Chapter 4

Chapter 4: Individual Income Tax Overview, Dependents, and Filing Status

Learning Objectives

• Calculate individual taxpayer’s taxes due or refund.

• Identify requirements for taxpayer dependents and understand how they affect tax benefits.

• Determine taxpayer’s filing status, impacting tax rates and deductions.

The Individual Income Tax Formula

Components of Tax Calculation

1. Gross Income

   • The initial starting point for calculating taxes owed. It includes all income received in the form of money, goods, or services that isn't specifically exempt from tax.

2. Deductions

   • For AGI (Above the Line): These deductions reduce gross income to arrive at Adjusted Gross Income (AGI). Examples include contributions to retirement accounts, alimony payments (for agreements pre-2019), and rental/royalty expenses.

   • From AGI (Below the Line): Taxpayers can take the greater of the standard deduction or itemized deductions (such as mortgage interest, state income taxes, and charitable contributions) to reduce the AGI further. The qualified business income deduction may also apply if eligible.

3. Taxable Income

   • This is calculated as AGI minus from AGI deductions. It forms the basis for determining the taxpayer's tax liability.

4. Calculation of Taxes Due

   • Taxable Income x Tax Rates: This step determines the individual's income tax liability based on progressive tax brackets.

   • Add Other Taxes: This includes additional taxes that may apply, such as the alternative minimum tax or self-employment tax.

   • Total Tax: The sum of the income tax and other additional taxes owed.

   • Subtract Credits and Prepayments: After calculating the total tax, applicable credits and prepayments (like withholding and estimated payments) are subtracted to arrive at the final amount due or the potential refund.

Understanding Income Types

Realized and Recognized Income

• Realized Income: This refers to a measurable change in property rights that is included in gross income unless specifically excluded or deferred under the tax code.

• Recognized Income: This is the income that must be reported on a tax return, essentially what the taxpayer has to report to the IRS.

Excluded and Deferred Income

• Excluded Income: This type of income is never taxed, such as interest from municipal bonds.

• Deferred Income: This refers to income on which tax liability is postponed to a future tax year (such as installment sales).

Character of Income or Loss

• Different categories affect applicable tax rates:

  • Tax-exempt: No tax obligation required.

  • Tax-deferred: No current-year taxes due.

  • Ordinary Income: Generally taxed at the regular rates applicable to the taxpayer.

  • Qualified Dividends: Such dividends attract tax rates that vary based on the taxpayer’s income level, which can be 0%, 15%, or 20%.

Capital Gains and Losses

• Types of Capital Gains:

  • Short-term: Gains on assets held for one year or less, taxed at ordinary income rates.

  • Long-term: Gains on assets held for over a year, taxed at preferential rates.

  • Net Capital Gains: These are taxed at lower rates than ordinary income, providing tax equality and spurring long-term investment.

Deductions in Tax Calculation

Deductions for AGI (Above the Line)

• These deductions serve to directly reduce AGI. Notable examples include:

  • Alimony payments made under agreements established prior to 2019.

  • Expenses related to rental and royalty income.

  • Contributions made to qualifying retirement accounts.

Deductions from AGI (Below the Line)

• These deductions determine taxable income and include:

  • Taking the greater of standard or itemized deductions.

  • Common itemized deductions consist of mortgage interest, state and local taxes, and charitable contributions.

Standard Deductions for 2024

• Married filing jointly: $29,200

• Qualifying surviving spouse: $29,200

• Married filing separately: $14,600

• Head of household: $21,900

• Single: $14,600These amounts can change with each tax year and are subject to inflation adjustments.

Tax Calculations

Progressive Tax Rate Schedule

• Federal income tax rates range from 10% to 37%, applying progressively as income brackets increase.

• Special rates apply to capital gains and qualified dividends, which usually allow for lower taxation than ordinary income.

Additional Taxes and Credits

Types of Additional Taxes

• Alternative Minimum Tax (AMT): A parallel tax system aimed at ensuring that high-income earners pay a minimum amount of tax.

• Self-Employment Tax: Additional tax applied to self-employed individuals, funding Social Security and Medicare.

• Net Investment Income Tax (NIIT): A 3.8% tax on unearned income for higher-income individuals.

• Additional Medicare Tax: A 0.9% tax on earnings that exceed certain thresholds, adjusting the contribution to Medicare for higher earners.

Tax Credits

• Child Tax Credit:

  • Taxpayers can claim $2,000 per qualifying child under age 17.

  • Additionally, $500 is available for dependents who do not qualify for the higher credit.Tax credits directly reduce tax liability and can increase the taxpayer’s refund.

Tax Prepayments

• Key components of tax prepayments include:

  • Withheld income taxes throughout the year.

  • Estimated tax payments made by self-employed individuals or those with significant income not subject to withholding.

  • Overpayments from the previous year's taxes that can be applied to the current year.

Dependents Criteria

• Dependents: The status of dependents affects filing status and eligibility for tax benefits, including the Child Tax Credit.

• Dependency Requirements: To qualify as a dependent, the individual must be:

  • A U.S. citizen or resident of the U.S., Canada, or Mexico.

  • Not filing a joint return unless certain conditions are met.

Qualifying Child Criteria

• Relationship Test: Must be the taxpayer's child, stepchild, sibling, or a descendant.

• Age Test: Generally, under age 19, or under 24 if a full-time student or permanently disabled.

• Residence Test: Must live with the taxpayer more than half the year.

• Support Test: The taxpayer must provide more than half of the child's total support.

Tiebreaking Rules for Dependents

• When multiple taxpayers attempt to claim the same child, the IRS has established tiebreaking rules where parents are prioritized over non-parents, influenced by the child’s residence and AGI if necessary.

Examples of Dependency Testing

• Rodney and Anita’s Children: An in-depth evaluation of qualifications for their children Braxton (12) and Tara (21), examining whether they meet all dependency criteria.

Dependency with Multiple Claims

• Scenarios involving various relatives claiming the same individual as a dependent, with clear criteria to resolve conflicts.

Qualifying Relative Definition

• Criteria for qualifying relatives include:

  • Relationship Test: Must be related to the taxpayer or live with them for the entire year.

  • Support Test: The taxpayer must provide more than half of the relative's support.

  • Gross Income Test: The individual’s gross income must be below a certain threshold to qualify as a dependent.

Filing Status Overview

• There are five possible filing statuses:

  1. Married filing jointly

  2. Married filing separately

  3. Qualifying surviving spouse

  4. Head of household

  5. SingleEach filing status can greatly impact the amount of tax owed and the eligibility for certain deductions or credits.

Filing Status Details

• Qualifying Surviving Spouse: Provides certain benefits for two years following the death of a spouse, allowing for joint filing.

• Head of Household: To qualify, one must be unmarried and pay more than half the household expenses, also needing a qualifying child or relative.

Filing Status Examples

• Anita as a Qualifying Surviving Spouse: An example illustrating the tax benefits available to Anita in the year following her spouse’s death.

• Anita as Head of Household after Divorce: Explanation of how Anita’s filing status changed following her divorce, affecting her tax obligations.

• Shawn’s Status after Supporting His Mother: A case analysis on how Shawn can claim head of household or qualifying relative status while financially supporting his mother.