Chapter 6 Paying Taxes 2010 Pearson Education Inc

Chapter 6 Paying Taxes © 2010 Pearson Education, Inc. All rights reserved

Learning Objectives • Describe the basic principles of taxation and the major categories of taxes. • Explain payroll taxes • Describe the purpose and process of filing tax returns • Explain how taxes affect your financial plan © 2010 Pearson Education, Inc. All rights reserved 0 -2

Tax Basics • Tax is money collected by a government from its citizens for the purpose of operating the government • Gross pay is the total amount of money you earn • Take-home pay is the amount of money you get to keep and use • Net Pay is the amount of money you take home © 2010 Pearson Education, Inc. All rights reserved 0 -3

Tax Basics • • • Everyone pays taxes Taxes pay the cost of government The government levies taxes on different things States can have different taxes too There all different types of taxes, such as: – Sales Taxes – Real Estate Taxes – Payroll Taxes © 2010 Pearson Education, Inc. All rights reserved 0 -4

Math for Personal Finance • Ryan’s take-home or net pay was $147. 76 and his gross pay was $160. 00. Assume the FICA withholdings are 7. 65. How much did Ryan pay in FICA from this check? © 2010 Pearson Education, Inc. All rights reserved 0 -5

Math for Personal Finance • Solution: Ryan paid 7. 65 percent of the $60 or $12. 24 in FICA from this check. © 2010 Pearson Education, Inc. All rights reserved 0 -6

Sales Tax • Sales tax is tax on purchases at a store • Some of the price we pay for an item is a tax • The merchant collects this money and sends it to the government • The federal government does not impose a sales tax • Many state governments do impose a sales tax © 2010 Pearson Education, Inc. All rights reserved 0 -7

Real Estate Tax • Governments calculate real estate taxes based on the value of the property • The government sends the property owner a bill for this tax • These taxes are primarily used to fund local schools • They also vary significantly from state to state and county to county. © 2010 Pearson Education, Inc. All rights reserved 0 -8

Payroll Taxes • Payroll Taxes are taxes on your paycheck • Many people pay taxes every time they get paid • These taxes can include federal and state income taxes and social security (or FICA) withholdings. • People who are self employed do not have taxes withheld from their earnings. • See figure 6. 1 for an example of a pay stub © 2010 Pearson Education, Inc. All rights reserved 0 -9

Figure 6. 1 © 2010 Pearson Education, Inc. All rights reserved 0 -10

The Internal Revenue Service • Internal revenue service (IRS) is the government body that carries out the federal tax system • The IRS is a branch of the United States Treasury Department • They enforce the tax laws and collect taxes • Each year in which you earn an income over a certain amount, you need to file a federal tax return with the IRS © 2010 Pearson Education, Inc. All rights reserved 0 -11

The Internal Revenue Service • Tax returns report to the IRS all the information relative to your income taxes • A tax return consists of a form called 1040 or 1040 EZ (see Figure 6. 2 a &b) • On this form you need to include how much income you earned and how much you paid to the IRS • You will either receive a refund or pay the difference to the government if you owe money © 2010 Pearson Education, Inc. All rights reserved 0 -12

Figure 6. 2 a © 2010 Pearson Education, Inc. All rights reserved 0 -13

Figure 6. 2 b © 2010 Pearson Education, Inc. All rights reserved 0 -14

The Internal Revenue Service • Taxes are figured based on your earnings from January to December • When the year is over, you have until April 15 th to file your return • Many careers involve helping people take advantage of tax laws to pay the lowest possible tax • Attorneys and accountants make good incomes by helping people with tax issues © 2010 Pearson Education, Inc. All rights reserved 0 -15

Check Your Financial IQ • What is the major purpose of taxes? © 2010 Pearson Education, Inc. All rights reserved 0 -16

Check Your Financial IQ • Taxes pay the cost of government © 2010 Pearson Education, Inc. All rights reserved 0 -17

