6.3: The U.S. Federal Income Tax Process
- Page ID
- 112069
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)- Identify the taxes most relevant for personal financial planning.
- Identify taxable incomes and the schedules used to report them.
- Calculate deductions, exemptions, and credits.
- Compare methods of tax payment.
The U.S. government relies on an income tax. Income tax is a crucial factor in personal financial planning, as everyone has some form of income throughout their lifetime. Most states model their tax systems on the federal model or base their tax rates on federally defined income.
Figure 6.3.1 shows an individual tax return, U.S. Form 1040.
Taxable Entities
There are four taxable entities in the federal system: individuals or family units, corporations, nonprofit corporations, and trusts. Personal financial planning focuses on your decisions as an individual or family unit, but other tax entities can affect individual income. Corporate profit may be distributed to individuals as a dividend, for example. That dividend must be included in the individual’s taxable income. Likewise, funds established for a specific purpose may distribute money to an individual that is taxable as individual income. A trust is a good example. It is a legal arrangement whereby control over property is transferred to a person or organization (the trustee) for the benefit of someone else (the beneficiary). If you are a beneficiary and received a distribution, that money is taxable as individual income.
The definition of the taxable “individual” is determined by filing status:
- Single, never married, widowed, or divorced
- Married, in which case two adults file as one taxable “individual,” combining all taxable activities and incomes, deductions, exemptions, and credits
- Married filing separately, in which case two married adults file as two separate taxable individuals, individually declaring and defining incomes, deductions, exemptions, and credits
- Qualified Surviving Spouse, valid for two years following the year the spouse died, and the surviving spouse has a dependent
- Head-of-household, for a family of one adult with dependent(s)
Some taxes are levied differently depending on filing status, based on the assumption that family structure affects one's ability to pay taxes.
Not everyone who files a return pays taxes. Individuals with low incomes and tax-exempt, nonprofit corporations typically do not. Nevertheless, all potential taxpayers are required to declare their income and demonstrate their obligations to the government. For the individual, that declaration is filed on Form 1040, U.S. Individual Income Tax Return, OR a Form 1040-SR, U.S. Tax Return for Seniors.
Income
For individuals, the first step in the process is to calculate total income. Income may come from various sources, and each source of income must be calculated and declared. Some kinds of income have a separate form or schedule to show their more detailed calculations. The following schedules are the most common for reporting incomes separately by source.
Schedule B: Interest and Dividend Income
Interest income is income from selling liquidity. For example, the interest your savings account, certificates of deposit, and bonds earn in a year is income; however, some interest income may not be taxable. When you deposit funds, you are essentially earning interest from lending cash to a bank, a money market mutual fund, a government, or a corporation. Dividend income, on the other hand, is income from investing in the stock market. Dividends are your share of corporate profits as a shareholder, distributed in proportion to the number of shares of corporate stock you own.
Schedule C: Business Income
Business income is income from self-employment, entrepreneurial ventures, or business enterprises. For many sole proprietors and partners in a partnership, business income may be their primary source of income. Other individuals may rely on wages, but have a small business on the side for extra income. Business expenses can be deducted from business income. For example, business use of your car or home is considered a business expense. If expenses exceed income, the business is operating at a loss. Business losses can be deducted from total income, just as business income adds to total income.
The tax laws distinguish between a business and a hobby that earns or loses money. You are considered to have a business for tax purposes if you made a profit in three of the past five years, including the current year, or if you are operating as a registered business and intending to make a profit. If you are operating your own business, you must also pay self-employment tax on business income. In addition, if you are self-employed, you must pay estimated income taxes in quarterly installments based on your expected income.
Schedule SE: Self-Employment Tax
Self-employment tax is an additional tax on income from self-employment or business income earned by a sole proprietor. It represents the employer’s contribution to Social Security, the federal government's mandatory retirement savings program. Both employers and employees are required to contribute to the employee’s Social Security account. When you are both the employee and the employer, as in self-employment, you must contribute both your share and the employer's share of the contribution.
Schedule D: Capital Gains (or Losses)
Gains or losses from investments derive from changes in asset value between the asset’s original cost and its market value at the time of sale. Recurring gains or losses from investments are derived from returns on financial instruments, such as stocks and bonds. One-time gains, such as profits from the sale of a home, are also reported on Schedule D.
The tax code distinguishes between assets held for a short time (one year or less) and assets held for a long time (over a year). Short-term capital gains are taxed at a different rate than long-term capital gains (Table 6.3.2 ). When you invest in financial assets, such as stocks, bonds, mutual funds, property, or equipment, be sure to keep good records by noting the date when you bought them and the original price. These records establish the cost basis of your investments, and you will use that to calculate gains or losses when you sell them.
