Preparing Your Taxes
Chapter 3
How Will This Affect Me?
There’s an old joke that people who complain about taxes can be divided into two groups: men
and women. This chapter helps you pursue the tax-planning goal of maximizing the money that
you get to keep by legally minimizing the taxes you have to pay. Income, various adjustments to
income, deductions, and credits are considered in computing taxes. The chapter walks through
the steps in completing representative tax returns. The impact of Social Security taxes and tax
shelters are considered. And a framework for choosing a professional tax preparer or tax
preparation software is provided. After reading this chapter you should be able to prepare your
own taxes or to better understand and evaluate how your taxes are prepared by software or a tax
professional.
The one continuing characteristic of the federal income tax is change. Congress feels compelled
to “improve” the tax law, frequently doing so in December of the tax year at issue. Thus, any
summary of the tax law will be out of date whenever it is written. This chapter is based upon the
law in effect for the tax year 2014. The tax rates for 2015 are included for your information,
however, the tax forms for 2015 will not be available until November of 2015 or later. After all
the Congress is talking about changes and by December they may enact some of the changes.
Whether or not such changes will improve the law is in the eye of the beholder.
The student who is serious about personal financial planning needs to take an individual tax
course. While only about half of all people pay income tax [that half pay a lot of FICA taxes] the
people who ask for help with their financial planning are in the top 20% and they do pay income
taxes. Minimizing that tax is a concern to the clients of financial planners.
Learning Goals
LG1 Discuss the basic principles of income taxes and determine your filing status.
All taxes have a tax base and a tax rate, thus tax = base * rate. The name of the tax indicates the
tax base, thus, the tax base for the income tax is income; for the sales tax, the base is sales; and
so on. Income in general is similar for accounting purposes and for tax purposes, with several
differences designed to achieve some public policy goal. The concept of personal exemptions,
standard deduction, and itemized deductions are not a part of accounting income, but they serve
various public purposes. Most criminals do not pay taxes on their illegal income. This chapter
does not discuss how to illegally pay taxes or how to otherwise be a criminal. The goal is to pay
only the tax required by the law, no more nor no less. So much of the chapter discusses how to
reduce the tax base and how to reduce the tax rate.
Key concepts are exclusions [proceeds from life insurance received by reason of the death of the
insured are excluded from gross income], deductions [investment interest may be deducted up to
the amount of investment income], exemptions [personal exemptions and dependency
exemptions reduce taxable income], credits [child tax credit reduces tax-not taxable income- by
$1,000 per child], and rates [gains from sale of capital gains are taxed at a lower rate than salary
or interest income]. The tax rates are progressive, that is the marginal tax rates increases as
income increases in steps or brackets. For a single taxpayer, the first $9,075 of taxable income
[gross income less all deductions] is taxed at a marginal rate of 10%. The first dollar over
$9,075 is taxes at 15%, and so on to the top tax rate of 39.6%. [Why not 40%, only your
Congressman knows, or not.]
There are four sets of rates – Single, Joint, Married filing separately, and Head of households.
The 2014 rates are in the textbook. The 2015 rates are below. The chapter has several examples
of computing the tax. You can build the tax by computing the tax on each bracket of income or
use the rate schedule that computes the tax on income up to the first number in the bracket and
then you add the additional tax using the appropriate marginal tax rate. Using the 2014 single
tax rate, the tax on $36,900 is $5,081.25 computed as
10% * $9,075 + 15% * (36,900 – 9,075 = $27,825) = $5,081.25
The filing status determines which rates you can use. There are five filing status: Single,
Married filing jointly, Married filing separately, Surviving spouse, and Head of household. The
surviving spouse status is for the two years after a spouse dies if the surviving has a dependent
child living with him/her. Qualifying surviving spouse uses the Joint rates.
2015 Tax Rates
Individual Taxpayers
Married Individuals Filing Joint Returns and Surviving Spouses
Married Individuals Filing Separate Returns
Heads of Household
LG2 Describe the sources of gross income and adjustments to income, differentiate between
standard and itemized deductions and exemptions, and calculate taxable income.
Exhibit 3.1 gives the steps to compute taxable income and the related tax liability. It will be
good to go over these steps.
