Federal Income Tax Key Concepts Tax Brackets

Posted on June 28, 2008 
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The concept of tax brackets is shorthand for the grouping of various levels of taxable income according to tax rates. In a progressive tax system such as the U.S. federal income tax, the point at which an increase in taxable income results in a marginally higher tax rate marks the beginning of a new tax bracket.

For individuals filing a federal tax return in 2007, there are six tax brackets that group together tax rates and levels of taxable income according to filing status: the 10%, 15%, 25%, 28%, 33%, and the (pdf file), 35%. Individuals married filing jointly (including surviving spouses) are in the most favorable tax brackets, those married filing separately in the least favorable. An unmarried individual (or a married person living apart from his or her spouse for the last half of the tax year) who maintains a household for a child, parent, or other qualifying relative can file as head of household and land in a more favorable tax bracket than those condemned (or unwittingly choosing) to file as single or married filing separately.

For example, the 10% tax bracket includes taxable income up to $7,825 for single and married filing separately, $11,200 for head of household, and $15,650 for married filing jointly. The 15% tax bracket ranges from $7,825.01 to $31,850 for single and married filing separately, $11,200.01 to $42,650 for head of household, and $15,650.01 to $63,700 for married filing jointly. The 25% tax bracket ranges from $31,850.01 to $64,250 for married filing separately, $31,850.01 to $77,100 for single, $42,650.01 to $110,100 for head of household, and $63,700.01 to $128,500 for married filing jointly. Click on for details on the 28%, 33%, and 35% brackets. (Please note in the example that follows, I round beginning and ending amounts in tax brackets to the nearest dollar.)

For a taxpayer with enough income to fill some but not all of a bracket, the rate applicable to that bracket is the taxpayer’s marginal tax rate. Any taxable income in excess of $349,700 ($174,850 for married filing separately) is subject to the top marginal tax rate of 35%. The effective tax rate is simply tax due divided by taxable income, and the effective rate will be lower than the top or marginal rate.

As an example, a head of household filer with 2007 taxable income of, say, $97,500 from her salary as an accountant (and no capital gains or dividends, both of which are taxed according to different schedules than ordinary income), the first $11,200 will be taxed at a rate of 10% ($1,120 in taxes for this bracket), the next $31,450 ($42,650 - $11,200) at 15% ($4,717.50 in taxes for this bracket); the next and final increment of $54,850 ($97,500 - $42,650) represents this taxpayer’s top bracket and will be taxed at a marginal tax rate of 25% ($13,712.50 in taxes for this bracket). Her tentative total tax liability is $19,550. But for filers with 2007 taxable income under $100,000, the IRS requires the use of its 2007 Tax Table and, according to this table, our head of household filer will pay taxes of $19,556 because her income is at least $97,500 but less than $97,550. The (pdf file) is graded in increments of $50, and the calculation takes the tax due for the high point in the increment, adds this to the tax due for the low point, and then divides by two, rounding to the nearest dollar. So, the tax due for our head of household filer reporting $97,500 in taxable income would be $19,562.50 (tax due for high point in increment, $97,550) plus $19,550 (tax due for low point in increment, $97,500, which also happens to be our filer’s unfortunate location in this interval) or $39,112.50. Next, we divide this subtotal by two and round to the nearest dollar and arrive at the 2007 Tax Table amount of $19,556. Her effective tax rate is 20.1% (tax due of $19,556 divided by taxable income of $97,500) and lower than her marginal tax rate of 25%.

Additional resources for those interested in tax brackets are listed below:

Many happy returns, Roger

Federal Income Tax Key Concepts Itemized Deductions

Posted on June 26, 2008 
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To paraphrase Einstein, there is nothing so complicated as the income tax, and the device of itemized deductions only adds to the complexity of the Internal Revenue Code.

The proximate cause of the category (and complexity) of itemized deductions is the two-tier concept of income in our federal tax system, namely, the “tiers” of gross income and adjusted gross income.

The first tier, gross income, is a net concept despite the adjective “gross”; that is to say, gross income is not the same as gross receipts. Instead, gross income equals gross receipts less return of capital, cost of goods sold, cost of sales, or recovery of cost. In the context of this article’s focus on the federal income tax for individuals, gross income is the recipient’s net gain from a transaction not his or her gross receipts. Also note that the scope of this article is limited to a general discussion of the concept of itemized deductions; key elements in this category will be covered in subsequent articles. (But for those seeking immediate guidance on itemized deductions, see my article .)