Source: Topic no. 409: Capital gains and losses (www.irs.gov/taxtopics/tc409)
| Type of Capital Asset | Holding Period | Tax Rate for Tax Year 2023 |
|---|---|---|
| Short-term capital gains (STCG) | One year or less | Ordinary income tax at graduated tax rates |
| Long-term capital gains (LTCG) | More than one year |
A Long-term capital gain (LTCG) rate of 0% applies if your taxable income is less than or equal to
An LTCG rate of 15% applies if your taxable income is
An LTCG rate of 20% applies to the extent that your taxable income exceeds the thresholds set for the 15% capital gain rate. |
Schedule E: Rental and Royalty Income; Income from Partnerships, S Corporations, and Trusts
Rental or royalty income is income earned from renting an asset, such as real property or a creative work, including a book or a song. This can be a primary source of income, although many individuals rely on wages and have some rental or royalty income on the side. Homeownership may be made more affordable, for example, if the second half of a duplex you live in can be rented for extra income. Rental expenses can also be deducted from rental income, possibly creating a net loss from rental activity. Unlike a business, which must become profitable to remain a business for tax purposes, rental activities can generate losses for years. Such losses are a tax advantage, as they reduce total income.
Partnerships and S corporations are alternative business structures for businesses with one or more owners. For example, partnerships and S corporations are commonly used by professional practices, such as accounting firms, law firms, and medical practices, as well as family businesses.
The partnership or S corporation is not a taxable entity; however, the share of its profits distributed to each owner is taxable income for the owner and must be reported on Schedule E.
Schedule F: Farm Income
Farm income refers to the money earned from growing food, raising livestock, or producing related products, such as wool, for sale. Farmers have a special status in the tax code, stemming from the original agricultural basis of the U.S. economy and the strategic importance of food self-sufficiency. Thus, the tax code offers numerous exemptions that are specifically tailored to farmers.
Other Taxable and Nontaxable Income
Other taxable income includes alimony, state or local tax refunds, retirement fund distributions from individual retirement arrangements (IRAs) and/or pensions, unemployment compensation, and a portion of Social Security benefits.
Your total income is then adjusted for items that the government determines should not be taxed under certain circumstances, such as some expenses of educators, performing artists, and military reservists; savings in health savings or retirement accounts; moving expenses; a portion of self-employment taxes; student loan interest; and alimony paid. Income that is not taxed by the U.S. government and does not have to be reported as income includes the following:
- Welfare benefits
- Interest from most municipal bonds
- Most gifts
- Most inheritance and bequests
- Workers compensation
- Veteran’s benefits
- Federal tax refunds
- Some scholarships and fellowships
However, not everything you might think qualifies as non-taxable does. It is important to read tax filing instructions carefully. The government allows adjustments to be reported (or not reported) as income only under certain circumstances or up to certain income limits, and some adjustments require special forms.
The result of deducting adjustments from your total income is a calculation of your adjusted gross income (AGI). Your AGI is further adjusted by amounts that may be deducted or exempted from your taxable income and by amounts already credited to your tax obligations.
Deductions and Credits
Deductions and exemptions reduce taxable income, while credits reduce the amount of tax owed. Deductions are tax breaks for incurring certain expenditures or living in certain circumstances that the government thinks you should not have to include in your taxable income. There are deductions for age and blindness. For other deductions, you can claim a standard, lump-sum deduction, or you may choose to itemize your deductions. You can detail each deduction separately and then calculate the total. If your itemized deductions are more than your standard deduction, it makes sense to itemize.
Other deductions involve financial choices that the government encourages by offering an extra incentive in the form of a tax break. For example, home mortgage interest is a deduction that encourages home ownership; investment interest is a deduction that encourages investment; and charitable donations are deductions that encourage charitable giving.
Deductions are also created for expenditures that may be considered nondiscretionary, such as medical and dental expenses, or state and local income and property taxes. However, as with income adjustments, you must read the instructions carefully to know what expenditures qualify as deductions. Some deductions only qualify if they exceed a certain percentage of income, while others may be deducted regardless. Some deductions require an additional form to calculate specific details, such as charitable gifts not given in cash, investment interest, and certain types of mortgage interest.
After deductions are subtracted from adjusted gross income, the remainder is your taxable income. Your tax is based on your taxable income, on a progressive scale. You may have additional taxes, such as self-employment tax, and you may be able to apply credits against your taxes, such as the Child Tax Credit or the Earned Income Tax Credit for lower-income taxpayers with children.
