Personal Financial Planning: An "How-To" Guide (part 23)

The Automobile Lease Versus Purchase Analysis

by

Charles Lamson

To decide whether it is less costly to lease rather than purchase a car, you need to perform a lease versus purchase analysis to compare the total cost of leasing to the total cost of purchasing a car over equal periods. In this analysis, the purchase is assumed to be financed with an installment loan with the same term as the lease.

For example, assume that Mary Dixon is considering either leasing or purchasing a new Ford Focus sedan costing $15,000. The three-year, closed-end lease she is considering requires a $1,500 down payment (capital cost reduction), a $300 security deposit and monthly payments of $300 including sales tax. If she purchases the car she will make a $2,500 down payment and finance the balance with a three-year, 8 percent loan requiring monthly payments of $392. In addition she will have to use 5 percent sales tax ($750) on the purchase and she expects the car to have a residual value of $8,000 at the end of 3 years. Many can earn 4 percent interest on her savings with short-term CDs. After filling in Worksheet 1, Mary concludes that purchasing is better because its total cost of $9,662 is $2,854 less than the $12,516 total cost of leasing---even though the monthly lease payment is $92 lower. Clearly, all else being equal, the least costly alternative is preferred.

Excel 2010: Buy versus lease calculation

Some Web sites can help you with your analysis. Intellichoices lease area, www.intellichoice.com, has descriptions of current manufacturer lease details. Or click on the "calculate" page of FinanceCenter, www.financecenter.com, and go to the auto section for several calculators to analyze a car purchase, including lease versus purchase. You can quickly run several "what if " scenarios to compare costs. The average cost per year of either owning or leasing is the highest in the first 2 years. Note also that the average cost of ownership is usually much lower if you own a vehicle for 4 years or more.

If you are fortunate enough to be able to pay cash for your car, you may still want to investigate leasing. Sometimes, dealers offer such advantageous lease terms that you can come out ahead by leasing and then investing the money you would pay for the car. To compare the total cost of a cash purchase, simply take the cost of the car, including sales tax, add to it the opportunity cost of using all cash, and deduct the car's value at the end of the lease or loan term.

smart.sites If you are still unsure whether to lease or buy, try letting the numbers help you make the right decision. Go to www.edmunds.com “Decision Calculator” and see how much leasing or buying will cost for the same car.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 185-187*

end

smart.sites

If you are still unsure whether to lease or buy, try letting the numbers help you make the right decision. Go to www.edmunds.com “Decision Calculator” and see how much leasing or buying will cost for the same car.

Personal Financial Planning: An "How-To" Guide (part 22)

A Variety of Ways To Save

by

Charles Lamson

During the past couple decades or so there has been a tremendous proliferation of savings and short-term investment vehicles, particularly for the individual of modest means.

smart.sites If you are not satisfied with the CD rate at your local bank, go to Bankrate.com (www.bankrate.com). You will find not only the highest rates on CDs and savings accounts nationwide but also the checking account and ATM fees at banks in your city.

Today, investors can choose from savings accounts, money market deposit accounts, money market mutual funds, NOW accounts, certificates of deposit, U.S. Treasury bills, Series EE bonds, and asset management accounts. Let's look at three types of deposits and securities.

Certificates of Deposit

Certificates of deposit (CDs) Differ from other savings instruments in that CD funds (except for CDs purchased through brokerage firms) must remain on deposit for a specified period, which can range from 7 days to as long as 7 or more years. Although it is possible to withdraw funds prior to maturity, an interest penalty usually makes withdrawal somewhat costly. Although the bank or other depository institution is free to charge whatever penalty it likes, most require forfeiture of some interest. Since October of 1983, banks S&Ls, and other depository institutions have been free to offer any rate and maturity CD they wish. As a result, a wide variety of CDs are offered by most banks, depository institutions, and other financial institutions such as brokerage firms. Most pay higher rates for larger deposits and longer periods of time. CDs are convenient to buy and hold because they offer attractive and highly competitive yields plus federal deposit insurance protection.

U.S. Treasury Bills

The U.S. Treasury bill (T-bill) is considered the ultimate safe haven for savings and investments. T-bills are issued by the U.S. Treasury as part of its ongoing process of funding the national debt. They are sold on a discount basis in minimum denominations of $1,000 and are issued with three month (13-week) or 6-month (26-week) maturities. The bills  are auctioned off every Monday. Backed by the full faith and credit of the U.S. government, T-bills pay an attractive and safe return that is free from state and local income taxes.

