Income Taxation of Individuals Chapter 11 Income Taxation of Individuals

Individual Income Tax Model Gross income Less: Deductions for adjusted gross income Equals: Adjusted Gross Income (AGI) Less: Itemized or standard deduction Less: Personal & dependency exemptions Equals: Taxable income

Tax Model (continued) Taxable income Times: Tax rate Equals: Gross income tax liability Less: Tax credits Plus: Additions to tax Less: Tax prepayments Equals: Net tax due or tax refund

Deductions For AGI Deductions discussed in previous chapters Retirement plan contributions including IRAs Moving expenses 50% of self-employment taxes Self-employed health insurance Alimony paid

Deductions For AGI Deductions discussed in this chapter Educator expenses Student loan interest expense Tuition and fees deduction Health savings accounts Penalty on early withdrawals of savings Other deductions for AGI

Educator Expenses Kindergarten through 12th grade teachers may deduct up to $250 of unreimbursed expenses for books, supplies, computer equipment, software, and other supplemental materials used in the classroom Due to expire at end of 2005 unless extended by Congress

Student Loan Interest Deduction allowed for interest paid on qualified student loans incurred and used for tuition, fees, room, board, books, and supplies Deduction limit is $2,500 Limit is phased out for modified AGI of $50,000 - $65,000 ($105,000 - $135,000 for married persons filing jointly) Individuals claimed as dependents cannot take deduction on their own tax return Eligible expenses must be reduced for tax-exempt scholarships and education credits

Tuition & Fees Deduction $4,000 deduction for 2004-2005 for tuition & fees for taxpayer, spouse, and dependents Income limits apply ($65,000 if single and $130,000 if married filing jointly) Deduction is reduced to $2,000 for singles with income $65,000 - $80,000 ($130,000 - $160,000 for joint filers) Individuals who are claimed as dependents cannot take deduction on their own tax return No double benefit - no deduction if expense is deductible under any other provision (including education credits)

Health Savings Accounts Taxpayers covered by high-deductible medical insurance policies only may deduct amounts set aside in an HSA Contributions and earnings on HSAs are not taxed when withdrawn to pay medical expenses Distributions not spent on qualifying expenses are included in income and subject to a 10% penalty

Health Savings Accounts To qualify for an HSA in 2005, individuals must have health insurance with deductibles of at least $1,000 ($2,000 for families) Maximum contribution to HSA equal to lesser of $2,650 ($5,250 for families) or the annual policy deductible

Medical Savings Accounts MSAs are similar to HSAs but with different limits Qualified policies are those with deductibles of $1,750 - $2,650 for individuals ($3,500 - $5,250 for families) in 2005 Contributions to MSAs are limited to 65% of policy deductible for individuals (75% for families) Distributions not spent on qualifying expenses are included in income and subject to a 15% penalty

Penalty on Early Withdrawals Penalties assessed on premature withdrawals from certificates of deposits or other savings accounts are deductible Gross interest income, unreduced by the penalty, is included in taxable income Deducting the penalty ensures that only net interest income is included in taxable income

Other Deductions For AGI Unreimbursed travel expenses to attend National Guard or military reserve meetings more than 100 miles from home Maximum deduction is general government per diem rate for the area Expenses of fee-basis government officials Expenses of performing artists

Exemptions Each taxpayer (who is not a dependent) is entitled to one personal exemption Exemption deduction is $3,200 for 2005 Additional exemptions allowed for each person who is considered a dependent Anyone who is claimed as a dependent cannot claim a personal exemption For purposes of the dependency exemption, a dependent is a qualifying child or qualifying relative

Qualifying Child Must meet four tests Residency test - live with taxpayer more than 6 months Relationship test - son, daughter, brother, sister, or descendant Age test - under 19 (or under 24 if full-time student) Support test - child cannot provide more than half his own support

Qualifying Relative If not a qualifying child, then three similar tests must be met: Relationship test - must either be a qualifying relative of the taxpayer or a resident in the taxpayer’s household for the entire year Gross income test - the qualifying relative's gross income from taxable sources must be less than the exemption amount ($3,200 for 2005) Support test

The Support Test Taxpayer must provide more than 50% of the dependent's total support Support includes amounts spent for food, clothing, shelter, medical care, education and capital expenditures such as a car Value of services and scholarship funds are omitted in determining support received by a student Dependent’s nontaxable income used for support must be included in support determination

Multiple Support Agreement Multiple support agreements allow one member of group of support providers to claim the exemption when Together the group meets the support test All other dependency tests are met Member who claims exemption must provide more than 10% of the total support and other members providing more than 10% support agree to exemption

