CFP 503 - Module 1 - Income Tax Concepts, Basic Terminology, and Tax Calculations
Married taxpayer filing jointly has taxable income of $160,200 for 2019. Included in the taxable income is $15,000 of qualifying dividends and net long-term capital gains. Total tax?
Taxable income $160,200 Less preferential rate (15,000) $145,200 Less (from tax rate schedule) (78,950) Amount over $78,950 66,250 Times (marginal rate, from tax rate schedule) 22% Tax on amount over $78,950 = $14,575 Plus (from tax rate schedule) 9,086 Tax on items not subject to preferential rate $23,661 Plus: 15% times $15,000 = 2,250. Total Tax $25,911
Tax Liability example:
Taxable income $214,575.00, Less: qualified dividends (6,500.00), Taxable income not subject to preferential rates $208,075, Less (from tax rate schedule) 204,100.00 Amount over $204,100 = $3,975.00 Times marginal rate, from tax rate schedule 35% Tax on amount over $204,150 $1,391.25 Plus (rom tax rate schedule 46,629 Tax on items not subject to preferential rates $48,020.25 Plus: $6,500 times 15%* 975.00 Total Tax $48,995.25
Qualifying Relative - Relationship Test
Taxpayer's father or mother or an ancestor of either; a stepfather or stepmother; a niece or nephew; brother or sister of mother or father; or father-, mother-, brother-, sister-, son-, or daughter-in-law.
Can Deduct One-Half of the Self-Employment Tax
Taxpayer's self-employment tax for 2019 is $5,000. On tax return deduct $2,500 from total income in determining adjusted gross income.
No Filing a Tax Return If
Taxpayer's total income is equal to or less than their applicable standard deduction, no return will be required.
Child and Dependent Care Credit
Taxpayers who incur household and dependent care expenses with respect to a qualifying individual may be allowed a tax credit if paying these expenses enabled the taxpayer to be gainfully employed. Nanny, housekeeper, etc.
Adjusted gross income example:
Total income $266,175, Alimony payment $24,000, Total deductions for AGI 24,000, Adjusted gross income $242,175.
Not an Active Participant in Employer Sponsored Retirement Plan
Traditional IRA contribution is deductible no matter how high the AGI. For MFJ IRA deduction phased out for MAGIs between $103,000 and $123,000 if both spouses active participants. If not, no phaseout. Eligible.
Refinanced Indebtedness
Treated as debt incurred on or before December 15, 2017 or as if incurred on the date the original indebtedness was incurred. Acquisition indebtedness still limited to $1 million/$500,000.
Many Deductions Subject to Phaseout
Typically based on adjusted gross income or modified adjusted gross income (MAGI). Gradual reduction of deduction amount as AGI or MAGI increases. As income increases through phaseout range, deduction becomes smaller until eliminated.
Tax Deferral
Unlike avoiding taxes, does not produce a permanent reduction in tax liability instead current reduction in tax liability, but ultimately will have to be paid in the future. IRAs defer taxes until earnings withdrawn.
Adoption Credit
Up to $14,080 (for 2019). Eligible adoptee not yet age 18 at the time of adoption or who is physically or mentally incapable of caring for themselves. Phased out between $211,160 and $251,160 of modified AGI.
Educator Expense Deduction
Up to $250 (for 2019) of expenses incurred by an educator for materials used in the classroom. Professional development courses may also be treated as a qualifying expense.
TCJA "Old Debt" Maximum
Up to a maximum debt of $1 million or $500,000 for married filing separately.
New Debt Home Equity Loan Interest May not be Deductible if
Used for other than acquiring, constructing, or substantially improving the house. If proceeds of a home equity line of credit (a HELOC), for example, used to remodel the taxpayer's residence, that debt is treated as acquisition debt.
Moving Expenses Prior to the Tax Cuts and Jobs Act of 2017 (TCJA)
Were deductible if met time test/distance test related to start of a job. Moving expense reimbursement from an employer to an employee also no longer excluded. Moving expense deduction now only for military.