T-bills are almost as liquid as cash because they can be sold at any time (in a very active secondary market) without any interest penalty. However, should you have to sell before maturity, you may lose some money on your investment if interest rates have risen, and you will have to pay a broker's fee as well. Treasury bills pay interest on a discount basis and thus are different from other savings or short-term investment vehicles---that is, their interest is equal to the difference between the purchase price paid and their earned value at maturity. For example, if you paid $980 for a bill that will be worth $1,000 at maturity, you will earn $20 in interest ($1,000 - $980).

An individual investor may purchase T-bills directly by participating in the weekly Treasury auctions or indirectly through a commercial bank or a security dealer who buys bills for investors on a commission basis. In addition, T-bills may now be purchased over the Internet or by using a touch-tone phone (call 800-722-2678 and follow the interactive menu to complete transactions).

smart.sites At the T-bill page of the Bureau of the Public Debt Online, www.publicdebt.treas.gov/sec/sec.htm, you can learn about T-bills and then buy them online.

Outstanding Treasury bills can also be purchased in the secondary market through banks or dollars. This approach gives the investor a much wider selection of maturities from which to choose, ranging from less than a week to as long as 6 months.

Series EE Bonds

Although issued by the U.S. Treasury on a discount basis, and free of state and local income taxes, Series EE bonds are quite different from T-bills. Savings bonds are accrual-type securities, which means that interest is paid when they are cashed in or before maturity, rather than periodically during their lives. The government does make a 10-year maturity and are available in denominations of $500 to $10,000. Unlike EE bonds, HH bonds are issued at their full face value and pay interest semiannually at the current fixed rate.

Series EE bonds are backed by the full faith and credit of the U.S. government and can be replaced without charge in case of loss, theft, or destruction. You can purchase them at banks or other depository institutions, or through payroll deduction plans. Issued in denominations from $50 through $10,000, their purchase price is a uniform 50 percent of the face amount (thus a $100 bond will cost $50 and be worth $100 at maturity).

The actual maturity date on EE bonds is unspecified because the issues pay a variable rate of interest. The higher the rate of interest being paid, the shorter the time it takes for the bond to accrue from its discounted purchase price to its maturity value. Bonds can be redeemed any time after the first six months (in May and November) and change with prevailing Treasury security market yields. To obtain current rates on Series EE bonds, call your bank, call 800-487-2663, or use the Web link below for the savings bond site.

Smart.sites Everything you always wanted to know about U.S. Savings Bonds---how to buy them, current rates, and a pricing calculator for bonds you own---is at www.savingsbonds.gov.

In addition to being exempt from state and local taxes. Series EE bonds provide their holders with an appealing tax twist: Savers need not report interest earned on their federal tax returns until the bonds are redeemed. Although interest can be reported annually (for example, when the bonds are held in the name of a child who has limited interest income), most investors choose to defer it. A second attractive tax feature allows partial or complete tax avoidance of EE bond earnings when proceeds are used to pay education expenses, such as college tuition, for the bond purchaser, a spouse, or an other IRS defined dependent. 

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 153-155*

end

smart.sites

At the T-bill page of the Bureau of the Public Debt
Online, www.publicdebt.treas.gov/sec/sec.htm, you
can learn about T-bills and then buy them online.

Smart.sites

Everything you always wanted to know about U.S. Savings
Bonds---how to buy them, current rates, and a pricing
calculator for bonds you own---is at
www.savingsbonds.gov.

smart.sites

If you are not satisfied with the CD rate at your local
bank, go to Bankrate.com (www.bankrate.com). You
will find not only the highest rates on CDs and
savings accounts nationwide but also the checking
account and ATM fees at banks in your city.

smart.sites

At the T-bill page of the Bureau of the Public Debt
Online, www.publicdebt.treas.gov/sec/sec.htm, you
can learn about T-bills and then buy them online.

Smart.sites

Everything you always wanted to know about U.S. Savings
Bonds---how to buy them, current rates, and a pricing
calculator for bonds you own---is at
www.savingsbonds.gov.

