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CHAPTER 4
TAX PLANNING AND STRATEGIES
CHAPTER CONTEXT: THE BIG PICTURE
This chapter, the last in the section entitled “Part 1: Financial Planning,” introduces the tax
implications involved in personal financial planning. This chapter discusses the tax structure,
major tax features, tax calculations, and federal income tax forms as they pertain to financial
planning. Taxes deplete both earned and investment income, and effective financial planning
attempts to limit tax losses as much as possible. This chapter helps students understand how to
receive as much benefit from their investment as possible, while showing them how to reduce
their overall tax liability.
CHAPTER SUMMARY
This chapter considers the important role of tax laws and regulations within the context of
financial planning and investment management. Other non-income-based taxes such as sales
taxes and property taxes are also introduced. The “pay-as-you-go” tax collection methods are
addressed to help students better understand their role as taxpayers. This chapter also introduces
the concept of taxable income and illustrates specific tax calculations. Tax rates, tax forms, and
tax features are outlined and discussed to promote better tax planning as a component of the
financial plan. Also discussed are strategies for filing late or amended returns, for preparing for
an audit, and for seeking tax preparation assistance.
LEARNING OBJECTIVES AND KEY TERMS
After reading this chapter, students should be able to accomplish the following objectives and
define the associated key terms:
1. Identify and understand the major Federal income tax features that affect all taxpayers.
a. progressive or graduated tax
b. tax brackets
c. personal exemptions
d. deductions
e. itemized deductions
f. standard deductions
g. taxable income
h. adjusted gross income (AGI)
i. marginal tax rate or marginal tax bracket
j. tax-deferred
Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

57 Chapter 4
k. capital asset
l. capital gain/capital loss
m. capital gains tax
n. bracket creep
2. Describe other taxes that you must pay.
a. Social Security
b. Medicare
3. Understand what is taxable income and how taxes are determined.
a. dependent
b. total or gross income
c. active income
d. portfolio or investment income
e. passive income
f. adjusted gross income (AGI)
g. IRA
h. home equity loan
i. exemption
j child tax credit
k. Hope Scholarship tax credit
l. Lifetime Learning tax credit
m. child and dependent care credit
n. earned income credit
o. adoption credit
4. Choose the tax form that’s right for you, file, and survive an audit if necessary
a. schedules
b. audit
5. Calculate your income taxes.
a. Keogh plan
6. Minimize your taxes
a. trust
b. 401(k) plan
CHAPTER OUTLINE
I. Taxes Then, Taxes Now

A. Originally a progressive tax system, but has undergone numerous changes
1. Funds the government
2. Influences the economy
3. Promotes socially desirable actions
4. Satisfies powerful special interest groups

Tax Planning and Strategies 58
B. U.S. tax bill is the largest single annual expenditure for most households.
C. Average American works more than one-quarter of each year to earn enough to pay
federal, state, and local taxes.
D. Tax planning is important for everyone.
a) The Federal Income Tax Structure

E. Marginal versus average rates
F. Effective marginal tax rate
G. Capital gains taxes and dividend income
1. What does this mean to you?
2. Long-term capital gains on homes
H. Filing status
I. Cost of living increases in tax brackets, exemptions, and deductions
J. Paying your income taxes
a) Other Taxes
2. Other income-based taxes
3. Social Security or FICA
4. State and local income taxes
5. Non-income-based taxes
6. Excise taxes
7. Real estate and property taxes
8. Sales taxes—a regressive tax
9. Gift and estate taxes
II. Calculating Your Taxes

A. Who has to file a return?
B. Determining gross or total income
C. Calculating adjusted gross income (AGI)
1. Gross income – adjustments = adjusted gross income
2. An adjustment for (almost) everyone: interest on student loans
D. Subtracting deductions
1. Itemizing deductions
2. The standard deduction
3. The choice: itemizing or taking the standard deduction
E. Claiming your exemptions
F. Calculating your taxable income, and, from that, calculating your base income tax
G. Subtracting your credits and determining your credits
1. Child credit
2. The Hope Scholarship tax credit and the Lifetime Learning credit
3. Other tax credits

59 Chapter 4
III. Other Filing Considerations

A. Choosing a tax form
B. Electronic filing
C. Filing late and amended returns
1. Filing late
2. Amending returns
D. Being audited
E. Help in preparing taxes
IV. Model Taxpayers: The Taylors File Their 2004 Return

A. Determining gross or total income (line 22)
B. Subtracting adjustments to gross or total income and calculating adjusted gross
income (AGI) (line 36)
C. Subtracting deductions (line 39)
D. Claiming exemptions (line 41)
E. Calculating total tax (line 62)
V. Tax Strategies to Lower Your Taxes

A. Maximize deductions
1. Using tax-deferred retirement programs
2. Using your home as a tax shelter
3. Shifting and bunching deductions
B. Look to capital gains and dividend income
C. Shift income to family members in lower tax brackets
D. Receive tax-exempt income
E. Defer taxes to the future
APPLICABLE PRINCIPLES
Principle 4: Taxes Affect Personal Finance Decisions

The amount of tax paid is based on income, expenses, and tax-planning decisions from the
previous year. Given that the average American spends more than one-quarter of each year
earning enough to pay the annual federal, state, and local taxes, it is very important not to
overpay. Consider the tax implications when making every financial decision.
Principle 3: The Time Value of Money

If you can defer paying your taxes, you can invest those dollars to earn a return. Since a
dollar today is worth more than a dollar tomorrow, your tax bill is being reduced each day
that the money remains invested for you.

