# CAULB Purchasing an Insurance Policy Definition Terms

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Chapter 4
Managing
Money
1
Unit 4A
Taking Control of your
Finances
2

Know your bank balance. Avoid bouncing a check
or have a debit card rejected.

Know what you spend, in particular, keep track of
debit and credit card spending.

purchase makes sense.
Make a budget, and don’t overspend it.
3
Example: Credit Card Interest (1 of 2)
Cassidy has recently begun keeping her spending
under better control, but she still can’t fully pay off
her credit card. She maintains an average monthly
balance of about \$1100, and her card charges a
24% annual interest rate, which it bills at a rate of
2% per month. How much is she spending on credit
card interest?
Solution
Her average monthly interest is 2% of the \$1100
average balance.
0.02  \$1100 = \$22
4
Example: Credit Card Spending (2 of 2)
Multiply by 12 months in a year gives her annual
interest payment.
12  \$22 = \$264
Interest alone is costing Cassidy more than \$260
per year – a significant amount for someone living
on a tight budget. Clearly, she’d be a lot better off if
she could find a way to pay off that credit card
balance quickly and end those interest payments.
5
A Four-Step Budget-Making Process
1. Determine your average monthly income. Be sure to
include an average monthly amount for any income you do
not receive monthly (such as once-a-year payments).
2. Determine your average monthly expenses. Be sure to
include an average amount for expenses that don’t recur
monthly, such as expenses for tuition, books, vacations,
3. Determine your net monthly cash flow by subtracting your
total expenses from your total income.
6
Example: College Expenses (1 of 2)
following college expenses that you pay twice a
year: \$3500 for tuition each semester, \$750 in
student fees each semester, and \$800 for textbooks
each semester. How should you handle these
expenses in computing your monthly budget?
Solution
Amount paid over a whole year:
2  (\$3500 + \$750 + \$800) = \$10,100
7
Example: College Expenses (2 of 2)
2  (\$3500 + \$750 + \$800) = \$10,100
To average this total expense for the year on a
monthly basis, we divide by 12.
\$10,100  12  \$842
Your average monthly college expense for tuition,
fees, and textbooks comes to a little less than \$850,
so you should put \$850 per month into your expense
list.
8
Example: Cost of a College Class (1 of 2)
Across all institutions, the average cost of a
three-credit college class is approximately \$1500.
Suppose that, between class time, commute
time, and study time, the average class requires
that you could have had a job paying \$10 per
hour, what is the net cost of the class compared
to working? Is it a worthwhile expense?
9
Example: Cost of a College Class (2 of 2)
Solution
A typical college semester lasts 14 weeks, so your
“lost” work wages for the time you spend on the class
comes to
10 hr \$10
14 wk 

= \$1400
wk
he
We find your total net cost of taking the class by adding
this to the \$1500 that the class itself costs. The result is
\$2900. Whether this expense is worthwhile is
subjective, but remember college graduates earn
nearly \$1 million more over a career than a high school
10
Insurance Costs
The premium is the amount you pay to purchase the
policy. Premiums are often paid once or twice a year,
though sometimes you may pay them more often.
A deductible is the amount you are personally
responsible for before the insurance company will pay
anything.
A co-payment usually applies to health insurance
and is the amount you pay each time you use a
particular service that is covered by the insurance
policy.
11
Example: Emergency Room Visit (1 of 2)
Suppose you have an accident and end up in the
emergency room, receiving a \$7000 bill for your
treatment. Fortunately, you have health insurance,
but your policy has a \$1000 annual deductible, a
\$250 co-payment for emergency room visits, and
pays only 80% of the remaining balance. How much
will you pay out of pocket for the emergency room
visit? Assume that you haven’t had any other
medical expenses in the current year.
Solution
Your total payment has three parts:
12
Example: Emergency Room Visit (2 of 2)
• The \$1000 deductible, which you will pay in full
since you have not already paid any of it earlier in
the year
• The \$250 co-payment for an emergency room visit
• Your share of the remaining balance. The total bill
is \$7000, but you’ve already paid \$1250 (the \$1000
deductible plus the \$250 co-payment). Therefore,
the remaining balance is \$7000 – \$1250 = \$5750.
The insurance company pays 80% of this, so you
owe the other 20%, which is 0.2 × \$5750 = \$1150.
\$1000 + \$250 + \$1150 = \$2400.
13
Base Financial Goals on Solid
Understanding

Find a way to make your budget allow for savings;
understand how savings work and how to choose
appropriate savings plans.

