Individual Income Tax Computation and Tax Credits

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1 Individual Income Tax Computation and Tax Credits 1. What is a tax bracket? What is the relationship between filing status and the width of the tax brackets in the tax rate schedule? A tax bracket is a range of taxable that is taxed at a specified tax rate. Because only the in the particular range is taxed at the specified rate, tax brackets are often referred to as marginal tax brackets or marginal tax rates. The level and width of the brackets depend on the taxpayer s filing status. The tax rate schedules include six tax rate brackets. The rates for these brackets are 10%, 15%, 25%, 28%, 33%, and 35%. In general, the tax brackets are widest for Married filing jointly (for example, more is taxed at 10%), followed by Head of household, Single, and then Married filing separately (the brackets for Married filing separately are exactly one-half the width of the brackets for Married filing jointly and the width of the 10% and 15% brackets for Single and Married filing separately are the same). 2. In 2010, for a taxpayer with $50,000 of taxable, without doing any actual computations, which filing status do you expect to provide the lowest tax liability? Which filing status provides the highest tax liability? For a taxpayer with $50,000, the married filing jointly filing status should provide the lowest tax liability in 2010 because the MFJ tax rate schedule taxes more of this at 10% and 15% than the other rate schedules (the 10% and 15% tax brackets are wider). Conversely, the married filing separately and the single filing statuses will generate the highest tax liability because a smaller amount of is taxed at 10% and 15% (the 10% and 15% tax brackets are more narrow) than other tax rate schedules. 3. What is the tax marriage penalty and when does it apply? Under what circumstances would a couple experience a tax marriage benefit? A marriage penalty (benefit) occurs when, for a given level of, a married couple has a greater (lesser) tax liability when they use the married filing jointly tax rate schedule to determine the tax on their joint than they would have owed (in total) if each spouse would have used the single tax rate schedule to compute the tax on each spouse s individual. The marriage penalty applies to couples with two wage earners while a marriage benefit applies to couples with single breadwinners. 4. Once they ve computed their taxable, how do taxpayers determine their regular tax liability? What additional steps must taxpayers take to compute their tax liability when they have preferentially taxed? Once taxpayers have determined their taxable, they should split the into two portions: (1) ordinary and (2) taxed at preferential rates (if any), and compute tax on each portion separately.

2 Taxpayers compute the tax on the ordinary portion by applying the appropriate tax rate schedule (based on their filing status). Taxpayers generally compute their tax on the preferentially taxed by multiplying the amount of by 15%. However, to the extent that it would have been taxed at a rate of 15% or l0% if it were ordinary, the preferentially taxed (dividends and long-term capital gains) is taxed at 0% in A taxpayer s total regular tax liability is the sum of the tax on ordinary and the tax on preferentially taxed. 5. Are there circumstances in which preferentially taxed (long-term capital gains and qualified dividends) is taxed at the same rate as ordinary? Explain. Generally, no. If the preferentially taxed would have been taxed at 10% or 15% if it were ordinary, it is taxed at a lower 0% rate. If it would have been taxed at a rate higher than 15%, it is taxed at 15%. This is why we refer to the as preferentially taxed. There are certain types of long-term capital gains that are taxed at a maximum rate of 25% (unrecaptured 1250 gain) and 28% (capital gains from collectibles). These gains are taxed at the taxpayer s marginal ordinary rate unless the ordinary rate exceeds the maximum rate. Then these gains are taxed at the maximum rate. However, we did not address these special situations in this chapter (that s why this is a research question). See 1(h)(1). 6. Augustana received $10,000 of qualified dividends this year. Under what circumstances would all $10,000 be taxed at the same rate? Under what circumstances might the entire $10,000 of not be taxed at the same rate? The entire qualified dividend will be taxed at the same rate in two scenarios. First, the dividend will all be taxed at 15% if Augustana s ordinary exceeds the threshold for the 15% marginal tax bracket (it is taxed at a rate higher than 15%). Second, the entire dividend will be taxed at 0% as long as the Augustana s ordinary plus her $10,000 qualified dividend does not exceed the threshold for the 15% marginal tax bracket. The qualified dividend will be taxed at different rates if the amount of Augustana s ordinary is below the 15% marginal tax bracket but the qualified dividend causes her total taxable to exceed the 15% marginal tax bracket threshold. In this scenario, her qualified dividends will be taxed at 0% to the extent they would have been taxed at 15% as ordinary and the remainder would be taxed at 15%. 7. What is the difference between earned and unearned? Earned is earned by the taxpayer from services or labor. Unearned is from investment property such as dividends from stocks or interest from bonds. 8. Does the kiddie tax eliminate the tax benefits gained by a family when parents transfer

