Personal Finance Course for High School Graduates
Tax Basics (“Basics of taxes, why they matter”)
Objectives: Students will develop a comprehensive understanding of the taxation system,
specifically focusing on how various taxes affect individual and business financial situations.
This specialized knowledge enables strategic financial decision-making and efficient tax
planning.
In this session, students will learn:
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Fundamentals of the tax system and its significant impact on personal financial management
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Core aspects of tax filing, emphasizing the strategic use of deductions and credits to minimize tax liability
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The mechanics of tax filing, including recognizing common forms and terminology
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The significance of understanding taxes in personal financial management
Vocabulary: Income Tax, W-2, Payroll Tax, Tax Deduction, Tax Credit, Retirement Accounts
401(k), IRA
Concepts: Understanding taxes, basics of filing taxes, common deductions and credits
1. Understanding Taxes: The Basics
Taxes are required payments made by individuals and businesses to the government. These contributions fund public goods and services, such as education, healthcare, infrastructure, and national defense. Understanding how taxes work is crucial for managing personal finances effectively and complying with legal obligations.
1.1 Fundamentals of the Tax System
The US tax system comprises various types of taxes, each with its specific purpose and rules. Here are the key types of taxes you need to know:
Income tax is a tax on the money you earn from various sources such as wages, salaries, tips, interest, dividends, and investments. The federal government, most state governments, and some local governments impose income taxes. Income taxes are typically progressive, meaning the tax rate increases as your income increases. The federal income tax system uses tax brackets, which are ranges of income taxed at specific rates. For example, in 2024, the federal tax brackets for single filers range from 10% to 37%, depending on income levels.
The W-2 form, also known as the Wage and Tax Statement, is provided by your employer at the end of each year. This form shows how much money you earned and how much tax was taken out of your paycheck. You need your W-2 form to complete your federal and state tax returns. It ensures you accurately report your earnings and the taxes already paid throughout the year.
The W-2 form includes:
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Total wages, tips, and other compensation
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Federal income tax withheld
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Social Security tax withheld
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Medicare tax withheld
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State and local income tax withheld (if applicable)
Payroll taxes are taxes imposed on employers and employees to fund Social Security and Medicare programs. These taxes are automatically deducted from your paycheck. Payroll taxes are crucial for maintaining the Social Security and Medicare systems, which provide benefits to retirees, disabled individuals, and survivors.
The key components of payroll taxes are:
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Social Security Tax: In 2024, the Social Security tax rate is 6.2% for employees and employers, each contributing this percentage of the employee's wages up to a certain limit (the wage base limit).
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Medicare Tax: The Medicare tax rate is 1.45% for employees and employers, with no wage base limit. High-income earners may pay an additional Medicare tax.
2. Core Aspects of Tax Filing
Filing taxes involves reporting your income and taxes paid to the government. It can seem daunting, but understanding the basics simplifies the process. This involves accurately reporting your income, understanding which deductions and credits apply to you, and timely submission of tax returns to avoid penalties. Common forms involved include the W-2 for employed individuals and various other forms depending on one’s financial activities throughout the year.
Tax Deductions and Tax Credits are critical elements in reducing one’s taxable income and tax liability, respectively. Deductions lower your overall taxable income, while credits directly decrease the amount of tax owed, dollar for dollar. Understanding these can significantly affect one’s financial health by reducing the overall tax burden.
2.1 Tax Deduction
A tax deduction reduces the amount of income that is subject to tax, thereby lowering your overall tax liability. Common tax deductions include:
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Standard Deduction: A fixed dollar amount that reduces the income on which you are taxed. For 2024, the standard deduction is $12,950 for single filers and $25,900 for married couples filing jointly.
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Itemized Deductions: Specific expenses that you can deduct from your income, such as mortgage interest, state and local taxes, medical expenses, and charitable contributions. You can choose between the standard deduction and itemizing deductions based on which option lowers your tax bill more.
2.2 Tax Credit
A tax credit directly reduces the amount of tax you owe. Unlike deductions, which reduce taxable income, tax credits provide a dollar-for-dollar reduction in your tax liability. Common tax credits include:
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Earned Income Tax Credit (EITC): A refundable credit for low- to moderate-income working individuals and families, particularly those with children. The amount of the credit varies based on income and the number of qualifying children.
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Child Tax Credit (CTC): A credit for parents or guardians with qualifying children under 17 years old. In 2024, the credit amount is up to $2,000 per child. Part of the credit may be refundable, depending on the taxpayer's income.
