1. The Individual Tax Formula
Chapter 13
The Individual Tax Formula
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., All Rights Reserved.

2. Objectives filing status computing taxable income
standard deduction versus itemized deductions
exemptions
tax rates
marriage penalty
Child credit and dependent care credit and AMT
payment and filing requirements

3. Filing Status Filing status:
reflects an individual’s marital and family situation,
affects the calculation of taxable income, and
determines the rates at which income is taxed.

4. 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 or widower with a dependent child for two more years after death of spouse may file as Surviving Spouse.
MFS (married filing separately) rates are less favorable than single.

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

6. Filing Status Examples
Application Problem 1:
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, Mr. J has not remarried and maintains a home for one dependent child.

7. Application Problem 1 ( continued)
Mrs. J died on May 30, Mr. J has not remarried and has no dependent children.
Mr. J and Mrs. J were legally divorced on May 30, Mr. J has not remarried and maintains a home for his two dependent children.

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

9. Step One: Taxable income includes: Business income
Salary or wage payments
Investment income

10. 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.

11. Step Three: Subtract the greater of: the standard deduction,
or allowable itemized deductions.

12. Standard Deduction Depends on filing status. For 2005:
MFJ = $10,000
MFS = $5,000
HOH = $7,300
Single = $5,000
Blind or aged (>=age 65)
MJF, MFS = additional $1,000
HOH or Single = additional $1,250
Ben, age 65, and Mary, age 64, are married filing joint. What is their standard deduction for 2005?
$10,000 + $1,000 = $11,000

13. Itemized Deductions See Schedule A (Chapter 16 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.

14. Bunching Example
My dad gives $5,000 to charity each year. He is 77 and single. What is his standard deduction each year?
$5, , 250 = $6,250
Does he itemize?
No, as the standard deduction of $6,250 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.

15. 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.

16. 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 $3,200 for 2005 for each personal and dependency exemption.

17. Exemptions for Dependents
If an individual passes all five tests, you may claim him 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 $3,200 in 2005
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

18. Application Problem 3
Mr. and Mrs. O file a joint income tax return. Determine if they can claim a personal exemption for any of the following individuals:
Their son is age 22, unmarried, and a full-time graduate student at Indiana University. Mr. and Mrs. O provided 75% of his financial support for the year. During the year, the son earned $5,200 as a teaching assistant.
Their daughter is age 26, unmarried, and unemployed. Mr. and Mrs. O provided 100% of her financial support for the year.

19. Application Problem 3 (continued)
Their daughter is age 26 and unemployed. Mr. and Mrs. O provided 75% of her financial support for the year. The daughter married in December and filed a joint return with her new spouse.
Their nephew is age 18, unmarried, and a full-time high-school student. Mr. and Mrs. O provided 60% of his financial support for the year During the year, the nephew earned $3,650 from a part-time job.

20. High-income Taxpayers
Phase-out of itemized deductions - If AGI greater than $142,700 (MFJ) in 2004, itemized deductions are reduced by 3% of income > $142,700. Can’t reduce itemized deductions below 20% of the total.
Phase-out of exemptions - IF AGI greater than $214,050 (MFJ) in 2004, reduce exemption by 2% for each $2500 that AGI is above the threshold. Can reduce to $0.
See appendices at back of chapter for computations. Phase outs scheduled to be eliminated gradually starting 2006.

21. 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

22. Tax Computations
Calculate the tax liability for each of the following using the tax rate schedules:
Taxable income of $85,000, MFJ status
$8, ($85,000 - $59,400) = $14,580
Taxable income of $120,000, Single status
$14, ($120,000 - $71,950) = $28,106.50

23. 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!

24. Credits
Child Credit = $1,000 per child under age 17 as of Dec. 31 in 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.

25. Credits
Earned income credit. This is refundable - a transfer payment to working poor. Increases progressivity of tax rates.
Credit is higher for taxpayers with children and phases out as income increases.
Maximum credit in 2005 is $4,400 for households with two or more children.
Excess FICA withholding is refunded through a tax return claim.

26. 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.

27. 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.

28. AMT
Taxable income +/– adj. (e.g. standard deduction or exemption amounts)
+ preferences = AMTI before exemption - exemption ($58,000 MFJ, phases out for rich) = AMTI x 26% (or 28% for higher AMTI levels) = TMT

29. 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.

30. 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 2003 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).