Phaseout of Exemptions Both personal and dependency exemptions are phased out at a rate of 2% (4% for MFS) for each $2,500 (or fraction thereof) of AGI above thresholds for 2005 of $145,950 if single $182,450 if head of household $218,950 if married filing jointly $109,475 if married filing separately

Exemption Phaseout (AGI – threshold AGI)/$2,500 = Phaseout Factor (always round up to next whole number) Phaseout Factor x 2% = Phaseout Percentage Exemption Amount x (1 – Phaseout Percentage) = Adjusted Exemption Deduction Once AGI exceeds the threshold AGI by more than $122,500 ($61,250 for MFS), the exemption deduction is completely phased out

Filing Status Taxpayer’s filing status determines standard deduction and tax rate schedule Marital status determined on the last day of the tax year Separated spouses are considered married until divorce becomes final

Filing Status - Married Can file jointly if both spouses are US citizens or US residents (or if nonresident alien agrees to be taxed on worldwide income) If the couple files separately, both must itemize deductions or both must use the standard deduction

Surviving Spouse Marital status is determined at the date of death so a joint return can be filed for the year in which a spouse dies A surviving spouse may continue to use the tax rates and standard deduction for married persons filing jointly for the next 2 years only if a dependent child lives with the taxpayer

Filing Status – Unmarried Unmarried taxpayers file as Head of household - an unmarried person who provides more than half of the cost of maintaining a home in which a qualifying child or other qualifying relative lives for more than half the year Single

Head of Household Claimed if taxpayer is unmarried (and not a surviving spouse) Taxpayer pays more than half the cost of maintaining home which is the principal residence for more than half the year of A qualifying child An individual for whom the taxpayer may claim a dependency exemption A parent is not required to live with the taxpayer

Abandoned Spouse A taxpayer who is married but whose spouse did not live with him or her at any time during the last six months of the tax year and who provides more than half the cost of maintaining the home in which a dependent child lives A qualifying abandoned spouse uses head of household tax rates and standard deduction

Standard Deductions Standard Deductions $10,000 married filing a joint return $5,000 married filing separately $7,300 head of household $5,000 single individual Additional standard deduction if taxpayer is elderly (age 65 or older) or blind $1,250 if single or head of household $1,000 if married

Dependent’s Standard Deduction Dependent’s standard deduction is limited to the greater of: $800 or Earned income + $250 (up to otherwise allowable standard deduction) Earned income includes salary and wages Earned income does not include interest income, dividend income, capital gains, or income as beneficiary of a trust

Itemized Deductions Itemized deductions provide tax benefit only to the extent that, in total, they exceed the taxpayer’s standard deduction Taxpayers can maximize use of the standard deduction and itemized deductions by timing certain deductible payments

Medical Expenses Medical expenses paid for the taxpayer, spouse and dependents, after reduction for insurance reimbursements, are deductible only to the extent they exceed 7.5% of AGI for the year Qualified medical costs includes prescription drugs and insulin, costs of a hospital, clinic, doctor, dentist, eyeglasses, contract lenses, transportation for medical care and health insurance costs

Medical Expenses Health insurance premiums for taxpayers and their dependents are deductible only if paid from after-tax income Premiums paid through an employer-sponsored cafeteria plan are not deductible Premiums for disability insurance and for loss of life, limb or income are not deductible Premiums for long-term care insurance are deductible, subject to limits based on age

Deductible Taxes Deductible taxes include State, local, and foreign real property taxes State and local personal property taxes State, local, and foreign income taxes Other federal, state, local, and foreign taxes incurred in a business or other income-producing activity For 2004 & 2005 can elect to deduct state & local general sales taxes instead of state & local income taxes

Nondeductible Taxes Nondeductible taxes include Federal income taxes Employee's share of payroll taxes Federal excise taxes not incurred for business Assessments on property that increase property value

Interest Expense Deductible interest includes Investment interest Home mortgage interest No deduction for most other personal interest (except previously mentioned student loan interest) including interest on Auto loans Life insurance loans Credit card debt Delinquent tax payments

Investment Interest Expense Investment interest includes interest on loans to acquire or hold investment property and margin account interest paid to a broker Investment interest expense is only deductible to the extent of net investment income Net investment income = excess of investment income over investment expenses Excess is carried forward (indefinitely) subject to same limit in future years

Investment Interest Expense Investment income includes gross income from interest, annuities, and short-term capital gains from investment property Long-term capital gains or dividends taxed at favorable rates are excluded unless election made to forgo the favorable rate Investment expenses include safe deposit box rental fees, investment counsel fees, brokerage account maintenance fees Limited to the lesser of total investment expenses or net miscellaneous itemized deductions after reduction for 2% AGI floor