Miscellaneous itemized deductions eliminated by the TCJA
Were not subject to 2% of adjusted gross income floor. Impairment-related work expenses of handicapped individuals, unrecovered basis in a commercial annuity, gambling losses to the extent of gambling winnings.
Gross Income for Tax Purposes
"All income from whatever source derived," unless specifically excluded by the Internal Revenue Code (IRC). From 16th amendment.
Marginal Income Tax Bracket
"Percent on excess," or rate of tax pay on the last dollar of taxable income. Say marginal tax bracket is 24%. The taxpayer's average income tax rate, on the other hand, is the total tax liability divided by taxable income.
Spent $7,000 on day care for their two children (ages 9 and 10) in the current tax year to allow both to work outside the home. Their adjusted gross income is estimated at $71,000. Calculate the child care credit.
$1,200 ($6,000 × 20% = $1,200). Max $3,000 per child, or $6,000 for two or more children. By the time the taxpayer's AGI has exceeded $43,000, the percentage is reduced to its lowest point of 20%.
Child Tax Credit
$2,000 ifor each qualifying child. Phaseout $50 for each $1,000 or part thereof, for MAGI exceeding $400,000 for MFJ, $200,000 for singles and $200,000 for married taxpayers filing separately.
What amount of deduction would be necessary to provide a tax benefit equal to that provided by the child care credit if in the 32% marginal income tax bracket?
$960 divided by 32% = $3,000
What amount of deduction would be necessary to provide a tax benefit equal to that provided by the child care credit if Sarah is in the 37% marginal income tax bracket?
$960 divided by 37% = $2,594.59
Heads of Household Must:
(1) U.S. citizen or resident for entire taxable year; (2) unmarried/considered unmarried at close of taxable year; and (3) provide more than half of cost of household as principal place of residence for qualifying child/dependent.
Qualifying widows or widowers Can use MFJ Rates if:
(1) Unmarried at year-end; (2) have a child who may be treated as a dependent; (3) furnish more than half the cost of maintaining a household that is the principal place of residence for such children.
Four fundamental methods used in tax planning enabling achievement of tax-saving objective often used in conjunction with one another:
(1) avoiding taxes with exclusions, credits, and certain deductions to legitimately reduce tax liability, but not evading them (2) deferring taxes, (3) conversion, and (4) income shifting.
Four primary filing statuses for individuals:
(1) married individuals filing joint returns and surviving spouses, (2) heads of households, (3) unmarried individuals, and (4) married individuals filing separate tax returns.
Married individuals living apart or Abandoned spouse doctrine Continued
(3) Entitled to treat child as a dependent; (4) provide more than half of household maintenance; and (5) do not live with spouse for any period during last six months of tax year. Other spouse usually married filing separately.
Qualifying widows or widowers Can use MFJ Rates if - continued:
(4) Entitled to file a joint return with deceased spouse for year of death. Entitled to use MFJ tax rates for the succeeding two taxable years, provided the requirements remain satisfied.
Qualifying Dividends Taxed at Long-term Capital Gains Rates
0% rate for qualified dividends if taxable income under $78,750 for MFJ; 15% rate if fall between taxable income breakpoints of $78,750 to $488,850 for MFJ. 20% rate falling above $488,850 breakpoint for MFJ.
Taxable income example:
Adjusted gross income $242,175 Less: State and local income taxes, and real estate taxes $10,000, Home mortgage interest 17,600, Total itemized deductions $27,600 so greater than standard deduction, Taxable income $214,575.
Taxable income
Adjusted gross income reduced by greater of the standard deduction or itemized deductions and reduced by personal exemptions. Calculated by applying tax rate schedule or tax table to taxable income.
Deductions for Adjusted Gross Income (AGI) or "above-the-line" deductions with AGI being "the line"
Adjustments to income that reduce total income for AGI often called deductions for AGI—those deductions that reduce total income dollar for dollar. AGI is bottom line on front of Form 1040.