CLASSROOM APPLICATIONS
1. Ask the class to develop a list of tax benefits to promote socially desirable actions. Consider
examples such as the tax benefits of home ownership, continued education, or adoption.
What are implications for taxpayers, the economy, or society?
2. Survey the class about their experiences filing federal tax returns. How many students have
completed and filed their returns? How many leave the responsibility to their parents or
others? How many have never filed? Discuss which forms they used and why.
3. Invite a CPA or other tax preparation professional to visit the class and present suggestions
for (1) record keeping to facilitate tax preparation and (2) record keeping to prepare for a
future audit. Ask about their experiences with good and bad record keepers. What are the
direct and indirect costs to the consumer?
4. Discuss Tax Freedom Day and the implications for the average taxpayer and the reversal of
the trend in 2004. Will Tax Freedom Day stabilize in late April, move earlier, later? What
factors might contribute to a stabilization or change?
REVIEW QUESTION ANSWERS
1. The three factors that affect taxable income are:

• Adjusted gross income (gross income minus allowable expenses designated as
adjustments)
• Deductions (standard deduction amount established by the IRS or itemized
deductions)
• Exemptions (IRS-allowed reduction for the earner and each dependent)
The tax rate is applied to the taxable income or the difference between income and
deductions.
2. No. Part of the taxable income will be taxed at the 10 percent tax rate, part of the taxable
income will be taxed at the 15 percent tax rate, part of the taxable income will be taxed at
the 25 percent tax rate, and the remaining amount of taxable income falling into the 28
percent tax bracket will be taxed at that rate. The amount of taxable income falling into each
bracket will vary by filing status. While the current tax bracket system will be in place
through 2010 unless there is Congressional action, the income limits on each bracket will
change because the limit amounts are indexed to inflation in an attempt to minimize bracket
creep.

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3. The taxpayer has little control over when interest income is received, and prior to the 2003
Tax Act all interest income was taxed annually at the same rates as earned income. Thus,
because of reduced tax rates applied to long-term capital gains and control of the timing of
the income tax payment, capital gains were considered better than investment income.
However, current law reduces the tax rate structure for long-term capital gains and qualified
dividend income to 15 percent for those in tax brackets of 25 percent or higher and to 5
percent for those in the 10 or 15 percent brackets. Ultimately, this means that dividend
income is better than interest income and that the tax rates are the same for long-term capital
gains and dividend income.
4. The date of determination for appropriate tax filing status is the last day of the year for
which the taxes are being filed.
• Single Status: Tax filer in unmarried and does not claim any dependent children.
• Married Filing Jointly (or surviving spouse): Tax filers are legally married at the
end of the year or was widowed (widowered) during the most recent two years.
• Married Filing Separately: Tax filers are legally married, but for some financial or
personal (separated, planning on divorce) reason choose to file separate returns.
Note: the tax laws are written to discourage this practice.
• Head of Household: Tax filer in unmarried but claims a dependent child or other
relative that lived with the filer for more than half the year and for which the filer
provided 50 percent or more financial support.
5. “Bracket creep” refers to the increase in taxes caused by increases in wages to keep pace
with inflation. To control bracket creep, the IRS makes annual cost of living, or inflation,
adjustments to the marginal tax bracket, the personal exemption, and the standard deduction
amounts.
6. The primary method for the collection of income tax is “pay-as-you-go.” This means that
the taxes are paid as you earn the money rather than once at the end of the year. This is done
to keep the public from “feeling the bite” if the taxes were collected all at once. The three
other methods are (1) quarterly tax payments, (2) withholdings from investment earnings,
and (3) withholdings of gambling or prize winnings.
The W-4 tax form provides employers information about a filer’s tax-filing status and any
dependents. Therefore, making sure that the form is accurate will assist the employer to
make the most appropriate withholding – enabling the filer to not under- nor overpay taxes.
7. The federal government also collects Social Security and Medicare taxes. The FICA taxes
total 7.65 percent of income: 6.20 percent for Social Security up to a certain income cap

($94,200 in 2006, $97,500 in 2007 $102,000 in 2008), and 1.45 percent for Medicare with
no cap on income. Applied as a flat tax rate, this tax is neither progressive nor regressive.
The tax is not progressive, as the rate does not increase for higher incomes. FICA is not
regressive. It does not consume a higher overall percentage of the income earned by those
with lower incomes, such as a regressive state sales tax would.
8. The non-income based taxes include:

