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Income Taxation of Individuals

Income Taxation of Individuals. Chapter 11. Individual Income Tax Model. Gross income Less: Deductions for adjusted gross income Equals: Adjusted Gross Income (AGI) Less: Deductions from AGI (greater of itemized or standard deduction)

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Income Taxation of Individuals

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  1. Income TaxationofIndividuals Chapter 11

  2. Individual Income Tax Model Gross income Less: Deductions for adjusted gross income Equals:Adjusted Gross Income (AGI) Less: Deductions from AGI (greater of itemized or standard deduction) Less: Exemptions (personal & dependency) Equals: Taxable income

  3. Tax Model (continued) Taxable income Times: Tax rates Equals: Gross income tax liability Less: Tax credits Plus: Additions to tax Less: Tax prepayments Equals: Net tax due or tax refund

  4. Deductions For AGI • Deductions discussed in previous chapters • Retirement plan contributions including IRAs • Moving expenses • 50% of self-employment taxes • Self-employed health insurance • Alimony paid

  5. Deductions For AGI • Deductions discussed in this chapter: • Educator expenses • Student loan interest expense • Tuition and fees deduction • Archer medical savings accounts (MSA) • Penalty on early withdrawals of savings

  6. Educator Expenses • For kindergarten through 12th grade teachers • Deduct up to $250 of unreimbursed expenses teachers pay for books, supplies, computer equipment, software, and other supplemental materials used in the classroom • For tax years 2002 and 2003

  7. Student Loan Interest • Deduction for interest paid on qualified student loans incurred and used for tuition, fees, room, board, books, and supplies • Deduction limit is $2,500 • Phases out with modified AGI of $50,000 - $65,000 ($100,000 - $130,000 for married persons filing jointly) • Individuals claimed as dependents cannot take deduction on their own tax return • Eligible expenses must be reduced for tax-exempt scholarships and education credits

  8. Tuition & Fees Deduction • $3,000 deduction for 2002-2003 for tuition & fees for taxpayer, spouse, and dependents • Individuals who are claimed as dependents cannot take deduction on their own tax return • No double benefit - no deduction if expense is deductible under any other provision (including education credits) • Income limits apply ($65,000 if single and $130,000 if married filing jointly)

  9. Tuition & Fees Deduction • For 2004 and 2005 • Deduction increases to $4,000 for singles with income below $65,000 ($130,000 if married filing jointly) • Deduction is $2,000 for singles with income $65,000 - $80,000 ($130,000 - $160,000 for joint filers)

  10. Archer Medical Savings Account • Taxpayers covered only by high-deductible medical insurance may deduct amounts set aside in MSA • Contributions and earnings on MSAs are not taxed when withdrawn to pay medical expenses • For 2003, qualified policies are those with deductibles of $1,700 - $2,500 for individuals ($3,350 - $5,050 for families) • Contributions limited to 65% of policy deductible for individuals (75% for families) • Distributions not spent on qualifying expenses are included in income and subject to 15% penalty

  11. Penalty on Early Withdrawals • Penalties assessed on premature withdrawals from certificates of deposits or other savings accounts are deductible • Gross interest income, unreduced by the penalty, is included in taxable income • Deducting the penalty ensures that only net interest income is included in taxable income

  12. Filing Status • Taxpayer’s filing status determines standard deduction and tax rate schedule • Marital status determined on the last day of the tax year • Separated spouses are considered married until divorce becomes final

  13. Filing Status - Married • Can file jointly if both spouses are US citizens or US residents (or if nonresident alien agrees to be taxed on worldwide income) • If the couple file separately, both must itemize deductions or both must use the standard deduction

  14. Surviving Spouse • Marital status is determined at the date of death so a joint return can be filed for the year in which a spouse dies • A surviving spouse may continue to use the tax rates and standard deduction for married persons filing jointly for the next 2 years only if a dependent child lives with the taxpayer

  15. Filing Status – Unmarried • Unmarried taxpayers file as • Head of household - an unmarried person who provides more than half of the cost of maintaining a home in which a child or other qualifying relative lives for more than half the year • Single

  16. Head of Household Qualifying relatives • Unmarried child who lives with the taxpayer for more than half of the taxable year (does not need to be taxpayer’s dependent) • A parentof the taxpayer who is a dependent (does not need to live in taxpayer's home) • Other qualifying relatives must live with the taxpayer for more than half the year and be a dependent

  17. Head of Household • Qualifying relatives include brothers, sisters, parents, grandparents, nieces, nephews, aunts and uncles (defined as brother or sister of father or mother) • Cousins and more distant relatives are not included in the definition of qualifying relative

