Understanding Taxes by ja2349


									                          Understanding Taxes

                                     Chapter 6

Planning Your Financial Future, 4e
     by: Boone, Kurtz & Hearth

 Many Americans don‟t understand the tax
  system (or the forms)
 For most people, taxes represent the biggest
  single expense they have—as much as
  housing or food
 Since you pay (or will pay) so much of your
  income in taxes, you should understand the
  tax laws, and what you can/cannot deduct

What Are Taxes?

 A payment required by a state, local, or federal
  government of individuals and organizations
  having property, receiving income, or engaging in
  various activities
      Example: own property, pay property taxes; buy goods,
       pay sales tax
 Taxes are collected by governments to raise money
  to cover operating costs and to pay for goods and
  services (roads, police, parks, etc.)
      May also be used to influence behavior (i.e., tax on
       tobacco products)
Philosophies of Taxation

 Benefits-received philosophy
     Those who receive the benefits should pay the
        Example: Gasoline taxes go to pay for highway
        repairs and new road construction
 Ability-to-pay philosophy
     Those who can afford to pay more should (on a
      proportional basis)

Progressive and Regressive

 Progressive tax requires that those who earn
  more money pay progressively more in taxes
     Example: federal income taxes
 With a regressive tax, as income rises, the
  payee pays a smaller percentage (because the
  tax itself is a fixed amount)
     Example: Gasoline, sales and property taxes are
      pre-established percentages

Types of Taxes

 Income taxes (progressive)
      Levied by federal government, most state governments,
       few local governments
         Federal income tax
               Federal government gets about 45% of revenues from income
               Largest single tax that most Americans pay (average two-wage
                family pays $6,000/year)
         State and local income taxes
               41 states have an income tax
               Income taxes are less important to states as a revenue source

Types of Taxes

 Social Security and Medicare taxes
     Listed on pay stub as FICA (Federal Insurance
      Contributions Act)
     You pay half and employer pays other half
        15.3% of first $87,000 and 2.9% of wages in excess of
     Can be a significant household expense

Types of Taxes

 Property taxes
      Real estate is the most often taxed property
      Some states tax automobiles and boats
      Tax is typically based on the fair market value of item
      Tax percentage varies across the U.S.
 Sales taxes
      45 states have a sales tax
         Tax on the retail prices of goods and services
         What‟s taxable varies across states
               Some states provide an exemption for items such as food,
                medication, and medical care

Types of Taxes

 Excise taxes
      Tax levied on the consumption/purchase of specific
         Gasoline, airline tickets, etc.
 State and local licensing fees
      Hunting/fishing, driving, getting married/divorced, dog
       tag, etc.
 Estate and gift taxes
      Estate may be subject to federal estate tax
      Recipient of a gift pays no federal taxes, but giver may
       have to pay federal gift tax
How Much People Pay in Taxes

 Average one-wage earner pays
     $9,675 in taxes per year (in 2001)
 Average two-wage earner pays
     $20,000 in taxes per year
 Federal income taxes are the largest amount
 Social Security/Medicare taxes are the

The Federal Income Tax System

 Administered by the Internal Revenue Service
 Employs over 100,000 people

How the IRS Works

 Returns are received by ten service centers across
      Clerks sort return (refund vs. owe), input data,
       gather/deposit checks, etc.
      IRS personnel briefly review each return to weed out
       outrageous deductions
      Once data is inputted, information is compared to that
       sent in by employers, banks, etc.
      Computer will „spit out‟ returns that warrant further
       investigation (audit)

Taxpayer Compliance

 Tax audit
     Thorough examination of return (specific portion, such
      as itemized deductions) or the entire return
     Generally, IRS will not audit a return if it is more than
      three years since filed
     An audit can be conducted via correspondence or in
     IRS collects an additional $2,000 per audit on average
     About 1% of all returns are audited every year
        Depends on your income and complexity of return

