3.1 The Andersons Tackle Their Tax Return
Noah and Olivia Anderson are a married couple in their early 20s living in Dallas. Noah
Anderson earned $73,000 in 2014 from his job as a sales assistant. During the year, his
employer withheld $4,975 for income tax purposes. In addition, the Andersons received
interest of $350 on a joint savings account, $750 interest on tax-exempt municipal bonds,
and dividends of $400 on common stocks. At the end of 2014, the Andersons sold two
stocks, A and B. Stock A was sold for $700 and had been purchased four months earlier for
$800. Stock B was sold for $1,500 and had been purchased three years earlier for $1,100.
Their only child, Logan, age 2, received (as his sole source of income) dividends of $200
from Hershey stock. Although Noah is covered by his company’s pension plan, he plans to
contribute $5,000 to a traditional deductible IRA for 2014. Here are the amounts of money
paid out during the year by the Andersons:
Medical and dental expenses (unreimbursed) $ 200
State and local property taxes 831
Interest paid on home mortgage 4,148
Charitable contributions 1,360
Total $6,539
In addition, Noah incurred some unreimbursed travel costs for an out-of-town business
trip:
Airline ticket $250
Taxis 20
Lodging 60
Meals (as adjusted to 50 percent of cost) 36
Total $366
Critical Thinking Questions
1. Using the Andersons’ information, determine the total amount of their itemized
deductions. Assume that they’ll use the filing status of married filing jointly, the standard
deduction for that status is $12,400, and each exemption claimed is worth $3,950. Should
they itemize or take the standard deduction?
Medical and dental expenses (unreimbursed) $200 less 10% of AGI, thus 0 deductible
State and local property taxes 831
Interest paid on home mortgage 4,148
Prepare a joint tax return for Noah and Olivia Andesrson for the year ended December 31,
2014, that gives them the smallest tax liability. Use the appropriate tax rate schedule
provided in Exhibit 3.3 to calculate their taxes owed.
2. How much have you saved the Andersons through your treatment of their deductions?
If they itemized, the deductions would be $6,339
Standard deduction for married couple is 12,400
3. Discuss whether the Andersons need to file a tax return for their son.
A taxpayer claimed as a dependent on another’s tax return and receiving unearned income has a
standard deduction of $1,000. Since Logan’s income is only $200, he is not required to file.
4. Suggest some tax strategies that the Andersons might use to reduce their tax liability for
next year.
1. The can increase the amount of their IRA deduction. Noah Can contribution another $500
3.2 Cheryl Stern: Waitress or Tax Expert?
Cheryl Stern, who is single, goes to graduate school part-time and works as a waitress at
the Sunset Grill in Seattle. During the past year (2014), her gross income was $18,700 in
wages and tips. She has decided to prepare her own tax return because she cannot afford
the services of a tax expert. After preparing her return, she comes to you for advice. Here’s
a summary of the figures that she has prepared thus far:
Gross income:
Wages $10,500
Tips 8,200
Adjusted gross income (AGI) $18,700
Less: Itemized deductions −2,300
$16,400
Less: Standard deduction −6,200
Taxable income $10,200
Cheryl believes that if an individual’s income falls below $20,350, the federal government
considers him or her “poor” and allows both itemized deductions and a standard
deduction.
Critical Thinking Questions
1. Calculate Cheryl Stern’s taxable income, being sure to consider her exemption. Assume
that the standard deduction for a single taxpayer is $6,200, and that each exemption
claimed is worth $3,950.
Use for part 1 and 3 Cheryl John Brooks Joint
1. Adjusted Gross Income $18,700 $18,700 $37,400
2. Standard Deduction 6,200 6,200 12,400
2. Discuss Cheryl’s errors in interpreting the tax laws, and explain the difference between
itemized deductions and the standard deduction.
We all wish the tax law say something it does not. Taxpayer may deduct either standard
deduction or itemized deductions, not both. A point could be made to remind all that if the tips
3. Cheryl has been dating John Brooks for nearly four years, and they are seriously
thinking about getting married. John has income and itemized deductions that are identical
to Cheryl’s. How much tax would they pay as a married couple (using the filing status of
married filing jointly and a standard deduction of $12,400) versus the total amount the two
would pay as single persons (each using the filing status of single)? Strictly from a tax
perspective, does it make any difference whether Cheryl and John stay single or get
married? Explain.
