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A Primer on Federal Income Tax

February 24, 2020

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UPDATE: On March 21, 2020, The Treasury Department and Internal Revenue Service announced that the federal income tax filing due date is automatically extended from April 15, 2020, to July 15, 2020.

For more than a century, Americans have viewed income taxes with a mix of uncertainty and anxiety. This dates to the ratification of the Sixteenth Amendment in 1913, where Congress first gained the power to tax us directly. And the oft-times scary reputation of our tax system has only grown as the tax code has expanded and changed over the years. While, admittedly, there are some confusing and complex corners in the current code, most Americans can avoid these areas and get by just by knowing a few straightforward rules.

Over the next few weeks, our aim is to explain some of the basics of federal income taxes and hopefully make the prospect of filing your taxes a little less scary. To start, we offer an overview of the main items that make up your Form 1040. In essence, this tax form requires you to report your gross income, followed by your deductions, to determine your taxable income. At this point, you calculate how much tax you owe. After you know the total bill, you may reduce it by tax credits and prepayments you have already made. When the dust settles, you find out whether you are in for a refund or if you must write a check come April 15.

What is Income?

A seeming small question gets a pretty big answer in the tax code. In general, individual income tax is based on income accrued from a variety of sources. Included are wages, salaries, tips, taxable interest and dividend income, business and farm income, realized net capital gains, income from rents, royalties, trusts, estates, partnerships, and taxable pension and annuity income. Just to emphasize how broad this definition is, the tax code indicates, “gross income means income from whatever source derived . . .”

While the definition is expansive, the law does exclude some specific items. For example, employer-provided health insurance, pension contributions and certain other employee benefits are excluded from taxable income. Further, common items like gifts and inheritances are not considered income.

What are Deductions?

Once you have calculated your gross income, the tax code allows you to chip away at it by taking deductions. These are divided into two categories – “above the line” and “below the line.” The first category is deductions you subtract from gross income in order to calculate your adjusted gross income (AGI). AGI is an all-important number that everyone from the government to banks to student loan lenders use to make decisions about you. As a rule of thumb, the lower this number is the better – so “above the line” deductions are the best kind of deductions! In general, contributions to individual retirement accounts (IRAs), interest paid on student loans and certain business expenses can be deducted above the line.

The other kind of deductions – “below the line” – are those subtracted from AGI in order to calculate taxable income. The government offers everyone a standard amount they can deduct for this or taxpayers can add up what they spent during the year for certain items donations to charity or mortgage interest, etc. and deduct that total if it works out better.

The 2019 Tax Rates and Filing Status

After you whittle your gross income down to your taxable income, you are ready to calculate the amount of tax you owe. Here, it is important to mention that not all income is taxed the same way. For example, the wages you earn from your job are considered “ordinary income” and are taxed between 10% and 37%. These same rates would also apply to any business income you earn, such as from a sole proprietorship. The table below shows the ordinary income tax brackets for 2019. As you can see, the brackets depend on a taxpayer’s filing status, which we will explain more about in a later post.

Tax rateSingleMarried, filing jointlyMarried, filing separatelyHead of household
10%$0-$9,700$0-$19,400$0-$9,700$0-13,850
12%$9,701-$39,475$19,401-$78,950$9,701-$39,475$13,851-$52,850
22%$39,476-$84,200$78,951-$168,400$39,476-$84,200$52,851-$84,200
24%$84,201-$160,725$168,401-$321,450$84,201-$160,725$84,201-$160,700
32%$160,726-$204,100$321,451-$408,200$160,726-$204,100$160,701-$204,100
35%$204,101-$510,300$408,201-$612,350$204,101-$306,175$204,101-$510,300
37%$510,301 or more$612,351 or more$306,176 or more$510,301 or more

Not all income is taxed according to the above table. For example, some types of income are classified as “capital gains” and are taxed at lower rates, usually 0% t20%. This applies to income earned from selling investment assets (e.g., like stocks) that you have owned for a certain period.

Tax Credits and Prepayments

The tax code offers certain credits (i.e., dollar-for-dollar reductions on your tax bill). Sometimes these credits are family related – like for people with young children or with daycare expenses. Other times, these credits are school- or business-related – like for people paying tuition for higher education. In fact, some of these credits can put money in your pocket even if you do not owe taxes.

Conclusion

In a couple of months, the calendar will turn to April 15, the general date when we are required to file our tax forms with the government. Our aim over the next few posts is simply to make the process clearer and to arm you with a little more confidence heading into April. In our next post, we will discuss IRS procedures related to deadlines, extensions and statute of limitations.

Disclaimer

The content of this blog should not serve as a substitute for legal advice from an attorney or accountant familiar with the facts and circumstances of your specific situation. If legal or accounting assistance is needed, we recommend that you seek the services of a qualified professional.