As you’ve no doubt gathered by now, paying your income taxes is a complex process involving several steps and many calculations. Exhibit 3.1 depicts the procedure to compute your taxable income and total tax liability owed. It looks simple enough just subtract certain adjustments from your gross income to get your adjusted gross income; then subtract either the standard deduction or your itemized deductions and your total personal exemptions to get taxable income; and finally, calculate your taxes, subtract any tax credits from that amount, and add any other taxes to it to get your total tax liability. This isn’t as easy as it sounds, however! Various sections of the Internal Revenue Code place numerous conditions and exceptions on the tax treatment and deductibility of certain income and expense items and also define certain types of income as tax exempt. As we’ll see, some problems can arise in defining what you may subtract
Gross Income
Gross income essentially includes any and all income subject to federaltaxes. Here are some common forms of gross income:
• Wages and salaries
• Bonuses, commissions, and tips
• Interest and dividends received
• Alimony received
• Business and farm income
• Gains from the sale of assets
• Income from pensions and annuities
• Income from rents and partnerships
• Prizes, lottery, and gambling winnings
Gross income essentially includes any and all income subject to federaltaxes. Here are some common forms of gross income:
• Wages and salaries
• Bonuses, commissions, and tips
• Interest and dividends received
• Alimony received
• Business and farm income
• Gains from the sale of assets
• Income from pensions and annuities
• Income from rents and partnerships
• Prizes, lottery, and gambling winnings
In addition to these sources of income, there are others that are considered tax exempt and as such are excluded totally or partially from gross income. Common types of tax-exempt income include child-support payments; municipal bond interest payments; certain types of employee fringe benefits; compensation from accident, health, and life insurance policies; federal income tax refunds; gifts, inheritances, scholarships, and fellowships (limited as to amount and time); and veterans’ benefits.
Three Kinds of Income
Individual income falls into one of three basic categories.
Three Kinds of Income
Individual income falls into one of three basic categories.
- Active income: Income earned on the job, such as wages and salaries, bonuses and tips; most other forms of noninvestment income, including pension income and alimony
- Portfolio income: Earnings (interest, dividends, and capital gains [profits on the sale of investments]) generated from most types of investment holdings; includes savings accounts, stocks, bonds, mutual funds, options, and futures
- Passive income: A special category that includes income derived from real estate, limited partnerships, and other forms of tax shelters
These categories limit the amount of deductions and write-offs that taxpayers can take. Specifically, the amount of allowable, deductible expenses associated with portfolio and passive income is limited to the amount of income derived from these two sources. For example, if you had a total of $380 in portfolio income for the year, you could write off no more than $380 in portfolio-related interest expense. However, if you have more portfolio expenses than income, you can “accumulate” the difference and write it off in later years (when you have sufficient portfolio income) or when you finally sell the investment. For deduction purposes, you cannot combine portfolio and passive income with each other or with active income. Investment-related expenses can be used only with portfolio income, and with a few exceptions, passive investment expenses can be used only to offset the income from passive investments. All the other allowances and deductions we’ll describe later are written off against the total amount of active income the taxpayer generates.
Capital Gains
Technically, a capital gain occurs whenever an asset (such as a stock, a bond, or real estate) is sold for more than its original cost. So, if you purchased stock for $50 per share and sold it for $60, you’d have a capital gain of $10 per share. Capital gains are taxed at different rates, depending on the holding period. Exhibit 3.2 shows the different holding periods and applicable tax rates based on the 2008 tax brackets. As a rule, taxpayers include most capital gains as part of portfolio income. They will add any capital gains to the amount of dividends, interest, and rents they generate to arrive at total investment income. Although there are no limits on the amount of capital gains taxpayers can generate, the IRS imposes some restrictions on the amount of capital losses taxpayers can take in a given year. Specifically, a taxpayer can write off capital losses, dollar for dollar, against any capital gains. For example, a taxpayer with $10,000 in capital gains can write off up to $10,000 in capital losses. After that, he or she can write off a maximum of $3,000 in additional capital losses against other (active, earned) income. Thus, if the taxpayer in our example had $18,000 in capital losses in 2008, only $13,000 could be written off on 2008 taxes: $10,000 against the capital gains
generated in 2008 and another $3,000 against active income. The remainder $5,000 in this case will have to be written off in later years, in the same order as just indicated: first against any capital gains and then up to $3,000 against active income. (Note: To qualify as a deductible item, the capital loss must result from the sale of some income-producing asset, such as stocks and bonds. The capital loss on a non income-producing asset, such as a car or TV, does not qualify for tax relief.)