Other Taxes and Total Tax Due
After credits have been subtracted from the tax liability, other types of taxes may need added such as self-employment and alternative minimum tax. Total tax due is amount after adding these in. Amount offset by any payments already made.
Recognized as income:
Alimony or separate maintenance received pre-2019 decree, Award for special services, Bonuses, sales commissions, Dividends received, Employee's moving expenses (reimbursed, except Active Duty military), gambling, honorariums, interest.
Deductions for AGI
Alimony payment (pre 2019 decrees) Note that IRA contribution is nondeductible if active participant status and high MAGI.
Itemized deductions "Below-the-line deductions" or "Deductions from AGI."
Allowable deductions other than deductions allowable in arriving at adjusted gross income or deductions for personal exemptions like property taxes, mortgage interest on a residence.
Old Debt Refinancing Example: Married taxpayers filing jointly, bought a residence in 2016 by financing $900,000 of acquisition debt. Several years later, when the principal amount of the loan is $780,000, they refinance in order to obtain a better interest rate.
Also pull some cash out to pay off credit card debt. New loan $850,000. Only the interest on the first $780,000 of debt will continue to be treated as acquisition debt.
Taxability of Social Security Benefits Function of Two Amounts:
Amount of Social Security benefits received, and taxpayer's other income, including tax-exempt interest. Most clients will have between 50% and 85% of their benefits included in income.
Dividends from a qualified foreign corporation qualify for the reduced rate
An entity incorporated within a U.S. possession or one that is eligible for benefits of a comprehensive satisfactory treaty that provides for the exchange of tax information.
Dividends from foreign stocks also cap gains rate eligible if:
Are readily tradable on an established U.S. securities market (i.e., an American depositary receipt).
Total income
As reported on front of Form 1040, is essentially gross income reduced by certain items such as net capital losses up to $3,000, losses from a sole proprietorship, and allowable rental losses.
Keogh retirement plan
Available to owners of unincorporated businesses that enables them to take a deduction on the contributions to the plan. Income earned on contributions to the plan not taxed until withdrawn.
Excluded from Income
Award (unsolicited) for scientific achievement given to charitable organization, Bargain purchases by employees or employee discount, child support payment received, nominal value Christmas gift, inheritance and gifts received, forgiveness of debt in bankruptcy.
IRA deduction phased out for a married couple filing a joint return with a modified adjusted gross income (MAGI) that is between $103,000 and $123,000 if:
Both spouses are active participants in a company-maintained retirement plan. If neither spouse is an active participant MAGI limitations do not come into play, and the IRA contributions are fully deductible.
Married individuals living apart or Abandoned spouse doctrine
Can use tax schedules for single taxpayers or, if they qualify, head of household if: (1) file a separate return; (2) maintain household that is a child's or stepchild's principal place of residence for more than half of tax year.
Nonrefundable Tax Credits
Can't be used to increase your tax refund or to create a tax refund when you wouldn't have already had one.
Exclusions
Certain items of income receive special treatment and are not included as income so not subject to taxation/included as gross income.
Active Participant Definition For Defined Contribution Plans, Profit sharing plan, 401(k), or a 403(b) Most Common
Contributions from the employer or the employee or forfeitures credited to individual's account. If waive participation not active participant. Allocation of investment earnings to an individual's account not active participant.
Traditional IRA
Contributions may or may not be deductible from gross income, depending upon the taxpayer's qualified retirement plan participation and adjusted gross income. Earnings taxed on withdrawal.
Conversion
Converting highly taxed income into more favorably taxed income. Most common is to convert ordinary income into more favorably taxed long-term capital gains.
Married Filing Jointly (MFJ)
Couples who are legally married including legally married same-sex couples as of the last day of the tax year of December 31 for most taxpayers. Surviving spouses can file a joint return with deceased spouse for year of death.
Exclusions .
Create an economic benefit not included as income so not taxable resulting from (1) under Constitution, not taxable by federal government, (2) does not fall within definition of income, or (3) expressly excluded by statute.