Understand the basic mathematics of loans.

Understand how taxes are computed and how
they can affect your financial decisions.

Understand how the federal budget affects future
personal finances.
14
Chapter 4
Managing
Money
1
Unit 4B
The Power of
Compounding
2
Definitions

The principal in financial formulas is the balance
upon which interest is paid.

Simple interest is interest paid only on the
original principal, and not on any interest added at
later dates.

Compound interest is interest paid both on the
original principal and on all interest that has been
3
Example: Savings Bond (1 of 2)
While banks almost always pay compound interest,
bonds usually pay simple interest. Suppose you
invest \$1000 in a savings bond that pays simple
interest of 10% per year. How much total interest
will you receive in 5 years? If the bond paid
compound interest, would you receive more or less
total interest? Explain.
Solution
Simple interest: every year you receive the same
interest payment.
10%  1000 = \$100
4
Example: Savings Bond (2 of 2)
Therefore, you receive a total of \$500 in interest
over 5 years.
With compound interest, you receive more than
\$500 in interest because the interest each year is
calculated on your growing balance rather than your
original investment.
Second interest payment: 10%  \$1100 = \$110
This raises your balance faster than simple interest.
5
Compound Interest Formula
(for Interest Paid Once a Year)
A = P  (1 + APR )
Y
A = accumulated balance after Y years
P = starting principal
APR = annual percentage rate (as a decimal)
Y = number of years
6
Example: Simple and Compound
Interest (1 of 3)
You invest \$100 in two accounts that each
pay an interest rate of 10% per year, but one
pays simple interest and the others pays
compound interest. Make a table to show the
growth of each over a 5-year period. Use the
compound interest formula to verify the result
in the table for the compound interest case.
7
Example: Simple and Compound
Interest (2 of 3)
Compare the growth in a \$100 investment for
5 years at 10% simple interest per year and at
10% interest compounded annually.
The compound interest account earns \$11.05 more
than the simple interest account.
8
Example: Simple and Compound
Interest (3 of 3)
To verify the final entry in the table with the
compound interest formula.
A = P  (1 + APR )
Y
= \$100  (1 + 0.1)
5
= \$100  1.15
= \$100  1.6105
= \$161.05
9
Compound Interest
Show how quarterly compounding affects a \$1000
investment at 8% per year.
10
Compound Interest Formula
for Interest Paid n Times per Year
 APR 
A = P 1 +

n 

( nY )
A = accumulated balance after Y years
P = starting principal
APR = annual percentage rate (as a decimal)
n = number of compounding periods per year
Y = number of years
11
Example: Monthly Compounding at 3% (1 of 3)
You deposit \$5000 in a bank account that pays an
APR of 3% and compounds interest monthly. How
much money will you have after 5 years? Compare
this amount to the amount you’d have if interest
were paid only once each year.
Solution
The starting principal is P = \$5000 and the interest
rate is APR = 0.03. Monthly compounding means
that interest is paid n = 12 times a year, and we are
considering a period of Y = 5 years.
12
Example: Monthly Compounding at 3% (2 of 3)
APR 

A = P  1+

n 

nY
(12×5 )
 0.03 
= \$5000   1 +

12 

60
= \$5000  (1.0025 )
= \$5808.08
For interest paid only once each year, we find the balance after
5 years by using the formula for compound interest paid once a
year.
Y
5
A = P  (1 + APR ) = \$5000  (1 + 0.03 )
= \$5000  (1.03 )
5
= \$5796.37
13
Example: Monthly Compounding at 3% (3 of 3)
After 5 years, monthly compounding gives you
a balance of \$5808.08 while annual
compounding gives you a balance of
\$5796.37. That is monthly compounding earns
\$5808.08 – \$5796.37 = \$11.71 more, even
though the APR is the same in both cases.
14
Definition