Understanding Payroll Taxes • Personal Income Taxes are federal income taxes and state income taxes (the states that have them) • Social Security provides payments to eligible retirees and disabled people • Medicare provides health care coverage to mostly older Americans and some younger disabled people © 2010 Pearson Education, Inc. All rights reserved • Payroll taxes include: – Social Security and Medicare taxes – Personal income taxes (state and federal) 0 -18

Social Security and Medicare • For most Americans, earned income is subject to FICA taxes • FICA taxes are withheld from your paychecks and sent to the government • These withholdings fund Social Security and Medicare • For both Social Security and Medicare, your employer matches your contributions and sends the total amount to the government © 2010 Pearson Education, Inc. All rights reserved 0 -19

Social Security and Medicare • Your portion of the Social security tax is equal to 6. 20 percent of your salary—up to a specific income level • This amount is linked to inflation and increases slightly every year • There is no cap on the amount of earnings subject to the Medicare tax © 2010 Pearson Education, Inc. All rights reserved 0 -20

Math for Personal Finance • Brogan’s grandfather made $112, 000 in 2007, and the Social Security cap in 2007 was $97, 5000. • How much Social Security was withheld from his pay and how much Medicare was withheld from his pay? © 2010 Pearson Education, Inc. All rights reserved 0 -21

Math for Personal Finance • Solution: Brogran’s grandfather had 6. 2% withheld from his pay for the first $97, 500 he made during 2007 for a total of $6, 045 or (. 062 x $97, 500). However, Medicare was withheld on the entire amount so Medicare withholdings were $112, 000 x. 0145 = $1, 624. © 2010 Pearson Education, Inc. All rights reserved 0 -22

Personal Income Taxes • Personal income taxes is the income reported on your tax return • Many people use a tax professional or tax preparation software for returns. • These programs guide you through preparing your tax returns and include all the necessary forms • Refer to Figure 6. 3 for the IRS table of individual tax rates © 2010 Pearson Education, Inc. All rights reserved 0 -23

Figure 6. 3 © 2010 Pearson Education, Inc. All rights reserved 0 -24

Other Income Taxes • Many people pay a state income tax, depending on where they live • Some cities also collect income taxes • Take a look at figure 6. 4 for a listing of states with the highest and lowest tax rates © 2010 Pearson Education, Inc. All rights reserved 0 -25

Figure 6. 4 © 2010 Pearson Education, Inc. All rights reserved 0 -26

Check Your Financial IQ • What are the payroll taxes? © 2010 Pearson Education, Inc. All rights reserved 0 -27

Check Your Financial IQ • Federal and state income taxes, Social Security, and Medicare payroll taxes © 2010 Pearson Education, Inc. All rights reserved 0 -28

Filing Taxes • A tax return form allows you to record several different categories of information, including: – Filing Status – Exemptions – Gross Income – Adjusted gross income – Tax and credits © 2010 Pearson Education, Inc. All rights reserved 0 -29

Filing Status • Taxpayers need to specify a filing status when they submit their income tax return • They must choose one of the following options: – Single – Married filing jointly – Married filing separately – Head of household – Qualifying widow(er) with dependent child © 2010 Pearson Education, Inc. All rights reserved 0 -30

Filing Status • Tax rules and rates differ depending on which status you choose • Until the age of 18, most of you will be considered dependents by the IRS © 2010 Pearson Education, Inc. All rights reserved 0 -31

Gross Income or Total Income • Gross income is the total income consisting of the total amount of a person’s income from (almost) any source • The first step in calculating the federal tax you owe is to determine your gross income • Your employer will send you a W-2 form that details how much money you made • See Figure 6. 5 for a sample W-2 form © 2010 Pearson Education, Inc. All rights reserved 0 -32

Figure 6. 5 © 2010 Pearson Education, Inc. All rights reserved 0 -33

Gross Income or Total Income • Capital gains occur when you sell an asset for more than what you paid for it • Other forms of income include interest income, dividend income, and capital gains • Gross income also includes income from tips, rental properties, and business income. • Some types of income are not included in gross income and therefore are not taxes, such as: – Insurance reimbursements – Child support payments – Veteran’s welfare benefits © 2010 Pearson Education, Inc. All rights reserved 0 -34

