Personal Finance Part 1: Lesson 2

Briefly describe some common itemized deductions

Common itemized deductions include the following. Certain taxes, such as state and local income tax, real estate property tax, and personal property tax (such as ad valorem taxes on automobiles) Certain types of interest, including mortgage interest and investment interest to the extent of net investment income Charitable contributions to qualified charitable organizations Most taxpayers who itemize can take the above deductions without limitations. However, deductions which often provide no benefit to the taxpayer because of limitations include the following. Medical and dental expenses—These expenses must exceed 7.5% of adjusted gross income. Only the portion in excess of 7.5% of adjusted gross income is then deductible. Casualty and theft losses—Losses of this type which are not reimbursed by insurance or any other source are deductible to the extent they exceed 10% of adjusted gross income less $100. Unreimbursed employee expenses and miscellaneous other expenses—These must exceed 2% of adjusted gross income to be deductible. Only the portion in excess of 2% of adjusted gross income is then deductible. (Pages 109-111)

Identify some common strategies that can be used to minimize income taxes.

Certain strategies can be used to minimize income taxes. A taxpayer who expects to be in the same or lower tax bracket next year should do the following. Accelerate deductions into the current year—These are deductions such as real estate taxes or charitable contributions. The taxpayer will also benefit by making the January mortgage payment in December. Delay the receipt of income until the following year. A taxpayer who expects to be in a higher tax bracket next year should do the following. Delay deductions until the following year when they will have greater benefit Accelerate the receipt of income into the current year to have it taxed at a lower rate (Pages 126-127)

Identify the main benefits in using a budget.

A budget is essential for successful financial planning. It helps a person to do the following. Live within a particular level of income Spend money wisely Reach financial goals Prepare for financial emergencies Develop wise financial management habits (Page 88)

Define adjusted gross income and explain how to determine it.

Adjusted gross income (AGI) is gross income after certain reductions have been made. It is used as the basis for computing various income tax deductions, such as medical expenses. To compute AGI, follow these steps. Add up your gross (or total) income, which may consist of three main components. Earned income is money received by an individual for personal effort such as wages, salary, commission, fees, tips, or bonuses. Investment income (also called portfolio income) is money received in the form of dividends or interest. Passive income is the result of business activities in which you do not actively participate, such as a limited partnership. Make adjustments to that income. For example, total income is affected by exclusions. An exclusion is an amount not included in gross income, such as foreign income when working in another country. They are also referred to as tax-exempt income - income not subject to tax. Total income will also be affected by tax-deferred income, which refers to income that will be taxed at a later date. (Pages 107-109)

List three major money management activities and describe some of the opportunity costs of money management decisions.

Three major money management activities are listed below. Storing and maintaining personal financial records and documents Creating personal financial statements, such as balance sheets and cash flow statements Creating and implementing a spending and savings plan Money management decisions involve certain trade-off situations, or opportunity costs. For example, spending more money on living expenses reduces the amount available for saving and investing. At the same time, saving and investing reduce the amount available for current spending. Buying on credit reduces the amount of income available for future spending. Using savings to pay current expenses results in a loss of interest income. Comparison-shopping can save money and improve the quality of purchases, but this costs time, which cannot be replaced. (Page 78)

Explain the steps and information involved in creating a balance sheet. Identify some ways of increasing net worth.

A balance sheet, also known as a net worth statement, specifies what you own and what you owe. Items of value minus amounts owed equals net worth. There are three steps involved in completing a balance sheet. Step 1: List items of value. This includes assets, which are cash and other property that has a monetary value. Liquid assets are cash and items of value that can easily be converted into cash. Real estate includes a home, condominium, vacation property, or other land that a person or family owns. Personal possessions are the major portion of assets for most families. Investment assets consist of money set aside for long-term financial needs. Step 2: Determine the amount that is owed. Liabilities are amounts owed to others but do not include items not yet due, such as next month's rent. Current liabilities are debts that must be paid within a short time, usually less than a year. Long-term liabilities are debts that are not required to be paid in full until more than a year from now. Step 3: Compute your net worth Your net worth is the difference between your total assets and your total liabilities: Assets - Liabilities = Net worth Insolvency is the inability to pay debts when they are due; it occurs when a person's liabilities far exceed his or her available assets. Net worth can be increased in the following ways. Increasing the level of savings Reducing the level of spending Increasing the value of investments and other possessions Reducing the level of debt (Pages 81-84)

Briefly describe the five filing status categories.