Personal Financial Planning: An "How-To" Guide (part 21)

Establishing a Savings Budget

by

Charles Lamson

Most of us understand the value of saving for the future. The act of saving is a deliberate, well thought-out activity designed to preserve the value of money, ensure liquidity, and earn a competitive rate of return. Almost by definition, smart savers are smart investors. They regard saving as more than putting loose change into a piggy bank; rather, they recognize the importance of saving and know that savings must be managed as astutely as any security.

After all, what we normally think of as "savings" is really a form of investment---a short-term, highly liquid investment---that is subject to minimum risk. Establishing and maintaining an ongoing savings program is a vital element of personal financial planning. To get the most from your savings, however, you must understand your savings options and how different savings vehicles pay interest.

Starting Your Savings Program

Careful financial planning dictates that you hold a portion of your assets to meet liquidity needs and accumulate wealth. Although opinions differ as to how much you should keep as liquid reserves, the consensus is that most families have an amount equal to 3 to 6 months of after-tax income. Therefore if you take home $2,000 a month, you should have between $6,000 and $12,000 in liquid reserves. If your employer has a strong salary continuation program covering extended periods of illness, or if you have a sizable line of credit available, the lower figure is probably adequate. If you lack one or both of these, however, the largest amount is more appropriate.

A specific savings plan must be developed to accumulate funds. Saving should be a priority item in your budget, not something that occurs only when income happens to exceed expenditures. Some people manage this by arranging to have savings directly withheld from their paychecks. Not only do direct deposit arrangements help your savings effort, they also enable your funds to earn interest sooner. Or you can transfer funds regularly to other financial institutions such as commercial banks, savings and loans, savings banks, credit unions and even mutual funds. But the key to success is to establish a regular pattern of saving.

You should make it a practice to set aside an amount you can comfortably afford each month, even if it is only $50 to $100 (Keep in mind that $100 monthly deposits earning 4 percent interest will grow to more than $36,500 in 20 years.) Exhibit 1 lists 10 strategies you can use to increase your savings and build a nest egg.

Click to enlarge.

You must also decide which savings products best meet your needs. Many savers prefer to keep their emergency funds in a regular savings or money market deposit at an institution with federal deposit insurance. Although these accounts are safe, convenient, and highly liquid, they tend to pay relatively low rates of interest. Other important considerations include your risk preference, the length of time you can leave your money on deposit, and the level of current and anticipated interest rates.

Suppose that one year from now you plan to use $5,000 of your savings to make the down payment on a new car, and you expect interest rates to drop during that period. You should lock in today's higher rate by purchasing a 1-year certificate of deposit (CD). On the other hand if you are unsure about when you will actually need the funds or believe that interest rates will rise, you are better off with an MMDA (a deposit account that pays interest based on current interest rates in the money markets) or MMMF (a mutual fund that invests in short-term debt instruments such as Treasury bills, commercial paper, and large CDs) because their rates change with market conditions, and you can access your funds at any time without penalty.

Short-term interest rates generally fluctuate more than long-term rates, so it pays to monitor interest rate movements, shop around for the best rates, and place your funds in savings vehicles consistent with your needs. If short-term interest rates drop, you will not be able to reinvest the proceeds from maturing CDs at comparable rates. You will need to reevaluate your savings plans and may choose to move funds into other savings vehicles with higher rates of interest, but greater risk.

Many financial planning experts recommend keeping a minimum of 10 to 25 percent of your investment portfolio in savings-type instruments in addition to 3 to 6 months of liquid reserves. Thus someone with $50,000 in investments should probably have a minimum of $5,000 to $10,000---and possibly more---in such short-term vehicles as MMDAs, MMMFs, or CDs. At times the amount invested in short-term vehicles could far exceed the recommended minimum, approaching 50 percent or more of the portfolio. This generally depends on expected interest rate movements. If interest rates are relatively high, and you expect them to fall, you would invest in long-term vehicles in order to lock in the attractive interest rates. On the other hand, if rates are relatively low and you expect them to rise, you might invest in short-term vehicles so you can more quickly reinvest when rates do rise.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 148-150*

end

Personal Financial Planning: An "How-To" Guide (part 20)

Some Popular Tax Strategies

by

Charles Lamson

Managing your taxes is a year-round activity. Because Congress considers tax law changes throughout the year, you may not know all the applicable regulations until the middle of the year or later. Like other financial goals, tax strategies require review and adjustment when regulations and personal circumstances change.

