If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by HERE for a complete list of classes currently available and HERE for more information about the website.
Class Objectives: To understand the basics of federal income taxes including income, deductions, exemptions and credits.
Handout: Income Tax Calculations
Assignment: (see end of class below)
Those that have been around on my blog for a little while know that I’ve been really excited to finally reach the topic of taxes. I really, truly believe that knowledge of taxes is where you can make one of the absolute biggest impact on your finances. If the topic makes you want to cringe or hide, it’s probably because you just don’t understand the simple basics.
My first impressions of taxes were based on the following childhood experiences:
- I was so excited to buy a brand new doll that I wanted at the store–it was $19.99 and I had $20 so I could buy it! Except…then I found out the hard way about sales tax.
- Growing up, we would always know when my dad was working on the taxes because he was very short-tempered and would snap at us if we came into his office and asked him basically anything during that time. Because…taxes and stress are apparently synonymous.
- I wouldn’t have even dreamed of doing my own taxes before college. My dad did them for me (and I’m sure he enjoyed it immensely based on my previous comment). No way could I do them because…the forms are just too complicated for me to be able to figure them out.
However, I had an epiphany when I took my first tax class in college. Individual income taxes are really very simple in theory. It is simply a matter of summarizing the overall concept:
- In order to keep our governments running, we are required to pay a certain percentage of all of our income as a tax. “Rich” people pay a higher percentage than “poor” people.
- Then, in order to encourage certain specific spending behaviors, the government allows us specific deductions and credits.
- In addition, a specific exemption and allowance is made to make sure that taxes don’t prevent families and individuals from being able to pay their basic bills and living necessities.
That’s really basically it and for the average person, their personal taxes really aren’t very complicated. However, there are a lot of rules and exceptions for those deductions and credits and that’s where things get confusing. We’ll cover some of the rules in TX303: Intermediate Income Tax , but for this class, we are only going to focus on the broader basics of income tax.
THE BASIC STRUCTURE OF INCOME TAXES
If we set aside the 1040 form for a minute, we can greatly simplify taxes based on an extended formula using elementary school math.
By going through each of these categories, you will hopefully gain an increased understanding of your own personal tax situation.
All income is taxable unless there is a specific exception that exempts it from federal income tax. Common types of income that are taxable include:
- Salary, wage and consulting income
- Investment income such as interest, dividends and capital gains
- Gain on sale of investment property
- Business income
- Rental income
- Unemployment compensation
- Disability benefits (some), Social Security benefits (some) & traditional retirement distributions
- Court awards for punitive damages
- Gambling income
- Jury duty pay
Some types of income that are exempt from income tax include:
- Municipal bond income
- Academic scholarships
- Disability benefits (some), Social Security benefits (some) & Roth retirement distributions
- Gifts, life insurance proceeds & inheritances
- Sale of personal residence (with specific requirements)
- Child support
- Combat pay
- Court awards for physical injury or emotional distress
ABOVE THE LINE DEDUCTIONS
After adding up all the income items, the next step is to determine which deductions are allowed “above the line”. These deductions are specifically designated to be taken before reaching adjusted gross income. The order that the deductions are taken is important because adjusted gross income is the basis for many other deductions as well as the basis for most state income taxes. So, an above-the-line deduction is worth more than the itemized deductions and standard deductions listed later in the formula.
A few of the most common above-the-line deductions include:
- Educator expenses (up to $250)
- Health insurance, retirement plan contributions and 1/2 of self-employment tax for self-employed persons
- Health savings account and traditional IRA contributions
- Alimony paid
- Tuition and student loan interest
ADJUSTED GROSS INCOME
Adjusted gross income (AGI) is the total income that is taxable less the above-the-line deductions listed discussed above. Adjusted gross income is an important number that is used as a basis for calculating some deduction amounts. In addition, some deductions and the personal exemption are completely eliminated if you have adjusted gross income over a certain amount.
Adjusted gross income determines:
- the amount of medical deduction you can take (over 10% AGI)
- the amount of miscellaneous itemized deductions you can take (over 10% AGI)
- whether there is a phaseout of itemized deductions (starting at $311,300 for single filers)
- whether there is a phaseout of personal exemptions (starting at $311,300 for single filers)
- eligibility for the dependent care credit
- eligibility for the child tax credit (phaseout starts at $110,000 for married filing jointly)
- eligibility for the hope & lifetime learning credits for tuition
- eligibility for earned income credits
- eligibility for medical premium tax credits (with a couple adjustments to AGI)
- eligibility to deduct contributions to a traditional IRA (with a couple adjustments to AGI)
You may also hear the term “modified adjusted gross income” or MAGI. MAGI includes adjustments to certain deduction items that were taken to arrive at AGI as well as adding back tax-exempt interest and a couple other items.