Deduction Phaseout for Student Loan Interest Example
Deduction maximum $2,500 per year subject to phaseout based on MAGI between $140,000 and $170,000 for MFJ. At $140,000, interest fully deductible. Over $170,000, none of it is. At $155,000 MAGI, half of 2,500 deductible.
Itemized Deductions
Deductions from adjusted gross income and are allowed for certain expenditures primarily personal in nature. Medical expenses over 10% of AGI including long-term care insurance premiums up to a certain amount.
Preferential Rates Only for Eligible Dividends from Stock Continued
Dividends received from credit unions, mutual insurance companies, REITs, farmers' cooperatives, tax-exempt entities, deductible dividends from employer securities owned by an ESOP not eligible.
Tac Credits
Dollar-for-dollar offset against the tax liability typically determined by a formula, often a percentage of a base amount. Tax credits generally are often a means of implementing social or economic objectives.
Old age, survivors, and disability insurance (OASDI) portion of the Social Security taxes.
Employer required to withhold OASDI on first $132,900 of wages. taxpayers working for more than one employer may have excess amounts of OASDI tax withheld from their wages. Taxpayer entitled to a refundable credit.
Exclusions, Credits and Deductions
Exclusions e.g., interest on certain municipal bonds, not reported as income, credits e.g., qualifying child care expenses, dollar-for dollar reduction in tax liability, and deductions e.g., alimony paid, reduce taxable income.
Tax Credits Better than Exclusions or Deductions
Exclusions or deductions serve to reduce total income, and thus taxable income, but do not reduce tax liability directly so less beneficial than tax credits and provide fewer equitable benefits for those in lower marginal income tax brackets.
Old Debt Refinancing Example Continued
Fall under the old debt rules so interest on $780,000 is deductible, but remaining loan principal amount of $70,000, amount above the refinanced principal, not treated as acquisition debt so not deductible.
Tax Forms
Familiarity with the basic forms may aid understanding of some of the calculations. These forms are available at the IRS website at: http://www.irs.gov/Forms-&-Pubs.
Adjusted Gross Income and "above-the-line deductions" or "deductions for AGI" deducted on the front of Form 1040
Figure after deductions taken from total income like business expenses (Schedule C), contributions to self-employed retirement plans, deductions for alimony paid pre 2019 decrees, losses from sale/exchange of property.
Individual Retirement Account (IRA) Deduction
For 2019, limit is $6,000. 50 years of age or are older during tax year can make additional "catch-up" contribution of $1,000. For many taxpayers, contribution to traditional IRA deductible.
Legal Fees and Court Costs Related to Discrimination Lawsuits
For court costs and attorney's fees related to these lawsuits, an above-the-line deduction allowed. No line on the Form 1040 to account for this deduction.
IRA Contribution Deduction for Active Participants in an Employer Sponsored Retirement Plan
For singles, deduction phased out for modified adjusted gross incomes (MAGI) between $64,000 and $74,000. Active participant with under $64,000 of MAGI may still take a full deduction. Above $74,000, no IRA deduction.
W-2 Wages in Box One
Form 1040 reflects this amount. Compensation earned after reduction for amounts contributed to a qualified retirement plan, cafeteria plan, medical flexible spending account (FSA), or dependent care FSA.
Mortgage Insurance Premium Deduction Phaseout Example: Pay $1,600 for insurance:
Have AGI of $103,650 so deduction reduced by 40% of otherwise deductible amount—10% for each of four $1,000 amounts by which AGI exceeds $100,000. Deduction for qualified mortgage insurance $960. $1,600 minus $640 (40% of $1,600).
Alimony for Divorces After 2018
If divorce decree or separation executed after 2018, alimony payments not includible in income, nor are they deductible by the payor. Before were taxable to recipient, as deductible by payor.
Qualified Education Interest Deduction Eligibility
If eligible to be claimed as a dependent do not qualify. Also must be legally obligated to make the loan payments. If student legally obligated, parent claiming the child as a dependent may not claim the deduction.
