Income Taxes Part 2

Introduction: Light Bulb Moments

Income Taxes Part 1

     For my examples, I will be using 2011 tax rates and Turbo Tax Home and Business 2011 will crunch my numbers.  Millions of Americans use Turbo Tax, including yours truly.  That way if anyone wants to verify what I’m telling you, they can. It is important to note for my examples, I’m not including tax withheld during the year because I don’t care what their Refund is, I only care what their Total Tax is. However, in real life, if you don’t have enough withheld through the year, there will be penalties assessed. Remember Effective Tax Rate is determined by Total Tax / Adjusted Gross Income. The following examples do not represent any persons alive or dead. They are figments of my imagination used to illustrate a point.

Example 1: Let me introduce you to Fred and Hazel. They are a young married couple, no children, no house, no charitable contributions. Each earned wages of $10,000 in 2011 for a combined income of $20,000. Their combined savings account earned $10.00 interest. We will look at three scenarios for this income level.  In the first column is Fred and Haze just as described without any other modifications. In the second column, Fred is going to college and paid tuition of $6,000, all other assumptions are the same. In the third column, Fred and Hazel are over 25 years old, have one child, all other assumptions are the same.

Filing Status: Married Filing Joint

	No Extras	Fred is a student	Fred & Hazel over 25
Wages, Etc.	$20,000	$20,000	$20,000
Taxable Interest	$       10	$       10	$       10
Adjusted Gross Income	$20,010	$20,010	$20,010
Standard Deduction*	$11,600	$11,600	$11,600
Exemptions #	$  7,400	$  7,400	$11,100
Taxable Income	$  1,010	$  1,010	$          0
Tax Before Credits	$     101	$     101	$          0
NonRefundable Am Opp Credit^		$     101
Total Tax	$     101	$         0	$          0
Earned Income Credit◊			$   3,094
Additional Child Tax Credit§			$   1,000
Refundable Am Opp Credit^		$  1,200
Amt Received in Excess of Total Tax		$  1,200	$  4,094
Effective Tax Rate	.5%	0%	0%

*Fred and Hazel are allowed to take the Standard Deduction of $11,600 even though they don’t have any deductions to itemize.

# They are allowed two Exemptions of $3,700 because there are two people in their household.  In the third column they are allowed tree Exemptions because they have a child.

^Fred is allowed the American Opportunity Credit of $101 Nonrefundable (offset tax owed) and $1200 Refundable (meaning they get that money back even though it is more than they owe in taxes) for the tuition payments he made. For his tax situation it is more beneficial than taking the Tuition Deduction to reduce Adjusted Gross Income by $6,000.

§ The Child Tax Credit  is allowed for children under 17 years of age. It is called the Additional Child Tax Credit if it reduced tax more than the amount owed, as in this case. It is refundable.

◊ The Earned Income Credit is also Refundable. There are age and income limits and it is different if there are children.

Example 2: Now we will look at a different couple’s circumstances.  Dave and Jill are both college graduates and paying student loans. They paid $500 in student loan interest this year. They have 1 child. Dave makes $30,000/year. Their savings account earned $100. In column one, Jill is a homemaker. In column two, Jill also works, making $30,000/year, and they paid childcare of $5,000. In column three their situation is the same except that they bought their first home this year.

	Jill Homemaker	Jill Also Works	With a Home
Wages, Etc.	$30,000	$60,000	$60,000
Taxable Interest	$      100	$      100	$      100
Total Income	$30,100	$60,100	$60,100
Student Loan Interest Deduction¤	$      500	$      500	$      500
Adjusted Gross Income	$29,600	$59,600	$59,600
Standard Deduction*	$11,600	$11,600
Schedule A Itemized Deductionsδ			$16,800
Exemptions #	$11,100	$11,100	$11,100
Taxable Income	$  6,900	$36,900	$31,700
Tax Before Credits	$     693	$  4,689	$   3,909
Child & Dependent Care Credit~		$     600	$      600
Child Tax Credit§	$     693	$  1,000	$   1,000
Total Tax	$         0	$  3,089	$   2,309
Earned Income Credit◊	$  1,775	$         0	$         0
Additional Child Tax Credit	$     307
Amt Received in Excess of Total Tax	$  2,082
Effective Tax Rate	0%	5.2%	3.9%

¤Student Loan Interest Deduction is allowed even if you don’t have enough deductions to itemize. It is a “before the line” item meaning that it reduces Adjusted Gross Income).

# They are allowed three Exemptions of $3,700 because they have a child.

δ In this case, they can Itemized their deductions because they have more than the Standard level.  I assumed they paid $9,000 Mortgage Interest and Points, $200 Mortgage Insurance Premium, $5000 Property Taxes, $2,400 was withheld for State Income Taxes, $200 Property Tax on a car.

~The Child and Dependent Care Credit is available for people who pay for day care. There is a limit of $3,000, then you are allowed a credit of 40%. Turbo Tax said it would have helped the tax bottom line more to have had a Dependent Care Flex Account through your employer.

◊ In this case, the Earned Income Credit is reduced because of their income level.

§ The Child Tax Credit  is allowed for children under 17 years of age. It is called the Additional Child Tax Credit if it reduced tax more than the amount owed, as in this case. It is refundable.

Example 3: We’ve looked at different scenarios for the same couples in a few different ways.  Now I want to take Brad and Lisa and look at how their situation changes as their income increases. For this example, we will have all other information the same.