• Excise taxes—these taxes are imposed on certain items and are sometimes used to
control consumption (e.g., alcohol, tobacco, and gasoline).
• Sales taxes—these state taxes are imposed on most, if not all, purchases and are flat
taxes in relation to the sales value, but could be considered regressive in relation to
income level.
• Property taxes—these local taxes are based on the assessed value of the item taxed (e.g.,
real estate and automobiles). If the assertion is that as income increase then housing
values increase, then this tax could be considered progressive.
• Gift and estate taxes—these taxes are imposed on the transfer of money or property
from one taxpayer to another. Various limits are established to determine the amount of
tax imposed or if any tax is applicable on the transfer. Gift tax and estate tax are both
progressive, meaning that as the value of the gift increases the tax rate also increases.
A fairly general description of a progressive tax is a tax rate that increases on a percentage
basis as the value of the taxable item increases. Primary examples include personal and
corporate income tax, and estate tax.
Conversely, a flat tax is designed to tax at the same rate regardless of the value of the
taxable item. Examples include sales tax, most property tax, and Social Security tax.
Finally, a regressive tax is more of an income comparison definition which states that the
tax is regressive if takes a larger percentage of the income of low-income people than of
high-income people
9. The three types of income that make up gross income, according to the IRS, are:
• Active—income earned from wages or business.
• Investment—income earned from investments or securities.
• Passive—income earned from activities in which the taxpayer does not
significantly participate.
10. Taxable income is the amount of income subject to taxation by either the federal, state, or
local government.
Gross Income – Adjustments to Income = Adjusted Gross Income (AGI)
AGI – Deductions – Exemption(s) = Taxable Income

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11. Five primary categories of adjustments to income include:

• Retirement expenses, or traditional IRA tax-deferred contributions: Limited to $4,000
in 2007 and $5000 in 2008 if not covered by a retirement plan at work; other income
limitations apply if covered by a plan at work. Note that these contribution limits do not
include any applicable 50-and-over catch-up provisions.
• Interest paid on student loans
• Moving expenses: Note: Limited to moves to a new location at least 50 miles farther
from your home than your previous job.
• Self-employed benefit expenses: Limited to 50 percent of Social Security and Medicare
taxes.
• Alimony paid: Provided certain requirements are met.
• Health Savings Accounts (HSAs)
• Unreimbursed grade-school educator expenses
Assuming that the entire $10,000 savings doesn’t change the marginal tax rate of the filer
then the filer would save $2,500.
12. The six categories of itemized deductions are:

• Medical and dental expenses—health insurance premiums and expenses not reimbursed
for medical treatment, hospital care, and prescription drugs are tax deductible. However,
the deduction is limited to the amount that these expenses exceed 7.5 percent of AGI.
• Tax expenses—all state and local income taxes, as well as real estate and personal
property taxes are deductible. In certain situations state sales taxes are also deductible.
• Interest expenses—interest paid on mortgages, home equity loans, and investment loans
are all tax deductible. However, the tax deduction is limited to home equity loans up to
$100,000. The deductibility of interest paid on investment accounts is also limited to
the amount of investment income earned.
• Charitable gifts—all charitable gifts to a qualified organization are tax deductible. If a
single gift is over $250, a receipt is required for verification.
• Casualty and theft loss—applicable to taxpayers with huge losses or very low income.
Regulations regarding exclusions, insurance reimbursement, and limitations based on
AGI further restrict the use of this deduction.
• Miscellaneous—deduction for various job-related, tax preparation, and investment-
related expenses. Only the amount that exceeds 2 percent of AGI is actually deductible.
13. Dependents must pass the relationship or household member test. Almost any relation short
of cousin qualifies. If the person being claimed as a dependent is not related then that
person must have lived with the tax-filer for the entire year. Everyone who files an income
tax return is eligible to claim a personal exemption unless the filer is being claimed as a
dependent on another filer’s return.
14. Claiming the Hope Scholarship tax credit is contingent on meeting the following criteria:

• Student is enrolled in the first two years of study at an accredited vocational school,
college or university;
• Maximum tax credit of $1,650 per year (100% on first $1,100 and 50% of second
$1,100) for tuition and book expenses (not room and board) per student;
• Parent(s) must pay the tuition and list the student as a dependent;
• Financial aid and scholarship funds can reduce the amount of the credit;
• Income restrictions, based on modified AGI adjusted annually for inflation, apply for a
phase-out range and elimination of the credit.
Claiming the Lifetime Learning tax credit is contingent on meeting the following criteria:
• Student is enrolled at an accredited vocational school, college or university, or is
continuing education as a working adult, hence this credit is not available during the
first two years of enrollment;
• Maximum tax credit of $2,000 per year for tuition and book expenses (not room and
board) for the household, calculated as a credit of 20 percent of the first $10,000 of
eligible expenses;
• Parent(s) must pay the tuition and list the student as a dependent;
• Financial aid and scholarship funds can reduce the amount of the credit;
• Income restrictions, based on modified AGI adjusted annually for inflation, apply for a
phase-out range and elimination of the credit.
Other credits a household might claim, if applicable and contingent on income restrictions,
include the child credit, the child and dependent care credit, the earned income credit, or the
adoption credit.
15. Taxable income must be less than $100,000 to file the 1040A or 1040EZ forms.
16. Electronic filing of federal tax forms, either by a professional or the taxpayer, offers the
following advantages:
• Faster refunds through direct deposit or checks in the mail.
• More accurate returns as the IRS computers check submitted forms for errors or
omissions prior to electronic confirmation.
• Quick electronic acknowledgement from the IRS, while TeleFilers receive a
confirmation number while still on the phone.
• Elimination of paperwork to file.
• Easy payment options by electronic bank account withdrawal or credit card charge.
• Expedited filing as the IRS forwards the necessary information to the appropriate
agency in 37 states and the District of Columbia.
• FreeFile provide a free tax filing for qualified persons provided they access the site
through the IRS.gov web site.

