Overview of Federal Income Taxation for Individuals
Federal income taxes are assessed on a progressive level. This means that, the more income you earn, the higher your effective tax rate is. The first few hundred or thousand dollars you make may not be taxed at all, while high income earners may be taxed at a rate of 39.6% in federal income tax alone (in addition to state taxes and payroll taxes). For purposes of this presentation, we will discuss only federal income tax and not the various types of payroll taxes, including Social Security and Medicare taxes.
There are four basic types of information that are relevant to federal income taxation and that form the bulk of your annual Form 1040 (federal income tax return):
1. Your gross income
2. Your “above the line” deductions
3. Your “below the line” deductions
4. Your tax credits
Below, we will discuss each of these in greater detail, though an overview of their role in determining your federal income tax bill is important at the outset.
Your gross income is the amount you earned. For employees, this is typically the amount reported on their Form W-2s and/or 1099s, in addition to whatever other income the taxpayer may have received based on business income, dividends, interest, capital gains, royalties, etc.
Your “above the line” deductions are deductions that can be taken off your gross income before your “adjusted gross income” (“AGI”) is calculated. Because the amount of your AGI is important for many reasons, such as whether certain deductions and credits may be taken, above the line deductions are the best kinds of deductions.
Your “below the line” deductions are deductions that can be taken from your adjusted gross income before determining your taxable income, and thus how much you actually have to pay in income tax. The amount of income that remains after all of your income tax deductions is your “net income.”
The amount of income tax you actually pay is the applicable income tax rates multiplied by the amount of net income. The rates vary based on your filing status, with single filers paying the highest rates and married-filing-jointly filers paying the lowest rates. By way of example, the tax rates for married couples filing jointly in 2014 were:
• 10% on taxable income from $0 to $18,650, plus
• 15% on taxable income over $18,650 to $75,900, plus
• 25% on taxable income over $75,900 to $153,100, plus
• 28% on taxable income over $153,100 to $233,350, plus
• 33% on taxable income over $233,350 to $416,700, plus
• 35% on taxable income over $416,700 to $470,700, plus
• 39.6% on taxable income over $470,700.
Tax credits at the best type of tax benefit for the taxpayer. The amount of the tax credit is reduced, dollar for dollar, from the amount that the taxpayer actually has to pay, after that amount has been calculated based on the applicable rates.
Your taxable income includes all of the following:
1. All wages, salaries and tips earned by the taxpayer. For full-time employees, these are reported to the employee and to the IRS by a form W-2. Other types of compensation are reported by a Form 1099-MISC.
2. All taxable interest (certain types of interest such as those earned on municipal bonds are tax-exempt) earned by the taxpayer. These are typically reported by banks and brokerage firms to the taxpayer by a form 1099s-INT. Taxpayers who earned interest must also fill out a Schedule B with his or her income tax return that details the interest earned.
3. All dividends earned by the taxpayer. Dividends generally fall into two categories: qualified and non-qualified. Determining whether a dividend is qualified is fairly complex. The basic rule is that to be a qualified dividend, the stockholder must have held the stock on which the dividend was issued for more than 60 days during the 121-day period that begins 60 days before the first date following the declaration of a dividend. Dividends are reported by companies and brokerage firms via a form 1099-DIV. This form will also tell you how much of your dividend, if any, was qualified. Qualified dividends are taxed at the long-term capital gains rate, which is lower than the rate at which ordinary income is taxed. Nonqualified dividends are taxed as ordinary income. Taxpayers who earned qualified dividends must also fill out Schedule Ds with their income tax returns.
4. All refunds, credits and offsets of state taxes that the taxpayer received during the calendar year.
5. Alimony received by the taxpayer during the calendar year.
6. Income earned through the taxpayer's businesses during the calendar year. Losses suffered by the taxpayer while operating his or her businesses can be deducted from the taxpayer’s gross income. Taxpayers who earned income from one or more businesses must file a Schedule C with his or her income tax return.
7. Any capital gain earned by the taxpayer during the relevant calendar year. A capital gain is a profit earned by the taxpayer, which is generally measured by the sale price minus whatever the taxpayer paid for the property in the first place (with certain adjustments). Capital gains can be long-term (if held for more than one year) or short-term (if held for one year or less). Long-term capital gains are taxed at a lower rate than ordinary income (the same rate as qualified dividends) while short-term capital gains are taxed as ordinary income.
