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Federal Income Tax Base

Federal Income Tax Base

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Author: Sophia Tutorial
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Determine how to calculate individual or household income after taxes.

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Tutorial

what's covered
In this lesson, you will learn how to calculate taxable income. You will explore the various digital tools available to you. You will also learn the importance of not procrastinating to ensure you can be as productive as possible. Specifically, this lesson will cover:
  1. Overview of Federal Income Tax Returns
    1. The Tax Return Process
    2. Tax Formula
  2. Entering Personal Information
    1. Filing Status
    2. Dependents
  3. Calculating Total Income
    1. Gross Income
    2. Determining Adjusted Gross Income
    3. Taxable Income

1. Overview of Federal Income Tax Returns

Nearly every adult must complete and file a federal income tax return each year before mid-April. A tax return is information that a taxpayer compiles and reports to the IRS on a standardized form. Sounds simple, right? Consider the form shown below. For some, completing this form is simple. But for others, the tax return process may seem very complicated.

a standard ten forty form from the U.S. Government; includes personal information, signature spaces, and a worksheet for tax preparation

Productivity: Skill in Action
When returns are more complex, people may choose to work with an accountant. Like many professionals responsible for continually meeting deadlines, accountants also have to manage stress and prevent procrastination to stay successful. And they must prioritize their tasks to stay focused on the most important assignments first. Accountants couldn’t do any of it without practicing their productivity skill each and every day. It’s what allows them to strategize, organize, and plan so they can perform their best.

term to know

Tax Return
Information that a taxpayer compiles and reports to the IRS on a standardized form.
1a. The Tax Return Process
Employers, banks, investment companies, and businesses all report income and expense information about you to the IRS. When you send your tax return to the IRS, it is compared against this other information already submitted. If there are differences, the IRS may choose to contact you.

Productivity: Skill Reflect
What has been your experience with your taxes? Do you dread doing them? Do you use an accountant to help? No matter how you feel about taxes or filing them, if you want to make sure you are being productive and doing all you can to secure your financial future, you need to have a plan and execute it.

1b. Tax Formula
In this topic, we will guide you through the filing process and identify planning strategies that will help to minimize your tax base or tax rate. The first step is understanding the tax formula.

big idea
Knowing how income taxes work will empower you to be proactive in finding legal ways to minimize the taxes you must pay while maximizing your after-tax wealth. One of the best ways to gain this knowledge is by completing a tax form.

The following illustration shows the federal income tax formula that is captured in Form 1040.

  • Once you calculate your tax base, you will likely need to use more than one tax rate to calculate your total taxes.
  • Once you know the amount of your taxes, you may be able to reduce your tax liability (if any) by claiming a credit against the amount you owe.
a long math sentence oriented vertically: gross income minus deductions equals adjusted gross income, result minus deductions equals tax base, result times tax rate equals assessed income tax, result plus other taxes minus credits equals net tax due, or refund

By learning to effectively track your income and strategize for tax season, you can gain an understanding of your personal finances, which will pay off by freeing up more of your time and hard-earned money in the future.


2. Entering Personal Information

The first step when beginning to work on your taxes is to enter your personal information (i.e., name, address, and Social Security number). Next, you will need to determine your filing status and presence of dependents in your household.

2a. Filing Status
Filing status is determined by your marital status and the presence of dependents. There are two categories of dependents: (1) qualifying children and (2) qualifying relatives. The IRS uses five filing statuses, as shown in the illustration below.

an infographic showing five filing statuses: single, married filing jointly, married filing separately, head of household, and qualifying widower

EXAMPLE

Let’s consider Jeff and Maria’s situation.
  • Jeff and Maria are both 24 years old and recently married (on December 21).
  • Jeff earns $27,000 and Maria earns $35,000; they earned $125 in interest on their savings account for the year.
  • They have no children or other dependents.

Even though they were married near the end of the year, Jeff and Maria’s filing status can be either married filing jointly or married filing separately. In their case, Jeff and Maria have decided to file a joint tax return.

Jeff and Maria use Form 1040 to file their tax return. Although Jeff and Maria may use free tax preparation software to prepare their tax return, the underlying form that they are using is still Form 1040. You can see Jeff and Maria’s tax return below.

a completed ten forty form for Jeff and Maria Sample; combined wages, salary, and tips are sixty-two thousand dollars and taxable income is about thirty-eight thousand dollars

There are many online options like the one Jeff and Maria chose to use. You can find Form 1040 and any others that you may need to complete. Strong technology skills allow you to take advantage of these tools that lead to increased efficiency and accuracy. It is a wise investment to learn more about these tools so you can select the one that is the best fit for you.

term to know

Filing Status
Determined by your marital status and the presence of dependents.
2b. Dependents
If a taxpayer is providing a home for another person, then the taxpayer may be able to claim the other person as a dependent on his or her tax return. Claiming a dependent may entitle a taxpayer to preferential filing status (head of household) and other tax benefits. On the other hand, if you are claimed as a dependent by someone else, you may lose certain tax benefits (these benefits go to the person who claims you).

Although the definition of a tax dependent can get complicated, there are two basic categories of dependents: children and relatives. The most common type of dependent is a child. Qualifying children are considered dependents of the taxpayer. Qualifying children must pass four general tests: support, age, relationship, and abode. These are outlined in the chart below.

a chart with four regions that defines a qualifying child: (one) support, (two) age, (three) relationship, and (four) abode

Let’s say that you take care of your mom, who currently lives with you. She certainly would not qualify as your child, but you might be able to claim her as a dependent on your tax return as a qualifying relative (and therefore also be able to choose head of household filing status). A qualifying relative is a dependent who meets all the following requirements:

  • He or she is not a qualifying child of another person.
  • His or her relationship to the taxpayer is that of child (as defined previously), parent, grandparent or direct ancestor, aunt, or uncle.
  • The relative has less than $4,150 (in 2018) of gross taxable income.
  • The taxpayer provides more than half the dependent’s support.
hint
One important exception to the relationship requirement is that if an unrelated person lives with you for the entire year, then she or he satisfies the relationship test.

