Federal Taxation Explained
Congress created the Federal income tax system as it pertains to individual taxpayers based upon the concept that taxpayers who earn higher incomes should pay proportionately more in Federal income tax on their income. As your income increases, specific increments of your income are taxed at higher and higher rates. This tax system is based upon what are known as “graduated income tax rates”.
There are seven Federal income Tax Brackets and Tax Rates. To make matters more complicated, Congress established different sets of tax brackets and tax rates for each type of taxpayer filing status: married, filing jointly (MFJ); married, filing separately (MFS); single, or head of household (HOH).
Congress also stipulated that numerous adjustments could be made to various income streams before calculating one’s taxable income, and consequentially, the amount of Federal income tax owed.
The combination of all these various rules, regulations and adjustments makes it rather difficult for the average taxpayer to understand the Federal tax system, and thus calculate their own particular Federal income tax liability each year.
To develop a better understanding of the Federal income tax system as it pertains to individual taxpayers, taxpayers should try to focus on these two concepts:
- Adjusted Gross Income (AGI)
- Effective Tax Rate (ETR)
Both of these concepts are discussed below.
Gross Income
Your gross income is the sum of all the income streams that you received during the year. The numbers to the left refer to the line numbers found on Form 1040 or Form 1040-SR, p.1.
- Wages, salaries, tips, etc.
- Interest
- Dividends
- IRA distributions
- Pensions and annuities
- Social security benefits
- Capital gains or any realized gains after selling an asset for a profit
- Additional income as reported on Schedule 1, p.1, including:
-
- Taxable refunds of state and local income taxes:
- Alimony received (only from divorce decrees executed prior to 2019)
- Business income
- Other gains and losses reported on Form 4797
- Rental real estate, royalties, partnerships, S-corporations, trusts, etx.
- Farm income
- Unemployment compensation
- Other miscellaneous income
Your gross income will appear on Form 1040 or Form 1040-SR, p.1, line 9.
Adjusted Gross Income (AGI)
Your AGI is important because it’s your total taxable income calculated before your itemized deduction or standard deduction, exemptions and credits are taken into account. Your previous year’s AGI can be found on your Form 1040 or Form 1040-SR income tax return, p.1, line 11. Your AGI dictates whether and how you may be able to use various tax credits and exemptions.
Your AGI is equal to your gross income (above), less certain tax-deductible expenses, as reported on Schedule 1. The numbers to the left refer to the line numbers found on Schedule 1, p.2.
- Educator expenses
- Certain business expenses of reservists, performing artists, and fee-basis government officials
- Health Savings Account (HSA) contributions from Form 8889
- Moving expenses for members of the Armed Forces
- Deductible part of self-employment tax from Schedule SE
- Self-employed SEP, SIMPLE and qualified retirement plan contributions
- Self-employed health insurance deduction
- Penalties on early withdrawal of savings
- Alimony paid (only from divorce decrees executed prior to 2019)
- IRA deductions
- Student loan interest deductions
- (Reserved for future use)
- Archer MSA deductions
- Certain other miscellaneous deductions
Modified Adjusted Gross Income (MAGI)
The IRS uses MAGI to determine whether you qualify for specific tax programs and benefits. For example, MAGI is used to determine the allowed amount of your Roth IRA contributions. Knowing your MAGI can help you avoid certain tax penalties because over-contributing to these and other similar programs can trigger penalty and interest assessments.
Your MAGI is equal to your AGI (above), then adding back certain deductions that you took (above), including:
- Deductible part of self-employment tax from Schedule SE
- IRA contributions and taxable Social Security payments
- Student loan interest
- Tuition and fees
- Interest on Series EE U.S. Savings Bonds used to pay for higher education expenses
- Passive income or (losses)
- Rental real estate losses
- Losses from a partnership
- Excluded foreign income
- The exclusion for adoption expenses
Deduction from Income
The IRS allows you to deduct a certain amount from your AGI to determine your taxable income. This amount will be the greater of the Standard Deduction or your Itemized Deductions and will appear on Form 1040 or Form 1040-SR, p.2, line 12c.
Standard Deduction
Following the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), most taxpayers now claim the Standard Deduction from one of the following tables:
Standard Deduction
"Married, Filing Jointly" Filers
| Tax Year | Deduction Limits | ||
|---|---|---|---|
| Under Age 65 | Age 65 or Older | ||
| 2023 | 27,700 | Additional $1,850 each | |
| 2022 | 25,900 | Additional $1,400 each | |
| 2021 | 25,100 | Additional $1,350 each | |
Standard Deduction
"Single" Filers
| Tax Year | Deduction Limits | ||
|---|---|---|---|
| Under Age 65 | Age 65 or Older | ||
| 2023 | 13,850 | Additional $1,850 | |
| 2022 | 12,950 | Additional $1,400 | |
| 2021 | 12,550 | Additional $1,350 | |
Itemized Deductions
Itemized deductions are calculated on Schedule A of your Form 1040 or Form 1040-SR return. Following the passage of the Tax Cuts and Jobs Act of 2017 (TCJA), itemized deductions are generally limited to the sum of the following expenses subject to the limitations shown. The numbers to the left refer to the line numbers found on Schedule A.
| Itemized Deduction | Limitation | ||
|---|---|---|---|
| 4. | Medical and dental expenses | Expenses that exceed 7.5% of Adjusted Gross income (AGI) | |
| 7. | State and local income, real estate, and property taxes | $10,000 per Form 1040 Return | |
| 10. | Home mortgage interest | Interest on up to $750,000 of mortgage debt | |
| 11. | Gifts to charities | 60% of Adjusted Gross Income (AGI) |
Taxable Income
Your taxable income is the difference between your Adjusted Gross Income (AGI) and the greater of your Standard Deduction or your Itemized Deductions. This amount will appear on Form 1040 or Form 1040-SR, p.2, line 15.
Tax
The initial tax due on your taxable income is calculated on one of several worksheets build into Form 1040. This amount will appear on Form 1040 or Form 1040-SR, p.2, line 16.
Total Tax
The total tax is calculated by making several adjustments to the Tax reported on Form 1040 or Form 1040-SR, p.2, line 16 (above). These include the addition of any alternative minimum tax (AMT) as calculated on Form 6251 plus any excess advance premium tax credit repayment as calculated on Form 8962, less any nonrefundable child tax credit or credit for other dependents as calculated on Schedule 8812.
The total tax will appear on Form 1040 or Form 1040-SR, p.2, line 24.
Effective Tax Rate (ETR)
| Description | Source | ||
|---|---|---|---|
| 1. | Total Tax | Form 1040, p.2, line 24 | |
| 2. | Other Taxes | Form 1040, p.2, line 23 | |
| 3. | Adjusted Total Tax | = 1 – 2 | |
| 4. | Adjusted Gross Income | Form 1040, p.1, line 11 | |
| 5. | Effective Tax Rate (ETR) | = 3 ÷ 4 | |
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