Brad and Lisa have 2 children ages 14, and 17. Lisa has her own business and earned a net $5,000. They own a home, pay Mortgage Interest of $8,000, Property Taxes on their home of $5,000, Charitable Contributions of $1,000, State Income Taxes Withheld of $3,000 (even though this would change as their income changes, we will assume it stays the same) Property Tax on cars $200. They had Unreimbursed Medical bills totaling $5,000 (not covered by insurance or any Flexible Savings Account). I had wanted to take it in $10,000 increments, but that would make my chart too large, so instead, I took it in $15,000 increments. I could make my chart larger, but this should include all of the tax levels. Any further increases in wages should increase the Effective Tax as well, unless we introduced new variables.

Wages, Etc.	$30,000	$45,000	$60,000	$75,000	$90,000	$105,000	$120,000	$135,000	$150,000	$165,000	$180,000	$195,000	$210,000
Schedule C Income	$  5,000	$  5,000	$  5,000	$  5,000	$  5,000	$    5,000	$    5,000	$    5,000	$    5,000	$    5,000	$    5,000	$    5,000	$    5,000
Total Income	$5,000	$50,000	$65,000	$80,000	$95,000	$110,000	$125,000	$140,000	$155,000	$170,000	$185,000	$200,000	$215,000
Schedule SE Self-Employment Tax **	$   353	$     353	$     353	$     353	$     353	$      353	$      353	$      353	$      353	$      353	$       353	$       353	$       353
Adjusted Gross Income	$34,647	$49,647	$64,647	$79,647	$94,647	$109,647	$124,647	$139,647	$154,647	$169,647	$184,647	$199,647	$214,647
Itemized Deductionδ	$19,601	$18,476	$17,351	$17,200	$17,200	$  17,200	$  17,200	$  17,200	$  17,200	$  17,200	$  17,200	$  17,200	$  17,200
Exemptions #	$14,800	$14,800	$14,800	$14,800	$14,800	$  14,800	$  14,800	$  14,800	$  14,800	$  14,800	$  14,800	$  14,800	$  14,800
Taxable Income	$     246	$16,371	$32,496	$47,647	$62,647	$  77,647	$  92,647	$107,647	$122,647	$137,647	$152,647	$167,647	$182,647
Tax Before Credits	$      24	$  1,638	$  4,021	$  6,294	$  8,544	$  11,656	$  15,406	$  19,162	$  22,912	$  26,662	$  30,811	$  35,011	$  39,211
Child Tax Credit§	$      24	$  1,000	$  1,000	$  1,000	$  1,000	$    1,000	$      250	$          0	$          0	$          0	$          0	$          0	$          0
Tax Before Other Taxes	$        0	$     638	$  3,021	$  5,294	$  7,544	$  10,656	$ 15,156	$  19,162	$  22,912	$  26,662	$  30,811	$  35,011	$  39,211
Schedule SE Self Emp Tax	$     614	$     614	$     614	$     614	$     614	$      614	$      614	$      614	$      614	$      614	$       614	$       614	$       614
Total Tax	$     614	$  1,252	$  3,635	$  5,908	$  8,158	$ 11,270	$ 15,770	$  19,776	$  23,526	$  27,276	$  31,425	$  35,625	$  39,825
Earned Income Credit◊	$  2,405	$        0	$        0	$        0	$        0	$          0	$          0	$          0	$          0	$          0	$          0	$          0	$          0
Additional Child Tax Credit	$     976	$        0	$        0	$        0	$        0	$          0	$          0	$          0	$          0	$          0	$          0	$          0	$          0
Amt Received in Excess of Total Tax	$  2,767	$        0	$        0	$        0	$        0	$          0	$          0	$          0	$          0	$          0	$          0	$          0	$        0
Effective Tax Rate	0%	2.5%	5.6%	7.4%	8.6%	10.3%	12.7%	14.2%	15.2%	16.1%	17%	17.8%	18.6%

**The amount of Self Employment Tax attributable to the employer portion of Social Security tax reduces AGI.

δ Notice as Income increases, their Itemized Deductions decrease. This is due to Medical Expenses which are only allowed in amounts >7.5% AGI. By the 4^th column, Medical Expenses are no longer allowed.

# They are allowed four Exemptions of $3,700 because they have two children.

§ They are only allowed $1,000 for their 14 year old, once children turn 17, the Child Tax Credit is no longer allowed. The Child Tax Credit phases out beginning with AGI of $110,000 for Married Filing Joint.

For Example 3, I also looked at how $1,000 of Capital Gains would change the numbers for the above table, and determined that it would take higher amounts of Capital Gain to make a significant difference. The most significant thing I learned regarding Capital Gains is that for the 10% and 15% tax brackets, Capital Gains are taxed at 0%. For all other brackets, they are taxed at 15%. They do however, increase AGI for those calculations which use AGI.

     I could look at many more examples, such as retired couples, but this post has already gotten long. Also, remember, that as income rises, so generally do itemized deductions because of an increase in State Income Taxes, a larger house means more Mortgage Interest and Property Taxes, etc.  For these examples, I wanted all variables to be the same except Wages.  I hope you have learned something along the way, I know I did.  Remember, before you start judging another person’s Effective Tax Rate, take a look at your own, you might be surprised.

     P.S: I don't think I'll be doing those additional blog entries about specific entitlement programs just yet. I felt compelled to write about the Effective Tax Rate and I have. But I feel I'm done.