Qualified Residence Interest Interest paid for acquisition debt or home equity debt for up to 2 qualified residences Interest on acquisition debt of up to $1 million principal amount (combined limit for 2 homes) is deductible Acquisition debt includes mortgage to buy, construct, or improve the residence

Qualified Residence Interest Interest on up to $100,000 principal amount of home equity loan is deductible Loan proceeds can be used for any purpose Points (loan origination fees) paid on initial home mortgages are deductible Points paid to refinance an exiting loan must be amortized over life of loan

Charitable Contributions Congress allows individuals, corporations, estates and trusts to deduct contributions to certain qualified organizations Partnerships and S corporations pass the contributions through to their partners and shareholders who then claim the deductions on their own income tax returns

Charitable Contributions Qualified charitable organizations Governmental units (federal, state and local governments) and entities formed and operated exclusively for religious, charitable, scientific, literary or educational purposes, including churches, nonprofit hospitals, school and universities, libraries, and social service agencies Direct contributions to needy individuals are not deductible

Charitable Contributions No deduction allowed to the extent that valuable goods or services are received in return for the contribution Exception - contributors to universities who receive preferred rights to purchase tickets for university athletic events may deduct 80% of the amount of their contribution Individual’s deduction limited to 50% of AGI Excess contributions may be carried forward up to 5 years

Charitable Contributions No deduction for contributions of the taxpayer’s services and rent-free use of the taxpayer’s property Out-of-pocket costs incurred for volunteer work for a qualifying charity are deductible Property other than long-term capital gain property is valued at lesser of FMV or basis

Contributions of LTCG Property LTCG property is valued at FMV (which is usually greater than adjusted basis) Tangible personalty given to a charity which does not use the property in its tax-exempt activity is valued at adjusted basis, if lower than FMV Deduction for LTCG property limited to 30% of AGI 30% limit can be avoided (and 50% AGI limit applied) if taxpayer elects to use lower basis If made, election applies to all LTCG contributions that year

Charitable Contributions Stocks or other income producing property that have declined in value should be sold so that the loss can be claimed with the sale proceeds donated Fees incurred for appraisals of donated property may be deducted as a miscellaneous itemized deductions Deduction for donated vehicles sold by charity limited to gross sales proceeds

Casualty and Theft Losses Loss is the lesser of Asset’s adjusted basis or Decline in asset’s fair market value as a result of the casualty Loss is reduced for any insurance proceeds received $100 floor applies to each casualty Deductible only to extent total losses exceed 10% of AGI

Miscellaneous Deductions Only excess over 2% of AGI is deductible Unreimbursed employee business expenses Job hunting expenses (in searching for a new job in current line of business) Investment-related expenses Hobby expenses (up to hobby income) Tax preparation and planning advice

Phaseout of Itemized Deductions Total deductions phased out by 3% of AGI in excess of $145,950 in 2005 ($72,975 if MFS) Exception - deductions not phased out for Medical expenses Investment interest Casualty and theft losses Total deductions are not reduced by more than 80% regardless of type

Tax Rates for Married Filing a Joint Return For married filing a joint return for 2005 10% on first $14,600 taxable income 15% on $14,601 - $59,400 25% on $59,401 - $119,950 28% on $119,951 - $182,800 33% on $182,801 - $326,450 35% over $326,450

Tax Rates for Married Filing Separately For married filing separately for 2005 10% on first $7,300 taxable income 15% on $7,301 - $29,700 25% on $29,701 - $59,975 28% on $59,976 - $91,400 33% on $91,401 - $163,225 35% over $163,225

Tax Rates for Single Individuals For single individuals for 2005 10% on first $7,300 taxable income 15% on $7,301 - $29,700 25% on $29,701 - $71,950 28% on $71,951 - $150,150 33% on $150,151 - $326,450 35% over $326,450

Tax Rates for Head of Household For head of household for 2005 10% on first $10,450 taxable income 15% on $10,451 - $39,800 25% on $39,801 - $102,800 28% on $102,801 - $166,450 33% on $166,451 - $326,450 35% over $326,450

Special Tax Rates Dividend income is taxed at a maximum of 15% (5% for taxpayers in 10% or 15% tax brackets) Individuals with long-term capital gains file a Schedule D which includes a worksheet for determining the total tax liability

Credits vs. Deductions Deductions only reduce tax liability by a percentage based on the taxpayer’s marginal tax rate Credits are direct dollar-for-dollar reductions in the gross tax liability Tax credits have the same dollar value to all taxpayers, regardless of their marginal tax brackets