"Bunching" itemized deductions
If fall short of being able to itemize, may make two years of charitable contributions this year, but none in the following year. Or bunch non-urgent medical expenses to itemize. Need more deductions than the standard to itemize.
Married Filing Separately and Standard Deduction
If one spouse itemizes deductions, other spouse must also itemize deductions. Thus if one spouse itemizes, the other spouse may not claim the standard deduction.
Refundable Tax Credit
If refundable credit exceeds tax liability can generate a tax refund even when no tax liability exists. Include prior income tax payments, including estimated taxes paid, payments made with a request for an extension of time to file, etc.
Tax Rate Schedules for Those Making 100k or more indexed for inflation
If taxable income $100,000 or more, one of tax rate schedules must be used. Schedule X for single individuals, Schedule Y married, and Schedule Z unmarried who qualify for the head-of-household filing status.
Child and Dependent Care Credit Important Numbers
Important numbers to remember are the 20%, and the $3,000 limit for one dependent or $6,000 for two or more dependents.
Tier II miscellaneous itemized deductions repealed
Included expenses related to the determination of, or collection of, a tax liability, and unreimbursed employee business expenses, such as union dues, unreimbursed travel expenses, etc.
Effective Income Tax Rate
Income of 168,000 24 percent marginal, average tax rate is 17.1%; $28,861 in tax per the schedules divided by the taxable income of $168,800. Average income tax rate also known as effective income tax rate.
Expenses for services provided outside the taxpayer's home qualify if
Incurred for the care of a dependent under age 13 or any other qualifying individual who spends at least eight hours a day in the taxpayer's household and for whom care is provided in a qualified dependent care center.
Acquisition Debt
Incurred in acquiring, constructing, or substantially improving any of taxpayer's qualified residences. Also includes debt from refinancing.
Residential Energy Credit Example
Installs $2,000 of certified energy saving insulation and $2,000 of certified energy-efficient windows in main home. $400 credit for ($4,000 × .10). Available through December 2019 but likely that it will be extended.
Preferential Rates Only for Eligible Dividends from Stock
Interest earned from CDs, bonds, savings accounts not eligible. Dividends from stock owned for less than 61 days in the 121-day period beginning 60 days before the ex-dividend date do not qualify.
Personal Interest or Consumer Interest
Interest on personal debts, such as bank credit cards. Non-deductible.
Jury Duty Fees Paid Over to an Employer
Jury duty fees received by a taxpayer are taxable. If gave pay to employer because employer continued to pay taxpayer's salary while on the jury, taxpayer can deduct amount paid to employer.
Common Exclusions
Life insurance proceeds received by reason of death of insured, gift or most inheritances, municipal bond interest, child support payments received, workers' comp proceeds, many employee fringe benefits.
Some common exclusions
Life insurance proceeds received by reason of death of the insured, a gift or inheritance received, interest received from municipal bonds, and many employee fringe benefits.
Residential energy-efficient property credit
Likely to be extended past 2021, equal to sum of 30% of the amounts paid for qualified solar, fuel cell property up to a maximum credit of $500 for each 0.5 kilowatt of capacity, small wind energy, geothermal heat pump.
Limit on deductibility of state and local taxes (SALT) due to TCJA
Limit $10,000, or $5,000 for married filing separately on SALT deductibility and real estate and personal property taxes. Foreign income taxes also included in this limitation; but better treated as a tax credit than itemized deduction.
Tax Credits for things such as:
Low income housing expenses, child and dependent care expenses, both subject to limits.
Tax Deferral Timing
Lower taxable income during peak earning years when the taxpayer is in a higher marginal income tax bracket and receive the income during later years usually at retirement when the taxpayer may be in a lower tax bracket.
Tax Rates for Capital Gains and Qualified Dividends
MFJ: Under 78k 0%, over 15% until 488k when becomes 20%. Single Under $39,375 0%, then 15% until over $434,550. Head of household under $52,750 0%, over 15% until $461,700. Estates and trusts Under $2,650 0%, then 15% until over $12,950.