As with all tax issues, certain guidelines apply.

  • A taxpayer cannot claim a dependent if he or she is listed as a dependent on someone else’s tax return.
  • A dependent cannot be claimed on two different tax returns.
terms to know

Qualifying Children
Dependents of a taxpayer who must pass four general tests: support, age, relationship, and abode.
Qualifying Relative
A dependent who is not a qualifying child of another person, but meets other requirements to be lawfully recognized as a dependent.

3. Calculating Total Income

The first step in figuring your income tax amount is to calculate your total income, also known as your gross income.

3a. Gross Income
Gross income is the sum of all your income, including the following.
  • Wages and salary from work
  • Income from self-employment, partnerships, and so forth
  • Interest, dividends, capital gains, and rents
  • Scholarships and grants in excess of tuition and books
  • Unemployment benefits and bartering
  • Alimony received
  • Pensions and retirement plan distributions
Some types of income are excluded from gross income and therefore they are not calculated in determining the tax base:
  • Loan proceeds
  • Gifts and inheritances
  • Scholarships (educational assistance) used for tuition, fees, and required books and supplies
  • Capital gain on sale of primary residence (up to $250,000 for those who are single and $500,000 for those who are married)
  • Life insurance death benefits
  • Fringe benefits through employment, such as health insurance premiums
  • Qualifying distributions from Roth IRAs
  • A portion of, or all, Social Security benefits
  • Municipal bond interest
If you plan ahead, you can structure some of your financial endeavors in such a way as to produce income that is excluded from gross income, such as selling your personal residence, earning a scholarship for tuition/fees/books, or having your employer pay for your tuition.

term to know

Exclusion
A type of income that is excluded from gross income and not calculated in determining the tax base.
3b. Determining Adjusted Gross Income
Throughout the year, you may also incur daily living expenses that you can use to reduce your gross income. These deductions, which are specific expenses allowed by Congress that can be used to offset gross income, will result in an adjusted gross income (AGI) amount that is reported on Form 1040.

There are two types of deductions: (1) FOR AGI deductions which are used to calculate AGI and (2) FROM AGI deductions which reduce AGI further to calculate taxable income.

Examples of FOR AGI deductions include:

  • Interest paid on student loans
  • Contributions to a Health Savings Account (contribution limit for a single individual is $3,450 in 2018)
  • Contributions to a traditional IRA (contribution limit is $5,500) and contributions to other self-employed retirement plans
  • Health insurance premiums paid by self-employed individuals
FROM AGI deductions are not used to calculate AGI but do further reduce AGI. When claiming FROM AGI deductions, taxpayers can either claim the standard deduction (available to all taxpayers) or itemize their deductions.

hint
If Congress has not specifically allowed the deduction, then you can’t claim it on your tax return.

If you are ever in doubt about what is or is not allowed, check the IRS website.

terms to know

Deduction
Specific expenses allowed by Congress that can be used to offset gross income.
Adjusted Gross Income (AGI)
Income amount reported on Form 1040 after applying allowed deductions.
3c. Taxable Income
Taxable income is the amount remaining after the standard deduction or itemized deductions. Taxable income is your tax base that will be used to determine your income tax. Your income does not equal your taxable income (tax base). As we have discussed, there are many exclusions and deductions that you can take to minimize your tax base while still enjoying your full income to achieve your goals.

big idea
No two tax situations are the same! Check out one person’s experience with filing her taxes and how technology and hiring a professional played key roles.

Filing Taxes: Get Help When You Need It

term to know

Taxable Income
The amount remaining after the standard deduction or itemized deductions. It is your tax base used to determine your income tax.
summary
The tax return process affects every working American. It is important you don’t procrastinate to make sure your returns are accurate and precise. In this lesson, you looked at an overview of federal income tax returns. You studied the general tax formula and how it applies to the tax return process. After entering your personal information on your return, you list your filing status, such as married or single, and any people you care for, called dependents. Every tax return involves calculating total income, also called gross income. You can reduce your taxable gross income by subtracting allowable daily living expenses that you incur, as determined by Congress. The result is an adjusted gross income that you report on your tax return. Your taxable income is the amount on which the government bases your income taxes after standard or itemized deductions have been made. There are many digital tools available for calculating and filing your returns. Strong technology skill means you can choose what works best for you.

Source: This content has been adapted from Chapter 4.2 of Introduction to Personal Finance: Beginning Your Financial Journey. Copyright © 2019 John Wiley & Sons, Inc. All rights reserved. Used by arrangement with John Wiley & Sons, Inc.

Wiley and the Wiley logo are trademarks or registered trademarks of John Wiley & Sons, Inc. and/or its affiliates in the United States and other countries.

Terms to Know
Adjusted Gross Income (AGI)

Income amount reported on Form 1040 after applying allowed deductions.

Deduction

Specific expenses allowed by Congress that can be used to offset gross income.

Exclusion

A type of income that is excluded from gross income and not calculated in determining the tax base.

Filing Status

Determined by your marital status and the presence of dependents.

Qualifying Children

Dependents of a taxpayer who must pass four general tests: support, age, relationship, and abode.

Qualifying Relative

A dependent who is not a qualifying child of another person, but meets other requirements to be lawfully recognized as a dependent.

Tax Return

Information that a taxpayer compiles and reports to the IRS on a standardized form.

Taxable Income

The amount remaining after the standard deduction or itemized deductions. It is your tax base used to determine your income tax.