BUSN380 Week 2 TCO 2 Notes - Taxes
BUSN380 Week 2 TCO 2 Notes - Taxes
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Date Created: 11/06/15
IMPORTANCE OF TAXES FOR PERSONAL FINANCIAL PLANNING Know all the taxes you pay in order to understand tax planning, and make good decisions about spending, saving, borrowing, and investing decisions. Take advantage of appropriate tax benefits by knowing tax laws and keeping accurate tax records. TYPES OF TAXES Income Property Gift Sales Estate Social Security Excise Inheritance TO REDUCE QUESTIONS BY IRS IDENTIFY TAX ASSISTANCE SOURCES: IRS Services & Publications Other tax publications Internet Computer Software Professional Tax Preparers e.g., commercial tax services, enrolled agents, accountants REDUCE TAX BURDEN: Learn new tax info Plan financial decisions related to Consumer Purchasing, Debt, Investments, and Retirement Planning CALCULATE TAXABLE INCOME AND AMT OWED FOR FEDERAL INCOME TAX. Organize tax records to find info easily Subtract Adjustments to Income deductions, and Allowances for Exemption from Gross Income Total Tax Liability based on published tax tables or schedules less any tax credits PREPARE FEDERAL INCOME TAX RETURN BUSN380 Week 2 Notes On time each year Adjustments to Income Understand major Other taxes owed sections of Form 1040: Standard Deductions Amounts withheld or itemized (Withholding) or Filing Status deductions paid in advance Exemptions Tax Credits you Refund or additional qualify for amount owed Income from all sources KEY CONCEPTS and skills from Week 2: Provide an overview of how the federal tax system works. Explain the tradeoff between risk and return as this tradeoff pertains to common investment instruments. Explain the difference between income and cash flow. KEY SKILLS TO MASTER from Week 2: 1. Computing Taxable Income. 4. Analyzing Tax Preparation Software 2. Calculating Average Tax Rate. 5. Researching Tax Questions. 3. Comparing Taxes on Investments. 6. Comparing Tax Services. KEY TERMS Average Tax Rate is based on Total Tax Due/Taxable Income is less than marginal tax rate except for people in 10% bracket. Selfemployed have higher ATC because of selfemployment taxes including payments toward future Social Security benefits. If Taxable income $40,000 Total tax bill $4,200 = Then ATC = 4200/40,000 =10.5% BUSN380 Week 2 Notes Marginal Tax Rates are the 10, 15, 25, 28, 33, & 35% rates. used to calculate tax on the last and next dollar of taxable income After deductions, exemptions a person in 28% bracket pays 28 cents in taxes for every dollar of taxable income in that bracket. DETERMINING ADJUSTED GROSS INCOME (AGI) & COMPUTING TAXABLE INCOME (Net amt of income after allowable deductions on which income tax is computed) – STEP 1 Gross Income less Adjustments to Income = AGI AGI less Standard Deductions & Exemptions OR AGI less Itemized Deductions & Exemptions = Taxable Income (Tax based on tax tables or schedules) Taxes Owed: Taxable Income less Tax Credits + Other Taxes = Total Tax Due STEP 2 Deductions Amt subtracted from adjusted gross income to get taxable income Every taxpayer gets at least the standard deduction a set amt on which no taxes are paid. Since 2008 single ppl receive SD of $5,450, married couples filing jointly $10,900 Blind and over 65 get higher standard deduction. Itemized Deductions Expenses allowable as deduction from AGI. E.g. Medical expenses doctor fees, prescription meds, hearing aids, eyeglasses, medical travel not reimbursed or paid by others The amt is medical & dental expenses greater than 7.5% of AGI. If AGI = $20,000 you need > $1500 in unreimbursed med expenses before you can claim this deduction. If bills = $1600 you can deduct $100 BUSN380 Week 2 Notes Taxes State & Local income tax Real estate property tax Choose to deduct either sales tax or state income tax whichever is more. This benefits taxpayers in seven states with no State Income Tax Interest Mortgage interest Home equity loan interest Investment interest expense up to an amount equal to investment income. Contributions Cash or Property donated to qualified charitable organizations. Totals > 20% AGI subject to limitations. Casualty and Theft Losses Financial losses from natural disasters, accidents, or unlawful acts. Deduct amt > 10% AGI minus $100 for losses not reimbursed by an insurance company or other source. Moving Expenses when a change in residence is associated with a new job that is at least 50 miles further from your home than your old main job location. Deductible Moving Expenses include: Cost of transporting the taxpayer and household members Cost of moving household goods & personal property Jobrelated & Other Misc Expenses Unreimbursed Job Travel Tax Preparation Fees Union Dues Safe Deposit box rentals (for investment Required continuing education docs) Work clothes or Uniforms Total expenses should be > 2% AGI to Investment Expenses qualify BUSN380 Week 2 Notes Exceptions to 2% limit: Gambling losses to the extent of gambling winnings Physical or Mental Disability Expenses that limit employability. SD OR Total ID + value of Exemptions AGI = Taxable Income Exemptions Deduction from AGI for yourself, Social Security number of each spouse, & qualified dependents. dependent must be reported on the tax return, regardless of age. A dependent must not earn > a set amt unless younger than 19 or a fulltime For 2003, Taxable Income was student under 24 reduced by $3500 for each exemption Provide more than half of dependent's claimed. Amount revised every year based on Inflation. support Increased Exemptions and Standard Dependent must live in home or Deductions eliminate or reduce the specified relative and meet certain citizenship requirements taxes of lowincome Americans. For 2008 a family of four did not pay Federal Income Tax On first $24,900 of Gross income: $10,900 for standard deduction and $14,000 for 4 exemptions STEP 3 Calculating Taxes Owed Taxable Income is basis for computing amt of income tax. Use of Tax Rates and Benefits of Tax Credits are final phase of Tax Computation process. Use Taxable Income in conjunction with appropriate Tax Tables or Tax