The Individual Tax Formula Chapter 14 The Individual Tax Formula McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives Filing status Computing taxable income Standard deduction versus itemized deductions Exemptions Tax rates Marriage penalty Child credit and dependent care credit Individual AMT Payment and filing requirements

Filing Status Filing status Reflects an individual’s marital and family situation Affects the calculation of taxable income Determines the rates at which income is taxed

Filing Status - Married MFJ or MFS if married on the last day of the year MFJ (married filing joint) rates If spouse incomes are very similar, single rates generate lower overall tax If spouse incomes are dissimilar, married rates generate lower overall tax MFJ rates apply to Surviving Spouse status A widow/widower with a dependent child for two years after death of spouse may file as Surviving Spouse MFS (married filing separately) rates are less favorable than single

Filing Status - Unmarried The Head of Household filing status may be used if the taxpayer maintains a home for either a: Child (need not be dependent), or Dependent relative Single is the default filing status for unmarried individuals

Filing Status Examples Application Problem 2 Mr. J and Mrs. J were legally divorced on November 18. Mr. J has not remarried and has no dependent children. Mr. J and the first Mrs. J were legally divorced on April 2. Mr. J remarried the second Mrs. J on December 15. He has no dependent children. Mrs. J died on July 23. Mr. J has not remarried and has no dependent children. Mrs. J died on October 1, 2006. Mr. J has not remarried and maintains a home for one dependent child.

Application Problem 2 (continued) Mrs. J died on May 30, 2007. Mr. J has not remarried and has no dependent children. Mr. J and Mrs. J were legally divorced on May 30, 2005. Mr. J has not remarried and maintains a home for his two dependent children.

Taxable Income Computation Step One: Calculate total income on Line 22 on Form 1040 Step Two: Calculate Adjusted Gross Income (AGI) on Line 34 of Form 1040 Step Three: Subtract the greater of itemized deductions or the standard deduction Step Four: Subtract total exemptions

Step One Taxable income includes Business income Salary or wage payments Investment income

Step Two Adjusted Gross Income (AGI) equals total income less specific above-the-line deductions AGI is an extremely important number as many individual deductions and credits are limited by reference to a taxpayer’s AGI

Step Three Subtract the greater of The standard deduction Or allowable itemized deductions

Standard Deduction Depends on filing status. For 2008 MFJ = $10,900 MFS = $5,450 HOH = $8,000 Single = $5,450 Blind or aged (>=age 65) MJF, MFS = additional $1,050 HOH or Single = additional $1,350 Ben, age 65, and Mary, age 64, are married filing joint. What is their 2007 standard deduction? $10,700 + $1,050 = $11,750

Itemized Deductions See Schedule A (Chapter 17 details) Only 30% of individual filers elect to itemize their deductions Bunching: if itemized deductions are about equal to standard deduction each year, the taxpayer should bunch deductions on alternate years and claim standard deduction on other years

Bunching Example My dad gives $5,000 to charity each year. He is 77 and single. What is his standard deduction each year? $5,350 + 1, 300 = $6,650 Does he itemize? No, as the standard deduction of $6,650 is greater than itemized deductions of $5,000 Suppose he gave $10,000 to the church every other year? He would benefit by taking a $10,000 itemized deduction in the years of the charitable contribution and taking the standard deduction in the other years

Key Observation re: Individual Tax Deductions A deduction listed as an above-the-line deduction always reduces taxable income A deduction that must be itemized may have limited or even no effect on taxable income The classification as either above-the-line or itemized deductions often reflects tax policy concerns and can change from year to year

Step Four Subtract exemption amounts The taxpayer is allowed a personal exemption Two exemptions are allowed if Married Filing Joint If you are a dependent on someone else’s return, can you still claim an exemption for yourself? No! The exemption amount is $3,500 for 2008 for each personal and dependency exemption

Exemptions for Dependents If an individual passes all five tests, you may claim him or her as a dependent Family member OR live in your home for entire year You provide > 1/2 financial support Dependent’s gross income < exemption amount of $3,500 in 2008 Waived for child < 19 years OR student-child<24 years Dependent may not generally file a joint return Dependent must be a U.S. citizen OR a resident of US, Mexico, or Canada

Application Problem 5 Mr. and Mrs. O file a joint income tax return. Determine if they can claim a personal exemption for any of the following individuals Son Jack, age 20, who lives in his parents’ home and works full time as an auto mechanic. Jack is self-supporting except for the fact that he does not pay rent to his parents. Daughter Brenda, age 22, who is a full-time college student. Brenda lives in a dormitory during the school year but her parents’ home is her permanent residence, and her parents provide 100 percent of her financial support.

