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- Chapter 14
Tax Planning
1
- Chapter Goals
Discuss the widespread role of taxation in PFP.
Develop a knowledge of key tax planning strategies.
Compare the tax benefits of major investment
vehicles.
Understand and complete a tax return.
2
- Income Taxation
Income taxes are a nondiscretionary cost in
household operations, with the outlay dependent on
both revenues and expenses.
Decision making in most household activities is
influenced by taxes.
On the following slide, we consider a brief example
of the tax impact in each area of the financial plan.
3
- Income Taxation, cont.
Examples of tax impact on financial plan:
– Cash Flow Planning: Taxes influence the timing of
transactions and preparation for payment of sums due.
– Investments: The calculation of returns is often done on
an after-tax basis.
– Financing: The calculation of the cost of borrowing is done
on an after-tax basis.
– Risk Management: There is often a clear preference for
tax-deductible employee health and life insurance.
– Retirement Planning: There is a substantial benefit when
saving through qualified retirement – pension vehicles.
– Estate Planning: Tax minimization comprises a large part
of estate planning activities.
4
- Income Tax Format
Income earners are taxed on an individual basis
except for married couples, whose income is
generally combined for income tax purposes.
– The income tax return resembles a household cash flow
statement in form.
– Adjustments are made for certain expenses. The net is the
adjusted income figure called adjusted gross income
(AGI).
– Deductions follow based on fairness, popularity, and
society’s goals, and exemptions allowed based on the
number of people in the household and other factors. The
result is the amount available to be taxed, called taxable
income.
5
- Income Tax Format, cont.
We can summarize the individual income tax return,
IRS Form 1040, as follows:
Income
Wages
Dividends and Interest
Capital Gains
Other Income
Adjustments
401(k), IRA Contributions
Student Loan Interest
Deposits to Other Qualified Plans
Adjusted Gross Income
Deductions
Standard or Itemized Deduction
Exemptions
Taxable Income
Tax
Credits
Other Taxes
Total Tax Due
Total Payments Made
Amount Owed
6
- Tax Planning: A General Analysis
Tax planning is the analysis and implementation of
strategies to reduce tax expenditures. It also
involves the scheduling of tax payments and the
programming of tax-related cash outlays.
Your overall goal is generally to minimize taxes,
provided that doing so is consistent with efficient
household operations.
Alternatively, the goal is to maximize your after-tax
returns on investments including your investment in
human assets.
A tax planning statement provides a projection of
7 future tax expenses by year.
- Marginal Analysis
In making tax-planning decisions you must often
weigh the benefits of alternative approaches.
The Decisions often depend on your marginal tax
bracket. It is to be distinguished from the average
tax bracket.
Tax on Next Dollar Earned
Marginal Tax Bracket
Next Dollar Earned
Total Income Tax Outlays
Average Tax Bracket
Taxable Income
8
- Marginal Analysis, cont.
We obtain the total marginal tax bracket as follows:
9
- Marginal Analysis, cont.
You can use the marginal tax bracket to compare
alternative investments on an “apples to apples”
basis.
Doing so is necessary because market forces
adjust prices for investments with tax benefits and
reduce their pretax returns to investors.
Two approaches:
– After-Tax Return = Pretax Return × (1 – marginal tax bracket)
– Pretax Equivalent Returns = After-Tax Returns /(1-marginal tax
bracket)
10
- Tax Planning Strategies
We can use a number of techniques to reduce our
taxes. Many of these techniques involve planning
well before the actual tax return needs to be filed.
They include:
– Increasing deductible expenses.
– Deferrals.
– Conversions.
– Eliminations.
– Timing of income and expenses.
– Tax planning for investments.
11
- Increasing Deductible Expenses and
Credits
By carefully going through IRS publications or a
good tax-planning manual you may be able to
develop new deductions or credits.
Clustering can be a productive tax-planning tool:
– If you have medical or miscellaneous expenditures that fall
below the 7.5 percent or 2 percent limitations,
respectively, you may be able to pay and group two years’
outlays together in one year to bring your deductible
expenditures above their respective floors.
– This strategy is aided by the ability of individuals to deduct
expenses on a when paid rather than an accrual basis.
12
- Tax Deferral
Tax deferral: Postponing taxes to be paid today to
some time in the future.
Tax deferral can provide sizeable benefits due to
your ability to use that money in the interim.
Tax deferral is the key to the benefits of a pension
or deductible IRA.
Taxes are deferred on the portion of salary placed
in the pension or IRA as well as on the interest,
dividends, and capital gains earned while it is in this
tax shelter:
Taxes are paid on withdrawals and in many cases
13 for the remainder upon death.
- Conversion
Conversion involves the change from one amount
of tax due to a lower one.
– Shifting Income: Transferring income from a person in a
higher bracket to someone in a lower bracket. Typically, it
involves changing from being taxed at ordinary income
rates to being taxed at more favorable capital gains rates.
– Transforming Income: Changing income from a high tax to
a lower tax status. Typically, it involves changing from
being taxed at ordinary income rates to being taxed at
more favorable capital gains rates.
14
- Elimination of Taxes
Tax elimination involves not paying taxes at all on a
specific type of income being generated.
Permanent elimination of taxes can be a
particularly powerful tool.
Some methods include:
– Gifts to charities.
– Transfers to children.
– Establishment of Roth IRAs.
– Structuring of employee benefits.
15
- Gifts to Charities
Many charitable donations are in the form of cash,
check or property.
Those donations, made in property form, are based
on fair market value, not cost.
If you donate an investment to a charity, the capital
gains tax on any increase in the value of the
investment, which under normal circumstances
would have had to be paid by you when it was sold,
is eliminated.
Therefore, charitable gifts have two tax benefits, a
tax deduction for the contribution and the
16 elimination of any capital gains tax.
- Transfers to Children
The first $800 of investment income earned by a
child under 14 is not subject to tax.
– For example, assume you transferred $10,000 worth of
bonds with an income of 8 percent per year to your child
who had no other income. The amount would be tax free
to your child whereas retaining it in your name would
result in your paying taxes on the income generated,
based on your marginal tax bracket.
For children under 14, amounts of investment
income over $1,600 are taxed at the parent’s rate;
amounts between $800 and $1,600 are taxed at
the minimum rate, currently 10 percent.
17
- Roth IRAs
Roth IRAs are IRAs that are never subject to
income taxation once sums are placed into them.
Deposits into Roth IRAs are made with after-tax
dollars - dollars of income on which taxes have
been paid.
There are restrictions on the amount of money you
can deposit in your Roth IRAs, generally $4,000 per
person per year with a phase-out based on income.
It is also possible to transfer money from a regular
to a Roth IRA, after paying a tax on the money
18 transferred.
- Structuring of Employee Benefits
Certain benefits provided to employees are not
taxable to them.
One of those benefits is medical coverage.
Dollar for dollar it can be preferable for both
employee and employer to contract for extra
benefits rather than salary, with income taxes
eliminated for employees and Social Security taxes
eliminated for both the employee and employer.
19
- Timing of Income and Expenses
The timing of income and expenses involves
optional selection of the year in which to report
transactions.
The simplest use of timing methods is to maximize
tax-deductible payments in the current year.
Your marginal tax bracket may vary from year to
year because of such factors as fluctuations in
income earned, unusually high or low deductible
expenses, or just a change in the country’s taxation
methods or tax brackets.
Cash basis accounting for tax purposes makes it
20 easier to shift income and expenses.
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