Selling Your Home: A Special Case. Homeowners, for various reasons, receive special treatment in the tax codes, including the taxation of capital gains on the sale of a home. Under current law, single taxpayers can exclude from income the first $250,000 of gain on the sale of a principal residence. Married taxpayers can exclude the first $500,000. To get this favorable tax treatment, the taxpayer must own and occupy the residence as a principal residence for at least 2 of the 5 years prior to the sale. For example, the Holtzmans (married taxpayers) just sold their principal residence for $475,000. They had purchased their home 4 years earlier for $325,000. They may exclude their $150,000 gain ($475,000 - $325,000) from their income because they occupied the residence for more than 2 years, and the gain is less than $500,000. This exclusion is available on only one sale every 2 years. A loss on the sale of a principal residence is not deductible. Generally speaking, this law is quite favorable to homeowners.
Adjustments to (Gross) Income
Now that you’ve totaled your gross income, you can deduct your adjustments to (gross) income. These are allowable deductions from gross income, including certain employee, personal retirement, insurance, and support expenses. Most of these deductions are nonbusiness in nature. Here are some items that can be treated as adjustments to income:
• Educator expenses (limited)
• Higher education tuition costs (limited)
• IRA contributions (limited)
• Self-employment taxes paid (limited to 50% of amount paid)
• Self-employed health insurance payments
• Penalty on early withdrawal of savings
• Alimony paid
• Moving expenses (some limits)
(Note: The limitations on deductions for self-directed retirement plans, such as IRAs and SEPs, are discussed in Chapter 14.) After subtracting the total of all allowable adjustments to income from your gross income, you’re left with adjusted gross income (AGI). AGI is an important value, because it’s used to calculate limits for certain itemized deductions.
Deductions: Standard or Itemized?
As we see from Exhibit 3.1, the next step in calculating your taxes is to subtract allowable deductions from your AGI. This may be the most complex part of the tax preparation process. You have two options: take the standard deduction, a fixed amount that depends on your filing status, or list your itemized deductions (specified tax-deductible personal expenses). Obviously, you should use the method that results in larger allowable deductions.
Standard Deduction
Instead of itemizing personal deductions, a taxpayer can take the standard deduction, a blanket deduction that includes the various deductible expenses that taxpayers normally incur. People whose total itemized deductions are too small take the standard deduction, which varies depending on the taxpayer’s filing status (single, married filing jointly, and so on), age (65 or older), and vision (blind). In 2008, the standard deduction ranged from $5,450 to $15,100. For single filers it is $5,450, and for married people filing jointly it is $10,900. Those over 65 and those who are blind are eligible for a higher standard deduction. Each year the standard deduction amounts are adjusted in response to changes in the cost of living.
Itemized Deductions
Itemized deductions allow taxpayers to reduce their AGI by the amount of their allowable personal expenditures. The Internal Revenue Code defines the types of nonbusiness items that can be deducted from AGI. Here are some of the more common ones:
• Medical and dental expenses (in excess of 7.5% of AGI)
• State, local, and foreign income and property taxes; state and local personal property taxes
• Residential mortgage interest and investment interest (limited)
• Charitable contributions (limited to 50%, 30%, or 20% of AGI depending on certain factors)
• Casualty and theft losses (in excess of 10% of AGI; reduced by $100 per loss)
• Job and other expenses (in excess of 2% of AGI)
• Moving expenses (some restrictions; also deductible for those who don’t itemize)
Read the instructions accompanying the tax forms for detailed descriptions of allowable deductions in each category and of qualifying factors such as distance from previous residence. Taxpayers with an AGI over a specified amount, which is adjusted upward annually, lose part of their itemized deductions. In 2008, the level of AGI at which the phaseout begins is $79,975 for married taxpayers filing separately and $159,950 for single people and for married persons filing jointly. This limitation applies to certain categories of deductions, including other types of taxes, home mortgage interest, charitable contributions, unreimbursed employee expenses, moving expenses, and other miscellaneous deductions subject to the 2% limit. Medical expenses, casualty and theft losses, and investment interest are exempt from this limit on deductions; the amount of the total reduction in itemized deductions cannot be more than 80% of the total deductions to which the limitation applies. These total itemized deductions are reduced by the smaller of one-third of 3% of AGI over $159,950 (or $79,975 for married taxpayers filing separately) or 80% of the deductions to which the limitation applies. In 2006 this reduction started to be phased out, and it will be completely eliminated by 2010.
Selling Your Home: A Special Case. Homeowners, for various reasons, receive special treatment in the tax codes, including the taxation of capital gains on the sale of a home. Under current law, single taxpayers can exclude from income the first $250,000 of gain on the sale of a principal residence. Married taxpayers can exclude the first $500,000. To get this favorable tax treatment, the taxpayer must own and occupy the residence as a principal residence for at least 2 of the 5 years prior to the sale. For example, the Holtzmans (married taxpayers) just sold their principal residence for $475,000. They had purchased their home 4 years earlier for $325,000. They may exclude their $150,000 gain ($475,000 - $325,000) from their income because they occupied the residence for more than 2 years, and the gain is less than $500,000. This exclusion is available on only one sale every 2 years. A loss on the sale of a principal residence is not deductible. Generally speaking, this law is quite favorable to homeowners.