65 Chapter 4
17. To file a late return, the taxpayer must submit an IRS Form 4868, Application for
Automatic Extension of Time to File U.S. Individual Income Tax Return, and enclose a
check for the estimated taxes owed. If the taxpayer does not enclose a check, then the IRS
will charge interest on the estimated taxes. If the taxes due exceed 10 percent of the annual
tax bill, then the IRS imposes a late penalty of one-half percent per month on the late taxes.
Form 1040X, Amended U.S. Individual Income Tax Return is used to correct a mistake,
claim an overlooked deduction, or to take advantage of a retroactive IRS change. Note the
limitation for filing an amended return of 3 years after the original tax due date that you
filed. Amendments to the state and local returns may also be necessary.
18. The most common “signals” that the IRS looks for when selecting taxpayers to audit
include:
• Previously audited, particularly if an error was discovered.
• Income over $100,000.
• Deductions in excess of 44 percent of income.
• Schedule C for self-employment income.
• Schedule C expenses greater than one-third of Schedule C income.
19. Three main types of tax filing assistance are:

• The IRS (e.g., Publication 17, Your Federal Income Tax, or the “hotline” )
• Self-help tax publications (e.g., J. K. Lasser’s or Ernst & Young’s Income Tax Guides)
or computer programs and CD-ROMs (e.g., Intuit’s Turbo Tax).
• Tax specialists (e.g., national affiliates such as H&R Block or Jackson Hewitt, or
independent tax preparation professionals).
20. The five general tax reduction strategies are:

• Maximizing deductions by (1) using tax-deferred retirement programs to reduce taxable
earnings, (2) using your home as a tax shelter (i.e., mortgage interest deductibility;
avoidance of capital gains; home equity loan interest deductibility), and (3) shifting and
bunching deductions over multiple years to increase the itemized deduction.
• Taking advantage of reduced tax rates on long term capital gains and dividend income is
a useful strategy for taxpayers. Long term capital gains and dividend income are taxed at
15 percent, for investors in the top four marginal tax brackets. If the investor is in the 10
or 15 percent tax brackets, then the long term capital gains and dividend income will be
taxed at a 5 percent rate.
• Shifting income from a family member in a higher tax bracket to a family member in a
lower marginal tax bracket reduces the taxes paid and allows the asset to grow faster.
Transferring an asset from a taxpayer in the 30 percent marginal tax bracket to another
family member in the 15 percent bracket would reduce the tax liability by 15 percent.
Transfers can be complicated and require a gift or trust.

• Receiving tax-exempt income, such as interest from municipal bonds, does not create a
tax liability.
• Deferring taxes into future tax periods allows the taxpayer to avoid taxation today.
Money that would have been required to pay taxes can continue to earn interest or
dividends.
PROBLEM AND ACTIVITY ANSWERS

(Note: Since tax information is widely available on the web, the authors have decided to include
answers for both 2007 and 2008 information so that alternative years might be assigned.)
1. The Lees’ marginal tax bracket is 15 percent as shown in Table 4.1
2007 2008
$68,000.00 $68,000.00 Gross Income
$0.00 $0.00 Adjustments
-$10,700.00 -$10,900.00 Standard Deduction, Married filing jointly
-$13,600.00 -$14,000.00 Exemptions (x4)
$43,700.00 $43,100.00 Taxable income
2007 2008
$1,560.00 $1,605.00 Liability (10% bracket)
+$4,207.50 +$4,057.50 Liability (15% bracket)
$5,767.50 $5,662.50 Total tax liability
- $2,000.00 - $2,000.00 Tax credits (Child tax)
$3,767.50 $3,662.50 Final tax liability
Note: According to the IRS Tax Tables the Lees’ 2007 tax liability is $5,776 and his 2008 tax
liability is $5,666.
Average tax rate 2007: Total Tax Liability = $3,767.50 = 5.540%

Total Income $68,000
Average tax rate 2008: Total Tax Liability = $3,662.50 = 5.386%

Total Income $68,000
2. Assuming the 25 percent marginal tax bracket; Investors A, B and C will not pay the same
amount of taxes on their investment proceeds ($225, $375 and $225, respectively). Investors
A and C will have more money available than Investor B, as shown below.
Investors A and C will have $1,500 x (1 – 0.15) = $1,275 available after paying the federal
income tax based on preferential rate of 15 percent for qualified dividends and long-term
capital gains.

