Managing Income Taxes

Flashcards on how to manage income taxes.

Tax Planning

Seeking legal ways to reduce, eliminate, or defer income taxes.

What is the key to reducing income taxes?

Reduce taxable income, not total income.

What agency collects federal income taxes?

Internal Revenue Service (IRS)

Progressive Tax

A tax that requires a higher tax rate as income increases.

Regressive Tax

A tax where the rate decreases as a proportion of a person's income as income rises. Example - State Sales Tax

Marginal tax rate

The rate at which your last dollar of income is taxed.

Indexing

Adjusts the tax brackets each year for inflation.

Why is your marginal tax rate important?

Helps you make financial decisions.

Average tax rate

Proportion of total income paid in income taxes; always less than your marginal tax rate.

On what type of income do you pay personal taxes?

Taxable income

First step in calculating income taxes

Determine and report total income

Second step in calculating income taxes

Subtract adjustments to income to arrive at your adjusted gross income (AGI).

Third step in calculating income taxes

Subtract either the IRS’s Standard Deduction for your tax status or itemize deductions (form schedule A).

Fourth step in calculating income taxes

Subtract allowed charitable contributions and qualified business income deductions. This gives your taxable income.

Fifth step in calculating income taxes

Determine your total tax.

Sixth step in calculating income taxes

Subtract tax credits for which you qualify.

Seventh step in calculating income taxes

Calculate the balance due the IRS or the amount of your refund.

What is on a W-2?

Earned income and the amount of income tax withheld.

Total Income

Compensation from all sources.

Examples of Total Income

Wages, Salaries, Commissions, Tips Earned, Unemployment compensation, Gambling and Lottery Winnings, Business Income or (loss) from schedule “C,

Examples of Income to exclude

Gifts, Inherited money or property, Income from a carpool, Federal income tax refunds, Employee contributions to flexible spending accounts, Reimbursements from flexible spending accounts, Child support payments received

Adjustments to Income

Allowable subtractions from gross income. Examples: Educator expenses, Health savings account deductions, Moving Expenses, Part of self-employment tax, IRA deduction, Student loan interest deduction, Tuition and fees

Standard Deduction (2021)

$12,550 for single individuals; $25,100 for married couples; $18,800 for Head of Household

Itemized Deductions (Schedule A)

Unreimbursed medical and dental expenses, Taxes you paid, Interest you paid, Gifts to charity, Casualty and theft losses, Miscellaneous deductions in excess of 2% of adjusted gross income

What qualifies as 'taxes you paid' for itemized deductions?

Real Estate Property Taxes, Personal Property Taxes, State, Local, and Foreign Income Taxes, State and Local Sales Taxes

What qualifies as 'interest you paid' for itemized deductions?

Interest Paid on Home Mortgage Loans, “Points”, Interest Paid on Home-Equity Loans used for home improvement, Mortgage insurance premiums on new loans after January 1, 2007

Tax Credits

Child Tax Credit, Credit for other dependents, Child and Dependent Care Credit, Earned Income Tax Credit (EITC), The Retirement Contribution Savings Credit (Saver's Credit), American Opportunity Tax Credit (AOTC), Lifetime Learning Credit (LLC)

Flexible Spending Account (FSA)

Allows employees to fund qualified medical or dependent expenses on a pretax basis by reducing take-home salary.

Defined Contribution Retirement Plan

IRS approved retirement plan sponsored by an employer to which employees may make pretax contributions that lower their tax liability. Example - 401(k) Retirement Plan

IRA (traditional)

Investment accounts that reduce current year income and that are allowed to accumulate tax free. Tax deferral that allows investments to grow without being taxed until withdrawal.

Roth IRA

Investments made with after tax money; the interest on such accounts is allowed to grow tax free, and withdrawals are also tax free.

Municipal bonds

Long term debt issued by the state and local governments and their agencies to finance public improvement projects that normally produce tax-exempt income to the buyer.

Tax Avoidance Strategies

Prune taxable investments, Defer income, Accelerate deductions, Shift income to a child, Buy and manage a real estate investment, Take all your legal tax deductions.