Test Bank and Solution for Chapter 4_Personal Finance 13th Edition by Garman, Forgue and Johnson

SOLUTIONS MANUAL
CHAPTER 4

Managing Income Taxes
ANSWERS TO CHAPTER CONCEPT CHECKS
LO4.1
1.

A progressive tax is one that takes a higher percentage of income as income goes up. A
regressive tax does the opposite. The federal income tax is a progressive tax. State sales
taxes are often regressive.

2.

Your marginal tax bracket reflects the tax rate applied to your highest dollar of income.
Since any additional income you earn becomes your highest dollar of income, it is taxed
at that marginal rate.

3.

Adding the typical middle-income federal income tax bracket rate of 25% (remember, this
is higher than one’s average rate) to the Social Security rate of 7.65% and a state income
tax rate of 6% and a potential local income tax rate of 2%, you have a possible combined
marginal tax rate of 40.65%.

LO4.2
1.

Five examples of income that must be included in gross income are (1) employment
income from wages, salaries, commissions, and tips; (2) gambling winnings; (3) alimony
received; (4) interest and dividends from investments (unless in a qualified retirement

account); and (5) capital gains from investments sold.

2.

Short-term capital gains are taxed at your normal marginal tax rate. Long-term capital
gains are taxed at 0% if you are in the 10% or 15% income-tax brackets and 15% if you
are in one of the next four higher tax brackets. Those in the 39.6 percent tax bracket pay a
20 percent long-term capital gains rate.

3.

Five examples of exclusions from gross income are (1) interest income received on most
municipal bonds; (2) scholarship and fellowship income spent on course-required tuition,
fees, books, and supplies; (3) child support payments received; (4) gifts and inheritances;
and (5) life insurance death benefits.

4.

Alimony paid, contributions to a traditional IRA, and certain college education expenses
are examples of adjustments to income.

5.

A standard deduction is an amount established by the IRS that may be subtracted from
your adjusted gross income when arriving at your taxable income. The standard deduction
reflects an estimate of typical tax-deductible expenses a taxpayer might have. Taxpayers
who itemize their deductions and come up with a higher figure may use that figure instead
of the standard deduction. An exemption is an allowable subtraction from adjusted gross
income to arrive at your taxable income that reflects the number of people covered by
your tax return. In a recent year, each exemption was worth $4050. A husband and wife

Copyright © 2018 Cengage Learning. All rights reserved.


Chapter 4: Managing Income Taxes

23

with two children would have four exemptions, for example. Both the standard deduction
and the exemption amounts are adjusted upwards each year to reflect inflation.
6.

Form 1040X can be used to file these late returns. Doing so before being contacted by the
IRS may reduce the penalties you might pay.

7.

Tax credits include the American Opportunity and Lifetime Learning credits for
education expenses, a child and dependent care credit, a retirement savings contribution
credit for certain lower-income taxpayers, an adoption credit, and the earned income
credit.

LO4.3
1.

One type of tax-sheltered investment return is the earnings accrued each year within a
qualified retirement plan. These returns do not have to be reported each year as they
accrue. For some plans (plans with “Roth” in the name), these returns are forever tax-free
if withdrawn during retirement. A second form of tax-sheltered investment returns are the
returns from qualified 529 college savings plans. They are sheltered in a similar way as

retirement account returns are sheltered, and if the funds are used for qualifying
educational expenses, they can be withdrawn tax-free.

2.

The basic premise is to have portions of your income be used in a pretax mechanism and
thus not be reported to the IRS. Flexible spending accounts, defined contribution
retirement plans, and premium-only plans are three examples of these pretax mechanisms.

3.

The basic (traditional) individual retirement account (IRA) allows you to take any
contributions made in a given year as an adjustment to income when you file your tax
return. As a result, your taxable income and resulting tax owed is reduced. Then as the
investments made with these contributions earn investment returns over the years, you
can defer the taxes on these returns until you withdraw the funds during retirement at
which time taxes are owed on the withdrawals. Roth IRAs do not have the deductible
contributions feature. They do have the tax-deferred feature for the investment returns off
the deposited funds. The big attraction of the Roth IRA is that withdrawals of any funds
from the account during retirement are forever tax-free.

4.

