Personal Finance and Tax Management - Research Paper Example

Personal Finance------------------------ Tax Management Introduction Personal finance planning is the process of managing one’s finance in a way so as to achieve individual’s financial objectives. Personal finance management is the important thing to do because it enables individual’s earnings to benefit him for a very long time and in a desired way. Individuals pursue financial objectives that include maximizing wealth in the future, to be capable of repaying debts and pursuing a sound retirement plan. Such financial goals are driven by individual’s income. Income management in a way so as to minimize deductions from it is thus the integral to support the financial plans. Taxes are the compulsory charges against the income. Taxes are charged as per tax laws and these laws include provisions whose right understanding can lead to minimization of tax liability. This report will discuss the ways in which taxes on incomes can be minimized to leave individual with maximum possible take-home-pay to support his/her financial plans. This report will discuss tax management issues in the perspective of United States’ tax laws. Tax Administration, Nature of Taxes and Tax planning US citizens pay the largest amount of tax on incomes (Garman, 1999). In US the Internal Revenue Service (IRS) is responsible to collect tax on personal income of US citizens. The tax is collected as per the rules of ‘Internal Revenue Code’. The nature of US income tax is progressive which implies that higher tax would be charged from high income recipients and vice-versa. In progressive taxation system higher marginal portions of the income are charged to tax at higher rate. There are two ways in which U.S citizens discharge their tax liability. One method is tax ‘withholding by employer’. Employer deducts a specific amount on account of employee’s tax liability from its paycheck. Employer adjusts any allowable deductions when determining the amount of tax to be deducted from employee paycheck. Employer then pays that amount of tax on behalf of employee in government account. Another method is ‘Tax Estimation’ by the individual. Individuals, who are self-employed or work for the employers who are not required to withhold tax, estimate their tax liability based on their estimated earnings for the year. Tax is paid in four quarterly installments of April 15, June 15, September 15 and January 15. Rationales behind avoiding tax or minimizing it Paying tax involves the opportunity cost of forgoing some consumption that could have possibly satisfied a want. Moreover the substantial amount of money given in taxes also involves a loss of possible investment of that money in some venture that earns an interest. Hence if tax liability can be reduced legally, it is likely to benefit tremendously individual in terms of higher income to support his/her financial objectives. Ways to legally minimize tax liability 1. Reduction in taxable income If taxable income is somehow reduced it would result into lesser tax liability for an individual. There are various provisions that can make taxable income reduced. One such provision is the deduction allowed on account of contribution to IRS approved health premium plan. Under this plan employee pays a certain amount for heath benefit premium. This amount is deductible from income when calculating the taxable income. Hence such amount avoids income tax, social security and Medicare. ‘Flexible spending accounts’ is another tax shelter offered by employer. In this case employee is supposed to make contributions into government approved medical or dependent care reimbursements accounts. Such amounts are deducted when calculating taxable income and hence avoid any charge on account of income tax, Medicare or social security. 2. Tax-sheltering returns on investment Congress permits several investments whose return is exempted from tax either or such investment, in some way, cause reduction in tax liability. Such tax-shelter is provided specifically to encourage investment in certain industry. Either income in such ventures is allowed to grow with no taxes on them or there is another way of reducing tax through such investment by providing direct deduction or credit against such investments. Interest on investment in the municipal bonds and types of money market that exclusively invest in the municipal bonds is exempt from tax. Hence tax liability is 0 on returns from such investment. 3. Splitting or shifting the income Couples in U.S, when both of them earn, are supposed to pay tax on their joint-income. In such cases and others where the incomes of individuals fall into higher tax bracket and become subject to higher tax rate, a strategy to split or shift the income would result in reduced tax liability. One possible way to shift the income is to give gifts. IRS code provides the tax exemption to the giver of gift up to a certain amount and also the receiver is not charged any amount of tax on the value of goods. The gift may be given to close family members. Income may also be shifted if the taxable property is given as gift to minor. When minor sells it at the age of 14 then its gains would be taxed on the basis of child rate. Establishing trusts, making gifts for the purpose of education, medical and tuition etc are but the few ways that enable the shifting of income and consequently reduction in the tax liability. 4. Bunch deduction and postponement of income Bunch deduction refers to the deductions for the future periods. There could possibly be years in which individual has fewer deductions against its taxable income that may result into his/her income falling in the higher tax bracket. In such situations individual may pay some future expenses in prepay to claim deduction from the taxable income to lower the tax liability. Individual’s income may also fall into higher tax bracket with some income to be received at the end of the year. In such situations if the receipt of income is deferred to future period it will result in lower tax liability in the current period. Conclusion Income tax is the largest charge against individual’s income. Higher income tax means lower take-home pay. Individuals can support their financial objectives by their income. Lower income is likely to result in failure of achievement of the financial objectives because of inadequate financial support to them. Hence managing income in a way so as to reduce the tax liability on income is the key issue in personal finance. Internal Revenue Code prescribes certain tax-sheltering and tax-exempting provisions whose understanding and application in practical life could result into the lawful reduction in tax liability. To mention a few, tax liability can be reduced if the sufficient arrangements to reduce the taxable income are made. These may include making expenditure from pre-tax dollars and claiming their deduction from taxable income. Investment into the ventures that provide the tax-free returns is another provision to avoid taxes lawfully. Moreover splitting the income or shifting it in different ways could result in lower tax liability. One such way to shift income is to give gifts which are not taxable as per IRC code up to a certain limit. In addition to this arranging for bunch deductions and postponement of income is likely to reduce the tax liability. Besides the tax-reduction strategies mentioned in this report, there are also various other flexibilities prescribed in IRC Code whose understanding and prudent application in personal life will result in lower taxes on incomes in absolutely legal way. A properly managed tax is a key to successful financial planning that will result in the achievement of personal financial objectives of individual. References 1. Garman, E Thomas. (1999). Personal finance. Houghton Mifflin Harcourt. 2. 2011 Federal Income Tax Brackets, Rates and Taxable Income Thresholds. http://www.savingtoinvest.com/2010/04/2010-and-2011-tax-brackets-new.html, retrieved on October 27, 2011. Read More