Section PF.5 – Income Tax
| Taxes |
Taxes are levied on residents of the United States to fund the government’s financial obligations. There are four main levels of government at which taxes are collected: municipal (or city), county, state and federal (or national). In general, there are four things that are taxed: purchases, property, business profits, capital gains, and wages.
- Sales Tax: Taxes on purchases, or sales tax, is charged when things are bought by customers. Generally, these sales taxes are at the state, county, or municipal level.
- Property Taxes: These are taxed are levied on larger owned items such as real estate and cars, and those are generally county taxes. This topic will not be covered in this book.
- Capital Gains Tax: This is a federal government tax on the profits earned from buying and selling assets. For example, the buying and selling of real estate, other property, stocks, bonds, and other investments are taxed by the federal government. This topic will not be covered in this book.
- Taxes on Wages: These taxes fall into two categories payroll taxes and income taxes. Taxes on wages are usually the main type of taxes that people perceive and is collected at the state and federal levels. We will discuss payroll taxes in the next section. This can also include taxing windfall profits, such as gambling or lottery winnings.
- Business Taxes: States and the federal government tax the profits that businesses earn. This topic will not be discussed in this book. There’s a different tax code system for corporations but some small businesses often choose to report their profits as personal income tax.
| Income Tax |
Income tax returns are due annually in April, for the year previous. Employers register employees using a form called a W-4, from which information about the employee is gathered and shared with the Internal Revenue Service, or IRS. This agency is responsible for figuring and gathering taxes owed. The W-4 can be adjusted by employees to change the amount of tax withheld due to various circumstances.
Important Notes:
- As per the Income Tax Act (Section 288A), the Internal Revenue Service rounds all amounts to the nearest whole dollar.
- The information in this textbook may not reflect the current U.S. and state income tax code because Congress and states regularly makes changes to their income tax code. Use the provided textbook information for all problems in this course.
Certain aspects of the income tax code may change year to year, such as the exemption amounts, credit categories, tax rates, etc. Income tax preparation software is updated every year in order to provide accurate tax returns and tax preparers must also stay up to date on changes. This textbook will cover all the general features that have appeared in almost every version of the U.S. income tax code. This will help you have a general understanding of any U.S income tax code.
| Determining Taxable Income |
When an employee’s wages are computed, the gross amount is the total wages before any deductions or withholdings occur. Employers will earmark a certain percentage of the gross amount to be withheld for the government to account for income taxes. This withholding is given to the government as regular tax payments as the year progresses and forms a portion of the income tax that will be due for the year. Someone who is self-employed or own their own business must make regular tax payments throughout the year. FICA, or Federal Insurance Contributions Act, is money taken that is used for the Social Security and Medicare programs that most Americans are eligible for at retirement. FICA is approximately 7% of gross income, which is matched by the employer and goes into these social programs for the employee to use later. States can also withhold funds from gross paychecks to cover state income tax for the year.
Taxes are not the only thing deducted from gross earnings. Healthcare benefits, insurance, voluntary contributions, and retirement savings may also be subtracted from the gross amount. The final total of the gross pay minus all the withholding and deductions is known as net pay or take-home pay, and this amount is immediately available to the employee.
Income tax calculation is complicated and depends on many different factors. In general, the calculations start with the gross income. This amount is increased based on the addition of other sources of income, such as interest earned on loans or interest earned from a savings account. Capital gains, profits from investments, is also usually report on your personal tax return. However, these profits are taxed differently than wages and will not be covered here. The total of these revenue sources is known as the Adjusted Gross Income, or AGI.
Once the AGI is determined, taxpayers may take out a deduction to reduce the AGI. There is an option to take the standard deduction, which is a specific amount allowed by the government, or choose to itemize. Itemized deduction involves adding up a group of potential deductions and using that amount if it is more than the standard deduction. Items that can be deducted include mortgage interest, investment losses, charitable contribution, work expenses, medical bills, other taxes paid, tuition expenses, and others. Generally, people with higher income levels can utilize the itemized deductions more than standard earners.