Additional Standard Deduction for Elderly or Blind
Married age 65 before the close of the tax year or blind get additional standard deduction of $1,300 or $2,600 if both elderly and blind. Unmarried elderly or blind get $1,650 or $3,300 if both elderly and blind.
Standard Deduction Amounts for 2019
Married persons filing jointly $24,400. Heads of households $18,350. Single persons $12,200. Married persons filing separately $12,200. Adjusted yearly for inflation.
Additional Standard Deduction Example
Married taxpayers filing jointly both over age 65. Their standard deduction for 2019 is $27,000. This is the basic standard deduction of $24,400, plus an additional $2,600 for both spouses being age 65 or older.
Higher Education Deduction or Tuition and Fees Deduction
May or may not still be in force. Typically, get greater benefit from a credit than from a deduction so most of the time this deduction taken when AGI too high to qualify for Lifetime Learning credit.
Qualifying Child
Meets the relationship test, has the same principal place of abode as the taxpayer for more than one-half of the tax year , meets the age test of under 19, under 24 if student, disabled, has not provided more than one-half of own support for the tax year.
"New Debt"
Mortgage debt incurred after December 15, 2017. This deductibility of the interest on this debt is limited to $750,000 of acquisition indebtedness.
TCJA: Two sets of Rules for Mortgage Interest Deductions
Mortgage debt incurred on or before December 15, 2017 "old debt", and subject to old rule, which is less restrictive than newer rule, which applies for mortgage debt incurred after December 15, 2017 or "new debt".
TCJA "Old debt"
Mortgage debt, or qualified residence interest, incurred on or before December 15, 2017. Deductible qualified residence interest is limited to interest on acquisition indebtedness secured by a principal or secondary residence.
received an honorarium of $3,000 for a speaking engagement, $75 for jury duty, pays child support of $500 per month to his former spouse, received cash inheritance of $20,000. What amount of income must recognize from these events?
Must recognize $3,075—the honorarium and jury duty are the only items that must be recognized as income. The inheritance is specifically exempt from income tax. The child support paid is not a deductible item.
Even if Income under Standard Deduction Still Have to File if
Net earnings of $400 or more from self-employment income, wages of $110 or more from a church that is exempt from paying employer Social Security taxes, subject to special taxes like self-employment or alternative minimum tax.
Modified AGI (MAGI) vs AGI
On a joint return, MAGI reflects combined incomes of spouses. For most and for exam purposes, no difference between AGI and modified AGI. Technically, modified AGI is AGI without regard to the various above the line deductions.
Standard Deduction
On the back of Form 1040, tax calculation begins with AGI figure. The adjusted gross income is then reduced by greater of total itemized deductions or the standard deduction.
Household and dependent care expenses also are limited as follows:
One dependent, upper limit on expenses to which the percentage may be applied $3,000. Two or more dependents, limit $6,000. These limits reduced, by child care paid through a dependent care flexible spending account (DCFSA).
Spouses who are full-time students or who are incapable of caring for themselves are "deemed" to earn income in order to clam credit
One qualifying individual deemed income earned per month $250. Two or more deemed income earned per month is $500. Allows claiming of this credit by taxpayers who would otherwise be unable to do so due to lack of earned income.
Why File Separately
One spouse has significant potential deductions subject to limitation based on AGI, such as medical expenses or casualty losses. Spouse's lower separate AGI may result in larger deductions.
Deduction Floors - Medical Expenses Example
Only deductible if exceed 10% of AGI. AGI of $100,000, no medical expenses deductible until total expenses exceed $10,000. If $14,000, only $4,000 deductible; portion that exceeds 10% of AGI floor.
Qualifying Relative - Other Criteria
Or whose principal place of abode is taxpayer's home and is a member of household, gross income for tax year less than $4,150, over half of support provided by taxpayer, not a qualifying child of that taxpayer or any other taxpayer.
