Chapter 3 - Taxes in Your Financial Plan

Exemption

A deduction from adjusted gross income for yourself, your spouse, and qualified dependents.

Tax Audit

A detailed examination of your tax return by the Internal Revenue Service.

Standard deductions

A set amount on which no taxes are paid.

Exclusion

An amount not included in gross income.

Taxable income

The net amount of income, after allowable deductions, on which income tax is computed.

Marginal Tax Rate (MTR)

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

Average Tax Rate (ATR)

Total tax due divided by taxable income.

Tax Credit

An amount subtracted directly from the amount of taxes owed.

Tax deduction

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

Types of taxes (on purchases, on property, on wealth, and on earnings)

Excise Tax: A tax imposed on specific goods and services, such as gasoline, cigarettes, alcoholic beverages, tires, and air travel. Sales Tax Estate tax: A tax imposed on the value of a person's property at the time of death. Inheritance tax: A tax levied on the value of property bequeathed by a deceased person. Social Security (6.2%) Medicare (1.45%) Income Tax

Itemized deduction

Expenses that can be deducted from adjusted gross income, such as medical expenses, real estate property taxes, home mortgage interest, charitable contributions, casualty losses, and certain work-related expenses.

Adjusted gross income

Gross income reduced by certain adjustments, such as contributions to an individual retirement account (IRA) and alimony payments.

Passive income

Income resulting from business activities in which you do not actively participate.

Tax-exempt income

Income that is not subject to tax.

Tax-deferred income

Income that will be taxed at a later date.

401(K) Plan

The part of the tax code called 401(k) authorizes a tax-deferred retirement plan sponsored by an employer. This plan allows you to contribute a greater tax deferred amount ($18,000 in 2017) than you can contribute to an IRA. Workers age 50 and over may be allowed to contribute an additional $6,000 if their employer allows. However, most companies set a limit on your contribution, such as 15 percent of your salary. Some employers provide a matching contribution in their 401(k) plans. For example, a company may contribute 50 cents for each $1 contributed by an employee. This results in an immediate 50 percent return on your investment. Tax planners advise people to contribute as much as possible to a Keogh or 401(k) plan since (1) the increased value of 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.

Withholding

The pay-as-you-go system requires an employer to deduct federal income tax from your pay. The withheld amount is based on the number of exemptions and the expected deductions claimed. For example, a married person with children would have less withheld than a single person with the same salary, since the married person will owe less tax.

Taxes Owed

To calculate the tax on a specific amount of income, you must calculate the tax from each of the brackets as you progress up to your taxable income. (10%) Range of income ($0 ‒ $18,650) $18,650 × 10% = $1,865 (15%) Range of income ($18,650 ‒ $75,900) $57,250 ×15% = $8,588 (25%) Range of income ($75,900 ‒ $95,000) $19,100 ×25% = $4,775 Total tax due (all brackets) $1,865 + $8,588 + $4,775 = $15,228