Dealing with the IRS

 What should you do if you receive an automated
  adjustment letter or get called in for an audit?
      DO NOT assume automatically that the IRS is correct
      You should be OK if you didn‟t misrepresent the facts
       and you have documentation supporting the choices you
      You have 60 days to respond to an automated
       adjustment notice
 There are avenues of appeal available to you
      Tax court, federal district court, U.S. Court of Claims

Commonsense Tips for Dealing
with an IRS Audit

 You MUST provide documentation for your claims
 Ask questions to make sure you understand
  everything—don‟t let the auditor bully you
      Be polite, but firm
      You have the right to stop the audit to prepare further,
       but it will simply delay your audit to another date
 Never volunteer any additional information
 The IRS settles, on average, for 50% of what it
  claims audited taxpayers owed
      See if you can negotiate reduced taxes or penalties
Commonsense Tips for Dealing
with an IRS Audit

 You may be asked to sign a Form 870 Waiver, but if you
    sign it your rights to future appeals may be limited
       If you don‟t agree, don‟t sign
 If you get called in for a face-to-face audit, ask for a
    correspondence audit if you prefer one
       You may find it less stressful
       If you must have a face-to-face audit, do it at the IRS office
 If you are found to owe additional taxes that you cannot
    pay, ask for an installment payment plan
   You have the right to have a tax accountant or attorney
    present during the audit (or to even go in your place)
       You also have the right to temporarily stop the audit and consult
        with your representative in private

Recent and Proposed Changes
to the Federal Tax System

 Federal tax code is over 10,000 pages long
 Estimated cost of simply preparing and filling out forms for
    federal income taxes is estimated to be $600 billion (total
    for businesses and individuals)
   Some people have proposed a „flat tax‟
       Would no longer be a progressive system, which some people
       Would eliminate deductions, which some people dislike
 Some have proposed a modified flat tax
       Some deductions would be retained (such as home mortgage
        interest and charitable contributions)
       Tax rates would rise as income rises
       Would still simplify tax system
Recent and Proposed Changes
to the Federal Tax System

 Some like the idea of a complete elimination of the
  federal income tax—to be replaced with a national
  sales tax or value-added tax
      Supporters argue that it would encourage people to save
       because when they spend money they would be taxed
      Opponents argue that it would be burdensome to
       businesses to collect and would be highly regressive

Preparing a Federal Tax Return

 You should learn the rules that apply to you
  so you can figure out how to legally
  minimize your taxes
 By taking some of the responsibility, you can
  understand the importance of tax planning
  year round

Completing Your Tax Return

 Determine whether you have to file and your filing status
 Decide which form to use
 Add up your income
 Subtract any adjustments
 Subtract either the standard or itemized deductions
 Subtract personal exemption(s)
 Calculate your tax liability
 Subtract the amount of taxes withheld and other credits
 Determine amount of refund or how much extra you owe

Determining Whether You Have
to File and Filing Status

 Don‟t have to file if
      Single and earn less than $7,800
      Married and earn less than $15,600
         These change yearly, so make sure you know the current rules
 Filing Status
      Single
      Married, filing jointly
      Married, filing separately
      Head of household

Deciding Which Form to Use

 Three basic forms
     1040, AKA long form
        Everyone can use this form
     1040A, AKA short form
        Taxable income must be less than $50,000
        Cannot itemize deductions
     1040EZ
          Must be single or married, filing jointly with no dependents
          Taxable income of $50,000 or less
          No more than $400 in interest income
          Cannot itemize deductions or claim any adjustments to income

Subtracting the Standard Deduction or
Your Itemized Deductions

 General rule of thumb
     Itemize only if the itemized deductions exceed
      the standard deduction
 If you itemize, you must use Form 1040 and
 Schedule A

Subtracting the Amount of Taxes
Withheld and Other Tax Credits

 A tax credit is a dollar-for-dollar reduction
  in the amount of taxes owed
 Federal income taxes withheld by employer
  are reported in box 2 on W-2