Adjustments to (Gross) Income
Now that you’ve totaled your gross income, you can deduct your adjustments to (gross) income. These are allowable deductions from gross income, including certain employee, personal retirement, insurance, and support expenses. Most of these deductions are nonbusiness in nature. Here are some items that can be treated as adjustments to income:
• Educator expenses (limited)
• Higher education tuition costs (limited)
• IRA contributions (limited)
• Self-employment taxes paid (limited to 50% of amount paid)
• Self-employed health insurance payments
• Penalty on early withdrawal of savings
• Alimony paid
• Moving expenses (some limits)
(Note: The limitations on deductions for self-directed retirement plans, such as IRAs and SEPs, are discussed in Chapter 14.) After subtracting the total of all allowable adjustments to income from your gross income, you’re left with adjusted gross income (AGI). AGI is an important value, because it’s used to calculate limits for certain itemized deductions.
Deductions: Standard or Itemized?
As we see from Exhibit 3.1, the next step in calculating your taxes is to subtract allowable deductions from your AGI. This may be the most complex part of the tax preparation process. You have two options: take the standard deduction, a fixed amount that depends on your filing status, or list your itemized deductions (specified tax-deductible personal expenses). Obviously, you should use the method that results in larger allowable deductions.
Standard Deduction
Instead of itemizing personal deductions, a taxpayer can take the standard deduction, a blanket deduction that includes the various deductible expenses that taxpayers normally incur. People whose total itemized deductions are too small take the standard deduction, which varies depending on the taxpayer’s filing status (single, married filing jointly, and so on), age (65 or older), and vision (blind). In 2008, the standard deduction ranged from $5,450 to $15,100. For single filers it is $5,450, and for married people filing jointly it is $10,900. Those over 65 and those who are blind are eligible for a higher standard deduction. Each year the standard deduction amounts are adjusted in response to changes in the cost of living.
Itemized Deductions
Itemized deductions allow taxpayers to reduce their AGI by the amount of their allowable personal expenditures. The Internal Revenue Code defines the types of nonbusiness items that can be deducted from AGI. Here are some of the more common ones:
• Medical and dental expenses (in excess of 7.5% of AGI)
• State, local, and foreign income and property taxes; state and local personal property taxes
• Residential mortgage interest and investment interest (limited)
• Charitable contributions (limited to 50%, 30%, or 20% of AGI depending on certain factors)
• Casualty and theft losses (in excess of 10% of AGI; reduced by $100 per loss)
• Job and other expenses (in excess of 2% of AGI)
• Moving expenses (some restrictions; also deductible for those who don’t itemize)
Read the instructions accompanying the tax forms for detailed descriptions of allowable deductions in each category and of qualifying factors such as distance from previous residence. Taxpayers with an AGI over a specified amount, which is adjusted upward annually, lose part of their itemized deductions. In 2008, the level of AGI at which the phaseout begins is $79,975 for married taxpayers filing separately and $159,950 for single people and for married persons filing jointly. This limitation applies to certain categories of deductions, including other types of taxes, home mortgage interest, charitable contributions, unreimbursed employee expenses, moving expenses, and other miscellaneous deductions subject to the 2% limit. Medical expenses, casualty and theft losses, and investment interest are exempt from this limit on deductions; the amount of the total reduction in itemized deductions cannot be more than 80% of the total deductions to which the limitation applies. These total itemized deductions are reduced by the smaller of one-third of 3% of AGI over $159,950 (or $79,975 for married taxpayers filing separately) or 80% of the deductions to which the limitation applies. In 2006 this reduction started to be phased out, and it will be completely eliminated by 2010.
For example, assume that you’re married, filing a joint return, and your AGI is $180,000. Your deductions (in excess of any specified percentages of AGI) affected by the income limitation total $45,000, and other deductions total $10,000. You must reduce deductions by $201 [($180,000 AGI $159,950) × 0.03 × 1⁄3 = $201]. Therefore, you would subtract $201 from your $55,000 total itemized deductions, for an allowed deduction of $54,799. This loss of itemized deductions has the effect of raising the tax rate applied to your top bracket in this case, from 28% to 28.84% [28% + (3% × 28%)]. Married taxpayers with combined income over the AGI deduction threshold and high itemized deductions (such as medical expenses) that can be allocated to one spouse may find that they can avoid this limit on deductions by filing separately.
