Managing Your Personal Finances

Chapter 7: Federal Income Tax

Our Tax System• In the US, money is collected by the government from citizens and

businesses in the form of taxes, revenue. • The largest source of government revenue is income taxes. Other

taxes providing government revenue include social security taxes, unemployment insurance taxes, inheritance and estate taxes, excise taxes, import duties, and personal property taxes, etc.

• Progressive Taxes -taxes that increase in proportion to income. Tax rates increase as the level of taxable income increases.

• Regressive Taxes- taxes that decrease in proportion to income. The person with the higher income pays a lower percentage of income in taxes than a lower income person. Sales taxes.

• Proportional Taxes- Flat taxes rate remains constant. Property taxes are proportional. Semiannual or monthy payments.

Local Taxes

• Local taxes provide services such as education, parks and recreation, streets and roads, and police, fire, and health departments.

National Taxes

• On a national level, taxes provide salaries for Congress and funds for national defense, highways, parks, welfare, foreign aid, and other services.

History of Taxes• The Constitution, drawn in 1787, included the option to tax, but not

to tax individuals directly. Excise taxes and customs duties produced enough revenue to meet the nation’s needs at the time.

• The War of 1812 brought a temporary income tax, but when the war debts were paid, the tax was dropped.

• When the Civil War became an economic burden, an income tax to finance the war became necessary.

• 1862, President Lincoln signed into law a bill that provided for progressive income taxes on wages earned, when the war debts were paid off, the tax expired.

• WWI (1917) was paid for by income taxes. • 1935-Social Security Act was signed into law, creating the IRS,

Internal Revenue Service. The IRS was designed to collect taxes and turn them over for the payment of government debt.

• WWII, taxes were increased to finance the war. This set the precedent for the increase in taxes as we know it today.

IRS

• Internal Revenue Service is an administrative agency of the Department of Treasury.

• Headquarters in Washington, DC.• Main functions: Collect income taxes and to

enforce tax laws.• IRS employees assist taxpayers in finding

information and forms.• IRS prints brochures and pamphlets to aid

taxpayers in preparing their returns.• IRS furnishes tax information and instruction

booklets free to schools and colleges.

The Power to Tax

• The power to levy taxes rests with the Congress of the United States.

• Proposals to increase or decrease taxes may come from the president, the Department of Treasury, or from a congressperson representing the interests of a geographic area.

• Revenue bills must pass a vote in both the House and Senate and then be signed by the president before they become law.

Paying Your Fair Share

• Our income tax system is based on Voluntary Compliance, which means that all citizens are expected to prepare and file income taxes.

• Taxes owed are due on or before the deadline on April 15 of each year.

• Responsibility for filing a tax return and paying taxes due rests with the individual. Failure to do so can result in penalty, interest charges on the taxes owed, a fine, and/or imprisonment.

• Willful failure to pay taxes is called Tax Evasion, which is a felony punishable by a fine and/or imprisonment.

IRS Audit

• Tax payers called for an IRS Audit have three choices:• 1. They can represent themselves all the way to an

appeal in Tax Court if necessary.• 2. They can give someone the power of attorney to take

their place, as long as the designated person is a lawyer, CPA, a member of the immediate family, or a former employee of the IRS audit level.

• 3. They can bring anyone a all –tax preparer or therapist-for support during sessions.

• Audit sessions involve confirming supporting documentation; most tax payers can go alone unless the matter is complicated.

Filing Status

• 5 different ways to file a tax return:• 1. Single person (not married)• 2. Married person filing a joint return (even though only

one spouse may have earned income)• 3. Married person filing separate return• 4. Head of household (a person may qualify as a head

of household whether married or single if certain conditions are met in providing a residence for persons dependent on the taxpayer)

• 5. Qualifying widow(er) with a dependent child

Exemptions

• Exemption is an allowance a taxpayer claims for each person dependent on the taxpayer’s income.

• You are automatically allowed one exemption for yourself unless someone else (such as a parent) claims you on his or her return.

• If you are filing a joint return, you can take an exemption for your spouse.

• Once you are divorced, you cannot take an exemption for a former spouse!!!!

Exemptions• Any person who meets all five of the following requirements qualifies as a dependent:• 1. The person must be a relative. Relationships created by marriage are of ended by

divorce or death.• 2. The person must be a citizen or resident of the United States, or a resident of

Canada or Mexico, or an adopted child who is not a US citizen but has lived with you all year in a foreign country.

• 3. The person is married, he or she cannot file a joint return with his or her spouse.• 4. The person’s income must be less than the amount of her or his exemption

($2450). This does not apply to a child under age 19 or a student under 24.• 5. You must provide over half of the person’s support during the year.• Children of divorced or separated parents are special cases. The parent who has

custody of a child for most of the year, generally can claim the child as a dependent, unless (1) the custodial parent agrees not to claim the exemption, (2) the divorce decree entered into before 1985 allows the noncustodial parent to claim the exemption and the noncustodial parent contributed at least $600 for the child’s support during the year, (3) if the divorce decree grants the exemption to the noncustodial parent.

Gross Income

• Gross Income is all the taxable income you receive, including wages, tips, salaries, interest, dividends, unemployment compensation, alimony, worker’s compensation benefits, and so forth.

Wages, Salaries, and Tips

• Monies received through employment, from the Form W-2, Wage and Tax Statement.

Interest Income

• Taxable interest from banks, savings and loan associations, credit unions, series HH savings bonds. You should receive a Form 1099-INT from the payers of such interest (banks).

Dividend Income

• Distributions of money, stock, or other property that corporations pay to stockholders. You will receive a Form 1099-DIV.

Unemployment Compensation

• You should receive Form 1099-G showing total unemployment compensation received. This amount will be entered on a tax return as income earned.

Social Security Benefits

• 85% of Social Security benefits received are taxable if total income exceeds $34,000 for single taxpayers and $44,000 for married taxpayers. Form SSA-1099 lists total social security benefits paid to you during the year.

Child Support

• Money paid to a former spouse for support of dependent children is called child support. This income is not taxable for the person receiving it, nor is it deductible for the person paying it.

Alimony

• Money paid to support a former spouse.• It is taxable for the person receiving it and

deductible for the person paying it. You must use 1040 Long Form in this case.

• You are also taxed on other forms of income, including winnings from gambling, bartering income, pensions and annuities, rental income, royalties, estate and trust income, and income on sale of property.

Adjusted Gross Income

• Some adjustments or monies that are spent are allowed to be subtracted directly from gross income.

Taxable Income• Deductions are expenses the law allows the taxpayer to subtract

from adjusted gross income. • All taxpayers are allowed to list certain expenses which are called

itemized deductions. To itemize deductions, you must complete Schedule A and Form 1040 (can’t use 1040EZ).

• You can list medical and dental expenses; state and local income tax and property taxes, home mortgage interest; gifts to charity; qualifying casualty and theft losses; moving expenses; and qualifying job and miscellaneous expenses.

• Standard Deductions are higher for people age sixty-five or older, and for blind people.

• Taxable Income used to determine the tax liability from the tax tables.

Preparing to File

• A simple 1040EZ tax return may only take about 15 minutes to prepare. The long Form 1040 may require several days after all information has been gathered. Plus you may have to file a state income tax return as well.

Who Must File?