The annual percentage yield (APY) – also called
the effective yield or simply the yield – is the
actual percentage by which a balance increases
in one year. It is equal to the APR if interest is
compounded annually. It is greater than the APR
if interest is compounded more than once a year.
15
APR vs. APY
APR = annual percentage rate
APY = annual percentage yield
APY = APR if interest is compounded annually
APY > APR if interest is compounded more than
once a year
16
Continuous Compounding (1 of 2)
Show how different compounding periods affect the
APY for an APR of 8%.
17
Continuous Compounding (2 of 2)
18
Compound Interest Formula
for Continuous Compounding
A = Pe
( APRY )
A = accumulated balance after Y years
P = starting principal
APR = annual percentage rate (as a decimal)
Y = number of years
e = a special irrational number with a value
of e  2.71828
19
Example: Continuous Compounding
You deposit \$100 in an account with an APR of 8%
and continuous compounding. How much will you
have after 10 years?
Solution
We have P = \$100, APR = 0.08, and Y = 10 years of
continuous compounding.
The accumulated balance after 10 years is
A = P e
(
APR x Y
) = \$100  e
( 0.0810)
= \$100  e0.8 = \$222.55
20
Chapter 4
Managing
Money
1
Unit 4C
Savings Plans and
Investments
2
Savings Plan Formula
(Regular Payments)
 APR  ( nY ) 
 − 1
1 +
n 


A = PMT 
 APR 

 n 
A = accumulated savings plan balance
PMT = regular payment (deposit) amount
APR = annual percentage rate (as a decimal)
n = number of payment periods per year
Y = number of years
3
Example: Using the Savings Plan
Formula (1 of 2)
Use the savings plan formula to calculate the
balance after 6 months for an APR of 12%
and monthly payments of \$100.
4
Example: Using the Savings Plan
Formula (2 of 2)
Solution
(121/2)


APR (nY ) 
0.12 

 1 +
 1 +
− 1
− 1

n 
12 




A = PMT 
= \$100 
 APR 
 0.12 

 12 
 n 

 1.01 6 − 1
)
(

= \$615.20
= \$100 
0.01
5
Definitions

An annuity is any series of equal, regular payments.

An ordinary annuity is a savings plan in which
payments are made at the end of each month.

An annuity due is a plan in which payments are
made at the beginning of each period.

The future value of an annuity is the accumulated
amount at some future date.

The present value of a savings plan is a lump sum
deposit that would give the same end result as
regular payments into the plan.
6
Example: A Comfortable Retirement (1 of 3)
You would like to retire 25 years from now and have
a retirement fund from which you can draw an
income of \$50,000 per year – forever! How can you
do it? Assume a constant APR of 7%.
Solution
What balance do you need to earn \$50,000 from
interest? Since we are assuming an APR of 7%, the
\$50,000 must be 7% = 0.07 of the total balance.
\$50, 000
total balance =
= \$714,286
0.07
7
Example: A Comfortable Retirement (2 of 3)
In other words, a balance of about \$715,000 allows
you to withdraw \$50,000 per year without ever
reducing the principle.
Let’s assume you will try to accumulate a balance of
A = \$715,000 by making regular monthly deposits
into a savings plan. We have APR = 0.07, n = 12
(for monthly deposits) and Y = 25 years.
8
Example: A Comfortable Retirement (3 of 3)
APR
A+
n
PMT =