Application Problem 5 (continued) Nephew Eddie, age 16, who has lived in Mr. and Mrs. O’s home since 2004. Eddie is a high school student who earned $6,690 this summer working for a plumber. Since his aunt and uncle provide 100 percent of his financial support, Eddie is saving his earnings for college. Mr. O’s mother Mildred, age 64, who lives in a retirement community. Mr. and Mrs. O provide about 65 percent of her financial support. Mildred earned $4,650 this year as a part-time librarian. Mrs. O’s father Richard, age 76, who has lived in Mr. and Mrs. O’s home since 2005. Mr. and Mrs. O provide about 30 percent of his financial support. The rest of his support comes from Social Security.

High-income Taxpayers Phase-out of itemized deductions - If AGI > $159,950 (MFJ) in 2008, itemized deductions are reduced by 2% of income > $159,950. Can’t reduce itemized deductions below 20% of total Phase-out of exemptions - IF AGI > $239,950 (MFJ) in 2008, reduce exemption by 2/3% for each $2500 of AGI above the threshold See appendices 14A and B for computations. Phase outs scheduled to be eliminated gradually starting 2006

The Four-step Procedure Summarized as follows Total Income Less: Above-the-line deductions Equals: Adjusted Gross Income (AGI) Less: Standard Deduction or Itemized Deductions Less: Personal Exemption amounts Equals: Taxable Income

Tax Computations Calculate the tax liability for each of the following using the tax rate schedule Taxable income of $85,000, MFJ status $8962.50 + .25 ($85,000 - $65,100) = $13,938 Taxable income of $120,000, Single status $16,056.25 + .28 ($120,000 - $78,850) = $27,578

The Marriage Penalty Dilemma The federal income tax system is not marriage neutral Congress has provided some limited relief for lower income taxpayers 10 & 15% brackets are exactly twice that for single taxpayers Standard deduction for married couples is exactly twice that for single taxpayers A progressive tax system that allows married couples to file joint returns can be marriage neutral or horizontally equitable – but not both!

Credits Child Credit = $1,000 per child under age 17 as of Dec. 31. Phases out for high-income taxpayers Dependent care credit for children < 13 years old or a dependent who is physically or mentally incapable of caring for themselves. Credit amount is between 30% and 20% of child care costs depending on income range

Credits Earned income credit is refundable - a transfer payment to working poor that increases progressivity of tax rates Credit is higher for taxpayers with children and phases out as income increases Maximum credit in 2008 is $4,824 for households with two or more children Excess FICA withholding is refunded through a tax return claim

AMT (again!!) Why do we need AMT? To guarantee that high-income taxpayers who dramatically reduced their regular tax by overindulging in tax preferences will still pay a fair share of income tax More and more middle-income taxpayers with modest amounts of AMT adjustments or preferences are having to pay AMT

AMT (again!!) Middle-income taxpayers are being subjected to AMT because regular income tax rates are adjusted for inflation annually while AMT rates are not Unless Congress makes major changes, the AMT will affect 33 million individuals by 2010

AMT Taxable income +/– adj. (e.g. standard deduction or exemption amounts) + preferences = AMTI before exemption - exemption ($66,250 MFJ, phases out for rich) = AMTI x 26% (or 28% for higher AMTI levels) = TMT

Payment and Filing Requirements Taxes on wages are withheld each pay period Estimated taxes on self-employment income are due on April 15, June 15, September 15, and January 15

Payment and Filing Requirements An underpayment penalty can be avoided by paying 90% of current year tax, 100% of prior year (or 110% of prior year if AGI>$150,000) Tax return due 4/15; the filing of the return (not the payment of the taxes) may be extended to 8/15 then 10/15 (LAST DATE)