Tax planning can become very complex at times and may involve rather sophisticated investment strategies. In such cases, especially those involving large amounts of money, you should seek professional help. Many tax strategies are fairly simple and straightforward and can be used by the average middle-income taxpayer. You certainly do not have to be in the top income bracket to enjoy the benefits of many tax-saving ideas and procedures. Series EE bonds are an excellent vehicle for earning tax-deferred income. Some other popular (and fairly simple) tax strategies follow.

There are other strategies that can cut your tax bill. Accelerating or bunching deductions into a single year may permit itemizing deductions. Shifting income from one year to another is one way to cut your tax liability. If you expect to be in the same or a higher income tax bracket this year than you will be next year, defer income until next year and shift expenses to this year so you can accelerate your deductions to reduce taxes this year.

Maximizing Deductions

Review a comprehensive list of possible deductions for ideas, because even small deductions can add up to big tax savings. Accelerate or bunch deductions into one tax year if it will allow you to itemize rather than take the standard deduction. For example, make your fourth quarter estimated state tax payment before December 31 rather than January 15 to deduct it in the current taxable year. Group miscellaneous expenses and schedule nonreimbursed elective medical procedures to fall into one tax year to exceed the required "floor" for deductions. Increase discretionary deductions such as charitable contributions.

Income Shifting

One way of reducing income taxes is to use a technique known as income shifting. Here the taxpayer shifts a portion of his or her income---and thus taxes---to relatives in lower tax brackets. This can be done by creating trusts or custodial accounts or by making outright gifts of income-producing property to family members. For instance, parents with $125,000 of taxable income (28 percent marginal tax rate and $18,000 in corporate bonds paying $2,000 in annual interest might give the bonds to their 15 year-old child---with the understanding that such income is to be used ultimately for the child's college education. The $2,000 would then belong to the child, who would probably have to pay $125 (0.10 x [$2,000 - $750 minimum standard deduction for a dependent]) in taxes on this income, and the parents' taxable income would be reduced by $2,000, reducing their taxes by $560 (0.28 x $2,000).

Unfortunately, this strategy is not as simple as it might at first appear. Under current tax laws, investment income of a minor (under the age of 14) is taxed at the same rate as the parents to the extent that it exceeds $1,500. For example, if a five year old girl received $2,500 from a trust set up for her by her parents, the first $1,500 of that income (subject to a minimum of $750 standard deduction) would be used at the child's rate, and the remaining $1,000 would be subject to the parents' (higher) tax rate. These restrictions do not apply to children (and presumably, with other older relatives, such as elderly parents).

Parents need to be aware that shifting assets into a child's name to save taxes could affect the amount of college financial aid for which the child qualifies. Most financial aid formulas expect students to spend 35 percent of assets held in their own name, compared with only 5.6 percent of the parents' nonretirement assets.

Tax-Free and Tax-Deferred Income

There are some investments that provide tax-free income; in most cases, however, the tax on the income is only deferred (or delayed) to a later day. Although there are not many forms of tax-free investments left today, probably the best example would be the interest income earned on municipal bonds. Such income is free from federal income tax. No matter how much municipal bond interest income you make, you do not have to pay any taxes on it. Income that is tax deferred, in contrast, only delays the payment of taxes to a future date. Until that time arrives, however, tax-deferred investment vehicles allows you to accumulate earnings in a tax-free fashion. A good example of tax-deferred income would be income earned in a traditional IRA.

All the income you earn in your IRA accumulates tax-free. This is a tax-deferred investment, so you will eventually have to pay taxes on these earnings, but not until you start drawing down your account. Roth IRAs, introduced in 1998, provide a way for people with AGI (Adjusted gross income is an individual's total gross income minus specific deductions. Wikipedia) below a given level to contribute after-tax dollars. Not only do earnings grow tax-free, but so do withdrawals if the account has been open for five or more years and the individual is over 59.5. In addition to IRAs, tax-deferred income can also be obtained from other types of pension and retirement plans and annuities.

smart.sites For still more tips and long-term tax planning strategies, head to SmartMoney’s tax guide at www.smartmoney.com/tax/. This well-organized site also features a mini-course on tax basics and articles on a variety of tax topics.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 120-123*

end

smart.sites

For still more tips and long-term tax planning strategies, head to SmartMoney’s tax guide at www.smartmoney.com/tax/. This well-organized site also features a mini-course on tax basics and articles on a variety of tax topics.

