Chapter 7

Federal Income Tax

"In this world nothing is certain but death and taxes.“

- Benjamin Franklin

GOALS

Lesson 7.1Our Tax System

Discuss the purpose of taxes, different types of taxes, and the history of taxes in the United States.Describe components of the tax system, including the IRS, the power to tax, and paying your fair share.

Types of Taxes

RevenueTaxes (money) collected from citizens and businessesLargest source is income taxesOther sources include social security, unemployment insurance, inheritance, estate and property taxes, and import duties.

Types of Taxes

“Ability-to-Pay Principle”Theory that people with higher incomes should pay more, lower incomes pay less

Progressive taxesFederal income taxesMore you make, the higher percentage of income you pay in taxes

Types of Taxes

Regressive taxesSales taxFixed percentage, so the smaller your income the greater percentage of your income it taxes to pay

Types of Taxes

Example of Regressive TaxLow income ($10,000 per year)

Buy stereo for $2000Pay $2000(.06) = $120 in sales tax$120/$10,000 = .012 or 1.2% of income

High income ($80,000 per year)Still pay $120 in sales tax for stereo$120/$80,000 = .0015 or 0.15% of income

Types of Taxes

Proportional taxesAlso called “flat taxes”Tax rate stays the same regardless of the amount

Property taxes are a good examplePercentage is the same if home is $150,000 or $1.5 million

Components of the Tax System

The IRSInternal Revenue Service

Headquarters in Washington, DC7 regional offices

Established to collect taxes and enforce tax lawswww.irs.gov

Components of the Tax System

The power to taxCongress has power to levyProposals to increase may come from President, Dept. of Treasury or Congressmen

Components of the Tax System

Paying your fair shareTax brackets

Tax ranges that increase as income increasesTaxes increase when government needs more money to balance budget

All citizens are expected to prepare and file tax returns (voluntary compliance)

Components of the Tax System

Tax evasion“Willful failure to pay taxes”

AuditIRS examines your tax returnsUp to 7 years prior

History of Taxes

Revolutionary WarNo direct income tax

Constitution stated “option to tax” but not individuals directly

Paid for by contributions from FranceWar of 1812 had a temporary income taxGovernment didn’t collect taxes, but didn’t provide services either

History of Taxes

Civil War1862 Lincoln instituted a progressive income tax on wagesAfter war, income tax removed

16th Amendment to Constitution1909 introduced first permanent income taxRatified by ¾ of states in 1913

History of Taxes

World War IFinanced by income taxes

Social Security ActAs a result of the Great Depression, government expanded1935 as part of FDR’s “New Deal” created the IRS

History of Taxes

World War IITaxes raised to pay for warSet precedence to pay for growing government

GOALS

Lesson 7.2Filing Tax Returns

Define and discuss the significance of exemptions, dependents, and taxable and nontaxable income on tax returns.Prepare Forms 1040EZ and 1040A.

Filing Status

Single personMarried person filing a joint returnMarried person filing a separate return“Head of household”Qualifying widow(er)

With a dependent child

Exemptions

ExemptionsAmount subtracted from income for each person who “depends” on you to liveDon’t pay tax on this amount

Personal exemptionExempt yourself and spouse, if filing jointly

Dependent exemptionNot limited to childrenReceives more than ½ living expenses from you

Gross Income

All the income you receiveWages, salaries, and tipsInterest incomeDividend incomeUnemployment compensationSocial security benefitsAlimony

Money paid to former spouseTaxable to receiver, deductible to payer

Others – lottery winnings, gambling, rental income, etc.

Gross Income

Child supportMoney paid by other parent to pay for child’s living expensesNot taxable to person that receivesNot deductible for person that pays

Adjusted Gross Income

Gross income

– Adjustments

Adjusted gross income

Taxable Income

Gross income

– Adjustments

Adjusted gross income

– Deductions

– Exemptions

Taxable income

Deductions

ItemizeIf you itemize (list) your deductions, use Form 1040

You’d list your deductions on Schedule ACommon deductions

Medical/Dental ExpensesState/Local Income TaxesProperty TaxesHome Mortgage InterestGifts to CharityLosses from Theft or Property DamageMoving Expenses

Deductions

Standard DeductionNot many deductions, then best to take standard deductionSubtract set amount from adjusted gross income without having to itemizeIndividual deductions don’t add up to standard deduction – take standard!

Deductions

ExemptionsTalk about when we complete tax formsBasically, how many people live with you

Taxable IncomeAmount used to determine amount of federal income tax due

Preparing to File

Who must file?Those listed on P185 in your textEven if your gross income is less than stated amount, file a tax return so you can get a refund!May have to file if…

Claimed as dependent on someone else’s returnOwe special taxesEarned $400+ from self-employmentEarned $100+ from a church organization that doesn’t pay social security taxes

Preparing to File

When to file?April 15 of the following year

If 4/15 falls on a weekend, then following MondayFile late – pay penaltiesKnow you are going to be late, file for an extension

Short form or long form?400+ tax forms and schedules1040EZ, 1040A and 1040 are most common

Select based on income, deductions and complexity of tax situation

Preparing to File

Where to begin?Save receipts for itemized deductions all yearSave pay stubs and check W-2 when you receive towards end of JanuaryGather all documents

Form 1099 DIV Form 1099 INTW-2 from each employer

Determine if you will itemizeMake sure you save originals or copies of EVERYTHING when you are finished

Preparing to File

Filing electronically1040EZ and 1040A may be submitted electronicallyOwe taxes, pay online with credit cardQuicker receipt of refundMake sure you print a copy of your return to save!

Form 1040EZ

According to book…Use 1040EZ if you have taxable income less than $50,000

NOW LIMIT IS $100,000!!Single or married filing jointlyUnder age 65No dependentsInterest income of $1500 or less

Form 1040EZ

EXAMPLE 1Darby L. Russell, 843 Thorn St., Sewickley, PA 15143.Social Security Number: 155-46-7819Does not want to contribute to presidential campaign fundSingle and claims herself as exemptionEarned $24,500 last year as a financial analyst, plus $650 in interest incomeTaxes withheld were $3,500

Form 1040EZ

EXAMPLE 2Rudder L. Healey, 1402 Bentley Ridge Blvd, Lancaster, PA 17603Social Security Number: 125-14-4447Does want to contribute to presidential campaign fundSingle and claims himself as exemptionEarned $9,500 last year as a waiter, plus $900 in tips – he works part-time while going to collegeHe has interest earnings of $100Taxes withheld were $479

Form 1040A

According to book…

Taxable income less than $50,000NOW LIMIT IS $100,000!!

Capital gains distributions, but no other capital gains or losses

Form 1040A

Only tax credits…Child TaxEducationEarned IncomeChild and Dependent Care ExpensesAdoption ExpensesRetirement Savings Contributions

Form 1040A

Only deductions…IRA ContributionsStudent Loan InterestEducator ExpensesHigher Education Tuition and Fees

No itemized deductions!

Form 1040

Taxable income of $50,000 or moreNOW LIMIT IS $100,000!!

Itemized deductionsSelf-employment incomeIncome from sale of property