Bill and Mary are husband and wife. They have two children, Thomas who is 14 and Stephen who is 10. Bill works as a manager for a large retailer. Last year, he earned a salary of $60,000. His employer provided the family with health insurance that cost $14,000. Mary is a schoolteacher who earned a salary of $45,000. Her employer provided her a group term life insurance policy with a death benefit of $50,000; her employer paid $250 to provide her this benefit. Their respective employers deducted employment taxes from every paycheck and paid each of them the balance. In addition to the above items, Bill and Mary own stock in a large American corporation, and that corporation paid them a dividend of $500. Bill and Mary later sold that stock for $10,000; they had paid $8000 for it several years ago. Bill and Mary have a joint bank account that paid interest of $400. Bill and Mary paid $3000 for daycare for Stephen. They also paid $3000 of interest on a student loan that Bill took out when he was in college. What is Bill and Mary’s tax liability? Assume that they will file as married filing jointly.
How much are Bill’s employment taxes? How much are Mary’s employment taxes?
Answer: Employment taxes are 6.2% 1for “social
security” and 1.45% for “Medicare.” The total is 7.65%. The tax base of employment taxes is wages.
- Bill: Bill’s wages were $60,000. 7.65% of $60,000 = $4590.
- Mary: Mary’s wages were $45,000. 7.65% of $45,000 = $3098.25.
How much is Bill and Mary’s “gross income?” You should see that this is the first line of the tax formula. We need to determine what is and what is not included in “gross income.” See §§ 61, 79, and 106.
- Answer: Since Bill and Mary will file jointly, we pool their relevant income figures. Notice that the employment taxes do not reduce Bill and Mary’s adjusted gross income. Thus, they must pay income taxes on at least some of the employment taxes that they have already paid.
- “Gross income,” § 61, is a topic that we take up in chapter 2. It encompasses all “accessions to wealth.” However, there are some “accessions to wealth” that we do not include in a taxpayer’s “gross income.” The Code defines these exclusions in §§101 to 139E. The Code also defines the scope of certain inclusions in §§ 71 to 90 – and implicitly excludes what is outside the scope of those inclusions.
- Bill and Mary must include the following: Bill’s salary (§ 61(a)(1)) of $60,000; Mary’s salary (§ 61(a)(1)) of $45,000; dividend (§ 61(a)(7)) of $500; capital gain (§ 61(a)(3)) of $2000; interest income (§ 61(a)(4)) from the bank of $400. TOTAL: $107,900.
- Bill and Mary do not include the amount that Bill’s employer paid for the family’s health insurance (§ 106)(a)), $14,000, or the amount that Mary’s employer paid for her group term life insurance (§ 79(a)(1)), $250. Bill and Mary certainly benefitted from the $14,250 that their employers spent on their behalf, but §§ 106 and 79 provide that they do not have to count these amounts in their “gross income.”
How much is Bill and Mary’s adjusted gross income (AGI)? See §§ 221 and 62(a)(17). Do not adjust the § 221 phaseout by the inflation adjustment of § 221(f).
- Section 221 entitles Bill and Mary to deduct interest on the repayment of a student loan. While the couple paid $3000 in student loan interest, § 221(b)(1) limits the deduction to $2500.
- Section 221(b)(2) requires the computation of a phaseout – or a phasedown, in this case. Section 221(b)(2)(A) provides that the deductible amount must be reduced by an amount determined as per the rules of § 221(b)(2)(B). Section 221(a)(2)(B) establishes a ratio.
- Since Bill and Mary are married filing a joint return, § 221(a)(2)(B)(i) establishes a numerator of: $107,900 − $100,000 = $7900. Section 221(b)(2)(b)(ii) establishes a denominator of
- The § 221(b)(2)(B) ratio is $7900/$30,000 = 0.26333.
- § 221(b)(2)(B) requires that we multiply this by the amount of the deduction otherwise allowable, i.e., $2500.
- 0.2633 x $2500 = $658.33. Reduce the otherwise allowable deduction by that amount, i.e., $2500 − $658.33 = $1841.67.
- Section 62(a)(17) provides that this amount is not included in taxpayers’ AGI.
- Thus: Bill and Mary’s AGI = $107,900 − $1841.67 = $106,058.33.
