Chapter 14Chapter 14

The Individual Tax Formula

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ObjectivesObjectives

• Determine an individual’s filing status• List the four steps for computing individual taxable

income• Explain the relationship between the standard

deduction and itemized deductions• Compute an exemption amount• Compute the regular tax on ordinary income

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Objectives (continued)Objectives (continued)

• Explain why a marriage penalty exists in the federal income tax system

• Describe the child credit and dependent care credit• Recognize circumstances that may trigger the

individual AMT • Describe the individual tax payment and return filing

requirements

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Filing StatusFiling Status

• Filing status• Affects calculation of taxable income• Determines rates at which income is taxed• Reflects marital and family situation

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Filing Status - MarriedFiling Status - Married

• MFJ or MFS if married on the last day of the year• MFJ (married filing joint) rates

• If spouse incomes are similar, single rates generate lower overall tax

• If spouse incomes are dissimilar, married rates generatelower overall tax

• MFJ rates apply to Surviving Spouse status• A widow/widower with a dependent child for two years

after death of spouse

• MFS (married filing separately) rates are less favorable than single

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Filing Status - UnmarriedFiling Status - Unmarried

• 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

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Filing Status ExamplesFiling Status Examples

• Determine Mr. J’s filing status in 2014• Mr. J and Mrs. J were divorced on November 18. Mr. J has not

remarried and has no dependent children• Mr. J and the first Mrs. J were 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, 2013. Mr. J has not remarried and

maintains a home for one dependent child• Mrs. J died on May 30, 2013. Mr. J has not remarried and has no

dependent children.• Mr. J and Mrs. J were legally divorced on May 30, 2009. Mr. J has

not remarried and maintains a home for two dependent children.

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Taxable Income ComputationTaxable Income Computation

• Step 1: Calculate total income

• Step 2: Calculate adjusted gross income (AGI)

• Step 3: Subtract itemized deductions or standard deduction

• Step 4: Subtract exemption amount

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Step OneStep One

• Total income includes:• Salary, wages, fringe benefits• Net business income

• Income from sole proprietorship

• Income from partnership or S corporation

• Investment income• Interest • Dividends• Capital gains• Rental income

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Step TwoStep Two

• Adjusted gross income (AGI) equals total income less specific above-the-line deductions

• AGI is an important number because many deductions and credits are limited by reference to AGI

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Step ThreeStep Three

• Subtract the greater of:• Allowable itemized deductions• Standard deduction

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Standard Deduction (2014)Standard Deduction (2014)

• Depends on filing status • MFJ = $12,400

• MFS = $6,200

• HOH = $9,100

• Single = $6,200

• Blind or age 65 or older• MJF, MFS = additional $1,200

• HOH or Single = additional $1,550

• Dependent on another return• Limited to lesser of $1,000 or earned income plus $350

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Itemized DeductionsItemized Deductions

• See Schedule A (Chapter 17 details)

• Only one-third of individual filers elect to itemize deductions

• Bunching: if itemized deductions are close to standard deduction each year, taxpayer should bunch deductions in alternate years

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Individual Tax DeductionsIndividual Tax Deductions

• Above-the-line deduction always reduces taxable income

• Itemized deduction may have limited or no effect on taxable income

• Classification as either above-the-line or itemized deduction often reflects tax policy and can change from year to year

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Overall limitation on itemized deductionsOverall limitation on itemized deductions

• Individuals with AGI in excess of a threshold amount must reduce total itemized deductions by 3% of excess AGI

• Reduction limited to 80% of total itemized deductions

• Limitation has no effect on standard deduction

• Computation is presented in Appendix 14-A

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Step FourStep Four

• Subtract exemption amounts• Exemption is $3,950 for 2014

• Each taxpayer is allowed a personal exemption• Two exemptions are allowed for MFJ• No personal exemption if claimed as

another taxpayer’s dependent

• Taxpayer is allowed a dependency exemption for:• Qualifying child• Qualifying relative

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Exemption phaseoutExemption phaseout

• Individuals with AGI in excess of a threshold amount must reduce their total exemption amount by a percentage determined with reference to such excess

• Phaseout can reduce exemption amount to zero

• Computation is presented in Appendix 14-B

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Summary of Four-step ProcedureSummary of Four-step Procedure

Total income

(Above-the-line deductions)

Adjusted gross income (AGI)

(Itemized deductions orstandard deduction)

(Exemption amount)

Taxable income

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Tax ComputationsTax Computations

• Calculate 2014 tax on $100,000 taxable income

• MFJ status

$10,162.50 + .25 ($100,000 - $73,800) = $16,712.50

• Single status

18,193.75+ .28 ($100,000 - $89,350) = $21,175.75

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Marriage Penalty DilemmaMarriage Penalty Dilemma

• Federal income tax is not marriage neutral

• Limited relief for lower income taxpayers• 10% and 15% brackets for MFJ are twice that for

singles

• Standard deduction for MFJ is twice that for singles

• Progressive tax system that allows married couples to file joint returns can be marriage neutral or horizontally equitable – but not both!

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Kiddie TaxKiddie Tax

• Children who earn income in their own name must file their own tax return• If child is claimed as a dependent on another

taxpayer’s return:• Limited standard deduction• No personal exemption

• Unearned income (in excess of $2,000) of children under age 18 is taxed at parents’ marginal rate

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CreditsCredits

• Child credit = $1,000 per child under age 17• Phases out for high-income taxpayers

• Dependent care credit for children < 13 years old or dependents who can’t care for themselves• Credit is between 35% and 20% of child care costs

depending on AGI

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Credits (con’t)Credits (con’t)

• Earned income credit is refundable• Transfer payment to working poor that increases

progressivity of tax rates • Credit is higher for taxpayers with children and

phases out as AGI increases

• Excess Social Security tax withholding is refunded as a credit against income tax

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Individual AMTIIndividual AMTI

• Individuals are subject to AMT on their AMTI in excess of an exemption• Exemption amount based on filing status

• AMTI = taxable income +/- AMT adjustments + preference items• Positive adjustments include standard deduction and

exemption amount

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AMT ComputationAMT Computation

• Tentative minimum tax:

26% on first $182,500 excess AMTI (2014)

28% on additional excess AMTI

• AMT is any excess of tentative AMT over regular income tax for the year

• Individuals pay both regular income tax and AMT

• Total tax equals tentative minimum tax

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Payment and Filing RequirementsPayment and Filing Requirements

• Income taxes on salaries and wages are withheld each pay period

• Estimated taxes on self-employment and investment income are due on April 15, June 15, September 15, and January 15

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Payment and Filing RequirementsPayment and Filing Requirements

• Underpayment penalty avoided by paying:• 90% of current year tax• 100% of prior year tax (110% if AGI > $150,000)

• Form 1040 must be filed by April 15• Automatic extension until October 15• Balance of tax due must be paid with extension request

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