nY
(
)
1 + APR 
− 1
n 


\$715,000  0.0058333
=
(1.0058333)300 − 1


0.07
\$715,000 +
12
=

12

15
(
)
1 + 0.07 
− 1
12 


= \$882.64
If you deposit \$883 per month over the next 25 years,
9
Total Return
Consider an investment that grows from an original
principal P to a later accumulated balance A.
The total return is the percentage change in the
investment value:
A − P)
(
total return =
 100%
P
10
Annual Return
Consider an investment that grows from an original
principal P to a later accumulated balance A in Y
years.
The annual return is the annual percentage yield
(APY) that would give the same overall growth.
 A
annual return =  
P
(1 / Y )
−1
11
Example: Mutual Fund Gain (1 of 2)
You invest \$3000 in the Clearwater mutual
fund. Over 4 years, your investment grows in
value to \$8400. What are your total and annual
returns for the 4-year period?
Solution
A − P)
(
total return =
100%
P
\$8400 − \$3000 )
(
=
 100% = 180%
\$3000
12
Example: Mutual Fund Gain (2 of 2)
1/Y
A
 
annual return =  
−1
P 
1/ 4
 \$8400 
=
−1

 \$3000 
= 4 2.8 − 1  0.294
= 29.4%
13
Types of Investments (1 of 3)
Stock (or equity) gives you a share of ownership in a
company.

Invest some principal amount to purchase the
stock.
The only way to get your money out is to sell the
stock.
Stock prices change with time, so the sale may
give you either a gain or a loss on your original
investment.
14
Types of Investments (2 of 3)
A bond (or debt) represents a promise of future cash.

Buy a bond by paying some principal amount to
the issuing government or corporation.
The issuer pays you simple interest (as opposed
to compound interest).
The issuer promises to pay back your initial
investment plus interest at some later date.
15
Types of Investments (3 of 3)
Cash investments generally earn interest and include
the following:

Money you deposit into bank accounts
Certificates of deposit (CD)
U.S. Treasury bills
16
Investment Considerations

Liquidity: How difficult is it to take out your
money?

Risk: Is your investment principal at risk?

Return: How much return (total or annual) can
17
Stock Market Trends
The Dow Jones Industrial Average (DJIA) reflects the
average prices of the stocks of 30 large companies.
18
Financial Data—Stocks
In general, there are two ways to make money on
stocks:
1. Sell a stock for more than you paid for it, in
which case you have a capital gain on the sale
of the stock.
2. Make money while you own the stock if the
corporation distributes part or all of its profits to
stockholders as dividends.
19
Example: Understanding a Stock Quote
(1 of 5)
Answer the following questions by assuming that the
figure shows an actual Microsoft stock quote that you
found online today.
20
Example: Understanding a Stock Quote
(2 of 5)
a. What is the symbol for Microsoft stock?
b. What was the price per share at the start of the day?
c. Based on the current price, what is the total value of
the shares that have been traded so far today?
d. What fraction of all Microsoft shares have been
e. Suppose you own 100 shares of Microsoft. Based on
the current price and dividend yield, what total
dividend should you expect to receive this year?
21
Example: Understanding a Stock Quote
(3 of 5)
Solution
a. As shown at the top of the quote, Microsoft’s
stock symbol is MSFT.
b. The “Open” value is the price at the start of the
day, which was \$68.14.
22
Example: Understanding a Stock Quote
(4 of 5)
c. The volume shows that 25,529,982 shares of
Microsoft stock were traded today. At the current
price of \$68.41 per share, the value of these
shares is 25,529,982 shares × \$68.41/share ≈
\$1,747,000,000
\$1.747 million.
23
Example: Understanding a Stock
Quote (5 of 5)
d. We divide the 25,529,982 shares traded today by
the total number of shares outstanding, which is
quoted as 7720 million, or 7,720,000,000, to find
that about 0.0033, or 0.33%, of all shares have
e. At the current price, your 100 shares are worth
100 × \$68.41 = \$6841. The dividend yield is
2.28%, so at that rate you would earn
\$6841 × 0.0228 = \$155.97 in dividend payments
this year.
24
Financial Data—Bonds
Bonds are issued with three main characteristics:
1. The face value (or par value) is the price you
must pay the issuer to buy the bond.
2. The coupon rate of the bond is the simple
interest rate that the issuer promises to pay.
3. The maturity date is the date on which the issuer
promises to repay the face value of the bond.
annual interest payment
current yield =
current price of bond
25
Example: Bond Interest
The closing price of a U.S. Treasury bond with a
face value of \$1000 is quoted as 105.97 points, for
a current yield of 3.7%. If you buy this bond, how
much annual interest will you receive?
Solution
105.97%  \$1000 = \$1059.70
annual interest
current yield =
current price
annual interest = current yield  current price
annual interest = 0.037  \$1059.70 = \$39.21
26
Financial Data—Mutual Funds
When comparing mutual funds, the most important
factors are the following:
1. The fees charged for investing (not shown on
most mutual fund tables)
2. How well the the funds perform
Note: Past performance is no guarantee of future
results.
27
Mutual Fund Quotations
28
Example: Understanding a Mutual Fund
Quote
Based on the Vanguard 500 mutual fund quote
shown on the previous slide, how many shares will
you be able to buy if you decide to invest \$3000 in
this fund today?
Solution
To find the number of shares you can buy, divide your
investment of \$3000 by the current share price, which is
NAV of \$222.21:
\$3000
 13.5
\$222.21
29
Chapter 4
Managing
Money
1
Unit 4D
Loan Payments, Credit
Cards, and Mortgages
2
Loan Basics