Filing status is determined mostly by marital status and dependents. The five filing status categories are as follows. Single—Available to never-married, divorced, or legally separated individuals with no dependents Married filing jointly—Combines the income and deductions of a husband and wife Married filing separately—Each spouse is responsible for his or her own tax Head of Household—Available to an unmarried individual or surviving spouse who maintains a household, paying for more than half the cost of support for a child or dependent relative Qualifying Widow or Widower—An individual whose spouse has died within the past two years and who has a dependent; this status is available for two years after the death of a spouse (Page 116)

Manually calculate the nine savings balances shown in Exhibit 3-10 on page 98 of your text, using the tables in the appendix, located at the end of Chapter 1. Identify the tables you use, in addition to the rate and the number of periods that coincide with the correct factor. Important Note: For the second goal (saving for a down payment to purchase a home), you must calculate the savings balance assuming quarterly compounding. To do this, divide the given interest rate by 4. Since the annual rate is 4%, the quarterly rate would be 1% (4 divided by 4 = 1). Therefore, you must use the column for 1%, not 4%. You must also multiply the number of years by 4 and use 8, 16, or 24 as the number of periods (2 years x 4 quarters = 8, 4 years x 4 quarters = 16, and 6 years x 4 quarters = 24).

Shown below are the calculations for the nine savings balances shown in Exhibit 3-10 on page 98 using the tables or formulas in the Appendix (located at the end of Chapter 1 on pages 31-40). Goal #1: Set aside an emergency fund for unexpected expenses and financial emergencies by making a single deposit of $6,000. Savings balance after: 2 years $6,000 x 1.061 = $6,366 (Exhibit 1-A, factor for 3% for 2 years) 5 years $6,000 x 1.159 = $6,954 (Exhibit 1-A, factor for 3% for 5 years) 10 years $6,000 x 1.344 = $8,064 (Exhibit 1-A, factor for 3% for 10 years) Goal #2: Save $200 every three months for the down payment on a house. Savings balance after: 2 years $200 x 8.286 = $1,657.20 (Exhibit 1-B, factor for 1% for 8 periods) 4 years $200 x 17.258 = $3,451.60 (Exhibit 1-B, factor for 1% for 16 periods) 6 years $200 x 26.970 = $5,394.00 (Use formula from page 33) Goal #3: Save $2,000 per year for retirement living expenses. Savings balance after: 10 years $2,000 x 14.487 = $28,974 (Exhibit 1-B, factor for 8% for 10 years) 20 years $2,000 x 45.762 = $91,524 (Exhibit 1-B, factor for 8% for 20 years) 30 years $2,000 x 113.280 = $226,560 (Exhibit 1-B, factor for 8% for 30 years)

Identify some common income tax filing errors.

Some common income tax filing errors include failing to do the following. Use the proper tax rate schedule or tax table column Check the arithmetic several times Make the check payable to United States Treasury instead of IRS Keep a copy of the return (Page 125)

Examine the seven steps of the budget process.

The seven steps of the budget process are listed below. Step 1: Setting Financial Goals. Financial goals are plans for future activities that require you to plan spending, savings, and investing. Step 2: Estimating Income. Available money should be estimated for a given time period—such as a month. Income variations (due to seasonal work or sales commissions) should be based on the recent past and realistic expectations. Step 3: Budgeting an Emergency Fund and Savings. An emergency fund and savings for irregular payments should be set aside first in order to avoid not having anything left for savings. Step 4: Budgeting Fixed Expenses. Definite obligations (rent, mortgage, and credit payments) should be allocated first. Step 5: Budgeting Variable Expenses. Planning for variable expenses is more difficult than planning for fixed expenses. These expenses will fluctuate based on household situation, time of the year, health, economic conditions, and other factors. Step 6: Recording Spending Amounts. A budget variance is the difference between amount budgeted and the actual amount received or spent. Step 7: Reviewing Spending and Saving Patterns. The results of your budget may be obvious—having extra cash, falling behind in payments. Or the results may need to be reviewed in detail to determine areas of needed changes. The most common overspending areas are entertainment and food, especially away-from-home meals. At this point of the budgeting process, you should also evaluate, reassess, and revise your financial goals.