After deductions are taken, every taxpayer typically gets a personal exemption from their AGI; this amount is determined by the government. (Note that Congress reduced the personal exemption amount to $0.00 for the years 2018 to 2025.) Exemptions are also allowed for each dependent that the taxpayer claims, dependents being children, elderly parents, or other wards for whom the taxpayer has financial responsibility for.
Once this is taken, the remaining total is known as taxable income. From the taxable income figure, the total tax owed can be determined. This amount can be further reduced by tax credits, which can include child tax credit, public schools tax credit, private schools tax credit, and contributions to organizations that assist the working poor. Once the credits are taken, this is the final tax owed.
The tax owed is compared to the total tax payments made during the year. If the total taxes paid is less than the tax owed, then the difference is due to the government by April 15th. If the total taxed paid is more than what is owed, then the difference is disbursed back from the government and known as a tax refund.
Understanding what things are often considered Income, Adjustments, Itemized Deductions or Tax Credits is helpful to understanding your personal income tax. Below is a table of common examples of each. (Note that this can change from year to year due to tax code changes)
| Income | Adjustments | Itemized Deductions | Tax Credits |
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Wages Tips Rental Income Interest earned from savings accounts or loans Profits from a personal business Unemployment Compensation Game show winnings |
Tax-deferred savings or retirement plan (i.e. 401(k), 403(b), IRA – Individual Retirement Account) HAS – Health Savings Accounts Alimony payments Interest paid on student loans |
Interest paid on home mortgages State income taxes Property taxes Charitable Contributions Medical expenses exceeding 7.5% of adjust gross income
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Public School or Charter School tax credit (Extracurricular activities) School tuition Contributions to qualifying charitable organizations Contributions to qualifying foster care charitable organizations
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| Calculating Income Tax
1. Determine your adjusted gross income: Adjusted gross income = Gross income – Adjustments 2. Determine your taxable income: Taxable income = Adjusted gross income – (Exemptions + Deductions) 3. Determine income tax: Income tax = Tax computation using marginal tax table – Tax credits |
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Sample Federal Income Tax Rates Table |
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Tax Rate |
Single |
Married Filing Separately |
Married Filing Jointly |
Head of Household |
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Unmarried, divorced, or legally separated |
Married and each partner files a separate tax return |
Married and both partners file a single tax return |
Unmarried and paying more than half the cost of supporting a child or parent |
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10% |
Not over $11,000 |
Not over $11,000 |
Not over $22,000 |
Not over $15,700 |
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12% |
Over $11,000 but not over $44,725 |
Over $11,000 but not over $44,725 |
Over $22,000 but not over $89,450 |
Over $15,700 but not over $59,850 |
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22% |
Over $44,725 but not over $95,375 |
Over $44,725 but not over $95,375 |
Over $89,450 but not over $190,750 |
Over $59,850 but not over $95,350 |
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24% |
Over $95,375 but not over $182,100 |
Over $95,375 but not over $182,100 |
Over $190,750 but not over $364,200 |
Over $95,350 but not over $182,100 |
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32% |
Over $182,100 but not over $231,250 |
Over $182,100 but not over $231,250 |
Over $364,200 but not over $462,500 |
Over $182,100 but not over $231,250 |
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35% |
Over $231,250 but not over $578,125 |
Over $231,250 but not over $346,875 |
Over $462,500 but not over $693,750 |
Over $231,250 but not over $578,100 |
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37% |
Over $578,125 |
Over $346,875 |
Over $693,750 |
Over $578,100 |
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Sample Federal Deductions and Exemptions |
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Single |
Married Filing Separately |
Married Filing Jointly |
Head of Household |
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Standard Deduction |
$13,850 |
$13,850 |
$27,700 |
$20,800 |
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Exemptions (per person) |
$4350 |
$4350 |
$4350 |
$4350 |