The principal is the amount of money owed at
any particular time.

An installment loan (or amortized loan) is a loan
that is paid off with equal regular payments.

The loan term is the time you have to pay back
the loan in full.
3
Loan Payment Formula
(Installment Loans)
 APR 
P

n 

PMT =
  APR  ( − nY ) 

1 − 1 +

n 
 

PMT
P
APR
n
Y
=
=
=
=
=
regular payment amount
starting loan principal (amount borrowed)
annual percentage rate
number of payment periods per year
loan term in years
4
Principal and Interest for
Installment Loans
The portions of installment loan payments going
toward principal and toward interest vary as the
loan is paid down.

Early in the loan term, the portion going toward
interest is relatively high and the portion going
toward principal is relatively low.

As the term proceeds, the portion going toward
interest gradually decreases and the portion
5
Example: Student Loan (1 of 4)
Suppose you have student loans totaling
\$7500 when you graduate from college. The
interest rate is APR = 9%, and the loan term
is 10 years. What are your monthly
payments? How much will you pay over the
lifetime of the loan? What is the total interest
you will pay on the loan?
6
Example: Student Loan (2 of 4)
Solution
We use the loan payment formula to find the
monthly payments:
 APR 
P

n 

PMT =
  APR  ( − nY ) 

1 − 1 +

n 
 

 0.09 
\$7500  

12

=
( −12  10 )
 

0.09 
1 − 1 +

12 
 

7
Example: Student Loan (3 of 4)
 0.09 
\$7500  

12

=
( −12  10 )
 

0.09 
1 − 1 +

12 
 

\$7500  ( 0.0075)
=
1 − (1.0075)( −120 ) 

\$56.25
=
1 − 0.407937305 = \$95.01
Your monthly payments are \$95.01. Over the
10-year term, your total payments will be
mo \$95.01
10 yr  12

= \$11, 401.20
yr
mo
8
Example: Student Loan (4 of 4)
Of the \$11,401.20, \$7500 pays off the principal.
The rest, or \$11,401 – \$7500 = \$3901,
represents the interest payments.
9
Table of First Three Months
For the student loan in the previous example, the table
shows the amount of the payment that is applied to the
principal. It is easier to use software that find principal and
interest payments with built-in functions.
Interest and Principle portions of Payments
on a \$7500 Loan (10-year term, APR = 9%)
End of…
Interest = 0.0075 × Balance
Payment Toward
Principal
New Principal
Month 1
0.0075 × \$7500 = \$56.25
\$95.01 − \$56.25 = \$38.76
\$7500 − \$38.76 = \$7461.24
Month 2
0.0075 × \$7500 = \$56.25
\$95.01 − \$55.96 = \$39.05
\$7461.24 − \$39.05 = \$7422.19
Month 3
0.0075 × \$7500 = \$56.25
\$95.01 − \$55.67 = \$39.34
\$7422.19 − \$39.34 = \$7382.85
10
Credit Cards
Credit cards differ from installment loans in that you
are not required to pay off your balance in any set
period of time.

