Before the analysis begins, the formula for taxable income and tax needs to be spelled out in more detail:
- (Gross income) minus (deductions) equals (adjusted gross income)
- (Adjusted gross income) minus (standard or itemized deductions) minus (personal and dependent exemptions) equals (taxable income).
- (Taxable income) times (sum of the tax in bracket rates) equals (income tax liability).
- (Income tax liability) plus (other tax liabilities) minus (credits) equals (tax due).
In the Internal Revenue Code, gross income includes a broad range of types of gain, such as cash compensation, gain from the sale or exchange of property, and net income derived from a business. (1) Some items that would otherwise fit the definition of “gross income” are excluded from the amount by law. For example, interest or dividends received from state and local municipal bonds are currently excluded from gross income.
The deductions that are applied to reduce gross income to adjusted gross income are commonly referred to as “above the line” deductions. These deductions can be claimed even if you do not claim itemized deductions on your return. These deductions include student loan interest, a portion of self-employment tax, and some education expenses. (2)
Under current law, taxpayers can choose to claim a standard deduction, which is a set dollar amount for everyone based on their filing status, or they can itemize their deductions. Examples of itemized deductions include medical and dental expenses (if they are large enough to qualify), state and local taxes, and mortgage interest on your residence. In some situations, the taxpayer’s standard deduction is zero, which will prompt them to itemize if they wish to claim any deduction between these choices.
Most taxpayers can also claim one personal exemption for each spouse and child. The exemption amount is a set dollar amount. In 2014, under current law, the exemption amount is $3,950. (3)
Income tax is computed as the sum of the tax on groups of income (“brackets”). Current law has seven brackets: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. How much income is taxed in each bracket depends on the filing status.
Example 1: Joe, filing as a single taxpayer, has taxable income of $50,000. Under current law, the 2014 tax on single taxpayers is imposed at 10% on the income between $1 and $9,075, 15% on the income between $9,076 and $36,900, and at 25% on the income between $36,901 and $89,350. (4) Thus, the top rate on Joe’s income is 25%. The tax due is $908 (10% of $9,075) plus $4,174 (15% times ($36,900 minus $9,075) plus $3,275 (25% times ($50,000 minus $36,901), for a total of $8,357.
I will bring up three other items of note, all of which relate to the changes in this draft legislation. First, the income brackets, the standard deduction, and the personal exemption are all indexed for inflation, meaning that the dollar amounts will increase based on a method set out by law. (5) The TRA seeks to change that method of computing inflation.
The second item is to point out that while the tax on taxable income is what most people pay to the federal government, it is not the only tax. For example, current law includes an alternative minimum tax, which requires taxpayers to do an alternative calculation of federal tax, a calculation that eliminates or limits certain deductions and credits, and to impose a different tax rate on the alternative minimum taxable income. The additional tax imposed is the excess of the alternative minimum tax and the regular tax (i.e., the tax on taxable income). (6) This draft legislation would eliminate the alternative minimum tax. (7)
Finally, some special types of income are taxed at rates different from the regular tax on taxable income. For example, under current law, net long-term capital gain is subject to a series of rates beginning at 0% and topping out at 28%. How this works with the regular tax can get complicated, but I just wanted to point out the existence of different tax rates on different types of income.
Some other devices in tax law are scattered in the TRA draft legislation, but hopefully the above will be a good reference point for most of the changes the legislation includes.
- Title 26, United States Code Section 61 (26 U.S.C. § 61).
- 26 U.S.C. § 62. You can see a list of these types of deductions on the federal Form 1040, Lines 23 through 36.
- 26 U.S.C. 63, §151. 2014 exemption is listed by the IRS in Rev. Proc. 2013-35, Page 15.
- Rev. Proc. 2013-35, Pages 5-7. The 2014 full tax chart hasn’t been published yet, but if you doubt this number, check out 2013’s income tax on $50,000 using the tax chart for that year. (Page 7) The only difference between 2013 rates and 2014 rates is the change to the bracket amounts to account for inflation. More on that in a bit.
- 26 U.S.C. §§ 1(f)(3), 63(c)(3), 151(d)(4).
- 26 U.S.C. § 55. The IRS has, among other items on the subject, a short introduction to the alternative minimum tax here
- Title II of the Tax Reform Act.