Personal Finance - Ch. 4 Managing Income Taxes
You and your spouse have $9000 in allowable itemized deductions in a year when the standard deduction is $6300 for single taxpayers and $12,600 for married taxpayers. How much in deductions are you allowed to take?
$12,600
Form 1040 and Part II of Schedule 3 list the following refundable tax credits:
- Earned Income Tax Credit - Additional child tax credit - American opportunity tax credit - Net premium tax credit - Credit for federal tax on fuels
Part I of Schedule 3 of tax Form 1040, "Additional Credits and Payments" lists the following nonrefundable tax credits:
- Foreign Tax Credit - Child and dependent care credit - Education credits (lifetime learning) - Retirement savings contribution credit - residential energy credit
types of adjustments
- Retirement plan contributions to an IRA or a company-sponsored 401(k) are adjustments to gross income. - Unemployment compensation is income. - Capital losses may be used to offset capital gains when calculating total income. - Child care expenses may qualify as tax credits. - Tax credits directly offset your taxes; you do not need to itemize your deductions to take advantage of tax credits.
The amount of federal income taxes that you are required to pay is based on your: ________________. The income tax tables are progressive , meaning the tax rates _____ as taxable income increases.
- filing status, your taxable income, and the IRS tax rate tables - increase
Seven basic steps used in calculating federal income taxes:
1.Determine your total income. 2.Determine and report your gross income after subtracting exclusions. 3.Subtract adjustments to income to get adjusted gross income. 4.Subtract either the IRS's standard deduction amount for your tax status or your itemized deductions to get taxable income. 5.Determine your preliminary tax liability by applying the tax table or tax rate schedule. 6.Subtract the tax credits for which you qualify. 7.Calculate the balance due to the IRS or the amount of your refund.
Which of the following directly reduces your tax liability rather than your income subject to federal income taxes? a. tax adjustment b. tax deduction c. tax exemption d. tax credit
d. tax credit
A taxpayer's gross income, minus adjustments to income, minus the amount for the standard deduction or total itemized deductions, and minus the amount subtracted based on the number of exemptions allowed is his or her _____
d. taxable income.
You pay federal taxes only on your a. employment income. b. gross income. c. investment income. d. taxable income.
d. taxable income.
Salary reduction programs that set aside a portion of an employee's pre-tax income for government approved dependent-care expenses are called _____
flexible spending accounts
The tax rate applied to a taxpayer's last dollar of income is called the _____
marginal tax rate
A tax credit that can reduce your tax liability to zero, but if the credit is more than the tax liability, the excess is not returned to you is _____. A tax credit that reduces your income tax liability to below zero with the excess being returned to you is a _____ tax credit.
nonrefundable refundable
If you are in the 22% tax bracket, your income falls between
•$39,476 and $84,200 if you are a single taxpayer •$78,951 and $168,400 if you are a married taxpayer filing jointly •$39,476 and $84,200 if you are a married taxpayer filing separately •$52,851 and $84,200 if you are filing as head of household
_____ taxes are characterized by higher tax rates on higher levels of income.
Progressive
Regressive tax
A tax rate that decreases as taxable income increases
Contributions
Contributions to an IRA, the interest on student loans, and contributions to health savings accounts are adjustments to income. Social Security contributions have no tax benefit.
tax credit
Dollar-for-dollar decrease in tax liability
- Education credits (lifetime learning) (nonrefundable)
Form 8863 covers the two tax credits for higher education. The lifetime learning credit is a nonrefundable tax credit for any level of college education. That credit is reflected here. The American Opportunity Tax Credit provides a refundable tax credit of up to $2,500 for undergraduate education. It is reflected on Form 1040, directly below the line where federal income tax withheld from Forms W-2 and 1099 is entered.
itemized deductions
Specific tax-deductible expenses that reduce adjusted gross income
Tax evasion
The act of reducing taxes by deliberately understating income or overstating deductions U.S. tax laws are strict and punitive and you will be penalized with heavy fines or jail time for tax evasion.
Tax Avoidance
The act of reducing taxes in ways that are legal and compatible with the intent of Congress It involves knowledge of the tax code and how to apply it to your personal circumstances. It makes good financial sense to consider taxes in your financial plans, and it is smart to avoid paying taxes so you get to keep more of the money you earn.
