Solutions to “Test Yourself” Questions
3-1 What is a progressive tax structure and the economic rationale for it?
The progressive tax structure uses a progressive tax rate where the rate increases [ from
10% to 39.6% as taxable income increases. The economic concepts supporting the progressive
3-2 Briefly define the five filing categories available to taxpayers. When might married
taxpayers choose to file separately?
The five filing statuses are:
Single—taxpayer is not married on last day of year
Married filing jointly—both parties to the marriage agree and take responsibility for the tax
return. They must be married on the last day of the year.
Married filing separate—there are two returns filed by the married couple. Each spouse is
It will be a rare case where a couple will decide to file married filing separately. Examples are
3-3 Distinguish between gross earnings and take-home pay. What does the employer do with
the difference?
Take-home pay is the gross earnings less required income tax withholding, FICA taxes [Social
Security and Medicare taxes], and less any fringe benefits paid for by taxpayer such as group life
3-4 What two factors determine the amount of federal withholding.
Tax withholding will vary by filing status, number of withholding exemptions claimed, and
3-5 Define and differentiate between gross income and AGI. Name several types of tax-
exempt income. What is passive income?
Goss income is income from whatever source derived unless excluded by Congress. Examples
Adjusted gross income is gross income less business expenses and other adjustments allowed by
law. Examples of other adjustments include contributions to IRAs, alimony paid, self-employed
health insurance premiums, expenses relating to serving in the National Guard or Reserves, and
3-6 What is a capital gain, and how is it treated for tax purposes?
Capital gain is gain from the sale of capital assets. Capital assets is defined in the negative, that
is it is anything except receivables, inventory, real property used in a trade or business, personal
Gains from the sale of capital assets held more than 12 months are subject to an alternative rate
Ordinary tax
rates
Alternative tax
rates
10% or 15% 0%
In addition, gains from the sale of collectibles are subject to an alternative rate of 28% and gain
Losses are not treated favorably. Net capital losses, capital gains less capital losses, are limited
3-7 If you itemize your deductions, you may include certain expenses as part of your
itemized deductions. Discuss five types of itemized deductions and the general rules that
apply to them.
Medical expenses—deductible if they exceed 10% of adjusted gross income
State and local taxes—Only income taxes and property taxes where the property tax is based
upon value of the property
Interest paid—only applies to interest on mortgages for up to two homes and limited to one
million dollars of principal.
Charitable Contributions—Only contributions given to a 501(c)-3 organization. Overall limit is
3-8 Dan Caldwell was married on January 15, 2014. His wife, Catherine, is a full-time
student at the university and earns $625 a month working in the library. How many
personal exemptions will Dan and Catherine be able to claim on their joint return? Would
it make any difference if Catherine’s parents paid for more than 50 percent of her support?
Explain.
Dan and Catherine may each claim a personal exemption on their return. If they file a joint
One general requirement to claim a dependent is that the dependent may not file a joint return.
Thus, if Dan and Catherine file a joint return, Catherine’s parents may not claim her as a
dependent regardless of amount of support they provide. If Catherine and Dan elected to file as
3-9 Define and differentiate between the average tax rate and the marginal tax rate.
How does a tax credit differ from an itemized deduction?
Average tax rate is the tax due divided by the taxable income. The marginal tax rate is the rate
on the next dollar of income which is determined by the bracket their income falls in. With a
A tax credit is a dollar for dollar reduction in the tax due. A tax deduction reduces taxable
income and is worth the marginal tax rate times the amount of the deduction to the taxpayer. A
3-10 Explain how the following are used in filing a tax return: (a) Form 1040, (b) various
schedules that accompany Form 1040, and (c) tax rate schedules.
a. Form 1040 is the main form used in filing federal income taxes. All individuals filing
may use Form 1040 accompanied by appropriate schedules as needed to file their tax
b. A variety of schedules may accompany Form 1040, with Schedules A, B, C and D
being some of the frequently used ones. The schedules provide detailed guidelines for
c. Tax rate schedules provide the information for calculating the tax due after all
3-11 Define estimated taxes, and explain under what conditions such tax payments are
required.
Taxpayers who do not work for an employer, must pay their own taxes four times a year: April
15, June 15, October 15, and January 15 of following year. Any income in excess of $600 on
3-12 What is the purpose of a tax audit? Describe some things you can do to be prepared if
your return is audited.
A tax audit is a review of a tax return to prove its accuracy with regard to proper
The best way to be prepared for an audit is to keep thorough records of cash receipts and
expenditures and receipts from other deductible items. Especially when you have
3-13 What types of assistance and tax preparation services does the IRS provide?
The IRS attempts to provide tax assistance on a walk-in basis at its various offices in the larger
cities. The IRS also attempts to provide telephone assistance via toll free numbers. Also at
3-14 What are the advantages of using tax preparation software?
3-15 Differentiate between tax evasion and tax avoidance.
Tax avoidance is the practice of using various legal strategies to reduce one’s tax liability. Tax
3-16 Explain each of the following strategies for reducing current taxes: (a) maximizing
deductions, (b) income shifting, (c) tax-free income, and (d) tax-deferred income.
a. Taxpayers can maximize deductions by accelerating or bunching their deductions into
one tax year. Examples include paying next year’s property taxes early in order to be able
b. Income shifting is a technique for reducing taxes by shifting some income to a family
member in a lower tax bracket. This is done by creating trusts or custodial accounts or
c. Tax-free income is income which is free from federal income taxation. For example,
qualified municipal bonds pay interest income which is free from federal income taxes.