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Investor B will have only $1,500 x (1 – 0.25) = $1,125 after paying the 25 percent federal
income tax since no preferential rate is available for interest income.
For taxpayers in the 15 percent marginal tax bracket, the rate for qualified dividend income
or long-term capital gains drops to 5 percent (2007) or 0 percent (2008), while the interest
income would be taxed as ordinary income. Using the formulas above, Investors A, B and
C would pay $75, $225, and $75, respectively for 2007 or $0, $225, and $0, respectively for
2008 in taxes as a result of their dividend income, interest income, and long-term capital
gains income.
3. Until the end of the second calendar year following the death of a spouse, a surviving
spouse may choose to continue file “jointly” if certain criteria are met. To use this filing
status, Sukeeta must have:
• a dependent child living with her
• paid more than half the cost of keeping her home
• and must not have remarried.
It is in Sukeeta’s best interest to continue filing “jointly” as the standard deduction is higher,
as shown in Figure 4.3 Standard Deduction Amounts, and the tax rates are lower for larger
amounts of income as shown in Table 4.1, 2007 Tax Rates and Brackets. After the 2 years
have passed, Sukeeta may file as Head of Household rather than Single status for the
reasons cited above.
4. The couple could claim exemptions of $17,000 ($3,400 x 5) in 2007 and $17,500 ($3,400 x
5) in 2008 based on two exemptions for the couple and three for the dependent children.
5. The Mayberrys’ must use Form 1040. Although they meet the income requirements to use
the 1040EZ or 1040A, itemizing deductions is not allowed on any Form except the 1040.
6. The single parent taxpayer’s total 2007 tax liability is $3,180.00 and 2008 tax liability is
$3,115.00 assuming the $1,000 child tax credit is the only credit available to the taxpayer
and the filer uses the Head of Household status.
2007 2008
$46,250.00 $46,250.00 Gross Income
-$7,850.00 -$8,000.00 Standard Deduction, Head of household
-$6,800.00 -$7,000.00 Exemptions (x2)
$31,600.00 $31,250.00 Taxable income

2007 2008
- $1,000.00 - $1,000.00 Tax credits (Child tax)
Note: According to the IRS Tax Tables the filer would have 2007 tax liability of $4,184 and 2008
tax liability of $4,119.
7. The estimated 2007 tax liability using the standard deduction is $4,857.50.
The estimated 2008 tax liability using the standard deduction is $4,777.50.
2007 2008
$55,100.00 $55,100.00 Gross Income
-$10,700.00 -$10,900.00 Standard Deduction, Married filing jointly
-$6,800.00 -$7,000.00 Exemptions (x2)
$37,600.00 $37,200.00 Taxable income
2007 2008
- $0.00 - $0.00 Tax credits
Note: According to the IRS Tax Tables the filers would have 2007 tax liability of $4,861 and 2008
The estimated 2007 tax liability using the itemized deduction is $4,700.00.
The estimated 2008 tax liability using the itemized deduction is $4,650.00.
Itemized deductions = (Mortgage Interest) + (Real Estate and State Income Taxes)
$11,750.00 = $7,900.00 + $3,850.00
(NOTE: $800 in job related expenses are not deductible because they do not exceed the 2%
of the $55,100 (AGI), or $1,102 threshold.)
2007 2008
$55,100.00 $55,100.00 Gross Income
-$11,750.00 -$11,750.00 Itemized Deductions (mortgage int. + taxes)
-$6,800.00 -$7,000.00 Exemptions (x2)
$36,550.00 $36,350.00 Taxable income

69 Chapter 4
2007 2008
- $0.00 - $0.00 Tax credits
Note: According to the IRS Tax Tables the filers would have 2007 tax liability of $4,704 and 2008
Shameka and Curtis will save money by claiming the itemized deductions. Always deduct
the larger of the standard or itemized deduction amounts to reduce the tax liability.
8. Although their gross taxable income of $17,200 (the $12,500 inheritance is tax exempt) is
less than $19,600 as shown in Figure 4.2, Who Has to File, they do have to file a 2007 tax
return because this amount included self-employment income of $8,000, which exceeds the
filing requirement threshold of $400. (Note: The same result would happen in 2008.) Even
if they did not have any self-employment income, if taxes were withheld from the pension
benefits, then they should file to possibly receive a refund for any overpayment of tax.
9. Assuming that Salem Marcos can itemize her deductions on her federal income taxes she
would pay less federal taxes by itemizing the sales tax paid.
State income tax = $41,250 x 0.03 = $1,237.50

Sales tax = $1,300.00
Although the benefit may not be worth the effort to track the sales tax, she would save 25
percent of the $62.50 difference, which is $15.63.
10. Lifetime Learning tax credit = $8,500 x 0.2 = $1,700