One strategy is called accelerating deductions. This involves making deductible
expenditures in such a way that you prepay them in a particular year in order to reach the
threshold where it is advantageous to itemize your deductions. Another technique is to
buy municipal bonds as an investment since the interest off these bonds is free from the
federal income tax. A third technique is to postpone income into a future year where your
marginal tax rate might be lower.

WHAT DO YOU RECOMMEND NOW?
1.

Tax regulations permit money spent on Ace’s tuition and related college expenses to be
claimed for a credit of up to $2000 under the regulations of the Lifetime Learning credit.

2.

Florence’s long-term capital gains tax rate will be 15 percent if she sells the stock. At
$130 a share, she will realize a profit of $12,000 [($130 – $90) × 300], and after taxes she
will net $10,200 [$12,000 ($12,000 ì 0.15)].

Copyright â 2018 Cengage. All rights reserved.


24

Chapter 4: Managing Income Taxes

3.

When Florence and Ace buy a home, they can record the interest and property taxes as
itemized tax deductions along with many previously nondeductible miscellaneous
deductions, plus later on when they sell the home, they can reap the enormous benefit of
the capital gains exclusion.

4.

Neither Florence nor Ace is currently saving much for retirement. For every additional
$100 of savings, up to their employers’ plan limits (perhaps $5000 or $8000), each would

save $25 in income taxes. By contributing so few dollars now, they also are probably
giving up matching contributions from their employers. Therefore, each should check into
his or her employer’s retirement plan rules and begin saving for retirement in earnest.
This will not only save taxes now but will better prepare them for retirement.

5.

Ace could deduct all his business expenses to offset income from his sideline jewelry
business. If his business lost money, all or a portion of the losses may be used to offset his
salary income.

LET’S TALK ABOUT IT
1.

Student answers will vary. Most students will not be in the high tax brackets affected by
such changes and, thus, may feel that reduced progressivity is not such a bad thing.
Some, however, may feel that it is fair that higher income people will pay less in taxes.

2.

It is correct to assume that the withholding by an employer is enough to cover the taxes
owed. However, in most such cases there is more than enough deducted and those excess
funds can be refunded. But this can occur only if the person files a tax return. If the
employer did not withhold enough, the taxpayer must make up the difference by April 15.
If the shortfall is more than 10% of the total amount owed, there will also be a penalty.
This can be avoided by paying estimated taxes throughout the year so that the
combination of the estimated taxes and employer withholdings are sufficient.

3.

Opinions will vary on this question. Some students will see higher-wealth people getting a
break. Others will see that capital gains accrue over many years, and it may be unfair to
tax them as if they all occurred during the year in question. They may also see the positive
motivation to invest that results from the lower capital gains rates.

4.

The pro is obvious. No taxes will be paid. The cons are numerous. First, this is an illegal
act—tax evasion. Second, by not reporting this income, one fails to add to their Social
Security earnings history. This will mean lower Social Security benefits in the future.
And third, eventually the IRS may catch up with the person and significant penalties and
interest will be owed on top of the taxes themselves.

5.

Answers will vary among students. Many have hobbies that could conceivably be turned
into a business.

6.

The American Opportunity credit and the Lifetime Learning credit are ones for which
many college students and/or their parents might qualify. Students who are or become
parents soon after graduation will qualify for the child credit.

7.

Answers will vary among students. Most commonly cited will likely be reducing their
taxable income by enrolling in pretax programs such as flexible spending arrangements
and health savings accounts, making tax-sheltered investment through an employer-based

Copyright © 2018 Cengage Learning. All rights reserved.


Chapter 4: Managing Income Taxes

25

defined contribution plan or an individual retirement account, setting up a tax-sheltered
savings plan for their children’s education, and buying a home so they can take advantage
of many different tax deductions.
8.

Student answers will vary based on their perceptions of the various credits. There will
likely be some discussion as to why some credits are refundable and the whole idea of
having any kind of refundable credit.

9.

Student answers will vary about which tax reduction strategies they might use in the
future. Most will probably choose reducing taxes via a tax-sheltered retirement plan.
Also common will be flexible spending accounts.

DO THE MATH
1.

$50,050 – $6,300 (standard deduction) – $4,050 (single exemption) = $39,700
Using Table 4.3, the tax on $39,700 is $5,703.

2.

(a) 15%, (b) 25%, (c) 25%, (d) 28%

3.

This is a potential “Do It In Class” exercise related to page 129 in the text.
(a) $14,099, (b) $10,199, (c) $3718, (d) $9879

4.