Schedules. For 2007 the sixrate system for federal income tax was established. Separate tax rate schedule exists for married persons filing separate. Comparing Taxes on Investments TaxExempt Income is: Adjusted Gross Income (AGI) after certain reductions e.g. IRA or Keogh retirement plan, penalties for early withdrawal of savings, alimony payments. Used as basis for computing income tax deductions like medical expenses. Tax Shelters Certain AIGs e.g. tax deferred retirement plans provide immediate tax benefits and a reasonable expectation of future financial return. Deductible IRAs provide tax relief up front, as contributions reduce current taxes. However taxed must be paid when withdrawals are made. Roth IRAs do not have immediate benefits but investment grows in value on taxfree basis. Withdrawals are exempt from federal & state taxes. Coverdell Education Savings Account Designed to help parents save for college education of children. Annual contribution not deductible and limited to $2,000. Only for taxpayers with AGI under a certain amt. Like Roth IRA, the earnings accumulate taxfree. Keogh Plan (HR 10) Retirement plan for selfemployed or business owners. MORE…. Tax Deferred Investments - income is taxed at a later date. Advantage in terms of opportunity cost is that paying a dollar in the future instead of today gives you the opportunity to invest or spend it now. Examples are: Taxdeferred annuities sold by insurance companies Section 529 Savings Plans staterun plans to save for child's education Retirement plans like IRAs, Keogh or 401K plans. Traditional IRAs contributions to and earnings from these are not taxed till withdrawn. Regular IRA deduction is available only to people who do not participate in employer sponsored retirement plans, OR who have AGI under a certain amount. Contribution limit for workers under 50 years of age $5000; over 50 $6000. Amounts withdrawn from deductible IRAs are included in gross income. An additional 10% penalty is imposed on withdrawals made before 59 1/2 unless for death, disability, medical expenses or for qualified higher education expenses. Roth IRAs $5000 annual contribution not tax deductible but earning on the account are tax free after five years. Funds may be withdrawn before 59 1/2 if account owner is disabled, or for the purchase of a first home up to a max of $10,000 Capital Gains profits from sale of a capital assets such as stocks, bonds, or real estate. Tax paid when assets are sold. You pay a lower tax rate on profits from stocks and other investments if you hold them for more than a year. As of 2008 a taxpayer in the 28% bracket would pay $280 tax on $1000 shortterm capital gain (held for less than a year), but would pay 15%, $150 on the same amt if held for more than a year. Certain gains such as art, antiques, stamps, and other collectibles, however, are still taxed at higher pre1997 capital gains rate of 28%. Shortterm capital gains are taxed as ordinary income. Taxpayers in lowest tax brackets have lower rates for both. Capital Losses is the sale of an investment for less than its purchase price, and can be used to offset capital gains or ordinary income up to $3000 per year. Capital Gains – Analyzing Tax Preparation Software. Software; Spreadsheet program to maintain and update Income & Expense Data. Software Packages like TaxCut & TurboTax to complete tax forms & Schedules to print for mailing or file online. Selection considerations: Personal situation employed or selfemployed Special tax situations re types of income, unusual deductions, various tax credits. Software features like Audit Check, future tax planning, & filing federal & state tax forms online Technical aspects hardware, & OS requirements, online support Earned Income money received for personal effort wages, salary, commission, fees, tips, bonuses Investment or Portfolio Income dividends, interest, rent from investments Passive Income from business activities in which you do not actively participate limited partnerships Other Income Alimony, Awards, Lottery Winnings, prizes Exclusion – an amt. not included in gross income a.k.a. taxexempt income e.g. interest earned on many city and state bonds (Municipal Bonds) Estate Tax Excise Tax Inheritance Tax Itemized Deductions Passive Income Tax Audit Tax Avoidance Tax Evasion Tax Credit Tax Deduction Taxdeferred Income PROBLEM from Lecture The rate of return on a longterm CD generally will be higher than the return offered by a money market account. Why? Among other reasons, longterm interest rates are riskier than are shortterm rates. Separately, to see why this is so, perform the following exercise for yourself (using the timevalueofmoney relationships presented in Lecture 1). Assume the 1year interest rate initially is 6% and the 5year annual interest rate initially is 7%. Also assume annual compounding and a terminal payout (at maturity) for each investment in the amount of $1,000. 5 To get you started, the present value (price) of the 5year instrument will be: $1,000/1.07 . Now, suppose each rate increases by 1%. In other words, the 1year instrument now carries an annual interest rate of 7% and the 5 year instrument now carries an annual interest rate of 8%. On a percentage basis, which instrument’s price has declined the most? ANS. $1,000 / 1.06 = $943.40 $1,000 / 1.07 = $934.58 $934.58 / $943.40 = .99 there is approximately a 1% decline $1,000 / (1.07^5) $1,000 / (1.08^5) $1,000 / 1.4025 = $713.01 $1,000 / (1.4693) = $680.60 $680.60 / $713.01 = .95 there is approximately a 5% decline If you invest in the CD, the rate will be higher than the rate received on a money market account, but your funds will remain inaccessible to you for a longer period. In addition, if you liquidate a bank CD prior to maturity you will typically pay a penalty fee. One key aspect surrounding your decision has to be an assessment of your short and longterm needs for liquidity. Personal financial statements and cash flow forecasts are critical in arriving at wellfounded assessments of which interestearning savings instrument best suits your goals and needs.
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