8. Distributions from IRAs, annuities or pension accounts, with certain exceptions (such as those from a Roth IRA).
9. Income from other miscellaneous sources such as rentals from real estate owned by the taxpayer, royalties, distributions from trusts or other companies of which the taxpayer is a beneficiary or owner, unemployment compensation, certain percentages of social security benefits and other miscellaneous income. Note that virtually all income is taxed, including income from gambling winnings, lost property found by the taxpayer and even income from illegal activities. Income that is not taxable is specifically exempted in the Internal Revenue Code. Some examples of exempted income include gifts received, inheritances and many types of life insurance payouts.
The addition of all taxable income leads to an initial determination of the taxpayer's “total income.”
Adjusted Gross Income
The next stage is to convert the taxpayer's total income into his or her “adjusted gross income.” To do this, the “above the line” deductions must be subtracted from the taxpayer's total income. The taxpayer’s “adjusted gross income” (or “AGI”) is important because many deductions and tax credits are limited by the taxpayer’s AGI. This is why “above the line” deductions are better than “below the line” deductions, as they decrease your AGI, thereby increasing eligibility for various other deductions and tax credits.
Above the line deductions include:
• Expenses incurred by educators in the course of their teaching activities
• Contributions to qualifying Health Savings Accounts (HSAs)
• Certain job-related moving expenses
• The “employer’s” half of payroll taxes paid by a self-employed taxpayer
• Contributions made to “SEP” IRA accounts and certain similar retirement accounts for self-employed people
• Contributions made to certain other qualified retirement accounts
• Interest paid on student loans
• Certain qualifying educational expenses, including tuition and fees, within certain limits.
Once the above the line deductions are taken and subtracted from the taxpayer’s total income, the number that results is the taxpayer’s AGI.
Below The Line Deductions
Once the taxpayer’s AGI is calculated, the taxpayer has two choices in taking further deductions. The taxpayer may take a “standard” deduction that is $6,350 for an individual as of the 2016 tax year. (Married couples filing jointly are entitled to twice that amount.) Any filing taxpayer is entitled to take the standard deduction, regardless of how many deductible expenses the person may have actually incurred during the year.
Alternatively, the taxpayer may choose to “itemize” deductions by listing all of his or her below-the-line deductions on Schedule A. Obviously, the taxpayer should choose to itemize deductions only if the amount of itemized deductions exceeds the amount of the standard deduction. Taxpayers may vary their deduction strategies from year to year. Therefore, in most cases, it pays for the taxpayer to calculate the total available itemized deductions before making a determination as to whether to take the standard induction or to itemize.
Schedule A of Form 1040 contains the below-the-line deductions that may be taken if the taxpayer chooses to itemize deductions. These include:
• Medical and dental expenses, but only to the extent that they exceed 7.5% of the taxpayer’s AGI;
• State and local taxes. The taxpayer may choose to deduct either income tax or sales tax. For most people, deducting state income tax provides the larger deduction;
• Real estate taxes;
• Interest paid on the mortgage loan of the taxpayer's primary residence;
• The value of charitable donations made by the taxpayer;
• Specified amount tax deduction for each dependent claimed on your return;
• Certain types of casualty or theft losses;
• Some unreimbursed job-related expenses, even if the taxpayer does not operate his/her own business.
Note that Schedule A deductions are limited for those taxpayers whose AGI is more than a little more than $150,000. A sliding scale that is based on the taxpayer’s AGI dictates the percentage of the below the line deductions that may be deducted by the taxpayer in determining the taxpayer’s taxable income.
The taxpayer’s “taxable income” or “net income” is calculated by subtracting all of these deductions from the taxpayer's AGI. The applicable amount of income tax is then calculated by applying the applicable tax rates. Once the total amount of income tax is calculated, it is then time to apply any applicable tax credits.
Tax credits are amounts that can be subtracted from actual tax due. These are, of course, superior to deductions since they reduce the tax amount dollar for dollar rather than merely decreasing the income upon which the tax would be calculated. Examples of tax credits include:
• The Earned Income Tax Credit. This tax credit is available to taxpayers with relatively low earned income, though the amount of allowed income increases with increasing family sizes. While quite complex to figure out, the EITC can be quite a substantial tax credit for low income wage earners. In fact, it is possible that the amount of the EITC will be more than the taxpayer's total tax bill, meaning that the taxpayer ends up paying a negative income tax.
• The child tax credit. As of the 2016 tax year, the amount is $1000 per dependent child.
• Credit for foreign taxes paid on the same income.
• Credit for certain educational expenses.
• Various other credits, including those for purchasing certain energy saving materials or systems, etc.
Other adjustments to a taxpayer’s bill are also possible, as the tax code is extremely complex in its entirety. Nevertheless, these four types of numbers are the fundamental building blocks upon which all individual income tax returns are based.