Individual Income Tax: Rates, Exclusions, Deductions, Credits, AMT

Overview:  The individual income tax is the federal government’s largest source of revenue.  In FY 2018, the tax generated 51% of federal government receipts, or $1.7 trillion.  Several steps are involved in calculating individual income taxes.  First, taxpayers must generally account for all types of income, subject to several exclusions.  Several types of  deductions (often called “above-the-line” deductions) are then applied to calculate Adjusted Gross Income (AGI), which is then further reduced by applying either a standard deduction or (“below-the-line) itemized deductions to calculate Taxable Income.  Tax liability is determined by applying the 7 marginal tax rates [10% – 12% – 22% – 24% – 32% – 35% – 37% ] to each bracket of ordinary income, and applying lower rates [15% or 20%] to capital gains and dividend income.  Finally, tax liability can be reduced by tax credits or increased by the Alternative Minimum Tax (AMT).


Types of “income” subject to tax:

  1. wages;
  2. salaries;
  3. tips;
  4. interest income;
  5. dividend income; CRS Report on Taxation of Dividends
  6. “pass-through” business and farm income;  [Pass-through businesses are non-corporate entities — sole proprietorships, partnerships, small businesses that elect to be treated like partnerships (Subchapter S) and LLCs — that “pass-through” business income to individual tax returns.  Note that taxation of pass-through income may be reduced by the deduction for qualified business income (see below) CRS Report on Pass-Through Income]
  7. capital gains (when a net gain is “realized”);
  8. rental income;
  9. royalties;
  10. trust income;
  11. estate income;
  12. pension and annuity income;
  13. Social Security income; and
  14. unemployment compensation.

Exclusions from Income:  Some items that might be considered “income” from an economic point of view, are excluded from the tax code’s definition of “income.”   The most significant exclusions from income are:

  1. employer-provided health insurance;
  2. employer-provided pension contributions;
  3. employer-provided contributions to Social Security;
  4. amounts received under life insurance contracts;
  5. interest received on certain state and local bonds;
  6. certain forgiven debts;
  7. “unrealized” capital gains (investments that have grown but are not yet sold);
  8. capital gains from sale of a primary residence; and
  9. returns to tax-preferred savings (e.g. retirement, education).

Subtract  “above-the-line” deductions to calculate Adjusted Gross Income (AGI) After all types of income are totaled up, deductions are subtracted that generate the taxpayer’s “Adjusted Gross Income” — the basic measure of income under the federal income tax.  These adjustments — often called “above-the-line” deductions — may be taken regardless of whether the taxpayer uses the standard deduction or itemizes their deductions.  Above-the-line deductions include:

  1. contributions to qualified retirement plans by self-employed individuals;
  2. contributions to individual retirement accounts (IRAs);
  3. self-employed health plan contributions;
  4. interest paid on student loans;
  5. higher education tuition expenses; and
  6. contributions to health savings accounts.

Subtract  below-the-line” deductions from AGI to calculate Taxable Income AGI is then reduced by either astandard deductionor “itemized deductions” — resulting in taxable income.  The 2018 standard deduction is $12,000 for single filers; $18,000 for heads of household; and $24,000 for married taxpayers filing jointly.  Alternatively, taxpayers may subtract “itemized deductions” which include:

  1. mortgage interest;
  2. charitable contributions;
  3. up to $10,000 in total deductions for state and local taxes (income, sales, or property taxes);
  4. medical expenses in excess of 7.5% of AGI in 2018 and 10% of AGI thereafter;
  5. casualty and theft losses attributed to federally declared disasters in excess of 10% of AGI;
  6. 20% of qualified business income for pass-through businesses such as a partnership, S-corp, sole proprietorship, or LLC (subject to limitations based on the taxpayer’s share of wages paid and a phase-out for income from certain types of services including healthcare, legal services, and accounting & investment services).  Background on QBI for pass-through businesses | CRS Report on Pass-Through Income
  7. 20% of qualified REIT (real estate investment trust) dividends, publicly traded partnership income, and cooperative dividends

Apply statutory tax rates to ordinary income to determine tax liability.   

  • 7 marginal tax rates for ordinary income:  The individual income tax has seven brackets for “ordinary” income [10% – 12% – 22% – 24% – 32% – 35% – 37% ] with statutory marginal tax rates increasing as income increases.  Within any particular tax bracket, all individuals regardless of their overall level of earnings, pay the same tax rate on taxable income within that bracket.  Once a taxpayer’s income surpasses a threshold level, placing them in a higher marginal tax bracket, the higher marginal tax rate is only applied on income that exceeds the threshold.  Threshold levels depend on which of the four filing status categories apply — single, head of household, married filing jointly, or married filing separately.
  • Click here for 2018 Tax Rate Tables for each of the four filing categories (source: Joint Committee on Taxation) 

Apply lower tax rates to determine liability for capital gains and dividend income: 

  • Lower Rates for Capital Gains and Dividends:  The tax rates on long-term capital gains and qualified dividends are generally lower than the rates on ordinary income.  These rates can be 0%, 15%, or 20%, depending on the taxpayer’s taxable income and filing status. The rates are linked to the statutory rate brackets that were in effect prior to 2018.  A 20% tax rate applies to taxpayers that would have been in the (pre-2018) 39.6% bracket.  A 15% rate is applied to taxpayers that would have been in the 35%, 33%, 28%, and 25% tax brackets under the former rate structure.  The rate is 0% for taxpayers that would have been in the 15% and 10% brackets under the former rate structure. There is also an exclusion of $500,000 ($250,000 for single returns) for gains on home sales.  Additional background – CRS report on Capital Gains Taxes

Tax Liability may be decreased by tax credits:  Unlike “deductions,” which reduce the amount of income that is subject to tax, tax “credits” reduce the amount of taxes owed.