ITEMIZED & STANDARD DEDUCTIONS
As shown in the summary chart, you are allowed to take the greater of either the standard deduction or your total eligible itemized deductions. The current standard deductions for 2016 are:
- Single filers – $6,300
- Married filing joint filers – $12,600
- Head of household – $9,300
Itemized deductions include:
- Medical expenses over 10% of AGI
- State and local income OR sales taxes (only one is allowed)
- Real estate and personal property taxes
- Mortgage interest, points and mortgage insurance premiums
- Investment interest
- Charitable contributions in cash or property
- Casualty or theft losses (over 10% of AGI with additional limitations)
- Miscellaneous expenses-unreimbursed employee expenses, tax preparation fees & safe deposit box
Allowing these itemized deductions encourages taxpayers to own homes and contribute more to charity as well as providing some relief for people with extensive medical expenses.
Each person is entitled to a personal exemption for tax purposes. For 2016, each exemption amount is $4,050. For a married couple with two kids, they would get 4 exemptions (totaling $16,200). It gets a little more complicated when you have other people that you provide support for such as elderly parents, other relatives or others that live with you. If you have any of those situations, be sure to look up the requirements on the IRS website here.
Once you’ve reached taxable income, you’ve reached the base (finally!) at which you will calculate how much tax you will be owe based on the tax rates from 10%-39.6%. An explanation of tax rates is below.
A big misconception about taxes is that your income is all taxed at the rate that applies to your taxable income. However, this isn’t the case at all. Income taxes are actually graduated rates where income is taxed at progressive tiers. The initial income range is taxed at a low rate of 10%, then additional income is taxed at higher rates as the total income increases. This is true for everyone regardless of their total income.
For example, if you file married filing jointly and have taxable income of $100,000, your first $18,550 of income is only taxed at 10%, the next $56,750 is taxed at 15% and the next $24,700 is taxed at 25%. Total tax will be $16,543 (assuming there are no credits applicable), which actually represents an overall tax percentage of only 16.54% ($16,543 tax divided by $100,000 taxable income).
The tax rates are included below. To use this table:
- Look up the line that includes the range with your taxable income (in our example above it would be the $75,300-$151,900 range under married filing joint status).
- Subtract the lower tier of the bracket you are in (so for the example it that would be $100,000 – $75,300 = $24,700).
- Multiply the rate shown by the amount in step 2 (for the example we would take $24,700 x 25% = $6,175).
- Add to step 4 the number in the cumulative column for that bracket. (for the example we would take $6,175 + $10,368 = $16,543).
The complete formula would look like this:
Tax = [(taxable income – lower tier amount) x rate] + cumulative of other tiers
Tax = [($100,000 – 75,300) x 25%] + $10,368 = $16,543
After determining tax, you may be eligible for certain tax credits, which we won’t go into detail in this class. The common credits include:
- Child tax credit
- Dependent & child care credit
- Premium tax credit
- Earned income credit
- Education credits
- Residential energy credit
There are other credits as well, and if you have any special tax situations, it’s wise to meet with a tax professional to make sure that you get all the credits that you are eligible for.
A common additional tax owed in addition to the calculation above is self-employment tax. Self-employed business owners are responsible for both portions of the FICA taxes (Social Security and Medicare) and pay them on their 1040 return. There are additional taxes as well that are outside the scope of this discussion.
SIMPLE TAX EXAMPLE
In narrative format, we could use the following example to go through the basic structure of income taxes:
Katy, a single 25-year-old paralegal, made $45,000 in gross wages this year and $250 interest income. Her income totals $45,250, none of which is exempt from federal income tax.
She paid $750 in student loan interest, which she is able to deduct from the $45,250 to reach her adjusted gross income of $44,500.
Katy has $150 in personal property taxes and $500 in charitable contributions for the year, but those are her only items that would qualify as itemized deductions ($650 total). Because the standard deduction is much higher at $6,300, she would take the standard deduction.
In addition, she is allowed one $4,050 personal exemption, since she does not have any additional dependents.
Subtracting both the $6,300 and $4,050 from her $44,500 adjusted gross income will result in a taxable income figure of $34,150.
So, although Katy actually made $45,250 in income this year, she will only pay federal income tax on $34,150 of that total income. Single filing status tax tables show that the first $9,250 is taxed at only 10% and the next $24,900 ($34,150-9,250) is taxed at 15%. Her total tax is $4,660 ($925 from the 10% tax bracket + $3,735 from the 15% tax bracket).
EXAMPLE: THE SMITH FAMILY
The Smith family tax return for 2015 (last year) is previewed below. Their return is fairly simple, as they don’t have additional business or investment income.
Their tax return can be summarized based on the basic tax structure below:
Your homework assignment is to analyze the income and deduction items on your 2015 tax return.
- IMPROVING – Go through the income tax calculation formula above and your 2015 tax return to make sure you understand each income and deduction item as well as any credits you took on your return.
- INVESTED – same as above.
- UNSTOPPABLE – same as above.
HANDOUT: Income Tax Summary
I’ve summarized the basic income tax calculation with a brief summary of each item in the handout below. Click on the preview to download.