The three types of income discussed are important because of the limits the type of income
imposes. Portfolio income limits the amount of investment interest that may be deducted.
Passive income limits the loss deduction from businesses in which the investor has a passive
interest [that is the investor does not work in the business). All real estate investments are
passive interests with a small exception for middle income taxpayers that allows a loss deduction
of $25,000 if the investor participates in the managing of the real estate investment. Active
income is everything else.
Exhibit 3.2 reports the various alternative rates for capital gains. Key point is that the reduced
rates applies only to gains on sales of assets held more than 12 months, so called “long-term
gains”. The top capital rate is 20% and applies if the ordinary income tax rate is 39.6%. There
are two additional alternatives rates that apply in limited cases: 25% on part of gain from sale of
depreciable real estate, and 28% on gains from sale of collectibles such as artwork, ceramics,
stamps, etc. Note that these are alternative rates: if the ordinary tax rates are lower, use them.
The standard deduction varies by taxpayer’s age and filing status. Most common are the single
status which has a standard deduction of $6,200 in 2014 and $6,300 in 2015, and the married
filing joint status which has a standard deduction of $12,400 in 2014 and $12,600 in 2015. They
change every year as the Consumer Price Index changes. If the taxpayer’s itemized deductions
are greater, the Schedule A is filed and the itemized deductions deducted. The itemized
deductions tend to be greater if the taxpayer has state income taxes and mortgage interest on up
to two personal residences.
The personal exemptions deduction is $3,950 in 2014 and $4,000 in 2015. Thus, in 2014, a
single taxpayer will have no taxable income if their income is $10,150 ($6,200 + $3,950) or less.
LG3 Prepare a basic tax return using the appropriate tax forms and rate schedules.
All taxpayers may file a form 1040. For taxpayers with a limited source of income, there are
Forms 1040EZ and Form 1040A. These forms are simpler to file if filing by hand. With tax
preparation software, the software selects the form to file.
Exhibit 3.3 displays the 2014 tax rate in the form that is normally reported by the IRS. The 2015
rates are above. Exhibit 3.5 demonstrates the difference between a tax credit and a tax
deduction. The value of a tax deduction is the amount of the deduction times the marginal tax
rate. Thus, the value of standard deduction to a single taxpayer in the 25% marginal rate is 25%
* $6,200 or $1,550. The value of a tax credit is the amount of the credit, thus the value of a
$1,000 child tax credit to a 25% marginal rate taxpayer is $1,000.
Worksheet 3.2 is an example of a form 2014. To download President Obama’s 2014 form 1040
go to the Whitehouse site below.
https://www.whitehouse.gov/blog/2015/04/10/president-obama-and-vice-president-biden-s-2014-
tax-returns
LG4 Explain who needs to pay estimated taxes, when to file or amend your return, and how to
handle an audit.
People frequently will say that they did not pay taxes because they got a refund. A refund only
means that you have overpaid the taxes you owe. If effect you have loaned money to the federal
government at zero interest. Better to have a small balance due, an amount that you can easily
pay. You pay taxes via your employer withholding the tax from you wages which reduces your
take home pay. If you are self-employed, you are required to pay estimated taxes four times a
year [April 15, June 15, October 15, and January 15]. If you have other income that is not
withheld upon, such as retirement annuities or withdrawals from retirement funds, you will also
have to pay estimated taxes.
The IRS has a program that uses a discriminate function to grade returns as to the probability of
an error on the return. Those with the highest score are then audited to determine the source of
the error. The taxpayer is then notified of the error and the additional tax due. If the taxpayer is
due a refund because of the error, that amount is sent to the taxpayer. All returns are checked for
arithmetical errors. With the current budget level of the IRS, only the most obvious erroneous
returns will actually get audited.
LG5 Know where to get help with your taxes and how software can make tax return preparation
easier.
Most taxpayers can prepared their own tax returns as well as change the oil in their car.
However, many people chose to hire someone to do both. Certainly when you prepare only one
tax return a year, it can take a long time to get it done. A professional tax return preparer can do
it faster. The chapter lists the most frequently used tax preparers.