Adjusted Gross Income • Adjusted gross income is figured by taking the total income and subtracting certain allowable amounts • The next step in filing a tax return is to figure your adjusted gross income, or AGI. • The allowable amounts include : © 2010 Pearson Education, Inc. All rights reserved – contributions to certain retirement accounts – alimony payments – interest paid on student loans 0 -35

Math for Personal Finance • Last year Colt’s salary was $32, 000 but he also received $1, 200 in dividend income and lost $400 on the sale of one stock and gained $650 on the sale of another stock. • What was Colt’s gross income? © 2010 Pearson Education, Inc. All rights reserved 0 -36

Math for Personal Finance • Solution: Colt’s gross income was $32, 000 + $1, 200 - $400 +$650 = $33, 450 © 2010 Pearson Education, Inc. All rights reserved 0 -37

Deductions and Exemptions • Standard deduction is a fixed amount all people are allowed to deduct from their AGI to reduce their tax liability • Itemized deductions are specific expenses that, under tax law, can be deducted from income to reduce the amount of income subject to income tax © 2010 Pearson Education, Inc. All rights reserved • You may be able to claim various deductions and exemptions that will reduce the amount of your AGI that is subject to your income taxes. • These deductions include: – Standard deduction – Itemized deduction 0 -38

Deductions and Exemptions • Congress has approved certain items as tax deductible in order to encourage certain behaviors • For example, Congress encourages home ownership • Homeowners can deduct the interest paid on a mortgage loan and the real estate taxes they pay © 2010 Pearson Education, Inc. All rights reserved 0 -39

Refund or Payment • Accurate completion of your tax return will show you if you need to pay additional income taxes or if you will receive a refund • In most cases, you will not receive a refund unless you pay taxes during the year © 2010 Pearson Education, Inc. All rights reserved 0 -40

Check Your Financial IQ • When does a person file his or her taxes? © 2010 Pearson Education, Inc. All rights reserved 0 -41

Check Your Financial IQ • A person fills out a tax return by April 15 of each year © 2010 Pearson Education, Inc. All rights reserved 0 -42

Taxes and Your Financial Plan • People want to lower their tax liability to the lowest possible level for their income • They will keep more of their own money rather than paying it to the government in taxes • Tax planning influences both your short-term and long-term future • Consider the tax implications of your financial life at all stages © 2010 Pearson Education, Inc. All rights reserved 0 -43

Check Your Financial IQ • Why are taxes an important part of your financial plan? © 2010 Pearson Education, Inc. All rights reserved 0 -44

Check Your Financial IQ • You must consider the tax consequences of all your financial decisions because the tax impact may make one course of action better than another © 2010 Pearson Education, Inc. All rights reserved 0 -45

Summary • Taxes are monies the government collects from citizens for the purpose of operation the government • The government collects taxes in a variety of ways and forms: – Sales taxes – Real estate taxes – Payroll taxes • The IRS is the governmental body that carries out the federal tax system © 2010 Pearson Education, Inc. All rights reserved 0 -46

Summary • Payroll taxes include personal income taxes (state and federal) and Social Security and Medicare taxes • Social Security and Medicare taxes are also known as FICA • Filing taxes involves reporting your earnings for the year on a tax return. • This is sent to the IRS and to any appropriate state or local tax collection agency © 2010 Pearson Education, Inc. All rights reserved 0 -47

Summary • Tax planning is another important step in your financial plan • Taking full advantage of the ways to reduce your taxable income takes planning © 2010 Pearson Education, Inc. All rights reserved 0 -48

Key Terms and Vocabulary • • • Adjusted gross income Capital gain Gross income Gross pay Internal Revenue Service (IRS) • Itemized deduction • Medicare © 2010 Pearson Education, Inc. All rights reserved • • • Net pay Payroll tax Personal income tax Sales tax Social security Standard deduction Take-home pay Tax return 0 -49

Websites • www. irs. gov • www. taxadmin. org/fta/rate/ind_inc. html © 2010 Pearson Education, Inc. All rights reserved 0 -50