Mortgage Insurance Premiums
Paid or accrued during 2007-2017, in connection with acquisition indebtedness, treated as qualified residence interest. Provision expired at end of 2017, may be retroactively reinstated and perhaps made permanent.
Investment interest
Paid or accrued on indebtedness incurred to purchase or carry property held for investment. This interest is deductible up to certain limits for all taxpayers.
AGI Determines Phaseouts and Floors for
Passive activity loss, education savings bonds and other education deductions, IRA and Roths, charitable contributions, medical expenses and casualty deduction floors.
AGI Limits Ability to Contribute to a Roth IRA
Phased out for individuals with AGIs between $122,000 and $137,000 or for joint filers between $193,000 and $203,000, without regard to active participant status. Contributions nondeductible but qualified distributions tax free.
TCJA provides for a $500 credit for each dependent who is not a qualifying child
Presumably, a dependent who is a qualifying relative. Taxpayer may claim the $500 credit for a dependent child who is over age 16, a full-time student under the age of 24, or a dependent parent or other relative.
Sale of Section 1250 property
Primarily depreciable real estate. Portion of the capital gain attributable to depreciation is subject to a maximum 25% tax rate. This 25% gain is referred to as unrecaptured Section 1250 income.
Itemized Deduction Phaseout
Prior to the TCJA, there was a phaseout of the itemized deductions, based on the taxpayer's adjusted gross income. This phaseout of itemized deductions was repealed as part of TCJA. It does not apply after 2017.
Personal Exemption Phaseout
Prior to the TCJA, there was a phaseout of the personal and dependency exemptions, based on the taxpayer's adjusted gross income. This phaseout of itemized deductions was repealed.
Tax credits and Tax Liability
Provide a direct offset against, or reduction of, a taxpayer's income tax liability on a dollar-for-dollar basis. Tax liability is the amount of money owed to Treasury after all allowable credits subtracted.
Residential energy credits
Qualified energy saving items installed at main home. Nonbusiness energy property credit allows lifetime credit of up to $500 for making qualifying energy saving improvements, only $200 of which may be for qualifying window expenses.
Marginal income tax bracket
Refers to the rate of tax on a taxpayer's last dollar of income.
Income Tax Calculation Process
Seven steps as noted above. Greater detail on pages 55-59 of Module 1 chapter 1.
Income Shifting
Shifting income from higher-taxed person to the lower-taxed person often parent gifting income or assets to a child under the "kiddie tax" rules. No taxes on first $1,100 probable lower rate than the parents on next $1,100.
Total Income and Gross Income Not Synonymous - Biggest Difference
Some subtractions allowed in computing total income but not deducted with gross income. Include losses from unincorporated businesses (sole proprietorships, or partnerships) or up to $3,000 of net capital losses.
Penalty on Early Withdrawal of Savings Deductible
Sometimes known as forfeited interest or principal, penalty assessed on early withdrawal of funds from a CD or time savings account deductible in arriving at AGI. Typically reported on 1099-INT.
Other Common Itemized Deductions
State and local income tax (SALT), domestic real estate and personal property tax, mortgage interest on primary and secondary residences
Deductions from AGI
State and local income taxes greater than sales taxes and real estate taxes limited to $10,000, home mortgage interest. Unreimbursed employee business expenses are not deductible, personal interest credit card and auto, not deductible
Seven steps required to calculate the tax liability: 1 -3
Step 1: Start with total income. Step 2: Subtract adjustments to income from gross income for adjusted gross income. Step 3: Determine itemized deductions to find if exceed the standard deduction amount.
Seven steps required to calculate the tax liability: 4-5
Step 4: Subtract greater of itemized deductions or standard deduction amount from adjusted gross income for taxable income. Step 5: Determine tax from either the tax table or the tax rate schedules, depending on which applies.
Seven steps required to calculate the tax liability: 6-6
Step 6: Subtract nonrefundable credits and add other taxes to determine net tax liability. Step 7: Subtract payments and refundable credits to determine amount owed or refundable.