Capital gain
The net income received from the sale of a capital asset above the costs incurred to purchase and sell it
average tax
The proportion of total income paid in income taxes It is calculated by dividing your taxes by your gross income
Which of the following is not considered to be a tax-sheltered investment? a. An investment in a mutual fund b. An investment in tax-exempt municipal bonds c. An investment in a Coverdell education savings account d. An investment in government savings bonds
a. An investment in a mutual fund
Select which term describes each of the following items or parts of the tax return. a. A gift received b. Capital gains c. Contributions to qualified personal retirement accounts (IRAs) d. An amount that is based on your filing status e. State and local taxes
a. Tax-exempt income b. Part of total income c. Adjustments to gross income d. Standard deduction e. Included in itemized deductions
marginal tax bracket
one of the seven income-range segments that are taxed at increasing rates as income goes up. Depending on your income, you fit into one of the brackets and should pay at one of those marginal tax rates: 10%, 12%, 22%, 24%, 32%, 35%, or 37%
Home ownership can provide significant income tax savings compared to renting a comparable home. This is because a taxpayer's _____ are tax deductible.
property taxes
tax shelter
reduces or eliminates a taxpayer's tax liability
marginal tax rate
the highest rate applied to your income, or the rate that is applied to your last dollar of earnings. Your effective marginal tax rate includes all taxes (federal, state, local, Social Security and Medicare taxes.)
According to the IRS, interest and dividend income should be included in the computation of a taxpayer's taxable income, while the following items can be excluded:
•Interest income received on tax-exempt government bonds issued by states, counties, cities, and districts •Inherited money or property •Life insurance benefits received •State and local tax refunds •Gifts •Withdrawals from state-sponsored Section 529 plans (prepaid tuition and savings) •Child support payments received •Employee contributions to flexible spending accounts •Disability insurance benefits (provided the taxpayer paid the premiums)
The tax form lists the following six classifications of itemized deductions:
•Medical and dental expenses •Taxes you paid •Interest you paid •Gifts to charity •Casualty and theft losses •Other itemized deductions
You have two investment choices: one paying 9% taxable, and one paying 6% non-taxable. You are in the 28% tax bracket. What is the after-tax equivalent yield on the taxable investment?
6.48%
Taxable Income =
=Total income - Exclusions - Adjustments to income - Deductions - Exemptions =Adjusted gross income - Deductions and exemptions
Exclusions
Income not subject to federal taxation They include items such as inherited money or property, income from a carpool, return of money loaned, and life insurance benefits received accounts.
Itemized deductions include
Medical and dental expenses, charitable contributions, and unreimbursed casualty and theft losses (during an officially declared disaster by the president)
- residential energy credit (nonrefundable)
This credit is for qualifying energy efficiency improvements to your home. This credit was not covered in the chapter, but you found it on the form. Good work.
- Earned Income Tax Credit (refundable)
This credit may be claimed by workers with a qualifying child and, in certain cases, by childless workers.
- Additional child tax credit (refundable)
This credit may be claimed for each qualified dependent child who is under the age of 17 at the end of the tax year.
- Credit for federal tax on fuels (refundable)
This credit was not covered in the chapter, but you found it on the form. Good work. Form 1040 and Part II of Schedule 3
- Net premium tax credit (refundable)
This credit was not covered in the chapter, but you found it on the form. Good work. Form 1040 and Part II of Schedule 3
Foreign Tax Credit (nonrefundable)
This credit was not covered in the chapter, but you found it on the form. Good work. Part I of Schedule 3 of tax Form 1040, "Additional Credits and Payments"
- Retirement savings contribution credit (nonrefundable)
This is a savers credit for money put away for retirement. You must meet income and age requirements to qualify.
- American opportunity tax credit (refundable)
This is the refundable education credit.
- Child and dependent care credit (nonrefundable)
This tax credit may be claimed by workers who pay employment-related expenses for care of a child or another dependent if that care gives them the freedom to work, seek work, or attend school full time.
