An overview of the Federal income tax calculation starting from your paycheck, which shows how income is defined for tax purposes and where the deductions are taken.
We present an overview of the Federal income tax calculation in Form 1040 starting from the W2. The W2 has two types of deductions: FICA and pre-tax. Items eligible for a FICA tax deduction are also deductible for Federal and State taxes. Examples include FSA, DCRA and the employee portion of a health insurance premium. These are amounts set aside for healthcare and childcare needs. The pre-tax deductions (e.g., 401k contributions) are only eligible for Federal and State taxes, and not the FICA taxes. The W2 income minus these two deductions is reported as Wages in a 1040. Any 1099 income is also included in Wages.
W2 and 1099 income are considered as Earned Income. Unearned Income (reported as Other Income) includes dividends, interest, IRA distribution, pension and Social Security benefits.
Schedule 1 income mainly includes business and investment income. Business income (or loss) flows from Schedule C/E. Distributions from S Corp, Partnerships and Trusts are reported on Schedule E. Rental income is also reported on Schedule E. Investment gain (or loss) is reported on Schedule D. Capital gains from property sale is also part of Schedule 1 income.
Schedule 1 adjustments offset income. These are deductions related to retirement plan, healthcare and self-employment taxes. Wages is combined with Other Income, Schedule 1 Income and Adjustments to arrive at AGI (Adjusted Gross Income).
A few more deductions are applied to AGI before Taxable Income is calculated. The Standard Deduction is a set amount based on your filing status (Single, Head of Household, Married, etc.). It is increased every year to account for price inflation. The Itemized Deduction is totaled in Schedule A, and it includes:
- Mortgage interest for up to $750K in outstanding loan balances
- Mortgage insurance premium
- Charitable contributions up to 60% of AGI
- Medical/Dental expenses greater than 10% of AGI
- State, local, sales and property taxes up to $10K
- Casualty and theft losses limited to Federally declared disaster areas
- Investment interest such as margin interest
- Student loan interest up to $2,500
- Educators’ supplies purchases up to $250
However, the two biggest items most people use are their mortgage interest and State/property tax deductions. You are allowed to take the larger deduction between Standard and Itemized deduction. TCJA law eliminated personal exemptions and made the Standard Deduction much bigger. These and other TCJA changes are discussed in our blog “Key Aspects of the TCJA Law.”
The TCJA law introduced a new significant deduction for business owners called QBI (Qualified Business Income). It allows deduction of up to 20% of net business income from Schedule C or E. QBI is explained with an example in our blog “Pass-Through Deduction.”
Federal tax is calculated on Taxable Income. All income except LTCG (Long Term Capital Gains) is considered Ordinary Income and its tax is calculated using one of the applicable 7 tax brackets with 10-37% tax rate. LTCG are gains from investments held for a year or longer and are taxed separately at a lower rate of 0-20%. However, an ACA (Affordable Care Act) surtax of 3.8% is levied on the investment income if MAGI (Modified AGI) is >$200K for Individuals / $250K for Married Filing Jointly (MFJ). MAGI disallows certain deductions such as IRA contributions, Social Security benefits, Self-Employment tax, foreign income, passive loss, etc., and hence could be higher than AGI.
The last step in the tax calculation is tax credits. The Child Credit is the most common type and it provides $2,000 for each child if MAGI is <$200K/$400K for Individuals/MFJ. Unlike a tax deduction, which only reduces taxable income, a tax credit reduces your tax liability. For example, if your marginal tax rate is 32%, then $1 of tax deduction will reduce your tax by $0.32, whereas $1 of tax credit will reduce your tax by $1. The marginal tax rate is the rate at which your next dollar of income will be taxed, also referred to as your tax bracket. Our blog “Quick Income Tax Calculation” presents the steps of this tax calculation along with examples.
We specialize in tax-free retirement strategy and investments such as IUL, Annuity and LTC. Prefer a quick and complimentary consultation? Just email us at Karthik@FinCrafters.com