User friendly tax preparation software is widely available. There are real advantages to using
such software and to use the same software each year. There is a learning curve to using the
software and there is a great deal of carryover data required in preparing a tax return. Using the
same software each year helps reduce the time required to get it done.
LG6 Implement an effective tax planning strategy.
There are two strategies to tax planning:
Income shifting – Shift income to a taxpayer in a lower tax bracket or between years, from a high
tax year to a low tax year. Perhaps you can bunch your itemized deductions. For example pay
your property tax in January for last year and December for this year, thus you can deduct two
years of property tax in one year.
Income Conversion – Convert ordinary income to capital gain income, or to tax exempt income..
For example sell your bonds and purchase preferred stock. Dividends from stock are taxes at
capital gain rates, while interest income is taxed at the higher ordinary rates. Or sell corporate
bonds and purchase bonds from state and local governments – that interest is tax exempt.
It would be useful to review the table Planning Over a Lifetime with the students. That table
emphasizes the role of taxes in investment decisions and retirement decisions.
Financial Facts or Fantasies?
These may be used as “teasers” to get the students on the right page with you. Also, they may be
used as quizzes after you covered the material or as “pre-test questions” to get their attention.
Are the following statements Financial Facts (true) or Fantasies (false)? Consider the answers to
the questions below as you read through this chapter.
Every individual or married couple is required to file a federal income tax return
regardless of the amount of income earned.
Fantasy: Only those individuals or married couples who earn a specified minimum level
of income or wish to receive a refund or withheld taxes are required to file a tax return.
The amount of federal income tax withheld depends on both your level of earnings and
the number of withholding allowances claimed.
Fact: The more you make and the fewer withholding allowances you claim, the more will
be withheld from your paycheck.
Federal income taxes are levied against the total amount of money earned.
Fantasy: Federal income taxes are levied against your taxable income, which is the
amount remaining after adjustments, deductions, and exemptions have been subtracted
from gross income.
Gains on the sale of investments such as stocks, bonds, and real estate are taxed at the
lower capital gains tax rate.
Fantasy: Only capital gains on investments held for longer than 12 months (long-term)
qualify for tax rates lower than those on ordinary income. Short-term capital gains are
taxed at ordinary income rates.
Tax credits, deductions and exemptions reduce your taxable income by comparable
amounts.
Fantasy: Tax credits are far more valuable than comparable dollar amounts of deductions
or exemptions because they directly reduce, dollar for dollar, the amount of taxes due.
An easy way to earn tax-deferred income is to invest in Series EE savings bonds.
Fact: The interest income from a Series EE savings bond can be tax deferred. The holder
can elect to delay payment of taxes until the earlier of the year the bonds are redeemed
for cash or the year in which they finally mature.
Financial Facts or Fantasies?
These may be used as a quiz or as a pre-test to get the students interested.
1. True False Every individual or married couple is required to file a federal income tax
return regardless of the amount of income earned.
2. True False The amount of federal income tax withheld depends on both your level of
earnings and the number of withholding allowances claimed.
3. True False Federal income taxes are levied against the total amount of money earned.
4. True False Gains on the sale of investments such as stocks, bonds, and real estate are
taxed at the lower capital gains tax rate.
5. True False Tax credits, deductions and exemptions reduce your taxable income by
comparable amounts.
6. True False An easy way to earn tax-deferred income is to invest in Series EE savings
bonds.
Answers:
YOU CAN DO IT NOW
The “You Can Do It Now” cases may be assigned to the students as short cases or problems.
They will help make the topic more real or relevant to the students. In most cases, it will only
take about ten minutes to do, that is, until the student starts looking around at the web site. But
they will learn by doing so.
Tax Planning
Consider whether you expect your tax rate to be lower, the same, or higher next year. Then do
some simple but effective tax planning:
• If your tax rate is expected to be lower or the same next year, if you can, delay receiving
income until next year so it will be taxed at the lower rate – or just later at the same rate.
• If your tax rate is expected to be higher next year, try to speed up the receipt of income so it
will be taxed at the currently lower rate. And consider waiting to take some deductions until next
year when the higher rate will shield you better from the higher rate.