  18. Abandoned Spouse • A taxpayer who is married but whose spouse did not live with him or her at any time during the last six months of the tax year and taxpayer provides more than half the cost of maintaining the home in which a dependent child lives • An abandoned spouse uses head of household tax rates and standard deduction

  19. Exemptions • Each taxpayer (who is not a dependent) is entitled to one personal exemption • Exemption deduction is $3,050 for 2003 • Additional exemptions allowed for each person who is considered a dependent • Anyone who is claimed as a dependent cannot claim a personal exemption

  20. Dependency Exemptions An individual qualifies as a dependent only if all 5of the requirements are satisfied: 1. Relative or member-of-household test 2. The support test 3. Gross income test 4. Joint return test 5. Citizenship or residency test

  21. Relative or Member-of-Household Test • The dependent must be either: • Qualifying relative or • Member of taxpayer's household for the entire taxable year • Qualifying relatives include child, grandchild, brother, sister, parent, grandparent, niece, nephew, aunt, and uncle

  22. The Support Test • Taxpayer must provide more than 50% of the dependent's total support • Support includes amounts spent for food, clothing, shelter, medical care, education and capital expenditures such as a car • Value of services and scholarship funds are omitted in determining support received by a student • Nontaxable income used for support must be included in support determination

  23. Multiple Support Agreement • Multiple support agreements allow one member of group of support providers to claim the exemption when • Together the group meets the support test • All other dependency tests are met • Member who claims exemption must provide more than 10% of the total support

  24. Gross Income Test • The dependent's gross income from taxable sources must be less than the exemption amount ($3,050 for 2003) • The gross income test is waived for • Child of taxpayer who is under age 19 at year end or • Child of taxpayer who is under age 24 at year end and was a full-time student for at least 5 months during the year

  25. Phaseout of Exemptions • Both personal and dependency exemptions are phased out at a rate of 2% (4% for MFS) for each $2,500 (or fraction thereof) of AGI above thresholds • $139,500 if single • $174,400 if head of household • $209,250 if married filing jointly • $104,625 if married filing separately

  26. Exemption Phaseout (1) (AGI – threshold AGI)/$2,500 = Phaseout Factor (always round up here) (2) Phaseout Factor x 2% = Phaseout Percentage (3) Exemption Amount x (1 – Phaseout Percentage) = Adjusted Exemption Deduction • Once AGI exceeds the threshold AGI by more than $122,500 ($61,250 for MFS) the exemption deduction is completely phased out

  27. 2003 Tax Act Changes • Standard deduction marriage penalty relief • For 2003 and 2004 married filing jointly deduction increases to double the deduction for single individuals (increases from $7,950 to $9,500 for 2003) • Married filing separately use single amount • After 2004 returns to present law

  28. Standard Deductions • Standard Deductions (after 2003 Tax Act) • $9,500 married filing a joint return • $4,750 married filing separately • $7,000 head of household • $4,750 single individual • Add on to standard deduction if taxpayer elderly (age 65) or blind • $1,150 if single or head of household • $950 if married

  29. Standard Deduction • Dependent’s standard deduction limited to greater of: (1) $750 or (2) Earned income + $250 (up to otherwise allowable standard deduction) • Earned income includes salary and wages • Earned income does not include interest income, dividend income, capital gains, or income as beneficiary of a trust

  30. Itemized Deductions • Itemized deductions provide tax benefit only to the extent that, in total, they exceed the taxpayer’s standard deduction • Taxpayers can maximize use of the standard deduction and itemized deductions by timing certain deductible payments

  31. Medical Expenses • Medical expenses paid for the taxpayer, spouse and dependents, after reduction for insurance reimbursements, are deductible only to the extent they exceed 7.5% of AGI for the year • Qualified medical costs includes prescription drugs and insulin, costs of a hospital, clinic, doctor, dentist, eyeglasses, contract lenses, transportation for medical care and medical insurance costs

  32. Medical Expenses • Health insurance premiums for taxpayers and their dependents are deductible only if paid from after-tax income • Premiums paid through an employer-sponsored cafeteria plan are not deductible • Premiums for disability insurance and for loss of life, limb or income are not deductible • Premiums for long-term care insurance are deductible subject to limits based on age

  33. Taxes • Deductible taxes include • State, local, and foreign real property taxes • State and local personal property taxes • State, local, and foreign income taxes • Other federal, state, local, and foreign taxes incurred in a business or other income-producing activity

  34. Nondeductible Taxes • Federal income taxes • Employee's share of payroll taxes • Federal excise taxes not incurred for business • State and local sales taxes on goods for personal use • Assessments on property