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Example 1 |
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Find the gross income, adjusted gross income, and taxable income. Correctional Officer, filing single, no dependents Gross income: $47,751, $140 in interest from a savings account Adjustments: $1,440 tax-deferred retirement plan (401(k) – Employer Sponsored plan) Deductions: $160 charitable contributions Tax credit: None Gross income: Adjusted gross income: Taxable income:
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The IRS (Internal Revenue Service) rounds to the nearest whole dollar. Gross income: This is the total income from the year. 47751 + 140 = $47,891 Adjusted gross income: This is the gross income minus the adjustments. In this case, a tax-deferred contributions 47891 – 1440 = $46,451 Taxable income: This is the adjusted gross income minus exemptions and deductions. You will need to know how many exemptions are allowed. Each person is entitled to an exemption. In this example, the person is single, with no dependents, so they are entitled to 1 exemption. Next you need to decide whether to take the standard deduction or itemized deductions. You want to pick the higher of the two amounts. Itemized deductions total $160. Standard deduction for a person filing single is $13,850. This is from the Marginal Tax Rates Table. For this example, the standard deduction is larger. The larger the exemptions and deductions are, the larger amount is subtracted from the adjusted gross income, decreasing your tax liability. 46451 – (1(4350) + 13,850) = $28,251 Answers: Gross income: $47,891 Adjusted gross income: $46,451 Taxable income: $28,251
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Example 2 |
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Find the gross income, adjusted gross income, and taxable income. Broadcast News Analyst and Urban Planner, married couple filing jointly, two dependents Gross income: Broadcast News Analyst $51,178, Urban Planner $82,617 Adjustments: $6000 tax-deferred savings plan Deductions: $11,120 interest on a home mortgage $7050 property taxes $12,000 charitable contributions Tax credit: $800 Gross income: Adjusted gross income: Taxable income:
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The IRS (Internal Revenue Service) rounds to the nearest whole dollar. Gross income: This is the total income from the year. 51,178 + 82,617 = $133,795 Adjusted gross income: This is the gross income minus the adjustments. In this case, a tax-deferred contributions 133,795 – 6000 = $127,795 Taxable income: This is the adjusted gross income minus exemptions and deductions. You will need to know how many exemptions are allowed. Each person is entitled to an exemption. In this example, the couple is married, with two dependents, so they are entitled to 4 exemptions. Next you need to decide whether to take the standard deduction or itemized deductions. You want to pick the higher of the two amounts. Itemized deductions total $30,170 (11,120 + 7050 + 12,000). Standard deduction for a married couple filing jointly is $27,700. This is from the Marginal Tax Rates Table. For this example, the itemized deduction is larger. The larger the exemptions and deductions are, the larger amount is subtracted from the adjusted gross income, decreasing your tax liability. 127,795 – (4(4350) + 30,170) = $80,225 Answers: Gross income: $133,795 Adjusted gross income: $127,795 Taxable income: $80,225 |
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You Try PF.5.A |
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Find the gross income, adjusted gross income, and taxable income. Computer Network Support Specialist, head of household, one dependent Gross income: $61,288 Adjustments: $2100 tax-deferred retirement plan (IRA – Individual Retirement Account) Deductions: $9,000 mortgage interest $3700 property taxes $2800 charitable contributions Tax credit: none
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Marginal Tax Rates |
The U.S. tax code is a progressive one, meaning that as income rises, the percent of income paid in tax also rises. This necessitates a number of different tax rates, which increase as various levels of income are surpassed. For example, someone with less than $11,000 in taxable income will pay 10% tax, but if they earn more than $11,000 but less than $44,725, the rate is 12%.
These ranges (known as tax brackets) only apply to the amount within each level. If someone has $20,000 in taxable income, the first $11,000 is taxed at 10% and the remaining $9,000 is taxed at 12%. The highest tax rate that someone reaches is called their marginal tax rate.
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Example 3 |
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Use the sample tax rates table to compute the income tax owed. A married man filing separately, coroner, with a taxable income of $62,179.