A minimum monthly payment is required.

Monthly payment generally covers all the
interest but very little principal.

It takes a very long time to pay off a credit card
loan if only the minimum payments are made.
11
Example: Credit Card Debt
Suppose you have a credit card balance of \$2300
with an annual interest rate of 21%. You decide to
pay off your balance over 1 year. How much will you
need to pay each month? Assume you will make no
further credit card purchases.
Solution
 APR 
 0.21 
P
\$2300 
 n 
 12 

 = \$214.16
PMT =
=
( − nY ) 
( −121) 
 
 
APR 
0.21 
1 − 1 +
 1 − 1 +

n
12

 
  

You must pay \$214.16 per month to pay off the
balance in 1 year.
12
Mortgages (1 of 2)

A home mortgage is an installment loan
designed specifically to finance a home.

The down payment is the amount of money you
must pay up front in order to be given a
mortgage or other loan.

Closing costs are fees you must pay in order to
be given the loan. These include

Direct fees: appraisal, credit check

Fees charged as points, where each point is
1% of the loan amount: “origination fee”,
“discount points”
13
Mortgages (2 of 2)

A fixed rate mortgage is one in which the
interest rate is guaranteed not to change over the
life of the loan.

An adjustable rate mortgage is one where the
interest rate changes based on the prevailing
rates.
14
Example: Closing Costs (1 of 3)
Great bank offers a \$100,000, 30-year, 5% fixed
rate loan with closing costs of \$500 plus 1 point. Big
Bank offers a lower rate of 4.75% on a 30-year
loan, but with Great Bank closing costs of \$1000
plus 2 points. Evaluate the two options.
Solution
Great Bank
 0.05 
\$100, 000  

12

 = \$536.82
PMT =
( −1230) 
 
0.5 
1 − 1 +

12 
 

15
Example: Closing Costs (2 of 3)
Great bank offers a \$100,000, 30-year, 5% fixed
rate loan with closing costs of \$500 plus 1 point. Big
Bank offers a lower rate of 4.75% on a 30-year
loan, but with closing costs of \$1000 plus 2 points.
Evaluate the two options.
Big Bank:
 0.0475 
\$100, 000  

12

 = \$521.65
PMT =
( −1230) 
 
0.0475 
1 − 1 +

12 
 

16
Example: Closing Costs (3 of 3)
You will save about \$15 per month with Big Bank’s lower
interest rate. Now we must consider the difference in
closing costs. Big bank charges an extra \$500 plus an
extra 1 point (1%), which is \$1000 on this loan. Big Bank
cost an extra \$1500 up front. We divide this to find the
time it will take to recoup this extra \$1500.
\$1500
1
= 100 mo = 8 yr
\$15 / mo
3
Unless you are sure you will be staying in the house for
much more than 8 years, it is most wise to go with Big
Bank.
17
The Relationship Between
Principal and Interest for a Payment
Portions of monthly payments going to principal and
interest over the life of a 30-year \$100,000 loan at 5%
18
Example: Rate Approximation for ARMs
(1 of 3)
You have a choice between a 30-year fixed
rate loan at 4% and an ARM with a first-year
rate of 3%. Neglecting compounding and
changes in principal, estimate your monthly
savings with the ARM during the first year on
a \$100,000 loan. Suppose that the ARM rate
rises to 5% by the third year. How will your
payments be affected?
19
Example: Rate Approximation for ARMs
(2 of 3)
Solution
Since mortgage payments are mostly interest in the
early years of a loan, we can make approximations
by assuming that the principal remains unchanged.
For the 4% fixed rate loan, the interest on the
\$100,000 loan for the first year will be approximately
4% × \$100,000 = \$4000. With the 3% ARM, your
first-year interest will be approximately 3% ×
\$100,000 = \$3000. The ARM will save you about
\$1000 in interest during the first year, which means
a monthly savings of about \$1000 ÷ 12 ≈ \$83.
20
Example: Rate Approximation for ARMs
(3 of 3)
By the third year, when rates reach 5%, the situation
is reversed. The rate on the ARM is now 1
percentage point above the rate on the fixed rate
loan. Instead of saving \$83 per month, you’d be
paying \$83 per month more on the ARM than on the
4% fixed rate loan. Moreover, if interest rates remain
high on the ARM, you will continue to make these
high payments for many years to come. Therefore,
while ARMs reduce risk for the lender, they add risk
for the borrower.
21
Chapter 4
Managing
Money
1
Unit 4E
Income Taxes
2
Income Tax Preparation Flow Chart
3
Example: Income on Tax Forms (1 of 3)
Karen earned wages of \$38,600, received
\$750 in interest from a savings account, and
contributed \$1200 to a tax-deferred
retirement plan. She was entitled to a
personal exemption of \$4050 and to
deductions totaling \$6350. find her gross
income, adjusted gross income, and taxable
income.
4
Example: Income on Tax Forms (2 of 3)
Solution
Karen’s gross income is the sum of all her income,
which means the sum of her wages and her interest.
Gross income = \$38,600 + \$750 = \$39,350
Her \$1200 contribution to a tax-deferred retirement plan
counts as an adjustment to her gross income, so her
AGI = gross income – adjustments
= \$39,350 – \$1200 = \$387,150.
5
Example: Income on Tax Forms (3 of 3)
To find her taxable income, we subtract her exemptions
and deductions.
Taxable income = AGI – exemptions – deductions
= \$38,150 – \$4050 – \$6350 = \$27,750
Her taxable income is \$27,750.
6
Filing Status
Tax calculations depend on your filing status, which
consist of the following four categories:

Single – unmarried, divorced, or legally separated
Married filing jointly – married and you and your
spouse file a single tax return
Married filing separately – married and you and
your spouse file two separate tax returns
Head of household – unmarried and paying more
than half the cost of supporting a dependent child
or parent
7
Exemptions and Deductions
Both exemptions and deductions are subtracted from

Exemptions are a fixed amount per person.
◼ Exemptions can be claimed for you and each of
Deductions vary from one person to another.
◼ A standard deduction depends on your filing
status.
◼ An itemized deduction is the sum of all the
individual deductions to which you are entitled.
8
Example: Should You Itemize?
Suppose you have the following deductible
expenditures: \$4500 for interest on a home
mortgage, \$900 for contributions to charity, and
\$250 for state income taxes. Your filing status
entitles you to a standard deduction of \$6350.
Solution
The total if your deductible expenditures is
\$4500 + \$900 + \$250 = \$5650.
The standard deduction of \$5650 will put you better
off.
9
Tax Rates

A progressive income tax means that people
with higher taxable income pay at a higher tax
rate.
◼ Marginal tax rates are assigned to different
income ranges (or margins).
10
2017 Marginal Tax Rates, Standard
Deductions, and Exemptions
Tax Rate*
Single
Married Filing
jointly
Married Filing
Separately
10%
Up to \$9325
Up to \$18,650
Up to \$9325
Up to \$13,350
15%
Up to \$37,950
Up to \$75,900
Up to \$37,950
Up to \$50,800
25%
Up to \$91,900
Up to \$153,100
Up to \$76,550
Up to \$131,200
28%
Up to \$191,650
Up to \$223350
Up to \$116,675
Up to \$212,500
33%
Up to \$416,700
Up to \$416,700
Up to \$208,350
Up to \$416,700
35%
Up to \$418,400
Up to \$470,700
Up to \$235,350
Up to \$444,550
39.6%
above \$418,400
above \$470,700
above \$235,350
above \$444,550
Standard deduction
\$6100
\$12,700
\$6350
\$9350
Exemption (per
person)
\$4050
\$4050
\$4050
\$4050
11
Tax Credits and Deductions
As a rule, tax credits are more valuable than tax
deductions.

A tax credit reduces your total tax bill by the full
amount of the credit.

