Determining Taxable Income
Focus on 26 USC §§ 61(a); 62(a); 67(a)-(b); 68; 151; 161
Gross Income, 61 – Above the line deductions, 62(a) = Adjusted Gross Income, 62. Adjusted Gross Income, 62 – Qualified Busines Income, 199A – the Standard Deduction, 63(b) or Itemized Deductions, 63(d) = Taxable Income, 63.
The above formula is known as the “tax ladder.”
Gross Income
§ 61 defines gross income as “all income from whatever source derived.” The section then goes on to list “some” of the sources of gross income.
Above the Line Deductions
§ 62(a) lists deductions that may be taken by anyone (assuming you qualify), in addition to the standardized or itemized deduction. These are the best kind of deductions because it is an additional deduction. They also decrease the adjusted gross income (which means it makes it easier to meet other requirements based on the AGI).
Adjusted Gross Income
This number is important because it becomes a baseline for how other deductions can be taken.
Qualified Busines Income Deduction
This deduction only part of the current law and is set to sunset at the end of 2025.
Standardized Deductions
Most poeple (70%) choose to take the standard deductions because it is convenient and normally is more than the total of itemized deductions. The goal is to choose the biggest deduction. If the standard deduction is bigger than itemized (adding it up yourself), then the standard will be chosen, and vice versa.
In 2017, the standard deduction was $6,000 (old law and potential future law). In 2022, the standard deduction was $12,950 per person or $25,900 for married couples.
Itemized Deductions
These deductions are further categorized as regular deductions or miscellaneous deductions. See § 67.
Miscellaneous
Miscellaneous deductions are only allowed if they exceed two percent of your AGI. However, under the current law, these deducations cannot be taken. This is known as the 2% haircut. That is, once you have your AGI, you can only take what is more than 2% of that number. For instance:
Assume an AGI of 100,000. 2% is 2,000. That means you only take deductions if they exceed 2,000. If you have 3,500 in miscellaneous, you only can claim 1,500 (3500–2,000).
Regular
67(b) lists deductions that are not miscellaneous.
Personal Exemption
This is a number congress has determined is necessary for basic needs to deducte from the taxes. You can take this number for yourself, spouse, and qualifying dependents (taxpayer paying more than half of the dependant’s needs). However, because the standard deduction had increased so much, the personal exemption was removed until 2026. These are below the line.
Phase-Out
Essentially, the more money you make, the more you “phase-out” of deductions (can claim less).
If the AGI is greater than 250,000 (300,000 for married), the taxpayer can only deduct the lesser of (1) 3% of AGI excess of itemized deductions or (2) 80% of their itemized deductions.
Taxible Income
This is the number that determines your tax bracket and the number you will owe.
Overview of Deductions and Credits
Focus on 26 USC §§ 21; 24; 25A; 26; 31(a); 32; 162; 212.
Everything discussed above is a deduction and is used to determine taxible income. After taxable income is determined, the rate tables are used to determine a “tenative tax liabilty.” Subtract applicable credits and that determines your final tax liablity (or refund). There are typically five significant tax credits (and these are preferential over deductions because credits are not subject to the tax rate).
Household and Dependent Care Credit
This credit is to help households who pay for daycare. Daycare is expensive. A two income household sending kids to daycare ultimately may gross more income than a single household, but net less income due to daycare expenses. And when it comes to taxes, these two income households would ultimately be paying higher taxes (because they grossed more). The purpose of the credit is to put these two scenarios on the same playing field.
The credit is a phase out. That is, the more income you make, the less of the credit you can take. The max credit is up to 3,000 (6,000 if you have multiple dependants). After you make more than 43,000, you may only take up to 20% of child care expenses. Qualified dependants include (1) dependants under 13, (2) dependants living in the house and unable to care for themselves, (3) spouses living in the house and unable to care for themselves. The taxpayer must provide at least half of their expenses.
This credit is traditionally nonrefundable (except for in 2021). That means if your tax liability would equate to receiving a refund, this credit would not be distrubited to the tax payer.
Higher Education Credits
Education credits are highly popular so politicians are always changing them. This information may be outdated very soon.
American Opportunity Tax Credit
A partially refundable tax credit that can be claimed for the first four years of postsecondary schooling. Requirements: (1) attend on a half-time basis, (2) don’t be convicted on a drug felony.
The first 2,000 spent on education will result in a 2,000 credit. Any spending above that is given a 25% credit. If the tax liability results in a refund, up to 40% of this credit is refundable.
This credit also phases out, but single household earners need to make 80,000 for it to start (160,000 for married) and will be fully phased out at 90,000 (180,000 married).
Lifetime Learning Credit
Can be used for any education designed to develop student job skills. This credit can only be 20% of the first 10,000 of expenses (maxing out at 2,000). Additionally, the credit cannot be used for the same expenses claimed under the American Opportunity Tax Credit (no double dipping).
Income Taxes Withheld on Wages
The federal government will collect income tax from employers who withhold amounts on behalf of the employees. This is a way of pre-tax payment before needing to file. Ultimately, the credit is balanced at the end of the year to determine how much of the tax liability was paid. If there is any left over, the credit is refunded to the taxpayer.
Taxpayers typically want as little withheld as possible because the taxpayer could invest the extra income with interest. For withholdings returned to the taxpayer in a refund, the return is not paid with interest. So, the more money you have to invest (not taken with withholdings), the more money you can make. In other context, the interest earned can be used to pay the tax (either way, more money in the taxpayer’s pocket).
Earned Income Credit
This is a refundable credit designed to help low-income families, and is used as an incentive for these families to make an income. Essentially, the credit ranges from 7.65 to 45% of earned income and is phased out. The credit percentage varies depending on the number of “qualifying children” the taxpayer has. Children qualify based on relationship to the taxpayer, living with the taxpayer for more than half of the year, and below a certain age.
Child and Family Tax Credit
A partially refundable credit (currently set at 2,000) for each of the taxpayers “qualifying children” under 17. A qualified child is someone the taxpayer could claim as a dependent for an exemption. This credit is also phased out.
Disclaimer
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.