Personal Financial Planning: An "How-To" Guide (part 19)

Effective Tax Planning

by

Charles Lamson

By keeping good records and thinking about tax implications of financial transactions, you make tax planning a key ingredient of your overall personal financial planning. The overriding objective of effective tax planning is to maximize total after-tax income by reducing, shifting, and deferring taxes to as low a level as legally possible.

Keep in mind that avoiding taxes is one thing, but evading them is another matter altogether. Do not confuse tax avoidance with tax evasion, which includes such illegal activities as omitting income or overstating deductions. Tax evasion, in effect, involves a failure to fairly and accurately report income or deductions, and, in extreme cases, a failure to pay taxes altogether. Persons found guilty of tax evasion are subject to severe financial penalties and even prison terms. Tax avoidance, in contrast, focuses on reducing taxes in ways that are legal and compatible with the intent of Congress.

Fundamental Objectives of Tax Planning

Tax planning basically involves the use of various instrument vehicles, retirement programs, and estate distribution procedures to (1) reduce, (2) shift, and (3) defer taxes. You can reduce taxes, for instance, by using techniques that create tax deductions or credits, or that receive preferential tax treatment---such as investments that produce depreciation (such as real estate) or that generate tax-free income (such as municipal bonds). You can shift taxes by using gifts or trusts to shift some of your income to other family members who are in lower tax brackets and to whom you intend to provide some level of support anyway, such as a retired, elderly person.

The idea behind deferring taxes is to reduce or eliminate your taxes today by postponing them to some time in the future when you may be in a lower tax bracket. Perhaps more important, deferring taxes gives you use of the money that would otherwise go to taxes---thereby allowing you to invest it to make even more money. Deferring taxes is usually done through various types of retirement plans, such as IRAs, or by investing in certain types of annuities, variable life insurance policies, or even series EE bonds (U.S. savings bonds).

The fundamentals of tax planning include making sure that you take all the deductions to which you are entitled and take full advantage of the various tax provisions that will minimize your tax liability. Thus comprehensive tax planning is an ongoing activity with both an immediate and a long-term perspective. It plays a key role in personal financial planning---in fact, one of the major components of a comprehensive personal financial plan is a summary of the potential tax impacts of various recommended financial strategies. Tax planning is closely interrelated with many financial planning activities, including investment, retirement, and estate planning.

smart.sites To find the latest IRS Revenue rulings, search the database at www.taxlinks.com.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 119-121*

end

smart.sites

To find the latest IRS Revenue rulings, search the database at www.taxlinks.com.

Personal Financial Planning: An "How-To" Guide (part 18)

Estimates, Extensions, and Amendments

by

Charles Lamson

You may need to file a declaration of estimated taxes with your return and to pay taxes on a quarterly basis. Or perhaps you are unable to meet the normal April 15 filing deadline or need to correct a previously filed return. Let's look at the procedures for handling these situations.

Estimated Taxes

Because federal withholding taxes are regularly taken only from employment income, such as that paid in the form of wages or salaries, the IRS requires certain people to pay estimated taxes on income earned from other sources. This requirement allows the principle of "pay as you go" to be applied not only to employment income subject to withholding but also to other sources of income. The quarterly payment of estimated taxes is most commonly required of investors, consultants, lawyers, business owners, and various other professionals who are likely to receive income in a form that is not subject to withholding. Generally, if all your income is subject to withholding, you probably do not need to make estimated tax payments.

If you meet certain IRS requirements with regard to your tax liability and withholding, you must file a declaration of estimated taxes (Form 1040-ES) and make estimated tax payments. When the total of tax withheld and estimated payments does not meet IRS guidelines, you must pay estimated taxes consistent with the actual income earned in the immediately preceding quarter to avoid penalties. The estimated tax form packet includes a worksheet to calculate your estimated tax liability for the coming year. Each estimated tax payment equals the tax payable on income earned in the preceding quarter, or one-fourth of the total amount paid in taxes during the immediately preceding year, or one-fourth of the total amount paid in taxes during the immediately preceding year, less the amount of tax withheld during  the preceding quarter. For example, after making a preliminary calculation, Terry Becker estimated that he would owe about $500 for the year 2016 on his additional income. Exhibit 1 shows the form that Terry Becker submitted on September 15, 2016 with his estimated tax payment for the preceding quarter---$125, or one-quarter of $500.