Terms Found in the Chapter
adjusted gross
income (AGI)
The amount of income remaining after subtracting all allowable
adjustments to income from gross income.
adjustments to
(gross) income
Allowable deductions from gross income, including certain
employee, personal retirement, insurance, and support expenses.
amended return A tax return filed to adjust for information received after the
filing date of the taxpayer’s original return or to correct errors.
average tax rate The rate at which each dollar of taxable income is taxed on
average; calculated by dividing the tax liability by taxable
income.
estimated taxes Tax payments required on income not subject to withholding
that are paid in four installments.
exemptions Deductions from AGI based on the number of persons supported
by the taxpayer’s income.
Federal Insurance
Contributions Act
(FICA), or Social
Security tax
The law establishing the combined Old-Age, Survivor’s,
Disability, and Hospital Insurance tax levied on both employer
and employee.
federal withholding
taxes
Taxes—based on the level of earnings and the number of
withholding allowances claimed—that an employer deducts
from the employee’s gross earnings each pay period.
gross income The total of all of a taxpayer’s income (before any adjustments,
deductions, or exemptions) subject to federal taxes; it includes
active, portfolio, and passive income.
income shifting A technique used to reduce taxes in which a taxpayer shifts a
portion of income to relatives in lower tax brackets.
income taxes A type of tax levied on taxable income by the federal
government and by many state and local governments.
itemized deductions Personal expenditures that can be deducted from AGI when
determining taxable income
marginal tax rate The tax rate that you pay on the next dollar of taxable income.
progressive tax
structure
A tax structure in which the larger the amount of taxable income,
the higher the rate at which it is taxed.
standard deduction A blanket deduction that depends on the taxpayer’s filing status,
age, and vision and can be taken by a taxpayer whose total
itemized deductions are too small.
tax audit An examination by the IRS to validate the accuracy of a given
tax return.
tax avoidance The act of reducing taxes in ways that are legal and compatible
with the intent of Congress.
tax credits Deductions from a taxpayer’s tax liability that directly reduce his
or her taxes due rather than taxable income.
tax deferred Income that is not subject to taxes immediately but that will be
subject to taxes later.
tax evasion The illegal act of failing to report income or deductions
accurately and, in extreme cases, failing to pay taxes altogether.
taxable income The amount of income subject to taxes; it is calculated by
subtracting adjustments, the larger of itemized or standard
deductions, and exemptions from gross income.
taxes The dues paid for membership in our society; the cost of living
in this country.
Chapter Outline
Learning Goals
I. Understanding Federal Income Tax Principles
A. The Economics of Income Taxes
B. Your Filing Status
C. Your Take-Home Pay
1. Federal Withholding Taxes
2. FICA and Other Withholding Taxes
*Test Yourself*
II. It’s Taxable Income That Matters
A. Gross Income
1. Three Kinds of Income
2. Capital Gains
a. Selling Your Home: A Special Case
B. Adjustments to (Gross) Income
C. Deductions: Standard or Itemized?
1. Standard Deduction
2. Itemized Deductions
3. Choosing the Better Option
D. Exemptions
*Test Yourself*
III. Calculating and Filing Your Taxes
A. Tax Rates
B. Tax Credits
C. Tax Forms and Schedules
1. Variations of Form 1040
D. The 2011 Tax Return of Terry and Evelyn Becker
1. Finding the Beckers’ 2014 Tax Liability: Form 1040
a. Gross Income
b. Adjustments to Gross Income
c. Adjusted Gross Income (AGI)
d. Itemized Deductions or Standard Deduction?
e. The Beckers’ Taxable Income and Tax Liability
f. Do They Get a Tax Refund?
*Test Yourself*
IV. Other Filing Considerations
A. Estimates, Extensions, and Amendments
1. Estimated Taxes
2. April 15th: Filing Deadline
3. Filing Extensions and Amended Returns
B. Audited Returns
C. Tax Preparation Services: Getting Help on Your Returns
1. Help from the IRS
2. Private Tax Preparers
D. Computer–Based Tax Returns
*Test Yourself*
V. E!ective Tax Planning
A. Fundamental Objectives of Tax Planning
B. Some Popular Tax Strategies
1. Maximizing Deductions
2. Income Shifting
3. Tax-Free and Tax-Deferred Income
*Test Yourself*
Summary
Financial Planning Exercises
Applying Personal Finance
Tax Relief
Critical Thinking Cases
3.1 The Andersons Tackle Their Tax Return
3.2 Cheryl Stern: Waitress or Tax Expert?
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