Federal Income Tax Accounting Unit 12 ReviewTaxation of Individuals

Key Concepts and Terminology

• Gross income encompasses all income from whatever source derived, including compensation for services, business income, gains from property, interest, rents, dividends, and alimony payments
• Adjusted gross income (AGI) is calculated by subtracting specific adjustments (IRA contributions, student loan interest) from gross income
• Taxable income is determined by subtracting deductions and exemptions from AGI
  • Taxpayers can choose between itemizing deductions or claiming the standard deduction
• Tax liability is the total amount of tax owed to the government based on taxable income and the applicable tax rates
• Credits directly reduce the amount of tax owed, while deductions reduce the amount of income subject to taxation
• Progressive tax system imposes higher tax rates on higher levels of income, based on tax brackets that vary depending on filing status
• Marginal tax rate is the rate applied to the last dollar of income earned, while the effective tax rate represents the average rate paid on all taxable income

Types of Income and Their Tax Treatment

• Earned income includes wages, salaries, tips, commissions, and self-employment income and is subject to ordinary income tax rates and payroll taxes (Social Security and Medicare)
• Unearned income encompasses interest, dividends, capital gains, rental income, and royalties and may be subject to different tax rates or special treatment
  • Long-term capital gains (assets held for more than one year) are taxed at preferential rates of 0%, 15%, or 20%, depending on the taxpayer's income level
• Passive income is derived from rental properties or businesses in which the taxpayer does not actively participate and is subject to unique tax rules and limitations on loss deductions
• Alimony payments received are considered taxable income to the recipient (for divorces finalized before 2019)
• Some types of income are fully or partially tax-exempt, such as municipal bond interest, qualified scholarships, and certain employer-provided benefits (health insurance premiums)
• Social Security benefits may be partially taxable depending on the taxpayer's income level and filing status
• Retirement account distributions (401(k)s, traditional IRAs) are generally taxed as ordinary income, while Roth IRA distributions are tax-free if certain conditions are met

Deductions and Credits

• Standard deduction is a fixed amount that reduces taxable income based on filing status ($12,950 for single filers, $25,900 for married filing jointly in 2022)
• Itemized deductions allow taxpayers to deduct specific expenses (mortgage interest, state and local taxes, charitable contributions) if the total exceeds the standard deduction
  • State and local tax (SALT) deduction is limited to $10,000 per year for the combined total of property, income, and sales taxes
• Above-the-line deductions, such as IRA contributions and student loan interest, are subtracted from gross income to calculate AGI
• Charitable contributions are deductible if made to qualified organizations, subject to limitations based on the type of donation and the taxpayer's AGI
• Medical expenses are deductible to the extent they exceed 7.5% of the taxpayer's AGI
• Child Tax Credit provides a credit of up to $2,000 per qualifying child under age 17, with a portion being refundable
• Earned Income Tax Credit (EITC) is a refundable credit for low to moderate-income working individuals and families, with the amount determined by income, filing status, and number of children
• Education credits, such as the American Opportunity Tax Credit and Lifetime Learning Credit, help offset the costs of higher education
• Retirement Savings Contributions Credit (Saver's Credit) provides a credit for eligible contributions to retirement accounts, with the amount determined by income and filing status

Filing Status and Tax Brackets

• Single filing status is for unmarried individuals or those considered unmarried on the last day of the tax year
• Married Filing Jointly (MFJ) allows married couples to file a single return, combining their incomes and deductions
  • Generally results in a lower overall tax liability compared to filing separately
• Married Filing Separately (MFS) requires each spouse to file a separate return, which may be advantageous in certain situations (e.g., one spouse has significant medical expenses)
• Head of Household (HOH) is for unmarried individuals who pay more than half the cost of maintaining a home for a qualifying person (child or dependent parent)
• Qualifying Widow(er) status allows a taxpayer to use the MFJ tax rates and brackets for two years following the death of their spouse, provided they have a dependent child
• Tax brackets determine the applicable tax rates based on taxable income and filing status, with rates ranging from 10% to 37% for the 2022 tax year
  • Income thresholds for each bracket are adjusted annually for inflation