The declaration of estimated taxes is normally filed with the tax return. Estimated taxes must be paid in fourth quarterly installments on April 15, June 15, and September 15 of the current year, and January 15 of the following year. Failure to estimate and pay these taxes in accordance with IRS guidelines can result in a penalty levied by the IRS.

April 15: Filing Deadline

At the end of each tax year, those taxpayers required to file a return must determine the amount of their tax liability---the amount of taxes that they owe as a result of the past year's activities. The tax year corresponds to the calendar year and covers the period January 1 through December 31. Taxpayers may file their returns any time after the end of the tax year and must file no later than April 15 of the year immediately following the tax year (or by the first business day after that date if it falls on a weekend or federal holiday). Taxpayers who file Form 1040EZ can file their returns by touch-tone phone using TeleFile.  (Qualifying taxpayers receive special TeleFile tax packages.) If you have a computer, a modem and tax preparation software, you can probably use the IRS's e-file and e-pay to file your return and pay your taxes electronically, using either a credit card or authorizing an electronic withdrawal from your checking or savings account. You can use an e-file provider, who may charge a fee to file on your behalf, or do it yourself using commercial or tax preparation software.

Depending on whether the total of taxes withheld and any estimated tax payments is greater or less than the computed tax liability, the taxpayer either receives a refund or has to pay additional taxes. For example, assume that you had $2,000 withheld and paid estimated taxes of $1,200 during the year. After filling out the appropriate tax forms you find your tax liability is only $2,800. In this case, you have overpaid your taxes by $400 ($2,000 + $1,200 - $2,800) and will receive a $400 refund from the IRS. On the other hand, if your tax liability had amounted to $4,000, you would owe the IRS an additional $800 ($4,000 - $2,000 - $1,200). Taxpayers can pay their taxes using a credit card, however, because the IRS cannot pay credit card companies an issuing fee, taxpayers must call a special provider and pay a service charge to arrange for the payment.

smart.sites It is easy to file and pay your taxes online, as you'll learn when you visit Link2Gov’s Pay 1040 Web site, www.pay1040.com.

Filing Extensions and Amended Returns

It is possible to receive an extension of time for filing your federal tax return. You can apply for an automatic 4-month filing extension, which makes the due date August 15, simply by submitting form 4868. In filing for an extension, however, the taxpayer must estimate the taxes due and remit that amount with the application. The extension does not give taxpayers more time to pay their taxes. Taxpayers can also request additional extensions beyond the 4-month automatic extension, but the IRS will review reasons for the request to decide whether to grant the extension.

After filing a return, you may discover that you overlooked some income or a major deduction or made a mistake, and, as a result, paid too little or too much in taxes. You can easily correct this by filing an amended return (Form 1040X) that shows the corrected amount of  income or deductions and the amount of taxes you should have paid, along with the amount of any tax refund or additional taxes owed. You generally have 3 years from the date you file your original return or 2 years from the date you paid the taxes, whichever is later, to file an amended return. If you prepare and file your amended return properly and it reflects nothing out of the ordinary, it generally will not trigger an audit. 

*SOURCE: PERSONAL FINANCIAL PLANNING, 10th ed., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 112-114*

end

smart.sites

It is easy to file and pay your taxes online, as you'll
learn when you visit Link2Gov’s Pay 1040 Web
site, www.pay1040.com.

Personal Financial Planning: An "How-To" Guide (part 17)

Taxable Income

by

Charles Lamson

Paying your income taxes is a complex process involving several steps and many calculations. Exhibit 1 (below) depicts the procedure to compute your taxable income and subsequent tax liability. It looks simple enough---just subtract certain adjustments from your gross income to get your adjusted gross income, then subtract either the standard deduction or your itemized deductions and your total personal exemptions to get taxable income, and finally subtract your taxes and any tax credits from that amount and add any other taxes to it. This is not as easy as it sounds, however! Various sections of the Internal Revenue Code place numerous conditions and exceptions on the tax treatment and deductibility of certain income and expense items and define certain types of income as tax-exempt. As we will see, a number of problems can arise in defining what you may subtract.

