tax rate
The proportion of a taxpayer's total taxable income that goes to paying taxes. =taxes paid/taxable income Will always be less than the marginal tax rate.
tax bracket
The range of income to which a particular marginal tax rate applies.
single
Unmarried or legally separated from your spouse.
Form 1040
long form; needs to be done if your income exceeds $50,000 a year or if you plan on itemizing your deductions.
When do you file your taxes?
must be postmarked by midnight April 15 of the year following the tax year. Can extend the deadline by 4 months to August 15th by filing form 4868, Application for Automatic Extension, on or before April 15 deadline. The IRS receives about 9 million extensions each year. Still have to pay taxes if you owe on the April 15th deadline.
head of household
single person who lives with and pays more than half of the support for a dependent child or relative.
Form 1040EZ
If make less than $50,000, do not want to itemize your deductions, do not have dependents or income adjustments or credits for IRA contributions or student loan interest.
inflation indexing of tax brackets
Has been in place since 1981. Taxes are automatically increased each year for inflation.
filing status
Household type for tax filing purposes. examples: single, married filing jointly, married filing separately, head of household, qualifying widow(er) with dependent child.
Alternative Minimum Tax
Federal income tax calculations designed to ensure that people who receive certain tax breaks pay their fair share of taxes.
Total Income
Gross income less certain exclusions allowed by the IRS.
Additional Forms
See page 110.
Most common filing errors
See page 111
tax avoidance
Strategic use of knowledge of tax rules to avoid overpayment of taxes.
marriage penalty
the standard tax deduction for married couples was historically less than twice that for singles. The Growth Tax Relief and Reconciliation Act of 2003 removed this long-standing inequity from the tax laws.