The maximum annual tax credit is limited to $2,000 (20 percent of the first $10,000 spent
for tuition and related expenses.)
11. Gordon’s total estimated tax liability in 2007 is $7,186 and in 2008 is $7,056.
Gross Income = $51,800.00 = $40,000 + $4,000 + $7,800
2007 2008
$51,800.00 $51,800.00 Gross Income
-$5,350.00 -$5,450.00 Standard Deduction, Single
-$3,400.00 -$3,500.00 Exemption
$43,050.00 $42,850.00 Taxable income

2007 2008
$782.50 $802.50 Liability (10% bracket)
- $0.00 - $0.00 Tax credits
Note: According to the IRS Tax Tables Gordon’s 2007 tax liability is $7,193 and his 2008 tax
Gordon’s marginal tax bracket is 25 percent as shown in Table 4.1, 2007 Tax Rates and
Brackets. His 2007 average tax rate is 13.87 percent, based on an estimated tax liability of
$7,186.
12. Aliza’s total tax liability for 2007 is $18,538.25 and for 2008 is $18,458.25
2007 2008
$55,000.00 $55,000.00 Taxable income
$782.50 $802.50 Liability (10% bracket)
- $0.00 - $0.00 Tax credits
Note: According to the IRS Tax Tables Aliza’s 2007 tax liability is $10,180 and her 2008 tax
Other 2007 and 2008 (no change across years) tax liabilities:
• State tax liability = $55,000 x 0.0575 = + $3,162.50
• Social Security = $68,000 x 0.0620 = + $4,216.00
• Medicare = $68,000 x 0.0145 = + $986.00
Total additional tax liability $8,364.50
Note: Becuase Aliza is self-employed her Social Security and Medicare tax liability is
actually doubled as she is responsible for both the employee and employer portions of the
tax. However, Aliza would also receive a tax deduction for the employer portion of the tax.
13. To prepare for the audit Mrs. Hubbard should

• Reexamine the areas where the IRS raised questions.
• Gather all supporting documents (e.g., checks, receipts, and records).
• Anticipate probable questions and develop responses.
• Hire an accountant or tax attorney, if necessary.

71 Chapter 4
If the audit turns out unfavorably, Mrs. Hubbard can

• Appeal with the auditor, by presenting additional material.
• Appeal with the auditor’s manager.
• File a formal appeal with the IRS.
• Go to tax court.
14. To reduce future estate taxes, the Porters should consider “shifting income to family
members in lower tax brackets.” Establishing trusts and giving gifts can accomplish this.
The Porters could each give $12,000 per year ($24,000 as a couple) to other people or an
unlimited sum to charity for tax year 2007. As long as the gift value is below the threshold,
neither the giver nor the recipient will pay any taxes on the gift. Furthermore, the income
earned on the gift-asset will be taxed at the lower rate of the recipient, allowing the gift to
grow faster than if the Porters had maintained possession.

DISCUSSION CASE 1 ANSWERS
1. Yes, Martha’s unreimbursed medical expenses are deductible on the Neals’ return. Martha
qualifies as a dependent because she
• Passes the relationship or household member test.
• Does not have earnings greater than the exemption amount.
• Provides less than half of her support, or living expenses.
• Is a U.S. citizen.
2. Although Martha qualifies as a dependent, thus triggering lower income tax filing
thresholds, she does not have additional income; therefore, her Social Security income is
inadequate to require filing of a separate tax return.
3. There are two tax advantages associated with Holly’s education expenses. First, they can
claim a Lifetime Learning tax credit equal to 20 percent of qualifying expenses of $5,450,
or a $1,090 credit, as the Neals’ income is below the income phase-out for the credit.
Second, the $590 in interest payments is an adjustment to income for tax year 2007 (or
2008), as the again Neals’ income is less than the phase out level for eligibility.
4. The Neals will be able to deduct any expenses exceeding 7.5% of AGI.
$56,900.00 (Gross Income = W2 inc. + 1099 inc. + gambling winnings)
- $5,000.00 (Adjustment for IRA Contribution)
- $590.00 (Adjustment for Student Loan Interest)
$51,310.00 (AGI)
The amount that exceeds the AGI threshold is $3,848.25 (0.075 x $51,310). Consequently,
the Neals will be able to include $2,951.75 ($6,800.00 – $3,848.25) of medical expenses in
their calculation of itemized deductions.
5. Yes, the Neals can claim their $5,000 traditional IRA contribution as an adjustment to
income. Because neither spouse is covered by a work plan, but the “working spouse” earned
more than $5,000, they were actually eligible to contribute and claim the amount as an
adjustment to income. The maximum allowable contribution was $4,000 per person
($8,000 for a married couple) in 2007 and increased to $5,000 per person ($10,000 for a
married couple) in 2008.
6. The Neals would benefit from itemizing their deductions. Their itemized deduction of
$11,554.25 exceeds the standard deduction amount in both 2007 ($10,700) and 2008
($10,900).
$2,951.75 (Allowable Medical Expenses, from question 4)
+$2,280.00 (State Taxes Withheld)
+$6,000.00 (Mortgage Interest)
$11,231.75 (Total Itemized Deductions)