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Married Filing Separately, the taxable income is $62,179 and is in the 22% tax bracket. Income tax owed = 0.10(11,000) + 0.12(44,725 – 11,000) + 0.22(62,179 – 44725) = 8986.88 This married man does not have a tax credit, so we will not subtract anything. This man filing separately will owe $8987 in taxes. Remember taxes are rounded to the nearest dollar. |
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Example 4 |
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Use the sample tax rates table to compute the income tax owed. A head of household, public relations manager, with a taxable income of $195,620 and a $3800 tax credit.
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Head of Household, the taxable income is $195,620 and is in the 32% tax bracket. Income tax owed = 0.10(15,700) + 0.12(59,850 – 15,700) + 0.22(95,350 – 59,850) + 0.24(182,100 – 95,350) + 0.32(195,620 – 182,100) = 39824.40 This taxpayer has a $3800 tax credit so we will subtract this amount. =39824.40 – 3800 = 36024.40 Rounded to the nearest dollar, this taxpayer will owe $36,024. |
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You Try PF.5.B |
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Use the sample tax rates table to compute the income tax owed. A single woman, statistician, with a taxable income of $97,722.
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You Try PF.5.C |
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Use the sample tax rates table to compute the income tax owed. A married couple filing jointly, promotions manager and registered nurse, with a taxable income of $558,790 and a $4150 tax credit.
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Example 5 |
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Calculate the income tax owed. Lia and Jovany are married and filed jointly. Lia earned $100,337 as an information security analyst and Jovany earned $92,187 as a criminal investigator. They earned $12,000 from a rental property they own, and they received $2650 in savings interest. They claimed five exemptions for themselves and three children. They contributed $5310 to their tax-deferred retirement plans, and their itemized deductions total $24,500. Lia and Jovany gave $800 in tax credits to their children’s public school.
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First, we find the gross income: 100,337+92,187+12,000+2,650 = $207,174 Next, we calculate the adjusted gross income: 207,174 – 5,310 = $201,864 Then, we obtain the taxable income: Itemized Deduction = $24,500, Standard $27,700 201,864 – (5(4350) + 27,700) = $152,414 (Five exemption and took the standard deduction) Lastly, we use the sample tax rates table to determine the income tax owed. 0.10(22,000) + 0.12(89,450 – 22,000) + 0.22(152,414 – 89,450) =$24,146.08 Subtract the tax credit, =$24,146.08.36 – $800 = $23,346.08 The couple will owe $23,346 in taxes. |
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Example 6 |
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Calculate the income tax owed. Suppose a co-worker, a skin care specialist, earned wages of $57,006, received $1790 in dividends and long-term capital gains, and contributed $2400 to a tax-deferred retirement plan. He filed head of household and is entitled to a personal exemption, an exemption for his elderly mother, and the same exemption for his son. The interest on his home mortgage was $14,125, he contributed $8,000 to charity, and he paid $680 in state taxes.
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First, we find the gross income: 57,006 + 1,790 = $58,796 Next, we calculate the adjusted gross income: 58,796 – 2,400= $56,396 Then, we obtain the taxable income: Itemized Deduction $22,805, Standard Deduction $20,800 56,396 – (3(4350) + 22,805) = $20,541 (Three exemptions and itemized deductions) Lastly, we use the sample tax rates table to determine the income tax owed. 0.10(15,700) + 0.12(20,541 – 15,700) =2150.92 There is no tax credit, so your co-worker will owe $2,151. |
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You Try PF.5.D |
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DeShawn is married, works as a public high school history teacher, earned wages of $82,300 received $885 in interest from a savings account. He contributed $2400 to a tax-deferred retirement plan, 403(b), and paid $2800 in interest on student loans. He is entitled to a personal exemption for himself and his daughter. The interest on his home mortgage was $6,800, he contributed $5,000 to charity, and he paid $3,050 in state taxes. DeShawn also gave a tax credit of $800 for his daughter to attend a private school. DeShawn is married and filing separately. |
Section PF.5 – Answers to You Try Problems
PF.5.A
Gross income $61,288
Adjusted gross income $59,188
Taxable income $29,688
PF.5.B
$16,853
PF.5.C
$135,216
PF.5.D
$6,483
