What are taxes? Federal Income Tax Principles. Federal Income Tax Principles

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1 What are taxes? Financial Planning: Preparing Your Taxes Honors Personal Finance 1 Taxes are required contribu4ons to local, state, & federal revenue, levied by the government on personal income and business profits or added to the cost of some goods, services, and transac4ons. Income Taxes a type of tax levied on taxable income by the federal government and many state and local governments. Personal income taxes are scaled on a progressive scale. Progressive Tax Structure a tax structure in which the larger the amount of taxable income, the higher the rate at which it is taxed. The purpose behind this system is to try and distribute the tax burden more evenly between the lower, middle, and upper classes. In the U.S. this system is defined by the Marginal Tax Bracket (MTB) - one of the 7 income ranges that are taxed at increasing rates as income goes up. Each ci4zen s income determines their Marginal Tax Rate - the tax rate you pay on the next dollar of taxable income. For Example: John has $45,000 in taxable income. While Adam has $95,000 in taxable income. That means that Adam s taxable income is just over twice that of John s. However, Adam will pay over 2.5 4mes more in taxes. John at $45,000 in taxable income. = [$9,226 x 0.10] + [($37,451 - $9,226) x 0.15] + [($45,000 - $37,451) x 0.25] $ $4, $1, = $7,

2 Adam at $95,000 in taxable income. = [$9,226 x 0.10] + [($37,451 - $9,226) x 0.15] + [($90,750 - $37,451) x 0.25] + [($95,000 - $90,750) x 0.28] $ $4, $13, $1,190 = $19, Therefore, John pays: $7, While, Adam pays: $19, This is a difference of: $12, Or 2.79 Lmes more. By dividing the amount of taxes due (tax liability) by the taxable income we get the average tax rate. Average Tax Rate the rate at which each dollar of taxable income is taxed on average. $7,043.60/$45,000 = or 15.65% Your Take-Home Pay Employers are required by law to withhold certain taxes from each employees paycheck. Even the self-employed have to prepay part of their taxes four 4mes per year. Gross income - is the total amount a worker is paid before any required or voluntary deduc4ons are made. Net income -, also called take home pay, is the amount a person receives when he/she cashes or deposits their check. Employers must pay these taxes deducted from employee paychecks to the IRS. 1 The most common taxes are federal, state, and local. 2 Social Security Tax (FICA), and 3 Medicare tax contribu4on with each paycheck. The Social Security tax or FICA tax. Federal Insurance Contribu5ons Act The law establishing the combined old-age survivor s disability, & hospital insurance tax levied on both employer & employee. Social Security taxes provide the following benefits for employees and their dependents: q supplemental re4rement benefits q benefits for the dependents of re4red workers q benefits for the disabled and their dependents The Medicare tax is used to provide medical benefits for certain individuals when they reach age 65. Workers, re4red workers, and the spouses of workers and re4red workers are eligible to receive Medicare benefits upon reaching age 65. 2

3 Property tax Sales tax Other Taxes Gasoline tax Local/City taxes Calculate Sales Tax You and your friends receive a lunch bill for $22.50 before tax is included. The Tennessee state sales tax rate is 7%. Coun4es and ci4es can charge an addi4onal local sales tax of up to 2.75%, for a maximum possible combined sales tax of 9.75%. What is the total cost when the tax is added? Calculate Sales Tax v x.0975 = v = v Total Bill: $24.70 Voluntary Payroll DeducLons Health Insurance Re4rement Savings Union Dues Charitable Contribu4ons Once all adjustments, deduc4ons, and exemp4ons are accounted for what your leo with is: Taxable Income the amount of income subject to taxes; it is calculated by subtrac4ng adjustments, deduc4ons, and exemp4ons from gross income. A separate form of taxable income is called capital gains. Capital Gains occur whenever an asset (such as a stock, bond, or real estate) is sold for more than its original cost. Capital Gains The tax rate for capital gains depends on the holding period of the investment. Less than = Same as ordinary 12 months income Over = 10% & 15% = 0% 12 months 39.6% = 20% All others = 15% Capital Gains When an investment is sold at a loss, the capital loss can be deducted dollar for dollar against capital gain up to $10,000. An addi4onal $3,000 can be deducted against other income. Any capital loss above that can be applied to future returns. Capital Gains EXAMPLE: Tax year 2016 John has $10,000 in capital gains. He has $18,000 in capital losses. Only $13,000 can be deducted in