Deduction Ceiling of Maximum Amount - Charitable Contributions Example
Subject to a 60% of AGI limit or ceiling. A taxpayer with an AGI of $100,000 may not deduct more than $60,000 of cash contributions in a given year.
Taxpayer in the 24% marginal income tax bracket qualifies for a $2,200 IRA deduction. Amount of tax credit that would provide a tax benefit equal to the moving expense deduction?
TC = $2,200 × 0.24 TC = $528
Equivalent tax benefit of exclusions or deductions to tax credits can be determined by applying the following formula:
TC = d × m where: TC = Amount of tax credit or tax savings, d = Before-tax benefit or amount of exclusions or deductions ,m = Marginal income tax bracket. Compares tax impact of alternatives of exclusions, deductions, or tax credits.
Two dependent children in Day Care while at work. Claim a credit for child and dependent care expenses of $960 in current tax year. What amount of deduction necessary to provide tax benefit equal to that provided by child care credit if in 12% marginal income tax bracket?
TC divided by M = d, $960 divided by 12% = 8,000
Contributed $12,000 to his company's 401(k) account this year. What tax planning strategies did Mark employ?
Tax reduction and tax deferral
Seven Steps in Income Tax Calculation - Steps 1 - 3
1. Start with total income; number 2/3 of way down Form 1040. 2. Subtract adjustments to income from total income (Step 1) for adjusted gross income. 3. Determine if itemized deductions exceed standard deduction amount.
Child and Dependent Care Credit Phaseout
35% of the household and dependent care expenses for AGIs of $15,000 or less. For each additional $2,000, or fraction thereof, of adjusted gross income above the $15,000 limit, the 35% is reduced by 1% to its lowest point of 20% above 43k.
Seven Steps in Income Tax Calculation - Steps 4-5
4. For taxable income, subtract greater of itemized deductions or standard deduction from adjusted gross income (Step 2). 5. Determine tax from either tax table or tax rate schedules, depending on which applies.
Seven Steps in Income Tax Calculation - Steps 6-7
6. Subtract nonrefundable credits, if any, from tax found in Step 5 and add other taxes to determine net tax liability. 7. Subtract payments and refundable credits to determine amount owed or refundable.
Major Types of Refundable Tax Credits
A portion of the American Opportunity tax credit is refundable. The earned income tax credit, available only to low-income working taxpayers, is another major refundable credit.
Head of Household and Parent Care
A taxpayer supporting a parent in a rest home, nursing home, or separate home able to qualify as long as the first two requirements above satisfied.
Child Tax Credit Phaseout Example
AGI $408,010, one qualifying child. Divide $8,010 excess by $1,000 = 8.01. Reduced by $50 for each $1,000 or part thereof so round up to nine. Nine multiples of $50 equals $450. Credit $1,550. Nonrefundable credit except for very poor.
IRA Contribution Deduction if MFJ and Only One Spouse an Active Participant
Active participant spouse subject to phaseout of $103,000 to $123,000. Non-active participant spouse may take a deduction subject to phaseout ranging from $193,000 to $203,000. Above 203,000, no deduction.
Single taxpayers—the IRA deduction is phased out for modified adjusted gross incomes between $64,000 and $74,000 if:
Active participant. Modified AGI is without regard to IRA deduction itself, student loan interest deduction, foreign earned income exclusion, the foreign housing or qualified savings bond interest exclusions, etc.
Married taxpayers filing jointly, with only one spouse as an active participant:
The active participant spouse is subject to the phaseout range of $103,000 to $123,000. The non-active participant spouse may take a deduction subject to a phaseout from $193,000 to $203,000. MAGI reflects combined incomes of both.
32% marginal income tax bracket qualifies for a $600 child care credit. The amount of exclusions or deductions that would provide tax benefits equal to the child care credit?
d = 600 divided by .32 = $1,875
If know amount of tax credit or tax savings and want to determine amount of exclusions or deductions that would equal the credit:
d = TC divided by M
Purchased $60,000 of municipal bonds for his portfolio. What tax planning strategy did Carl employ?
tax avoidance