Tax Planning Strategies

• Maximizing deductions by bunching itemized deductions (charitable contributions, medical expenses) into a single year to exceed the standard deduction
• Contributing to tax-advantaged retirement accounts (401(k)s, IRAs) to reduce taxable income and potentially qualify for the Saver's Credit
• Harvesting capital losses by selling investments that have decreased in value to offset capital gains and up to $3,000 of ordinary income
• Timing income and deductions to minimize tax liability, such as deferring income to a future year or accelerating deductions into the current year
• Utilizing Flexible Spending Accounts (FSAs) or Health Savings Accounts (HSAs) to pay for medical expenses with pre-tax dollars
• Investing in tax-efficient vehicles, such as index funds or municipal bonds, to minimize taxable income and capital gains
• Donating appreciated assets (stocks, real estate) to charity to avoid capital gains tax while claiming a deduction for the fair market value
• Employing family members in a business to shift income to lower tax brackets and provide valuable work experience

Common Tax Forms and Schedules

• Form 1040 is the primary form used by individuals to file their annual income tax return, summarizing income, deductions, credits, and tax liability
• Schedule A is used to itemize deductions, such as mortgage interest, state and local taxes, and charitable contributions
• Schedule B reports interest and dividend income, as well as any foreign bank accounts or trusts
• Schedule C is used by self-employed individuals to report income and expenses from their business
• Schedule D reports capital gains and losses from the sale of investments, such as stocks, bonds, and real estate
• Schedule E is used to report income and expenses from rental properties, partnerships, S corporations, and estates and trusts
• Schedule SE calculates the self-employment tax owed by self-employed individuals on their net earnings
• Form 8949 provides a detailed breakdown of capital gains and losses, which is then summarized on Schedule D

Special Considerations for Individual Taxpayers

• Self-employed individuals must pay both the employee and employer portions of Social Security and Medicare taxes (self-employment tax) on their net earnings
• Freelancers and contractors (1099 workers) are responsible for tracking their income and expenses, making estimated tax payments, and filing Schedule C
• Homeowners can deduct mortgage interest and property taxes (subject to limitations) as itemized deductions on Schedule A
• Investors must report and pay taxes on capital gains, dividends, and interest income, while also considering the tax implications of selling investments
• Students may be eligible for education credits (American Opportunity Tax Credit, Lifetime Learning Credit) or deductions for tuition and fees, student loan interest
• Retirees must navigate the tax treatment of Social Security benefits, pension income, and required minimum distributions (RMDs) from retirement accounts
• Taxpayers with foreign income or assets may have additional reporting requirements (Form 8938, FBAR) and potential tax liabilities
• Military personnel and reservists may qualify for special tax benefits, such as the exclusion of combat pay from taxable income and deductions for unreimbursed moving expenses

Recent Changes and Updates in Tax Law

• The Tax Cuts and Jobs Act (TCJA) of 2017 made significant changes to individual income taxes, including reducing tax rates, increasing the standard deduction, and limiting certain itemized deductions (SALT, mortgage interest)
  • Many of these provisions are set to expire after 2025, reverting to pre-TCJA rules
• The SECURE Act of 2019 raised the age for required minimum distributions (RMDs) from retirement accounts to 72 and eliminated the age restriction for traditional IRA contributions
• The CARES Act of 2020, in response to the COVID-19 pandemic, provided economic relief through stimulus payments, expanded unemployment benefits, and temporary changes to retirement account rules (waived RMDs, early withdrawal penalties)
• The American Rescue Plan Act (ARPA) of 2021 expanded the Child Tax Credit, increased the Child and Dependent Care Credit, and made a portion of unemployment benefits tax-exempt for certain income levels
• The Inflation Reduction Act of 2022 extended the expanded Affordable Care Act (ACA) premium tax credits through 2025 and introduced new tax credits for clean energy investments and electric vehicles
• States often have their own tax laws and changes that may differ from federal provisions, requiring taxpayers to stay informed about both federal and state-level tax updates