Choosing the Best Option
Your decision to take the standard deduction or itemize deductions may change from year to year, or even in the same year. Taxpayers who find they’ve chosen the wrong option and paid too much may recalculate their tax using the other method and claim a refund for the difference. For example, suppose that you computed and paid your taxes, which amounted to $2,450, using the standard deduction. A few months later you find that had you itemized your deductions, your taxes would have been only $1,950. Using the appropriate forms, you can file an amended return (Form 1040X) showing a $500 refund ($2,450 - $1,950). To avoid having to file an amended return because you used the wrong deduction technique, estimate your deductions using both the standard and itemized deduction amounts and then choose the one that results in lower taxes. Most taxpayers use the standard deduction; but homeowners who pay home mortgage interest and property taxes generally itemize, because those expenses alone typically exceed the allowable standard deduction.
Exemptions
There’s one more calculation for determining your taxable income. Deductions from AGI based on the number of persons supported by the taxpayer’s income are called exemptions. A taxpayer can claim an exemption for himself or herself, his or her spouse, and any dependents children or other relatives earning less than a stipulated level of income ($3,500 in 2008) for whom the taxpayer provides more than half of their total support. This income limitation is waived for dependent children under the age of 24 (at the end of the calendar year) who are full-time students. So a college student, for example, could earn $8,000 and still be claimed as an exemption by her parents as long as all other dependency requirements are met. In 2008, each exemption claimed was worth $3,500. The personal exemption amount is tied to the cost of living and changes annually based on the prevailing rate of inflation. Exemptions are phased out and eliminated altogether for taxpayers with high levels of AGI. After adjusting for inflation, it applies to single taxpayers with 2008 AGI over $159,950 and married couples filing jointly with 2008 AGI over $239,950. As with itemized deductions, in 2006 the reduction of exemptions began to be phased out, and it will be eliminated by 2010. A personal exemption can be claimed only once. If a child is eligible to be claimed as an exemption by her parents
then she doesn’t have the choice of using a personal exemption on her own tax return regardless of whether the parents use her exemption.In 2008, a family of four could take total exemptions of $14,000—that is, 4 × $3,500. Subtracting the amount claimed for itemized deductions (or the standard deduction) and exemptions from AGI results in the amount of taxable income, which is the basis on which taxes are calculated. A taxpayer who makes $50,000 a year may have only, say, $30,000 in taxable income after adjustments, deductions, and exemptions. It is the lower, taxable income figure that determines how much tax an individual must pay.
Choosing the Best Option
Your decision to take the standard deduction or itemize deductions may change from year to year, or even in the same year. Taxpayers who find they’ve chosen the wrong option and paid too much may recalculate their tax using the other method and claim a refund for the difference. For example, suppose that you computed and paid your taxes, which amounted to $2,450, using the standard deduction. A few months later you find that had you itemized your deductions, your taxes would have been only $1,950. Using the appropriate forms, you can file an amended return (Form 1040X) showing a $500 refund ($2,450 - $1,950). To avoid having to file an amended return because you used the wrong deduction technique, estimate your deductions using both the standard and itemized deduction amounts and then choose the one that results in lower taxes. Most taxpayers use the standard deduction; but homeowners who pay home mortgage interest and property taxes generally itemize, because those expenses alone typically exceed the allowable standard deduction.
Exemptions
There’s one more calculation for determining your taxable income. Deductions from AGI based on the number of persons supported by the taxpayer’s income are called exemptions. A taxpayer can claim an exemption for himself or herself, his or her spouse, and any dependents children or other relatives earning less than a stipulated level of income ($3,500 in 2008) for whom the taxpayer provides more than half of their total support. This income limitation is waived for dependent children under the age of 24 (at the end of the calendar year) who are full-time students. So a college student, for example, could earn $8,000 and still be claimed as an exemption by her parents as long as all other dependency requirements are met. In 2008, each exemption claimed was worth $3,500. The personal exemption amount is tied to the cost of living and changes annually based on the prevailing rate of inflation. Exemptions are phased out and eliminated altogether for taxpayers with high levels of AGI. After adjusting for inflation, it applies to single taxpayers with 2008 AGI over $159,950 and married couples filing jointly with 2008 AGI over $239,950. As with itemized deductions, in 2006 the reduction of exemptions began to be phased out, and it will be eliminated by 2010. A personal exemption can be claimed only once. If a child is eligible to be claimed as an exemption by her parents
then she doesn’t have the choice of using a personal exemption on her own tax return regardless of whether the parents use her exemption.In 2008, a family of four could take total exemptions of $14,000—that is, 4 × $3,500. Subtracting the amount claimed for itemized deductions (or the standard deduction) and exemptions from AGI results in the amount of taxable income, which is the basis on which taxes are calculated. A taxpayer who makes $50,000 a year may have only, say, $30,000 in taxable income after adjustments, deductions, and exemptions. It is the lower, taxable income figure that determines how much tax an individual must pay.
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