  • There are two types of credits — nonrefundable and refundable.
  • Nonrefundable credits reduce taxes dollar-for-dollar and, depending on the amount of the credit, can wipe out a taxpayer’s entire tax liability.  Nonrefundable credits include the Child and Dependent Care Credit; the Lifetime Learning Credit; and the Saver’s Credit.
  • Refundable credits go further; even if the amount of the credit exceeds the taxpayer’s tax liability, the Treasury will nevertheless “refund” the entire amount. In other words, a refundable tax credit can, in addition to erasing one’s tax liability, result in a check from the Federal government. Examples of refundable credits include the Earned Income Tax Credit (EITC), the Child Tax Credit (CTC), and the American Opportunity Tax Credit for tuition expenses.
  • From a budgetary perspective, the amount of refundable tax credits that offset tax liability are treated by budget scorekeepers as revenue reductions, while the amounts that exceed tax liability and are paid directly to taxpayers are scored as budget outlays.

Tax liability may be increased by the Alternative Minimum Tax:  Certain higher-income individuals may be subject to the alternative minimum tax (AMT) which was established to prevent higher- income taxpayers from using tax exclusions, adjustments, and deductions to avoid paying a sufficient amount of taxes.  The AMT applies lower tax rates — a two-tiered rate structure of 26% and 28% — but to a broader income base. The taxpayer compares AMT tax liability to regular tax liability and pays the greater of the two.

  • To calculate the AMT, an individual first adds back various tax items, including certain itemized deductions and business tax preferences, to regular taxable income. This becomes the income base for the AMT.
  • The AMT exemption is subtracted from the AMT’s income base. For 2018, the AMT exemption is $109,400 for married taxpayers filing a joint return, $54,700 for married taxpayers filing separate returns, and $70,300 for all other individual tax filers (indexed for inflation). In 2018, the AMT exemption amount begins to phase out at $1,000,000 for married taxpayers filing a joint return and $500,000 for all other individual tax filers.
  • Most nonrefundable personal tax credits are allowed against the AMT.
  • Congress’ Joint Committee on Taxation estimates that roughly 600,000 tax filers will pay the AMT in 2018.

Federal Income Tax in a Nutshell

Gross Income includes:
wages, salaries, tips, interest, dividends, pass-through business and farm income,
capital gains, rent, royalties, trust and estate income, pension and annuity income, and
Social Security benefits (for higher-income taxpayers).
Certain items are excluded from gross income, such as employer-provided health
care and pension contributions; interest on certain state/local bonds,
some forgiven debts, and unrealized capital gains.
is reduced by the following “Adjustments”:
IRA, SEP, and other retirement contributions
Contributions to Health Savings Accounts
Self-employed health insurance premiums
Certain student loan interest
One-half of self-employment tax
Adjusted Gross Income (AGI)
the basic measure of income in the Tax Code
AGI is reduced by Deductions:

Standard Deduction
or
Itemized Deductions
which include:
Home mortgage interest (up to a cap)
Up to $10k for State/local taxes
Charitable contributions
Medical expenses (over 7.5% AGI in 2018 and 10% thereafter)
20% of Qualified Business Income for Pass-Throughs
Taxable Income

Ordinary Income is taxed at these incremental rates in 2018 

Tax Rate Single Return Head of Household Married: Separate / Joint
10%
12%
22%
24%
32%
25%
37%
Up to $9,525
Up to $38,700
Up to $82,500
Up to $157,500
Up to $200,000
Up to $500,000
Over $500,000
Up to $13,600
Up to $51,800
Up to $82,500
Up to $157,500
Up to $200,000
Up to $500,000
Over $500,000
Up to $9,525 / $19,050
Up to $38,700 / $77,400
Up to $82,500 / $165,000
Up to $157,500 / $315,000
Up to $200,000 / $400,000
Up to $300,000 / $600,000
Over $300,000 / $600,000
Long-Term Capital Gains and Qualified Dividends are taxed at these rates in 2018
0%
15%
20%
(Single Return)
Up to $38,600
Up to $425,800
Over $425,800
(Head of Household)
Up to $51,700
Up to $452,400
Over $452,400
(Married: Joint)
Up to $77,200
Up to $479,000
Over $479,000
For example, an individual with ordinary income of $50,000, pays 10% on the amount up to $9,525,
12% on income between 9,525 and $38,700, and 22% on the income above that.
In this way, the tax rates apply to increments of income.
Tax Liability
can be
increased by the Alternative Minimum Tax (AMT)
or
reduced by refundable or nonrefundable tax credits
Refundable credits include the earned income tax credit (EITC), the child tax credit,
and the American Opportunity Tax Credit for tuition expenses.  Nonrefundable credits include
the Child and Dependent Care Credit; the Lifetime Learning Credit; and the Saver’s Credit.