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Education Credits: Credits such as the American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC) help offset the costs of higher education.
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American Opportunity Tax Credit (AOTC): Worth up to $2,500 per eligible student for the first four years of higher education. Up to 40% of the credit is refundable, meaning you can receive up to $1,000 even if you owe no taxes.
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Lifetime Learning Credit (LLC): Worth up to $2,000 per tax return for tuition and related expenses for any level of postsecondary education, with no limit on the number of years it can be claimed.
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These credits can significantly reduce your tax burden, making them valuable tools in managing your personal finances.
Clear it up: Filing Your First Tax Return
Consider Emily, a recent college graduate who has just started her first full-time job. Her employer issues a W-2 form at the end of the year showing her annual earnings and the taxes withheld. Emily learns about various deductions for which she qualifies, such as student loan interest deduction and potentially the Lifetime Learning Credit for her part-time graduate studies. By applying these deductions and credits, she can reduce her taxable income and, subsequently, her tax liability, making her first experience with tax filing less overwhelming and more financially beneficial.
Emily’s Tax Filing Information
W-2 Form Details:
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Annual earnings: $45,000
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Federal income tax withheld: $5,000
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Social Security tax withheld: $2,790
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Medicare tax withheld: $652.50
Deductions:
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Standard deduction for single filers in 2024: $12,950
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Student loan interest deduction: $1,500
Tax Credits:
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Lifetime Learning Credit: $1,000 (for part-time graduate studies)
Steps to File Emily’s Tax Return
Step 1: Calculate Adjusted Gross Income (AGI)
Annual earnings: $45,000
Subtract student loan interest deduction: $45,000 - $1,500 = $43,500
AGI: $43,500
Step 2: Apply Standard Deduction
AGI: $43,500
Subtract standard deduction: $43,500 - $12,950 = $30,550
Taxable income: $30,550
Step 3: Calculate Tax Liability
Use the IRS tax tables to find the tax owed on $30,550. For simplicity, let’s assume the tax rate is 12% for this income bracket.
Tax owed: $30,550 * 12% = $3,666
Step 4: Apply Tax Credits
Subtract Lifetime Learning Credit: $3,666 - $1,000 = $2,666
Final tax liability: $2,666
Step 5: Determine Refund or Amount Owed
Federal income tax withheld: $5,000
Final tax liability: $2,666
Refund: $5,000 - $2,666 = $2,334
Summary
Emily’s taxable income after deductions is $30,550. Her tax owed before credits is $3,666. After applying the Lifetime Learning Credit, her final tax liability is $2,666. Since her employer withheld $5,000 in federal income tax, Emily will receive a refund of $2,334. This practice example helps illustrate the basic process of filing a tax return, applying deductions and credits, and determining the final tax liability or refund.
3. The Role of Taxes in Financial Planning
Understanding the impact of taxes on personal finance is crucial. Effective tax planning involves foreseeing tax liabilities, understanding how different financial decisions will impact taxes, and using legal avenues to minimize tax obligations. This strategic approach ensures more of one’s earnings are directed towards savings and investments rather than tax payments.
3.1 Importance of Tax Planning
Tax planning is an essential component of financial planning. It involves analyzing your financial situation from a tax perspective to ensure tax efficiency. The primary objectives of tax planning include:
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Minimizing Tax Liability: Legally reducing the amount of tax you owe by taking advantage of deductions, credits, and tax-advantaged accounts. This can include contributing to retirement accounts, making charitable donations, and deducting mortgage interest.
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Maximizing After-Tax Income: Ensuring you retain the maximum amount of your income by minimizing taxes. This involves making strategic financial decisions that reduce taxable income and optimize the use of tax credits.
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Deferring Taxes: Delaying the payment of taxes to future periods allows your investments to grow tax-deferred. This can be achieved by contributing to retirement accounts such as 401(k)s or IRAs, where the taxes on contributions and earnings are deferred until withdrawal.
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Avoiding Penalties: Ensuring compliance with tax laws to avoid fines and penalties for late or incorrect filings. This includes timely filing of tax returns and making estimated tax payments if necessary.
3.2 Strategies for Effective Tax Planning
Effective tax planning involves several strategies, including:
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Income Shifting: Legally shifting income from a high-tax year to a lower-tax year or from a high-income earner to a lower-income earner in the family to reduce the overall tax burden. This can involve strategies such as:
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Gifting: Transferring income-producing assets to family members in lower tax brackets.
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Timing Income: Deferring or accelerating income and expenses to manage tax brackets.