Gross Income

Basically, gross income includes any and all income subject to federal taxes. Some of the more common forms of gross income include:

• Wages and salaries
• Bonuses, commissions, and tips
• Interest and dividends received
• Alimony received
• Business and farm income
• Gains from the sale of assets
• Income from pensions and annuities
• Income from rents and partnerships
• Prizes, lottery, and gambling winnings

In addition to these sources of income, some types of income are considered tax exempt and as such are excluded---totally or partially---from gross income. Tax-exempt income does not even have to be listed on the tax return. Common types of tax-exempt income include child support payments, certain types of employee fringe benefits, compensation for accident, health, and life insurance policies, federal income tax refunds, gifts, inheritances, scholarships, and fellowships (limited as to amount and time), and veterans' benefits.

Three Kinds of Income

Individual income falls into one of three basic categories of income:

• Active income: Income earned on the job such as wages and salaries, bonuses and tips; most other forms of noninvestment income, including pension income and alimony
• Portfolio income: Earnings (interest, dividends, and capital gains [profits on the sale of investments]) generated from most types of investment holdings; includes savings accounts, stocks, bonds, mutual funds, options, and futures
• Passive income: A special category of income that includes income derived from real estate, limited partnerships, and other forms of tax shelters

These categories limit the amount of deductions and write-offs that taxpayers can take. Specifically, the amount of allowable, deductible expenses associated with portfolio and passive income is limited to the amount of income derived from these two sources. For example, if you had a total of $380 in portfolio income for the year, you could write off no more than $380 in portfolio-related interest expense. Note, however, that if you have more portfolio expenses than income, you can "accumulate" the difference and write it off in later years (when you have sufficient portfolio income) or when you finally sell the investment.

For deduction purposes, you cannot mix or combine portfolio and passive income with each other or with active income. Investment-related expenses can be used only with portfolio income, and with a few exceptions, passive investment expenses can be used only to offset the income from passive investments. All the other allowances and deductions are written off against the total amount of active income the taxpayer generates.

Capital Gains

Technically, a capital gain occurs whenever an asset (such as a stock, a bond, or real estate) is sold for more than its original cost. Thus, if you purchased stock for $50 per share and sold it for $60, you would have a capital gain of $10 per share.

Capital gains are taxed at different rates, depending on the holding period. As a rule, taxpayers include most capital gains as part of portfolio income. They will add any capital gains to the amount of dividends, interest, and rents they generate to arrive at total investment income.

Although there are no limits on the amount of capital gains taxpayers can generate, the IRS imposes some restrictions on the amount of capital losses taxpayers can take in a given year. Specifically, a taxpayer can write off capital losses, dollar for dollar, against any capital gains. For example, a taxpayer with $10,000 in capital gains can write off up to $10,000 in capital losses. After that, he or she can write off a maximum of $3,000 in additional capital losses against other (active, earned) income. Thus, if the taxpayer in our example had $18,000 in capital losses in 2017, only $13,000 could be written off on 2017 taxes: $10,000 against the capital gains generated in 2017 and another $3,000 against active income. The remainder---$5,000 in this case---will have to be written off in later years, in the same order as indicated above: first against any capital gains and then up to $3,000 against active income. (Note: To qualify as a deductible item, the capital loss must result from the sale of some income-producing asset, such as stocks and bonds. The capital loss on non-income producing assets, such as a car or TV set, does not qualify for tax relief.)

Smart.sites The Guide to Capital Gains and Losses, www.fairmark.com/buystock/index.htm, can help you understand the tax treatment of securities sales. It is just one of many tax guides you will find at the site’s Tax Guide for Investors.

Selling Your Home: A Special Case

Homeowners, for a variety of reasons, receive special treatment in the tax codes, including the taxation of capital gains on the sale of a home. The Taxpayer Relief Act of 1997 made most home sales tax free. Under that law, single taxpayers can exclude from income the first $250,000 of gain on the sale of a principal residence for at least 2 of the 5 years prior to the sale. For example, the Greenmans (married taxpayers) just sold their principal residence for $475,000. They had purchased their home 4 years earlier for $325,000. They may exclude their $150,000 gain ($475,000 - $325,000) from their income because they occupied the residence for more than 2 years, and the gain is less than $500,000.

This exclusion is available on only one sale every 2 years. A loss on the sale of a principal residence is not deductible. Generally speaking, this law is quite favorable to homeowners.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED.,  2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 

END

Smart.sites

The Guide to Capital Gains and Losses,
www.fairmark.com/buystock/index.htm, can help
you understand the tax treatment of securities sales.
It is just one of many tax guides you will find at the
site’s Tax Guide for Investors.