Personal Finance Questions: Tax Planning and Strategies

Here are the most important personal finance questions on taxes:

Question: Why is tax planning so important?
 
Most people don't seem to understand tax planning and don't keep up with all the changes in tax law
- Many pay several thousand dollars more in income taxes than they really need to
- The average American spends over one-third of each year earning money to pay taxes
- Planning is vital to pay your fair share and to keep your fair share, regardless of income
- In sum, tax planning is not just for the wealthy.


Question: Name the categories of filing status
 
Single status, married filing jointly or surviving spouse, married filing separately, and head of household.


Question: Explain the ways income taxes are paid or collected
 
Income taxes are generally paid as withholdings from paychecks
- Other ways in which taxes are collected include quarterly estimated taxes sent to the IRS, payments with tax returns, and direct withholdings from stock dividends, retirement funds, and prizes or gambling winnings.


Question: Describe the four filing status classifications
 
Married Filing Jointly and Surviving Spouses: You file a joint return with your spouse, combining incomes and deductions into a single return
- If your spouse dies, you can still qualify for this status for up to two years after the year in which your spouse died if you have a dependent child living with you, you pay more than half the cost of keeping up your home, and you are not remarried
- Of course, if you remarry, you can file a joint return with your new spouse.
Married Filing Separately: Married couples also have the choice of filing separately.It is hard to say ahead of time whether you will do better filing jointly or separately
- The best idea is to figure your taxes both ways and, of course, go with the lower number
- This status is often used when a couple is separated or in the process of getting a divorce.
Question: Head of Household: Head of household status applies to someone who is unmarried and has at least one child or relative living with him or her
- The advantage of this status is that your tax rate will be lower and your standard deduction will be higher than if you had filed with single status
- To qualify for head of household status, you must be unmarried on the last day of the tax year, have paid more than half the cost of keeping up your home, and have had a child or dependent live with you for at least half of the year.


Name and describe the four general categories that reduce your taxable income, therefore reducing your tax liability.
adjustments to income allow certain legal reductions in gross income
- Examples include
IRA contributions, moving expenses, self-employment tax and retirement plans, and alimony payments
- Itemized deductions consist of medical and dental expenses, state, local, and real estate taxes, home mortgage and investment interest payments, gifts to charity, theft and casualty losses, and miscellaneous deductions
- As an alternative to itemizing deductions, the standard deduction may be used
- Personal and dependency exemptions serve to further reduce taxable income
- Finally, credits are subtracted directly from the tax liability, and while most credits are non-refundable, a few, such as the earned income credit allow for a refund in excess of taxes paid
- Examples of credits include child and dependent care expenses, hope scholarship credit, lifetime learning credit, child credit, the earned income credit., adoption credit, and the health care premium credit
- Note that the standard deduction amount and the exemption amount are adjusted upward annually in response to inflation.


Question: Explain how to calculate your taxable income, and how to determine the need for a tax payment or refund
 
First, calculate total gross income by adding income from all taxable sources
- Next, subtract all adjustments, deductions (the itemized or standard amount), and exemptions to calculate taxable income
- On the basis of your taxable income, use the tax tables or tax rate to determine your tax liability and then apply any tax credits that may apply
- If the amount of your tax liability is greater than the taxes withheld from you, then you owe the
IRS a tax payment for the difference
- If the tax liability is smaller than what was already withheld, then you are due a tax refund.


Question: Name the sources of tax-free income
 
These sources include interest on municipal bonds, tax-free money market funds, gifts, child support payments, welfare benefits, workers' compensation benefits, veterans' benefits, federal income tax refunds, certain Social Security benefits, interest earned inside a life insurance policy, earnings on an IRA, and inheritances.


Question: Explain the concept of using the standard deduction or using itemized deductions
 
The alternative to itemizing deductions is to take the standard deduction
- The standard deduction is the best estimate by the government of what the average person would be able to deduct by itemizing
- You don't need to figure your expenses and provide receipts or justification
- The standard deduction varies based on your filing status
- Many people have different situations that differentiates them from the average person.


Question: Why are the various tax 'credits' such a welcome relief?
 
Tax credits are subtracted directly from taxes due on a dollar-for-dollar basis
- The credits are not a deduction from income or a percentage of some entry in the tax form
- Your final income tax liability represents your base income tax less your tax credits
- The bottom line is a major savings in the tax burden.


Question: What combination of deductions and exemptions can the typical full-time college student who is employed during the summer, or perhaps during the school year, claim? Why?
 
The typical employed full-time college student, who is claimed as a dependency exemption by his or her parents, can only claim the standard deduction to reduce tax liability
- A dependency exemption cannot be claimed for anyone who earns more than the exemption amount
- However, the income test does not apply to children under the age of 19 or to full-time college students under the age of 24
- Finally, the parents must provide over half of the student's support
- Given the relationship, income, support, and citizenship test, the parents can claim the dependent exemption
- Because only one exemption can be claimed on any tax form, the typical full-time college student is limited to using the standard deduction to reduce his or her taxable income, and ultimately the tax liability.


Question: Six schedules are commonly used by taxpayers filing Form 1040 - Give the title of each of these six basic schedules: A, B, C, D, E, EIC
 
Schedule A: Itemized Deductions
Schedule B: Interest and Dividend Income
Schedule C: Profit or Loss from Business
Schedule D: Capital Gains and Losses
Schedule E: Supplemental Income and Loss
Schedule EIC: Earned Income Credit


Question: What are the benefits of filing taxes electronically?
 
Faster refunds: Direct deposit can speed refunds to e-filers in as few as 10 days.
More accurate returns: IRS computers quickly and automatically check for errors or other missing information, making e-filed returns more accurate and reducing the chance of receiving an error letter from the IRS.
Quick electronic confirmation: Computer e-filers receive an acknowledgment that the IRS has received their returns.
Reduced paperwork and the use of electronic signatures: There is nothing to mail to the IRS.


Question: What are the five general tax strategies in tax planning?
 
-Maximize your deductions.
-Look to capital gains and dividend income, especially if you are in the top tax bracket.
-Shift income to family members in lower tax brackets.
-Seek out tax-exempt income.
-Defer taxes to the future.


Question: What are two tax advantages of tax-deferred retirement plans?
 
(1) You don't pay taxes on the money you invest until such time as funds are withdrawn from the retirement account resulting in recognition of taxable income.
(2) You don't pay interest on the earnings from your retirement account until such time as funds are withdrawn from the retirement account resulting in recognition of taxable income.


Question: Strategies for maximizing deductions center on what three tactics?
 
(1) Using tax-deferred retirement programs to reduce taxes.
(2) Using your home as a tax shelter.
(3) Shifting and bunching deductions.
Each of these tactics has the same goal: to reduce taxable income to its minimum level.