3 -producing assets to children? Explain. No. Though the kiddie tax significantly limits the benefit of shifting producing assets to children, it does not eliminate it. The kiddie tax does not apply unless the child has unearned investment in excess of $1,900 ($950 standard deduction plus an additional $950). That is, parents can shift up to $1,900 of unearned investment to a child without the child paying the kiddie tax (paying tax on at the parent s marginal tax rate). 9. Does the kiddie tax apply to all children no matter their age? Explain. No, the kiddie tax applies to children who have net unearned in excess of $1,900 if the children (1) are under age 18 at the end of the year, (2) are age 18 at the end of the year and do not have earned in excess of half of their support, or (3) are over age 18 and under age 24, are full-time students, and don t have earned in excess of half of their support (excluding scholarships). 10. What is the kiddie and on whose tax return is the kiddie tax liability reported? Explain. The kiddie tax is a tax at the parent s marginal rate on the child s unearned in excess of $1,900. Generally, the kiddie tax liability is reported on the child s tax return. However, the parents can make an election to include on their own return the child s gross in excess of $1, Problems 11. Whitney received $75,000 of taxable in All of the was salary from her employer. What is her tax liability in each of the following alternative situations? a. She files under the single filing status. Whitney has an tax liability of $14,931. (1) Taxable $75,000 (2) Income tax liability $14, (75,000 34,000) x 25% + 4, (see tax rate schedule for Single individuals) b. She files a joint tax return with her spouse. Together their taxable is $75,000. Whitney has an tax liability of $11,125. (1) Taxable $75,000 (2) Income tax liability $11, (75,000 68,000) x 25% + 9, (see tax rate schedule for Married Filing Jointly)

4 c. She is married but files a separate tax return. Her taxable is $75,000. Whitney has an tax liability of $15,132. (1) Taxable $75,000 (2) Income tax liability $15, (75,000 68,650) x 28% + 13, (see tax rate schedule for Married Filing Separately) d. She files as a head of household. Whitney has an tax liability of $13,603. (1) Taxable $75,000 (2) Income tax liability $13, (75,000 45,550) x 25% + 6,235 (see tax rate schedule for Head of Household) 12. In 2010, Lisa and Fred, a married couple, have taxable of $300,000. If they were to file separate tax returns, Lisa would have reported taxable of $125,000 and Fred would have reported taxable of $175,000. What is the couple s marriage penalty or benefit The couple would have a marriage penalty of $5,205. That is they pay $5,205 more in taxes by filing jointly than their combined tax liability if they each had filed as a single taxpayer Marriage penalty or (benefit) Two vs. Single married couple Taxable Jointly Single Marriage penalty Married couple (benefit) (1) (2) (1) (2) Wife (Lisa) $125,000 $28,709 Husband (Fred) 175,000 42,867 Combined $300,000 $76,781 * $71,576 $5,205 *$46, [(300, ,250).33] $16, [(125,000 82,400).28] $41, [(175, ,850).33] 13. In 2010, Jasmine and Thomas, a married couple, have taxable of $150,000. If they

5 were to file separate tax returns, Jasmine would have reported taxable of $140,000 and Thomas would have reported taxable of $10,000. What is the couple s marriage penalty or benefit? The couple would have a marriage benefit of $3,746. That is they pay $3,746 less in taxes by filing jointly than their combined tax liability if they each would have filed as single taxpayer Marriage penalty or (benefit) Two vs. Single married couple Taxable Jointly Single Marriage penalty Married couple (benefit) (1) (2) (1) (2) Wife (Jasmine) $140,000 $32,909 Husband (Thomas) 10,000 1,081 Combined $150,000 $30,244 * $33,990 $(3,746) *$26, [(150, ,300).28] $16, [(140,000 82,400).28] $ [(10,000 8,375).15] 14.Lacy is a single taxpayer. In 2010, her taxable is $37,000. What is her tax liability in each of the following alternative situations? a. All of her is salary from her employer. Lacy s total tax is $5, Description Amount Explanation (1) Taxable $37,000 (2) Preferentially taxed 0 (3) Income taxed at ordinary rates 37,000 (1) (2) (4) Tax on taxed at ordinary rates $5, (37,000 34,000) 25% + 4, (see tax rate schedule for Single individuals) (5) Tax on preferentially taxed 0 Tax on taxable $5, (4) + (5) b. Her $37,000 of taxable includes $2,000 of qualified dividends. Lacy s total tax is $5, Description Amount Explanation (1) Taxable $37,000 (2) Preferentially taxed 2,000

6 (3) Income taxed at ordinary rates 35,000 (1) (2) (4) Tax on taxed at ordinary 4, (35,000 34,000) 25% + 4, rates (5) Tax on preferentially taxed 300 (2) 15% [Note that if (2) were ordinary it would have been taxed at 25%] Tax on taxable $5, (4) + (5) c. Her $37,000 of taxable includes $5,000 of qualified dividends. Lacy s total tax is $4, Description Amount Explanation (1) Taxable $37,000 (2) Preferentially taxed 5,000 (3) Income taxed at ordinary rates 32,000 (1) (2) (4) Tax on taxed at ordinary 4, (32,000 8,375) 15% rates (5) Tax on preferentially taxed 450 (34,000 32,000) 0% + (5,000 (34,000 32,000)) 15% Tax on taxable $4, (4) + (5)