Child Tax Credit $1,000 nonrefundable tax credit for each qualifying child under age 17 Qualifying children include the taxpayer’s son, daughter, stepson, stepdaughter, grandchild, or eligible foster child that the taxpayer claims as a dependent Phased out at rate of $50 for every $1,000 (or part thereof) of AGI in excess of $110,000 if married filing jointly ($55,000 if MFS) $75,000 if single or head of household

Education Credits Two elective nonrefundable tax credits are provided for college or vocational tuition and fees for the taxpayer, spouse, or dependents Hope Scholarship Credit – 100% of first $1,000 and 50% of second $1,000 tuition and fees for first 2 years only (maximum $1,500 per student) Lifetime Learning Credit – 20% of up to $10,000 tuition and fees (maximum $2,000 per taxpayer in 2005) A student who is a dependent cannot claim the credit

Education Credits Expenses paid with a Pell Grant, scholarship, or employer-provided educational assistance do not qualify The election is separate for each student, so a parent may choose one credit for one child and a different credit for a second child Both credits phase out over modified AGI of $43,000 - $53,000 if single $87,000 - $107,000 if married filing jointly

Earned Income Credit The purpose is to reduce the impact of payroll taxes for low-income individuals Credit is equal to a percentage of earned income below a maximum With one qualifying child, maximum credit is $2,662 ($7,830 x 34%) With two or more qualifying children, maximum credit is $4,400 ($11,000 x 40%) Smaller credit available to taxpayers without children

Earned Income Credit This is a refundable credit Taxpayers with investment income of $2,700 or more are not eligible Anyone who can be claimed as a dependent is not eligible A taxpayer without a qualifying child, must be between the ages of 25 and 64 to be eligible Credit starts phasing out when income exceeds $16,370 if married filing jointly ($14,370 for others)

Dependent Care Credit Nonrefundable credit for taxpayers who pay for child or dependent care so they can work Credit percentage varies from 20% to 35% of up to $4,000 for one qualifying child or $6,000 for 2 or more qualifying children under 13 35% if AGI does not exceed $15,000 Reduced by 1% for each $2,000 (or fraction thereof) AGI exceeds $15,000 20% if AGI exceeds $43,000

Retirement Contributions Credit To encourage participation by low-income wage earners, a credit for up to $2,000 contributed to employer-sponsored retirement plans or IRAs is available Credit varies with AGI 50% credit for joint filers with AGI up to $30,000 ($15,000 if single) 20% for joint filers with AGI of $30,000 - $32,500 ($15,000 - $16,250 if single) 10% for joint filers with AGI of $32,500 - $50,000 ($16,250 - $25,000 if single) Dependents or full-time students are not eligible

Excess Payroll Tax Credit Taxpayers working for more than one employer during the year with earnings exceeding the Social Security ceiling ($90,000 for 2005) usually have too much tax withheld Employee is allowed a refundable credit for any excess Social Security taxes withheld

Payment of Income Tax Estimated quarterly payments are made by persons with large amounts of income from sources not subject to withholding Due on April 15, June 15, September 15 of current year and January 15 of following year If payments are not 90% or more of the total tax owed (or an amount required based on the prior year’s tax), a penalty may be charged, unless balance due is less than $1,000

Filing Requirements Any taxpayer whose gross income is less than the sum of their standard deduction and their personal exemption (but not dependency exemptions) does not have to file a tax return $8,200 in 2005 for a single individual Returns should be filed if Net self-employment income is $400 or more A child claimed as a dependent has unearned income only of over $800 Any married person filing separately has income over $3,200

Alternative Minimum Tax The purpose of the alternative minimum tax is to ensure high-income taxpayers pay their fair share of tax Certain deductions are disallowed or reduced and certain exempt income items are subject to the AMT IF AMT is greater than the regular tax, taxpayers pay the larger amount Rate is 26% on first $175,000 and 28% on excess for individuals

AMT Model Taxable income Plus/minus Adjustments to taxable income Plus: Tax preferences Less: Allowable exemptions Equals: Alternative minimum taxable income Times: AMT tax rates Equals: Tentative minimum tax (TMT) Less: Regular income tax Equals: AMT

AMT Exemptions AMT exemptions for 2005 are $58,000 if married filing jointly $29,000 if married filing separately $40,250 if single or head of household Exemptions begin to phase out when AMTI reaches $112,500 for singles and $150,000 for married filing jointly ($75,000 if MFS) at a rate of $1 for every $4 above the threshold

Alternative Minimum Tax Itemized deductions are different from those calculated for regular income tax Medical expenses must exceed 10% AGI Taxes, home equity loan interest, and miscellaneous itemized deductions are not deductible Tax preferences that are added include Nontaxable interest on private activity bonds Bargain element of incentive stock options

The End