This is a potential “Do It In Class” exercise related to page 125 in the text.
Jared Goff’s tax liability:
Gross income is $162,000 = $160,000 + $2000
Adjustments to income are $5,000 for the IRA contribution
Adjusted gross income is $157,000 = $162,000 - $5,000
Jared can take $8,000 in itemized deductions as they exceed the standard deduction
Jared can take one exemption for $4,050
Jared’s taxable income is $144,950 = $157,000 - $8,000 - $4,050
Jared’s tax liability is $33,622.75 = $18,558.75 + [0.28 x ($144,950 – 91,150)]

5.

This is a potential “Do It In Class” exercise related to page 125 in the text.
Carson Wentz’s tax liability:
Gross income is $146,000 = $144,000 + $2000
Adjustments to income are $6,000 for the retirement plan contribution
Adjusted gross income is $140,000 = $146,000 - $6,000
Carson can take $10,000 in itemized deductions as they exceed the standard deduction
Carson can take one exemption for $4,050
Carson’s taxable income is $125,950 = $140,000 - $10,000 - $4,050

Copyright © 2018 Cengage. All rights reserved.


26

Chapter 4: Managing Income Taxes

Carson’s tax liability is $28,302.75 = $18,558.75 + [0.28 x ($125,950 – 91,150)]
6.

This is a potential “Do It In Class” exercise related to page 117 in the text.
Victoria begins with a $60,000 gross income from which she can subtract adjustments,
deductions and personal exemptions. She has no adjustments but after subtracting her
standard deduction and personal exemption, she has a taxable income of $49,650
meaning that $10,350 is not taxed. The first $9275 of her remaining taxable income is
taxed at 10 percent. The next $28,375 is taxed at 15 percent. This leaves $12,000 of
income to be taxed at 25 percent. Thus, she paid $8,183.75 in taxes on a gross income of
$60,000 for an average tax rate of 13.64 percent ($8,183.75/$60,000) with a marginal tax
rate of 25 percent.

FINANCIAL PLANNING CASES
CASE 1: The Johnsons Calculate Their Income Taxes
a.

The Johnsons’ income is $73,000 for Harry plus $94,000 in salary for Belinda and
$3400 in interest, for a total reportable gross income of $ $170,400.

b.

The Johnson’s AGI is $164,400 ($170,400 - $3000 - $3000)

c.

The Johnsons’ joint return entitles them to two exemptions totaling $8100.

d.

The Johnsons’ tax status is that of a married couple filing jointly. They are entitled to
a $12,600 standard deduction.

e.

Since they have $46,800 in itemized deductions, the Johnsons should take the
itemized deduction of $46,800. This leaves a taxable income of $109,500 ($164,400
– $8,100 – $46,800). Using Table 4.2 they calculated a tax liability of $23,696.75.

f.

Since they had $24,000 in federal taxes withheld, the Johnsons’ refund will be
$303.25.

g.

The Johnsons’ marginal tax rate is 28 percent.

h.

The Johnsons could reduce their tax liability next year by depositing more money in
qualified retirement contribution plans, making charitable contributions, deducting
their state and local income taxes, and participating in employer-sponsored programs

such as premium conversions and flexible spending arrangements.

CASE 2: This is a potential “Do It In Class” exercise related to page 125 in the text.
Victor and Maria Reduce Their Income Tax Liability
c.
Hernandez’s tax liability:
Gross income is $138,650 = $85,000 + $52,000 + $400 + $250 + $1,000
Adjustments to income are $5,500 for the IRA contribution

Copyright © 2018 Cengage Learning. All rights reserved.


Chapter 4: Managing Income Taxes

27

Adjusted gross income is $133,150 = $138,650 - $5,500
Victor and Maria can take $13,400 ($4,600 + $6,300 + $2,500) in itemized deductions as they
exceed the standard deduction
Victor and Maria can take four exemptions for $16,200 ($4050 x 4)
Their taxable income is $103,550 = $133,150 - $13,400 - $16,200
Victor and Maria’s tax liability is $17,430 = $10,367.50 + [0.25 x ($103,550 – 75,300)]

d.