  35. Interest Expense • Deductible interest includes • Student loan interest (deductible for AGI) • Investment interest • Home mortgage interest • No deduction for most other personal interest such as interest on auto loans, life insurance loans, credit card debt, and delinquent tax payments

  36. Investment Interest Expense • Investment interest includes interest on loans to acquire or hold investment property and margin interest paid to a broker • Investment interest expense is only deductible to the extent of net investment income • Net investment income = excess of investment income over investment expenses • Excess is carried forward (indefinitely) subject to same limit in future years

  37. Investment Interest Expense • Investment income = gross income from interest, annuities, and short-term capital gains from investment property • Long-term capital gains or dividends taxed at favorable rates are excluded unless election made to forgo the favorable rate • Investment expenses = safe deposit box rental fees, investment counsel fees, brokerage account maintenance fees • Use lesser of total investment expenses or net miscellaneous itemized deductions after reduction for 2% AGI floor

  38. Qualified Residence Interest • Interest paid for acquisition debt or home equity debt for up to 2 qualified residences • Interest on acquisition debt of up to $1 million principal (combined limit for 2 homes) is deductible • Acquisition debt includes mortgage to buy, construct, or improve the residence

  39. Qualified Residence Interest • Interest on up to $100,000 principal amount of home equity loan is deductible • Loan proceeds can be spent for anything • Points (loan origination fees) paid on home mortgages are deductible • Points paid on refinancing must be amortized over life of loan

  40. Charitable Contributions • Congress allows individuals, corporations, estates and trusts deductions for charitable contributions to certain qualified organizations • Partnerships and S corporations pass the contributions through to their partners and shareholders who claim the deductions on their own income tax returns

  41. Charitable Contributions • Qualified charitable organizations • Governmental units (federal, state and local governments) and entities formed and operated exclusively for religious, charitable, scientific, literary or educational purposes, including churches, nonprofit hospitals, school and universities, libraries, and social service agencies • Direct contributions to needy individuals are notdeductible

  42. Charitable Contributions • No deduction allowed to the extent that valuable goods or services are received in return for the contribution • Exception - contributors to universities who receive preferred rights to purchase tickets for university athletic events may deduct 80% of the amount of their contribution • Individuals can deduct up to 50% of AGI • Excess contributions carry forward up to 5 years

  43. Charitable Contributions • No deduction for contributions of the taxpayer’s services and rent-free use of the taxpayer’s property • Out-of-pocket costs incurred related to volunteer work are deductible • Property other than long-term capital gain property is valued at lesser of FMV or basis

  44. LTCG Property Contributions • LTCG property is valued at the higher FMV • Tangible personalty given to a charity which does not use the property in its tax-exempt activity is valued at the lower adjusted basis • LTCG property valued at FMV limited to 30% AGI • 30% limit can be avoided (then 50% AGI limit applies) if taxpayer elects to use lower basis • If made, election applies to all LTCG contributions that year

  45. Charitable Contributions • Stocks that have declined in value should be sold so that the loss can be claimed with the proceeds donated • Fees incurred for appraisals of donated property may be deducted as miscellaneous itemized deductions

  46. Casualty and Theft Losses • Loss is the lesser of • Asset’s adjusted basis or • Decline in asset’s fair market value from the casualty • Loss is reduced for any insurance proceeds • $100 floor applies to each casualty • Deductible only to extent total losses exceed 10% of AGI

  47. Miscellaneous Deductions • Only excess over 2% AGI is deductible • Unreimbursed employee business expenses • Job hunting expenses (in searching for a new job in current line of business) • Investment-related expenses • Hobby expenses (up to hobby income) • Tax preparation and planning advice

  48. Phaseout ofItemized Deductions • Total deductions phased out by 3% of AGI in excess of $139,500 in 2003 ($69,750 if MFS) • Exception - deductions not phased out for • Medical expenses • Investment interest • Casualty and theft losses • Total deductions are not reduced by more than 80% regardless of type

  49. 2003 Tax Act Changes • Individual income tax rates above 15% drop to 25%, 28%, 33%, and 35% • The 10% bracket expands • For 2003 and 2004 to the first $7,000 of taxable income for single individuals and married filing separately ($14,000 for married filing joint return) • 15% bracket expands to relieve marriage tax penalty

  50. 2003 Tax Act New Rates • For married filing joint return for 2003 • 10% on first $14,000 taxable income • 15% on $14,001 - $56,800 • 25% on $56,801 - $114,650 • 28% on $114,651 - $174,700 • 33% on $174,701 - $311,950 • 35% over $311,950

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