Chapter 3 Review

February 27, 2008

Objectives

In this chapter, you will learn to:

1. Identify the major taxes paid by people in our society.

2. Calculate taxable income and the amount owed for federal income tax.

3. Prepare a federal income tax return.

4. Select appropriate tax strategies for various life situations.

Concept Check 3-1

1. What are the four major categories of taxes?Taxes on purchases

sales taxexcise tax (sin tax)

Taxes on propertyreal estate taxpersonal property tax

Taxes on wealthestate taxinheritance tax

Taxes on incomeincome taxSocial security tax

Concept Check 3-1

2. For each of the following situations, list the type of tax that is being described.

a. A tax on the value of a person’s house. property tax

b. The additional charge for gasoline and air travel.excise tax

c. Payroll deductions for federal government retirement benefits.social security tax

d. Amount owed on property received from a deceased person.inheritance tax

e. Payroll deductions for a direct tax on earningsincome tax

Concept Check 3-2

1. How does tax-exempt income differ from tax-deferred income?

Exclusions may also be referred to as tax-exempt income, or income that is not subject to tax. For example, interest earned on most state and city bonds is exempt from federal income tax. Tax-deferred income is income that will be taxed at a later date.

2. When would you use the standard deduction instead of itemized deductions?

You would use a standard deduction if your itemized deduction is less than the standard deduction.

3. What is the difference between your marginal tax rate and your average tax rate?

Marginal tax rates are used to calculate tax on the last (and next) dollar of taxable income. average tax rate is based on the total tax due divided by taxable income.

Concept Check 3-2

4. For each of the following, indicate if the item is a tax deduction or a tax credit.

a. State personal income taxes paid

deduction

b. Charitable donations

deduction

c. Child care costs

credit

d. Moving expenses

deduction

Concept Check 3-3

1. In what ways does your filing status affect preparation of your federal income tax return?

Every citizen or resident of the United States and every U.S. citizen who is a resident of Puerto Rico is required to file a federal income tax return if his or her income is above a certain amount. The amount is based on the person’s filing status and other factors such as age.

2. What are the main sources available to help people prepare their taxes?

The IRS, tax publications, the internet, tax preparation services

Concept Check 3-3

3. What actions can reduce the chances of an IRS audit?

• Organize all tax-related information for easy access.

• Follow instructions carefully. • Use the proper tax rate schedule or tax table column.

• Be sure to claim the correct number of exemptions and correct amounts of standard deductions.

• Check your arithmetic several times.• Sign your return (both spouses must sign a joint

return), or the IRS won’t process it. Be sure to include the correct Social Security number(s) and to record amounts on the correct lines.

continued

• Attach necessary documentation such as your W-2 forms and required supporting schedules.

• Make the check payable to “U.S. Treasury.” Put your Social Security number, the tax year, and a daytime telephone number on your check—and be sure to sign the check!

• Keep a photocopy of your return.

• Put the proper postage on your mailing envelope.

• Finally, check everything again—and file on time! Care taken when you file your income tax can result in “many happy returns.”

Concept Check 3-3

4. Which 1040 form should each of the following individuals use?

a. A high school student with an after-school job and interest earnings of $480 from savings accounts.

1040A

b. A college student who, because of ownership of property, is able to itemize deductions rather than take the standard deduction.

1040

c. A young, entry-level worker with no dependents and income only from salary.

1040EZ

Concept Check 3-4

1. How does tax avoidance differ from tax evasion?Tax avoidance is the use of legitimate methods to

reduce one’s taxes.Tax evasion is the use of illegal actions to reduce one’s

taxes.2. What common tax-saving methods are available

to most individuals and households?Consumer purchasing (place of residence, consumer debt, job-related expenses)Investment decisions (tax-exempt, tax-deferred, self-employment, children’s investments)Retirement plans (IRA, Roth IRA, Keogh plan, Education IRA, 401 (K))

Concept Check 3-4

3. For the following tax situations, indicate if this item refers to tax-exempt income or tax-deferred income.

a. Interest earned on municipal bonds

tax exempt

b. Earnings on an individual retirement account

tax deferred

c. Education IRA earnings used for college expenses

tax exempt

d. Income of U.S. citizens working in another country

tax exempt

Vocabulary

• adjusted gross income (AGI): Gross income reduced by certain adjustments, such as contributions to an individual retirement (IRA) and alimony payments.

• average tax rate: Total tax due divided by taxable income.• capital gains: Profits from the sale of a capital asset such

as stocks, bonds, or real estate.• earned income: Money received for personal effort, such

as wages, salary, commission, fees, tips, or bonuses.• estate tax: A tax imposed on the value of a person’s

property at the time of death.• excise tax: A tax imposed on specific goods and services,

such as gasoline, cigarettes, alcoholic beverages, tires,and air travel.

More vocabulary

• exclusion: An amount not included in gross income.• exemption: A deduction from adjusted gross income for

yourself, your spouse, and qualified dependents.• inheritance tax: A tax levied on the value of property

bequeathed by a deceased person• investment income: Money received in the form of

dividends, interest, or rent from investments; also called portfolio income.

• itemized deductions: Expenses that can be deducted from adjusted gross income, such as medical expenses, real estate property taxes, home mortgage interest, charitable contributions, casualty losses, and certain work-related expenses.

Even more

• marginal tax rate: The rate used to calculate tax on the last (and next) dollar of taxable income.

• passive income: Income resulting from business activities in which you do not actively participate.

• standard deduction: A set amount on which no taxes are paid.

• taxable income: The net amount of income, after allowable deductions, on which income tax is computed.

• tax audit: A detailed examination of your tax return by the Internal Revenue Service.

And one last page…

• tax avoidance: The use of legitimate methods to reduce one’s taxes.

• tax credit: An amount subtracted directly from the amount of taxes owed.

• tax deduction: An amount subtracted from adjusted gross income to arrive at taxable income.

• tax-deferred income: Income that will be taxed at a later date.

• tax evasion: The use of illegal actions to reduce one’s taxes

• tax-exempt income: Income that is not subject to tax.