Other strategies that the Hernandezes could try that would reduce their tax liability
include increasing their contributions to qualified retirement plans; participating in
employer-sponsored programs such as premium conversions and flexible spending
arrangements; increasing their charitable contributions; deducting certain medical
and dental expenses not covered by insurance, in excess of 10 percent of their AGI;

deducting taxes on personal property; deducting any local, and foreign income taxes;
deducting qualified job expenses and miscellaneous deductions, in excess of 2
percent of their AGI; taking any tax credits for which they may qualify (American
Opportunity credit, child tax credit, etc.); and taking advantage of tax-sheltered
investments such as municipal bonds.

CASE 3: Julia Price Thinks About Reducing Her Income Taxes
While Julia has ruled out buying a home to reduce income taxes she may want to
revisit her thinking when the real estate have hit bottom in her community because
there will be some excellent prices at that time. Opening a sideline business should
give her lots of new deductions against her business. To succeed in reducing income
taxes she should keep excellent business records. Stretching out a job-hunting trip is a
legitimate deduction at least once a year. Getting a master’s degree is excellent and
Julia should review the tax rules to make certain her schooling expenses will be
deductible. In addition to her retirement plan at work, contributing to a Roth IRA is a
good idea even though it does not reduce income taxes.
CASE 4: A New Family Calculates Income and Tax Liability
e.

Kate and Richard’s income that must be included as total income for the IRS is the
$90,000 for Richard’s salary, $60,000 for Kate’s royalties, $140 interest on savings,
and $4380 alimony. Kate and Richard’s total reportable gross income is $154,520.

f.

Accounting for their $5600 contribution to a qualified pension plan, their adjusted
gross income is $148,920.

g.

They can claim four exemptions, one for each of themselves and one each for Kate’s
children. The exemption is $4050 per person for a total of $16,200.

h.

Assuming they will file jointly, their standard deduction is $12,600.

i.

The Beckett-Castle family has itemized deductions of $13,100. They should take the
higher itemized deduction instead of the standard deduction of $12,600. The larger
itemized deduction reduces their taxable income more than the smaller standard
deduction.

Copyright © 2018 Cengage. All rights reserved.


28

Chapter 4: Managing Income Taxes

j. The Beckett-Castle’s gross income is $154,520 and adjusted gross income (AGI) is
$148,920. The AGI minus exemptions, $16,200, and the itemized deduction, $13,100,
yields a taxable income of $119,620.

5.

k.

Using Table 4.2 yields a tax liability of $21,447.50 = $10,367.50 + [.025 x

($119,620 - $75,300)] on a taxable income of $119,620.

l.

If Richard’s employers withheld $25,000 from his paychecks for income taxes and
their tax liability is $21,447.50, they will receive a refund of $3,552.50.

This is a potential “Do It In Class” exercise related to page 140 in the text.
CASE 5: Taxable versus Tax-Exempt Bonds
The after-tax yield on each of Paxton’s investments is reduced by 30% from its taxable
yield. As a result, the ABC Bond pays 4.13% [5.9% x (1 - .30)], the DEF Bond pays
3.85% [5.5% % x (1 -.30)], the GHI Bond pays 4.06% [5.8% x (1 - .30)] and the JKL
Bond pays 3.78% [5.4% x (1 - .30)]

6.

This is a potential “Do It In Class” exercise related to page 122 in the text.
CASE 6: Taxable Versus Nontaxable Income
Brian’s earnings of $75,000
Brian’s $10,000 bonus
Morgan’s commissions of $70,000
Child support of $800 per month
Brian’s alimony income of $600 per
month
Brian’s $6000 retirement contribution
Morgan’s inherited car worth $13,000
Morgan’s $1500 gift to her aunt’s
church
The $5000 gift from Brian’s mother

taxable income
taxable income
taxable income
exclusion
taxable income
Adjustment to
income
exclusion
itemized
deduction
exclusion

ACTION INVOLVEMENT PROJECTS
1. Students should provide a brief summary of the question they posed to the IRS
spokesperson and the response given by the spokesperson.
2. Students should provide a brief summary of their findings as well as a statement
indicating what type of reform the student might prefer.
3. Students should provide a written summary of their findings in regards to who in
America pays federal income taxes.
4. Students should provide a brief summary of their findings on the USA Today article as
well as a summary of any additional Web reports they found on the same topic.
5. Response should be a brief summary of their findings and his/her impressions of the

Copyright © 2018 Cengage Learning. All rights reserved.


Chapter 4: Managing Income Taxes

results.
6. Students’ responses should be a brief summary of their findings.

Copyright © 2018 Cengage. All rights reserved.

29