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Family Employment: Employing family members in your business to shift income to their lower tax brackets.
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Tax-Advantaged Accounts: Utilizing accounts that offer tax benefits, such as:
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Traditional 401(k): Employer-sponsored retirement plan allowing pre-tax contributions, reducing taxable income now, and deferring taxes until withdrawal.
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Roth 401(k): Contributions are made with after-tax dollars, meaning no immediate tax benefit, but withdrawals during retirement are tax-free.
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Traditional IRA: Similar to a traditional 401(k), contributions may be tax-deductible, but withdrawals are taxed as income.
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Roth IRA: Contributions are made after-tax, and qualified withdrawals are tax-free.
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Health Savings Accounts (HSAs): Contributions are tax-deductible, and withdrawals for medical expenses are tax-free.
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529 College Savings Plans: Contributions grow tax-deferred, and withdrawals for qualified education expenses are tax-free.
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Deductions and Credits: Maximizing eligible deductions and credits can significantly reduce your taxable income and tax liability. Common deductions include mortgage interest, student loan interest, and medical expenses. Credits, such as the Earned Income Tax Credit (EITC), Child Tax Credit (CTC), and education credits (AOTC and LLC), directly reduce the amount of tax owed.
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Capital Gains Management: Timing the sale of investments to take advantage of lower long-term capital gains tax rates and offsetting gains with losses to reduce taxable income. Holding investments for more than a year can result in lower tax rates on gains compared to short-term holdings.
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Retirement Planning: Choosing the right retirement accounts and planning contributions and withdrawals to optimize tax benefits. This includes understanding the tax implications of different retirement accounts and strategically planning contributions to minimize current taxes and withdrawals to minimize taxes in retirement.
Clear it up: Tom’s Tax-Efficient Retirement Plan
Tom, nearing retirement, decides to review his financial plans to ensure a stable financial future. By understanding various retirement accounts and their tax implications, Tom strategically plans his contributions to benefit from tax deductions now and ensure tax-efficient withdrawal options during retirement, thereby maximizing his financial resources in his golden years.
Current Income and Contributions
Annual Salary: $100,000
Contribution to Traditional 401(k): $19,500 (plus $6,500 catch-up contribution for those over 50)
Contribution to Roth IRA: $7,000 (maximum allowed for those over 50)
Tax Benefits Now
Traditional 401(k) Contributions: $26,000
Reduces taxable income from $100,000 to $74,000
Assuming a 24% tax bracket, the immediate tax savings: $26,000 * 24% = $6,240
Retirement Savings Growth
Traditional 401(k) Growth:
Starting Balance: $0 (for simplicity)
Annual Contribution: $26,000
Average Annual Return: 6%
Duration: 10 years until retirement
Using a compound interest formula: Future Value = P * [(1 + r/n)^(nt) - 1] / (r/n)
Future Value ≈ $26,000 * [((1 + 0.06)^10 - 1) / 0.06] ≈ $358,913
Roth IRA Growth:
Starting Balance: $0
Annual Contribution: $7,000
Average Annual Return: 6%
Duration: 10 years until retirement
Future Value ≈ $7,000 * [((1 + 0.06)^10 - 1) / 0.06] ≈ $95,400
Withdrawals in Retirement
Traditional 401(k):
Balance at Retirement: $358,913
Withdrawals taxed at retirement (assuming 22% tax bracket): $358,913 * 22% ≈ $78,301 in taxes
Roth IRA:
Balance at Retirement: $95,400
Withdrawals are tax-free
Comparing Scenarios
Without tax-efficient planning:
No contributions to 401(k) or Roth IRA
No tax savings now
No growth in retirement accounts
Total taxes paid on $100,000 salary: $100,000 * 24% = $24,000 per year
Over 10 years: $24,000 * 10 = $240,000
With tax-efficient planning:
Total taxes paid on reduced salary (due to 401(k) contributions): $74,000 * 24% = $17,760 per year
Over 10 years: $17,760 * 10 = $177,600
Tax savings over 10 years: $240,000 - $177,600 = $62,400
Tax savings on withdrawals: Traditional 401(k) taxes ($78,301) compared to potential higher taxes without planning
Summary
By strategically planning his retirement contributions and withdrawals, Tom saves $62,400 in taxes during his working years and benefits from tax-efficient withdrawals in retirement. His 401(k) grows to $358,913, and his Roth IRA grows to $95,400, providing a substantial tax-free income source. This example shows the significant impact of tax-efficient retirement planning, highlighting the benefits of reducing current taxable income and optimizing future tax liabilities.