How much is Bill and Mary’s “taxable income”? See §§ 151, 63.
- Answer: Sections 151(a, b, and c) allow a deduction of an exemption amount for taxpayer and spouse and for dependents. Sections 151(d and e) provide that this amount is $2000; it is subject to adjustment for inflation.
- Section 63(a and b) defines ‘taxable income” as EITHER “gross income” minus allowable deductions OR AGI minus standard deduction minus deduction for personal exemptions.
- We are told of no deductions that would be “itemized,” so Bill and Mary will elect to take the standard deduction. Bill and Mary may claim a total of four personal exemptions: one each for themselves and one for each of their children.
- Go to the pages for “Consumer Price Index Adjustments for” for the current year that appear at the front of your Code.
- The standard deduction for taxpayers who are married and filing jointly is $12,200. The personal exemption amount is $3900. Do the math: $106,058.33 MINUS $12,200 MINUS $15,600 equals $78,258.33 of “taxable income.”
How much is Bill and Mary’s income tax liability? See §§ 1(a and h), 1222(3 and 11).
- Answer: Remember, not all income is taxed alike. Long-term capital gain and many dividends are taxed at a maximum rate of 20%. § 1(h)(1)(D) and § 1(h)(11). Bill and Mary received $2000 in long-term capital gain and $500 in dividends. Bill and Mary’s taxable income will not put them in the 39.6% bracket, so this portion of their taxable income will be taxed at the rate of 15%, i.e., $375.
- The tax on the balance of their taxable income will be computed using the tables at the front of your Code. $78,258.33 MINUS $2500 equals $75,758.33. Go to table 1(a). Bill and Mary’s
taxable income is more than $72,500 and less than $146,740. Hence their federal income tax liability on their ordinary income equals $9982.50 PLUS 25% of ($75,758.33 − $72,500) = $9982.50 +
$814.58 = $10,797.08.
- Do you see the progressiveness in the brackets?
- Total tax liability = $375 + $10,797.08 = $11,172.08.
Are Bill and Mary entitled to any credits? If so, what is the effect on their income tax liability? See §§ 21 and 24. Do not use indexed figures to determine the amount of any credit.
- Answer: Section 21 provides a credit of up to $3000 for the “dependent care” expenses for a “qualifying individual.” Stephen is a “qualifying individual,” § 21(b)(1)(A). Thomas is not a “qualifying individual,” but Bill and Mary did not spend any money for Thomas’s “dependent care.” The credit is 35% of the amount that Bill and Mary spent on such care that is subject to a phasedown of 1 percentage point for each $2000 of AGI that Bill and Mary have over $15,000 down to a minimum credit of 20%. § 21(a)(2). Bill and Mary may claim a tax credit for dependent care expenses of $600.
- Bill and Mary may also claim a “child tax credit” for each of their children equal to $1000. § 24(a). Both Thomas and Stephen are “qualifying” children. § 24(c)(1). While § 24 provides for a phasedown of the credit. Bill and Mary’s income is less than the threshold of that phasedown. Hence, Bill and Mary may claim a “child tax credit” of $2000.
- Total tax credits = $600 + $2000 = $2600.
- The effect of a tax credit is to reduce taxpayers’ tax liability – not their AGI or “taxable income.” $11,172.08 minus $2600 equals $8572.08.
What is Bill and Mary’s effective income tax rate?
Answer: Bill and Mary’s federal income tax liability is $8572.08. Their effective tax rate computed with respect to their “taxable income” is $8572.08/78,258.33, i.e.,
- Notice that we could use a different income figure to determine their effective tax rate, e.g., “gross income,” “gross income plus exclusions,” AGI.
What is Bill and Mary’s marginal tax bracket?
Answer: We answer this question with another question. Bill and Mary had $78,258.33 of taxable income. After making $78,258.33, what was the tax rate that they paid on the last
dollar (i.e., 78,258th dollar) that they made?
- 25%. You should recognize this as the multiplier that we obtained from the tax table.
Question: If Bill and Mary made a deductible contribution of $1, how much would this save them in federal income tax liability?
- 25% of the amount they contributed, i.e., $0.25.
Question: If the neighbors paid Bill for mowing their lawn, how much additional federal income tax liability would Bill and Mary incur?
- 25% of the additional income that Bill and Mary received, i.e., $2.50.