January is turning the corner, I am trying to remember my New Year’s resolutions, and my mailbox is starting to fill up with various tax forms. It is that time of year again, and hopefully I will get a refund!
Many of us sort through these documents that look like alphabet soup, either attempting to decode them ourselves or simply filling a box to drop off to a tax professional down the street. Taxes are expenses we often view as being ‘out of our control,’ but understanding the income tax formula can reveal opportunities to reduce your lifetime tax liability, pay only what you legally owe, and make well-informed decisions that align with your personal financial objectives. As we break it down, keep in mind that the tax code is an ever-changing landscape, and you should consult a tax professional to ensure that your tax planning assumptions are accurate. Let’s get to it!
Citizens and residents of the U.S. who are required to file a federal tax return will use Form 1040, which reports the taxpayer’s total income and income tax obligation to the IRS. Downloading the form and following along may help you grasp a better understanding of the tax formula as we proceed. There are various numbered and lettered ‘schedules’ for additional tax calculations and reporting, but we will focus primarily on Form 1040. Here is the basic income tax ‘formula’ we will deconstruct:
Taxpayers who file a tax return must specify a tax filing status. Filing as single (S), married filing jointly (MFJ), married filing separately (MFS), head of household (HH), or qualifying widow(er) (QW) results in varying eligibility for tax deductions, tax credits, and favorable tax rates. The IRS has created an interactive online tool to help you determine your filing status and whether you can claim dependents (qualifying children or relatives).
Gross Income & Exclusions
Calculating federal income tax begins by adding all sources of income. Gross income is the total of both earned income (salaries, wages, net earnings from self-employment, etc.) and unearned income (unemployment compensation, Social Security benefits, investment income, taxable distributions from pensions, annuities, and retirement accounts, etc.). Form W-2 and Form 1099 are commonly issued to taxpayers with these sources of income.
Certain income sources are specifically excluded from gross income. These may include a portion or all of Social Security benefits, military service-connected disability benefits, workers’ compensation, municipal bond interest, pre-tax employer retirement plan contributions, portion of gain on the sale of a main home (Sec. 121 exclusion), scholarships for tuition and fees (not room and board), gifts and inheritances, life insurance proceeds, some employer-provided benefits, and child support.
Adjustments to Income (‘Above-the-Line Deductions’)
After gross income is calculated, favorable adjustments to income are subtracted. These may include contributions to health savings accounts (HSAs), pre-tax contributions to Traditional IRAs, 50% of self-employment taxes, self-employed health insurance, educator expenses (up to $250 per educator), and up to $2,500 of paid student loan interest.
Adjusted Gross Income (AGI)
We reduced gross income by adjustments to income to arrive at Adjusted Gross Income (AGI). Makes sense, right? AGI directly impacts eligibility for tax deductions and credits, and many states also use federal AGI as the starting point for calculating state income tax.
Standard or Itemized Deductions (‘Below-the-Line Deductions’)
We are almost ready to calculate our tax liability, but the IRS provides additional tax relief by allowing us to further reduce the amount of income that is subject to tax by subtracting (claiming) either the standard or itemized deductions. A taxpayer’s filing status determines the amount of the standard deduction, and there is an additional standard deduction for taxpayers and their spouse who are age 65 and/or are blind. As a reference, the standard deduction for couples under age 65, married filing jointly in 2020 was $24,800. This can provide substantial tax savings!
On the other hand, a taxpayer can itemize deductions to determine if they can manually exceed the standard deduction for an additional reduction of taxable income. Common itemized deductions include medical expenses (exceeding 7.5% of AGI), state and local taxes (capped at $10,000), home mortgage interest, unreimbursed federally-declared disaster losses, and qualified charitable contributions (AGI limitations).
Note: The Tax Cuts and Jobs Act of 2017 (TCJA) changed the annual standard deduction amounts for taxpayers, nearly doubling the previous year’s limits. Along with the itemized deduction thresholds, these higher amounts have made it more difficult for taxpayers to exceed the standard deduction. An estimated 90% of taxpayers do not itemize their deductions, but there are strategic opportunities to itemize, especially if you give generously to charities.
Along with the higher standard deduction amounts, the TCJA added a temporary benefit called the Qualified Business Income (QBI) deduction, available for tax years 2018 through 2025 (unless changed or extended). The QBI deduction allows some taxpayers to deduct 20% of qualified business income + 20% of qualified real estate investment trust (REIT) dividends. The complexity of QBI is beyond the scope of this article, but here are additional details.
We have arrived! Now that AGI has been reduced by the standard or itemized deductions to determine taxable income, we can calculate the tentative tax liability.
The federal income tax system is progressive, meaning that the tax rates increase at higher levels of taxable income. There are seven federal tax brackets (marginal tax rates) for the 2020 tax year: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Here are the detailed tax brackets for 2020.
As an example of the progressive tax system, a couple filing jointly with ordinary taxable income of $90,000 in year 2020 will owe 10% tax on the first $19,750 ($1,975), then 12% on the next $60,500 ($7,260), then 22% on the last $9,750 ($2,145).
$1,975 + $7,260 + $2,145 = Tentative Tax of $11,380
Notice that your marginal tax rate only applies to your highest dollar of taxable income. If your taxable income falls within the 22% tax bracket, you will not owe 22% on every dollar of taxable income. Dividing the tentative tax of $11,380 into the taxable income of $90,000 comes to 12.6%, which is called the effective tax rate. This household has a marginal tax rate of 22% and an effective tax rate of 12.6%.
Income from qualified dividends and long-term capital gains within taxable brokerage accounts receive favorable tax treatment, and the taxes on these earnings are calculated separately using capital gains tax rates (0%, 15%, 20%), depending on taxable income.
Non-Refundable Tax Credits and Other Taxes
Once you have calculated your tentative tax, there are a handful of additions and subtractions before arriving at total tax. Additional taxes such as self-employment tax (Social Security + Medicare), alternative minimum tax, net investment income tax (NIIT), and ‘penalties’ for non-qualified distributions from retirement accounts may apply.
Depending on your filing status and income level, you may be eligible to receive non-refundable tax credits, which may reduce your tax liability dollar for dollar – even down to zero! These include the premium tax credit (PTC) for Marketplace health insurance, the child tax credit (CTC) and credit for other dependents, the child and dependent care credit, education credits, the foreign tax credit, and the saver’s credit. Each of these credits has its own income thresholds and filing requirements.
Total Payments and Refundable Tax Credits
Now that we have arrived at total tax, we can determine if we will receive a tax refund or owe taxes for the year. Withholding taxes from W2 income as an employee or making estimated tax payments throughout the tax year can fulfill the tax liability.
Unlike the non-refundable tax credits mentioned above, there are a few tax credits that are partially or fully refundable, meaning they can further reduce and result in a negative tax liability. These include the earned income credit (EIC), the additional child tax credit (ACTC), and the American opportunity tax credit (AOTC).
Whew! Income tax can feel endlessly complex, but I hope this overview helps you better understand the basic formula and boost your confidence before filing. If you need additional clarity to align the complexity of the tax code with your personal financial ecosystem, consult a licensed tax professional who files returns and also looks around the corner; there are great planning opportunities for tax efficiency!