Filing Your Tax Return

 Generally, return must be filed by April 15th
  of each year
     Can obtain an extension by filing Form 4868 by
      April 15th
        If you owe taxes, you must make a good faith
        estimate of the amount owed and send it in along
        with Form 4868

Electronic Filing

 Many Americans file returns electronically and use
  software to prepare return
 Benefits include
      Better accuracy
      Faster refunds
      Information is sent directly to IRS computers
 Some businesses advertise “rapid refunds”
      Really just short-term loan with very high interest rate

Getting Help With Your Taxes

 Many Americans don‟t like to do their own taxes
      Too complicated
      Takes too much time
      Worried about making an error
 Who needs a tax professional
      Some people who need it, don‟t get it
      Many people who don‟t need it, use it
         Generally, if you make less than $100,000 a year and have no
          extraordinary deductions (even if you earn interest and dividend
          income), you can probably do your own return
      Word of caution
         Different tax advisors may come up with different estimates of the
          same tax situation

Help From the IRS

 Invaluable source of information
      Contact via mail or telephone, local IRS office, Web site
 Will not complete form for you
 Goal is to help you understand so that in future
  you can do your own taxes without help
 Advice will be conservative
      Don‟t expect “creative” deductions

Using a Tax Preparation Firm

 H&R Block & others
     Charge an average of $75
     If you use one of these firms, you can probably
      do your return yourself
     Many of the employees have little experience
     Not as likely to take slightly questionable (but
      legal) deductions if they agree to pay penalty

Using a Tax Accountant or
Other Specialist

   May want to use if you have more complex issues
        Divorce
        Own rental property
        Bought/sold property
        Have a home office, etc.
   CPAs are expensive ( $175/hour), so have everything organized when
    you go in to see them
        Can legally represent you at a tax hearing
        Can offer expert advice on how to minimize your taxes—use them for help
         throughout the year
           What records should you be saving as allowable deductions
   An enrolled agent is accredited by IRS but not as expensive as a CPA
        Many charge a flat rate
        Can legally represent you at a tax hearing

Tax Information Sources

Lots of publications available, including
     Your Federal Income Tax (IRS Publication
      No. 17)
       Lists common deductions that are
        overlooked, etc.
       Free—available at IRS Web site

Web Links

      IRS Web site
      Your Federal Income Tax (IRS
      Publication No. 17)

Tax Planning

 Objective: Pay the absolute minimum in taxes that
  you legally can (AKA as tax avoidance)
 Tax evasion is illegally hiding taxable income or
  falsely claiming deductions, etc.
 Virtually all taxpayers should perform tax
  planning, although its importance increases with

Tax Planning

 You need to periodically review your situation to
  make certain that you are not going to owe taxes
  on April 15th
      Could have to pay a penalty
      You may want to have an additional amount withheld
       from your paycheck
 You also don‟t want to have a huge refund
      Your money doesn‟t earn interest
 Remember, tax planning is just that—a plan
      Tax tables, deductions, etc. change every year, so your
       numbers (estimates) may not be entirely accurate
Some Tax-Saving Tips

 Pay all your deductible state and local taxes before
  the end of the year so you can deduct them from
  this year‟s return
 Make sure you deduct all home mortgage interest
 Consider replacing credit card debt and auto loans
  with a home equity loan, as interest is tax
 Deduct legitimate medical expenses
      „Normal‟ medical expenses, plus cosmetic surgery,
       treatment for addictions, special equipment
Some Tax-Saving Tips

 Deduct for casualty and theft losses
      Amount that exceeds 10% of AGI + $100 per loss
 Contribute as much as you can to your retirement
 Don‟t overlook miscellaneous deductions
      Tax preparation fees, work uniforms, union dues,
       subscriptions to professional publications, professional
       organizational memberships, etc.
 Don‟t be afraid to challenge a property tax bill


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