However, if you live where there is a state and/or local income tax, qualified municipal
d. Tax-deferred income allows you to reduce or eliminate taxes today by postponing
them to sometime into the future after retirement. The appeal of tax-deferred vehicles,
such as IRAs and 401(k) plans, is their ability to allow the investor to accumulate
earnings in a tax-free fashion. This will allow the investment to grow to a larger amount
Solutions to Financial Planning Exercises
1. Mary Watson is 24 years old and single, lives in an apartment, and has no dependents.
Last year she earned $45,000 as a sales assistant for Focused Business Analytics; $3,910 of
her wages were withheld for federal income taxes. In addition, she had interest income of
$142.
Estimate her taxable income, tax liability, and tax refund or tax owed.
Taxable income = $45,000 + $142 = Adjusted gross income of $45,142. Less personal exemption
2. Debra Ferguson received the following items and amounts of income during 2014. Help
her calculate (a) her gross income and (b) that portion (dollar amount) of her income that is
tax exempt.
Salary $33,500
Dividends 800
Gift from mother 500
Gross income is:
Salary $33,500
Dividends 800
Tax exempt items are:
Gift from mother, $500
Child support from ex-husband, $3,600
3. If Amy Phillips is single and in the 28 percent tax bracket, calculate the tax associated
with each of the following transactions. (Use the IRS regulations for capital gains in effect
in 2014.)
a. She sold stock for $1,200 that she purchased for $1,000 5 months earlier.
b. She sold bonds for $4,000 that she purchased for $3,000 3 years earlier.
c. She sold stock for $1,000 that she purchased for $1,500 15 months earlier.
She has a capital loss of 1,000 – 1,500 = $500. It is a long-term capital loss and reduce
4. Demonstrate the differences resulting from a $1,000 tax credit versus a $1,000 tax
deduction for a single taxpayer in the 25 percent tax bracket with $40,000 of pre-tax
income.
Value of a tax credit is the amount of the credit, $1,000 here.
5. Use Worksheets 3.1 and 3.2. Qiang Gao graduated from college in 2014 and began work
as a systems analyst in July 2014. He is preparing to file his income tax return for 2014 and
has collected the following financial information for calendar year 2014:
Tuition, scholarships, and grants $ 5,750
Scholarship, room, and board 1,850
a. Prepare Qiang’s 2014 tax return, using a $6,200 standard deduction, a personal
exemption of $3,950, and the tax rates given in Exhibit 3.3. Which tax form should Qiang
use, and why?
The Form 1040EZ may be used. It is a one page form and is the simplest to use. The Tuition
scholarship is not subject to tax, it is an exclusion. The room and board scholarship is taxable.
b. Prepare Qiang’s 2014 tax return using the data in part a, along with the following
information:
Which tax form should he use in this case? Why?
The additional items will require a Form 1040 or 1040A because of the dividend and IRA
contribution, neither can be reported on a 1040EZ.
The modification from part a are:
Revised Adjusted Gross Income is $27,135 ($32,285 + 150 – 5,000)
Revised Taxable income = 27,135 – 6,200 – 3,950 = 16,985
Tax computation:
Tax on ordinary taxable income = $907.50 + 15%*(16,835 – 9,075) = $2,071.50
6. Steve and Beth Compton are married and have one child. Steve is putting together some
figures so that he can prepare the Compton’s.0 joint 2014 tax return. He can claim three
personal exemptions (including himself). So far, he’s been able to determine the following
with regard to income and possible deductions:
Total unreimbursed medical expenses incurred $ 1,155
Gross wages and commissions earned 50,770
IRA contribution 5,000
Mortgage interest paid 5,200
Capital losses realized 3,475
Interest paid on a car loan 570
Given this information, how much taxable income will the Compton’s have in 2014? (Note:
Assume that Steve is covered by a pension plan where he works, the standard deduction of
$12,400 for married filing jointly applies, and each exemption claimed is worth $3,950)
Income
Gross wages $50,770
Income from Limited Partnership 200
Dividend and interest income
[assumed all qualified dividends] 610
Total income $49,555
Adjustments to income
IRA Contribution $5,000
Alimony paid by Steve to his first
Taxable Income $14,305
Less Qualified dividends (610)
Notes: The qualified dividends are subject to the alternative tax which is 0% since the ordinary
Total Itemized Deductions: The total of the itemized deductions is $9,674, which is less than
Total unreimbursed medical
expenses incurred
$ 1,155 less 10% of AGI, thus 0 deductible
Mortgage interest paid 5,200
Job expenses and other allowable
deductions
875 less771 (2% of AGI) = 104
Nondeductible items: Interest paid on credit cards, Interest paid on a car loan, and Social
Earned Income Credit: The Compton’s will qualify for an earned income credit of $9,720 since
7. Shauna and Conan O’Farrell have been notified that they are being audited. What
should they do to prepare for the audit?
Keep calm, it is only an audit. Gather their records and supporting documents. If the notice is
from the criminal division of the IRS, you will need to contact a lawyer. If they had hired a
professional tax return preparer, that preparer should be contacted and you may want that person