A tax deduction reduces your taxable income by
the amount of the deduction.
12
Example: Tax Credits vs. Tax
Deductions (1 of 2)
Suppose you are in the 28% tax bracket. How
much does a \$1000 tax credit save you? How
much does a \$1000 charitable contribution
(which is tax deductible) save you? Answer
these questions both for the case in which
you itemize deductions and for the case in
which you take the standard deduction.
13
Example: Tax Credits vs. Tax
Deductions (2 of 2)
Solution
The entire \$1000 tax credit is a deducted from your
bill and therefore saves you a full \$1000 whether
you itemize or take the standard deduction. In
contrast \$1000 deduction reduces your taxable
income, not your total tax bill by \$1000. For a 28%
tax bracket, at best your \$1000 deduction will save
you \$280. However, you will only have this \$280 if
you itemize deductions. If you itemized deductions
are less than standard deductions, your contribution
will save you nothing at all.
14
Example: Varying Value of Deductions
(1 of 2)
Drew is in the 15% marginal tax bracket. Marian is
in the 35% marginal tax bracket. They each itemize
their deductions. They each donate \$5000 to
charity. Compare their true costs for the charitable
contributions.
Solution
The \$5000 contribution to charity is tax deductible.
His contribution saves him 15% × \$5000 = \$750 in
taxes. The true cost of his contribution is the
contributed about minus his tax savings, or \$4250.
15
Example: Varying Value of Deductions
(2 of 2)
For Marian, who is in the 35% tax bracket, the
contribution saves \$1750 in taxes. Therefore, the
true cost of her contribution is \$5000 – \$1750 =
\$3250. The true cost of the donation is considerable
lower for Marian because she is in a higher tax
bracket.
16
Social Security and Medicare Taxes
Some income is subject to Social Security and
Medicare taxes, which are collected under the name
FICA (Federal Insurance Contribution Act) taxes.

FICA applies to the following:
◼ Income from wages (including tips)
◼ Self-employment

FICA does not apply to the following:
◼ Income from interest
◼ Income from dividends
◼ Profits from sales of stock
17
Example: FICA Taxes (1 of 2)
In 2017, Jude earned \$26,000 in wages and tips from
her job waiting tables. Calculate her FICA taxes and her
total tax bill including marginal taxes. What is her overall
tax rate on her gross income, including both FICA and
income taxes? Assume she is single and takes the
standard deduction.
Solution
FICA tax = 7.65% × \$26,000 = \$1989
Now we must find her income tax. We get her taxable
income by subtracting her exemptions.
Taxable income = \$26,000 – \$4050 – \$6350 = \$15,600
18
Example: FICA Taxes (2 of 2)
From table 4.9, her income tax is 10% on the first \$9325
of her taxable income and 15% on the remaining
amount of \$15,600 – \$9325 = \$6275. Therefore, her
income tax is (10% × \$9325) + (15% × \$6275) =
\$1954.
total tax = FICA + income tax = \$1989 + \$1874 = \$3863
Her overall tax rate, including both FICA and income
tax, is
total tax
\$3863
=
 0.149
gross income \$26,000
Her overall tax rate is about 15.2%. She pays slightly
higher in FICA tax than in income tax.
19
Dividends and Capital Gains
Income with special tax treatment:

Dividends (on stocks)
Capital gains – profits from the sale of stock or
other property
◼ Short-term capital gains – profits on items sold
within 12 months of their purchase
◼ Long-term capital gains – profits on items held
for more than 12 months before being sold
20
Tax-Deferred Income
Tax-deferred savings plans allow you to defer
income taxes on contributions to certain types of
savings plans. These include the following:

Individual retirement accounts (IRAs)
Qualified retirement plans (QRPs)
401(k) plans
21
Example: Tax-Deferred Savings Plan
Suppose you are single, have a taxable income of
\$65,000, and make monthly payments of \$500 to a tax
deferred savings plan. How do the tax-deferred
contributions affect your monthly take-home pay?
Solution
Table 4.9 shows your marginal tax rate is 25%. Each
\$500 contribution reduces your tax bill by
25% × \$500 = \$125
While \$500 goes into your tax-deferred savings account,
your paychecks go down by only \$500 – \$125 = \$375.
22

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