Deductions
amounts that all taxpayers may subtract from their adjusted gross income to determine taxable income. Taxpayers may use the standard deduction or they can list their itemized deductions, which are specific items that may be used to directly reduce income.
What does it mean to be in the 22% tax bracket? Check all that apply. a. You pay 22% on your last dollar of taxable income earned. b. You pay 22% in taxes on your total taxable income. c. You save 22% in taxes on your last dollar of allowable deductions. d. If you are married and filing jointly, your income falls in the $78,951 to $168,400 range.
a. You pay 22% on your last dollar of taxable income earned. c. You save 22% in taxes on your last dollar of allowable deductions. d. If you are married and filing jointly, your income falls in the $78,951 to $168,400 range.
flexible spending account (FSA)
allows an employee (and an employer) to withhold a portion of an employee's pre-tax income to pay for out-of-pocket unreimbursed expenses for medical expenses, dental expenses, and dependent care for a child or parent.
premium-only plan (POP)
allows the employee to withhold a portion of their pre-tax income to pay the premium on an employer-provided health benefit.
Which of the following must be included in the computation of a taxpayer's taxable income? a. Employee contributions to flexible spending accounts b. Inherited money or property c. Life insurance benefits received d. Interest and dividend income
d. Interest and dividend income
Experts describe the U.S. tax system as being a progressive system. This means that: a. only those taxpayers that earn income will incur income taxes. b. a greater tax rate is applied to the last dollar of taxable income than on the first dollar of taxable income. c. a smaller tax rate is applied to the last dollar of earned income than on the first dollar of taxable income. d. every taxpayer in the United States pays the same tax rate on their taxable income.
b. a greater tax rate is applied to the last dollar of taxable income than on the first dollar of taxable income.
Which of the following tax avoidance strategies is generally not available to an employee of a large employer? a. tax-sheltered retirement accounts b. shifting income to a child c. capital gains on housing d. tax-exempt municipal bonds
b. shifting income to a child
Gross Income
consists of all income (both earned and unearned) received in the form of money, goods, services, and property (before exclusions and deductions) that a taxpayer is required to report to the IRS.
Why is a refundable tax credit more valuable than a tax deduction or a nonrefundable tax credit? a. It may reduce your tax liability to below zero (provide a refund). b. It reduces tax liability by one dollar for every dollar of the credit. c. It may be taken even if you do not itemize deductions. d. All of these are reasons.
d. All of these are reasons.
Which of the following is excluded from gross income reported to the IRS? a. Hobby income b. Gambling and lottery winnings c. Alimony received d. Child support payments received
d. Child support payments received Child support payments received are excluded from a taxpayer's taxable income. Alimony received, hobby income, and gambling and lottery winnings are treated as taxable income by the IRS.
The following are examples of tax-sheltered investments:
•Investments made in tax-exempt municipal bonds, also called munis, provide interest payments that are free from federal and state taxes—provided the bonds are purchased in your state of residence. Again, the bonds are purchased with after-tax dollars. •A flexible spending account (FSA) is funded with pre-tax dollars, but is not intended for long-term accumulation since it is subject to the use-it-or-lose-it rule, which means that at the end of the calendar year, all unspent dollars will be forfeited back to the employer unless the employer allows a grace period for spending the money. Withdrawals made to reimburse allowed expenses are made tax free .•A Roth IRA, which allows for after-tax contributions (up to $5,500 per year) and tax-free withdrawals. This account allows you to accumulate funds for the long-term without having to pay tax on the account each year. In contrast, a contribution to a traditional IRA allows you to contribute up to $5,500 per year of pre-tax income (thereby reducing your taxable income). Taxes are due, however, when withdrawals are made from traditional IRA accounts. •A Coverdell education savings account, also known as an education savings account, allows you to contribute up to $2,000 per year of after-tax income. Earnings accumulate tax-free and withdrawals made for qualified expenses, such as tuition, fees, room and board, uniforms, home computers and internet access, and transportation are also tax-free. •Investments made in Series EE and Series I government savings bonds generate interest income that is exempt from state and local taxes. The investment is made with after-tax dollars, but you can defer the federal income taxes due on the interest income until final maturity (30 years) or you can report and pay taxes on the interest annually. This provides you with a potential 30-year deferment on your taxes.