4 DeducLons Standard or Itemized A Standard DeducLon - is a fixed amount that depends on your filing status. An Itemized DeducLon - is a lis4ng of personal expenditures that can be deducted from AGI, when determining taxable income. Basic DeducLons 1 Medical Travel Expenses 2 Medical Expenses 3 Real Estate Taxes 4 Charitable Dona4ons 5 Job Expenses 6 College Tui4on Tax Credit ExempLons Another way of reducing your taxable income is through: ExempLons deduc4ons from AGI based on the number of persons supported by the taxpayers income. Your Filing Status Single unmarried or legally separated or divorced. Married Filing Jointly married couples who combine their income and allowable deduc4ons and file one tax return. Your Filing Status Married Filing Separately married couples who each files their own return, repor4ng only his or her income, deduc4ons, & exemp4ons. Head of Household unmarried & pays more than half of the cost of a home for themselves & a dependent child or rela4ve. Basic Federal Tax Forms W-4 Employee Withholdings W-2 Taxable Wages I-9 Employment Eligibility 1040ez Taxable income less than $100,000 from wages only 1040 Itemized Deduc4ons You use W-4 Employee's Withholding Allowance Cer4ficate Form to establish your withholding allowances for Federal income taxes. W4 Line 5 is where you write your withholding allowances. Usually a number between 0 &7. Less chance of tax return. Higher # = less $ withheld Lower # = more $ withheld Greater chance of tax return. Form W-2 reflects all taxable wages you received during the calendar year and all taxes withheld from those wages. 4

5 An I-9 Form is the Employment Eligibility Verifica4on Form required by the Immigra4on and Naturaliza4on Services (INS) to verify your iden4ty and your eligibility to work. The 1040EZ is a faster and easier way to file your taxes. This form is only eligible for people with income less than $100,000 from wages only & interest income of $1,500 or less. The 1040 form is used when the taxpayer is planning on using itemized deduc4ons. There are mul4ple versions of this form as your taxes become more complicated. Tax Planning: Seeking legal ways to reduce, eliminate, or defer income taxes, is a process every ci4zen should take very seriously. The 1 st step is to calculate your Assets: anything of value that a person or firm owns. Then you want to account for all possible deduc4ons (Standard or Itemized). The nest step is to find all exemp4ons allowed by the government. The more exemp4ons, the lower your taxable income. The government allows for these legal ways of reducing your tax burden. These ways are referred to as Tax Avoidance the act of reducing taxes in ways that are legal and compa4ble with the intent of Congress. Some take this avoidance to the extreme. When this happens you have Tax Evasion the illegal act of failing to accurately report income or deduc4ons and, in extreme cases, failing to pay taxes altogether. This can result in fines or even jail 4me. Be careful with which exemp4ons you use. Stretching the applicability of an exemp4on can lead to an audited return. Because the taxpayer provides the key informa4on for filing their taxes, the IRS is tasked with monitoring this process. 5

6 Tax AudiLng A Tax Audit an examina4on by the IRS to validate the accuracy of a given tax return, can occur based on a return being flagged as suspicious or can be a random act. Tax Audit Red Flags 1 High Income 2 Unreported Taxable Income 3 Higher-Than Average Deduc4ons 4 Home Office Deduc4ons 5 Business Meals, Travel, etc. 6 Business Use of a Vehicle Every ci4zen must file Personal Income Tax: A tax on a person's individual income from wages and salary, gambling winnings, and some other sources. Amount of income, types of income, deduc4ons, etc. will determine what forms must be filed. Comple4ng the proper forms will help you to calculate your taxable income, and any deduc4ons or exemp4ons you may qualify for. Two ways of legally reducing your taxable income is by inves4ng in: 1. Tax Deferred: Any income that one earns but does not receive un4l a later date, resul4ng in taxes on the income are not paid un4l later. For example: Tradi4onal IRA s, 401k, 403b. The 2 nd way this can be accomplished is by inves4ng in: 2. Tax Exempt: Describing income or organiza4on that is not subject to taxa4on. For example: Roth IRA s. This will not help with your current taxable income, but will help down the road. Aoer finding all your deduc4ons and exemp4ons you are leo with your AGI Adjusted Gross Income - gross income less any exclusions and adjustments. From this number you calculate your personal income taxes. Taxes q Why do we go through all this trouble? 1 It s the law. 2 This is how the government gets a large por4on of the revenue needed to pay for certain things. Where the Money Goes 6

7 Where the Money Comes From End of Taxes 7