73 Chapter 4
7. The Neals’ net estimated tax liability (after claiming any tax credits), using the tax rate
calculation, is $2,609.24 for 2007 or $2,544.24 for 2008.
2007 2008
$56,900.00 $56,900.00 Gross Income
- $5,590.00 - $5,590.00 Adjustments
-$11,231.75 -$11,231.75 Itemized Deduction (from Q6)
-$10,200.00 -$10,500.00 Exemption (x3)
$29,878.25 $29,578.25 Taxable income
2007 2008
- $1,090.00 - $1,090.00 Tax credits (from Q3)
Note: According to the IRS Tax Tables the Neals’ 2007 tax liability is $3,699 and their 2008 tax
8. The Neals should always compare their final tax liability to how much they had withheld. If
the result is that they had too much withheld then, in essence, they provided the government
with a short-term interest free loan. However, if they did not have enough withheld then
they could face a hardship paying the additional tax liability. The best planning practice is
to accurately estimate the tax liability for the coming year and increase or decrease
employer withholdings to match.
DISCUSSION CASE 2 ANSWERS
1. FICA tax liabilities = $6,120

• Anya’s Social Security tax liability = $40,000 x 0.124 = $4,960
• Anya’s Medicare tax liability = $40,000 x 0.029 = $1,160
Half of her FICA taxes ($3,060) are an adjustment to income because she is self-employed.
2. No, the moving expenses are not deductible, because the Goulds did not move more than 50
miles in association with taking a new job.
3. The Goulds should itemize their deductions, because their itemized deduction of $18,015 far
exceed both the 2007 ($10,200) and 2008 ($10,500) standard deduction. However, to
determine the miscellaneous deductible expense they must first calculate their adjustable
gross income (AGI).

$2,200.00 (Self-Employed Family Health Insurance Expenses for Anya)

+ $3,060.00 (Self-Employed FICA Taxes paid by Anya, from question 1)
$5,260.00 (Total Adjustments)
$73,000.00 (Gross Income)

- $5,260.00 (Adjustments)
$67,740.00 (AGI)
Total medical expenses = $5,100 ($1,500 + $3,600)

$67,740 x 0.075 (floor) = $5,080.50; therefore $5,100 – $5,080.50 = $19.50
Total business, investment, and tax planning expenses = $3,750 ($1,450 + $2,300)
$67,740 x 0.020 (floor) = $1,354.80; therefore $3,750 – $1,354.80 = $2,395.20
To calculate their itemized deductions, add the categories as follows:

• State Tax Expense $4,000.00
• Medical Expenses $19.50 (See equation above)
• Real Estate Taxes $900.00
• Mortgage Interest Expense $7,200.00
• Charitable Contribution $3,500.00
• Business, Investment, and Tax Planning Expense $2,395.20 (See equation above)
Total Deductions $18,014.70
4. The Goulds’ will need to file a 1040 “long form” because it is to their advantage to itemize
the deductions, and the 1040 form is the only form that also allows for additional schedules
to be filed, such as the Schedule A - Itemized Deductions, Schedule B - Interest and
Dividend Income, Schedule C - Business Income and Schedule D - Capital Gains and
Losses.
5. The Goulds’ should be eligible to claim the child tax credit for each of their two boys given
that their income does not exceed the $110,000 limit for a married couple filing jointly.

75 Chapter 4
2007 Tax Information

Federal Income Tax Schedules
Schedule X: Single
If taxable income is over-- But not over-- The tax is:
$0 $7,825 10% of the amount over $0
$7,825 $31,850 $782.50 plus 15% of the amount over 7,825
$31,850 $77,100 $4,386.25 plus 25% of the amount over 31,850
$349,700 no limit $101,469.25 plus 35% of the amount over 349,700
Schedule Y-1: Married Filing Jointly or Qualifying Widow(er)
Schedule Y-2: Married Filing Separately
Schedule Z: Head of Household
Standard Deduction Phase out of Exemptions Partial - Full
Single: $5,350 Single: $156,400 - $278,900
Married Filing Joint: $10,700 Married Filing Joint: $234,600 - $357,100
Married Filing Separately: $5,350 Married Filing Separately: $117,300 - $178,550
Head of Household: $7,850 Head of Household: $195,500 - $318,000
Qualifying Widow/Widower: $10,700 Qualifying Widow/Widower: $234,600 - $357,100
Dependent: $850-$5,350
Add. Amount if Blind: $1,050-$1,300 Phase out of Itemized Deductions
Add. Amount if over age 64: $1,050-$1,300 Single: $156,400
Married Filing Joint: $156,400
Personal Exemption Married Filing Separately: $78,200
Personal or Dependent: $3,400 Head of Household: $156,400
Qualifying Widow/Widower: $156,400