The second tier, adjusted gross income, is gross income less certain deductions expressly authorized by Congress. The deductions taken from gross income to arrive at the intermediate figure of adjusted gross income are commonly referred to as “above the line deductions.” Because, on the whole, above the line deductions comprise trade or business deductions (but with exceptions for alimony, contributions to health savings accounts and retirement plans, and student loan interest payments, among others), they are allowed in full and not subject to a floor. (The phrase “subject to a floor” means deductible only to the extent the expense in question exceeds some baseline figure, usually a fraction of adjusted gross income). On the other hand, many deductions from adjusted gross income (itemized or “below the line” deductions) are mainly personal in nature making them subject to a floor expressed as a percentage of adjusted gross income. Moreover, itemized deductions in the aggregate benefit the taxpayer only if they exceed the standard deduction amount (the 2007 standard deduction is $5,350 for single filing status, $10,700 for married filing jointly and surviving spouse, $5,350 for married filing separately, and $7,850 for head of household); that is, the comparison will pay off only if it tips the scales in favor of itemized deductions. Adjusted gross income (AGI) is therefore a key concept in the federal income tax because it represents the line, for the most part, between business and personal expenses. As with its above the line cousin, itemized deductions abide by the general rule that deductions are not allowed unless granted by the legislative grace of Congress. (For additional details on the role of the two tiers in the federal income tax, see my earlier Key Concepts articles on and .)

Historically, itemized deductions comprise medical and dental expenses (subject to a 7.5% of AGI floor), state and local taxes, home mortgage and investment interest expenses, charitable contributions (subject to various percentage-of-AGI limitations based on type of charity and character of gift), casualty and theft losses (subject to a 10% of AGI floor plus a $100 deductible for each casualty or theft loss), job expenses, and miscellaneous deductions (subject to a 2% of AGI floor); taxpayers list these expenses on Schedule A, the official (pdf file). High income taxpayers should also note that miscellaneous itemized deductions (except for gambling losses to the extent of gambling winnings, impairment-related work expenses, and several other expenses) are not allowed in the calculation of alternative minimum tax, and other restrictions may apply for the “regular” itemized deductions that are allowed, including the imposition of a higher 10% of AGI floor for medical and dental expenses. See my previously published articles on this topic, and .

Because of concern that itemized deductions are largely personal in nature, tend to erase the progressivity of the income tax because a deduction saves more per dollar for taxpayers in higher tax brackets (i.e., the net after-tax cost per dollar for a deductible expense for individuals in the 28% bracket is 72 cents but only 65 cents for those in the higher 35% bracket), and serve in substance as a tax expenditure, Congress in 1990 decided to enact an (but no phase out for medical and dental expenses, casualty and theft losses, investment interest expenses, and wagering losses up to wagering gains) for high income taxpayers. In 2006 and 2007, taxpayers must reduce the total of itemized deductions claimed by 2% of adjusted gross income in excess of $156,400 ($78,200 for those married filing separately). This phase out of itemized deductions according to income level cannot be more than 80% of otherwise allowable deductions and it applies after subtracting various floors.

Additional resources on the key concept of itemized deductions are listed below:

Many happy returns, Roger

Alternative Minimum Tax Credit

Posted on June 21, 2008 
Filed Under Alternative Minimum Tax | Leave a Comment

In a nutshell, the reason for having a credit or carryover for prior-year alternative minimum tax (AMT) is to avoid double taxation associated with the timing differences between tax deferrals in the AMT and regular tax systems. Although other deferral items such as incentive stock options or depletion could be used to explain the nature of, and rationale for, the AMT credit, this article focuses on the timing differences between regular and AMT depreciation.

(pdf file) substitutes methods with longer schedules for the regular (MACRS); these substitutions negate the substantial tax deferrals that accrue in the early years of cost recovery under regular MACRS schedules and increase tax liability down the road when alternative minimum tax depreciation exceeds MACRS depreciation. The reason for this double whammy is (1) any depreciation method is only a deferral and not a permanent exclusion of income because it lowers the of the asset involved and (2) total depreciation taken under AMT and MACRS is the same. Put differently, in the process of substituting the alternative straight line method for MACRS, at some point in the future, straight line depreciation will exceed MACRS depreciation, and the taxpayer, because he or she has been subject to the AMT, will have higher taxable income at this time. In short, without some form of allowance for this negative deferral effect under AMT depreciation, the taxpayer incurs higher taxable income in the future because of greater straight line depreciation relative to MACRS and loses the significant up-front deferrals associated with accelerated depreciation. This allowance or AMT credit–the amount by which the regular tax liability exceeds AMT tax liability because of a negative deferral effect–may not be used to reduce any future AMT liability, but it can be used to offset timing differences between the two regimes. IRS (pdf file) is used to figure the AMT credit.

For additional information on the credit for prior year minimum tax, consult the following resources:

Many happy returns, Roger

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