2008 Tax Information

Federal Income Tax Schedules
Schedule X: Single
If taxable income is over-- But not over-- The tax is:
Schedule Y-1: Married Filing Jointly or Qualifying Widow(er)
Schedule Y-2: Married Filing Separately
Schedule Z: Head of Household
Standard Deduction Phase out of Exemptions Partial - Full
Single: $5,450 Single: $159,950 - $282,450
Married Filing Joint: $10,900 Married Filing Joint: $239,950 - $362,450
Married Filing Separately: $5,450 Married Filing Separately: $119,975 - $181,225
Head of Household: $8,000 Head of Household: $199,500 - $322,450
Qualifying Widow/Widower: $10,900 Qualifying Widow/Widower: $239,950 - $362,450
Dependent: $900-$5,450
Add. Amount if Blind: $1,050-$1,350 Phase out of Itemized Deductions
Add. Amount if over age 64: $1,050-$1,350 Single: $159,950
Married Filing Joint: $159,950
Personal Exemption Married Filing Separately: $79,975
Personal or Dependent: $3,500 Head of Household: $159,950
Qualifying Widow/Widower: $159,950
Miscellaneous Tax Information

77 Chapter 4
2007
Tax Credits Limit
Hope Scholarship $1,650 per student
Lifetime Learning 20% of $10,000 qualified expenses per filer
Child and Dependent Care $3,000 per child (2+ $6,000)
Child Tax Credit $1,000 per child
Adoption Credit $11,390 of qualified expenses
2008
Tax Credits Limit
Hope Scholarship $1,800 per student
Lifetime Learning 20% of $10,000 qualified expenses per filer
Child and Dependent Care $3,000 per child (2+ $6,000)
Child Tax Credit $1,000 per child
Adoption Credit $11,650 of qualified expenses
Maximum Income to Avoid Filing

2007 (Under age 65) (Under age 65) (Over age 65)
Single: $8,750 $10,050
Married Filing Joint: $17,500 (Both under) $18,550 (one over) $19,600 (Both over)
Married Filing Separately: $3,400 $3,400
Head of Household: $11,250 $12,550
Qualifying Widow/Widower: $14,100 $15,150
Dependents (w/earned inc.) $5,350 $6,400
Dependents (w/unearned inc.) $850 $1,900
Any filing status with self-emp inc. $400 $400
2008 (Under Age 65) (Under age 65) (Over age 65)
Single: $8,950 $10,300
Married Filing Joint: $17,900 (Both under) $18,950 (one over) $20,000 (Both over)
Married Filing Separately: $3,500 $3,500
Head of Household: $11,500 $12,850
Qualifying Widow/Widower: $14,400 $15,450
Dependents (w/earned inc.) $5,450 $6,500
Dependents (w/unearned inc.) $900 $1,950
Any filing status with self-emp inc. $400 $400

Other Tax Rates

2007 Rate
Ordinary Dividends MTB
Qualified Dividend (MTB>15%) 15%
Qualified Dividend (MTB =10% or 15%) 5%
Net Long-term Capital Gains (MTB>15%) 15%
Net Long-term Capital Gains (MTB =10% or 15%) 5%
2008
Ordinary Dividends MTB
Qualified Dividend (MTB>15%) 15%
Qualified Dividend (MTB =10% or 15%) 0%
Net Long-term Capital Gains (MTB>15%) 15%
Net Long-term Capital Gains (MTB =10% or 15%) 0%

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CHAPTER 4

TAX PLANNING AND STRATEGIES

CHAPTER CONTEXT: THE BIG PICTURE

LEARNING OBJECTIVES AND KEY TERMS

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

I. Taxes Then, Taxes Now

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a) The Federal Income Tax Structure

II. Calculating Your Taxes

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III. Other Filing Considerations

IV. Model Taxpayers: The Taylors File Their 2004 Return

V. Tax Strategies to Lower Your Taxes

Principle 4: Taxes Affect Personal Finance Decisions

Principle 3: The Time Value of Money

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

REVIEW QUESTION ANSWERS

1. The three factors that affect taxable income are:

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8. The non-income based taxes include:

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11. Five primary categories of adjustments to income include:

12. The six categories of itemized deductions are:

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19. Three main types of tax filing assistance are:

20. The five general tax reduction strategies are:

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PROBLEM AND ACTIVITY ANSWERS

1. The Lees’ marginal tax bracket is 15 percent as shown in Table 4.1

Average tax rate 2007: Total Tax Liability = $3,767.50 = 5.540%

Average tax rate 2008: Total Tax Liability = $3,662.50 = 5.386%

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

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State income tax = $41,250 x 0.03 = $1,237.50

10. Lifetime Learning tax credit = $8,500 x 0.2 = $1,700

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13. To prepare for the audit Mrs. Hubbard should

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If the audit turns out unfavorably, Mrs. Hubbard can

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DISCUSSION CASE 1 ANSWERS

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DISCUSSION CASE 2 ANSWERS

1. FICA tax liabilities = $6,120

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

$2,200.00 (Self-Employed Family Health Insurance Expenses for Anya)

$73,000.00 (Gross Income)

Total medical expenses = $5,100 ($1,500 + $3,600)

To calculate their itemized deductions, add the categories as follows:

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

2007 Tax Information

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

2008 Tax Information

Miscellaneous Tax Information

Maximum Income to Avoid Filing

Copyright ©2010 Pearson Education, Inc. publishing as Prentice Hall

Other Tax Rates

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