Deductions and credits are among the most disputed areas of the tax code. Due to the depth of the dispute, they tend to change more frequently than other areas of the tax code. For example, in 2009, a credit was added to encourage first-time homebuyers to purchase a home, hoping to stimulate the residential real estate market. In 2017, Congress passed the Tax Cuts and Jobs Act, which introduced significant tax law changes, including modifications to the home mortgage deduction, charitable contributions, and a generous deduction known as the Qualified Business Income Deduction. As a taxpayer, you need to be alert to changes that may be to your advantage or disadvantage. Typically, such changes are introduced gradually, allowing you to incorporate them into your financial planning process.
Payments and Refunds
Once you have calculated your tax obligation for the year, you can compare that to any taxes you have paid during the year, and then calculate the amount still owed or the amount to be refunded to you.
You pay taxes during the tax year by having them withheld from your paycheck if you earn income through wages, or by making quarterly estimated tax payments if you have other kinds of income. When you begin employment, you fill out a Form W-4, Employee's Withholding Certificate, to determine the taxes to be withheld from your regular pay. You may adjust this amount, within limits, at any time. If you have both wages and other incomes, but your wage income is your primary source of income, you may be able to increase the taxes withheld from your paychecks. This additional withholding could cover the taxes on your other income and help avoid making estimated payments. However, if your non-wage income is substantial, you will have to make estimated payments to avoid a penalty and/or interest.
The government requires that taxes be withheld or paid quarterly during the tax year because it uses tax revenues to finance its expenditures; it needs a steady and predictable cash flow. Steady payments also decrease the risk of taxes being uncollectible. State and local income taxes must also be paid during the tax year and are similarly withheld from wages or paid on a quarterly basis.
Besides income taxes, other taxes are withheld from your wages: payments for Social Security and Medicare. Social Security, also known as the Federal Insurance Contributions Act (FICA), and Medicare are federal government programs. Social Security is insurance against loss of income due to retirement, disability, or loss of a spouse or parent. Individuals are eligible for benefits based on their contributions (or contributions from a parent or spouse) during their working lives. Medicare finances health care for the elderly. Both programs were designed to provide minimal benefits to those no longer able to sell their labor in exchange for wage income. Under Social Security and Medicare, your contributions pay for benefits that current beneficiaries receive.
If you paid more during the tax year than your actual obligation, you are due a refund of the difference. You may have that amount directly deposited into a bank account, or the government will send you a check.
If you have paid less during the tax year than your actual obligation, you will need to pay the difference (by Direct Debit, check, or credit card) and may incur a penalty and/or interest, depending on the size of your payment.
The deadline for filing income tax returns and paying any necessary amounts is generally April 15th (or the first business day after) following the end of the tax year on December 31st. You may file a request to extend the deadline for six months to October 15th. Should you miss a deadline without filing for an extension, you will owe penalties and interest, even if your actual tax obligation results in a refund. It pays to get your return in on time.
- The most relevant tax for financial planning is income tax, as it affects taxpayers over their entire lifetime.
- Different types of income must be defined and declared on specific income tax schedules and are subject to taxation.
- Deductions and exemptions reduce taxable income.
- Credits reduce tax obligations.
- Payments are made throughout the tax year through withholding from wages or through quarterly payments.
- Read the IRS document defining tax liability (www.irs.gov/publications/p17#en_US_publink100031858). Do you have to file a tax return for the current year? Why or why not? (Identify all the factors that apply.) Which tax form(s) should you use?
- Download and study the following schedules or their equivalent for the current year. In what circumstances would you have to file each one? Tentatively fill out any schedules that apply to you for the current year.
- Schedule A (www.irs.gov/pub/irs-pdf/f1040sa.pdf)
- Schedule B (www.irs.gov/pub/irs-pdf/f1040sb.pdf)
- Schedule C (www.irs.gov/pub/irs-pdf/f1040sc.pdf)
- Schedule D (www.irs.gov/pub/irs-pdf/f1040sd.pdf)
- Schedule E (www.irs.gov/pub/irs-pdf/f1040se.pdf)
- Schedule F (www.irs.gov/pub/irs-pdf/f1040sf.pdf)
- Find answers to the following questions about the taxability of scholarships (www.finaid.org/scholarships/taxability/):
- Is financial aid for college subject to federal income tax?
- Can federal and state education grants be taxed as income?
- Are student loans taxable?
- When is a scholarship tax-exempt?
- Do you have to be in a degree program to qualify for tax exemption?
- When can the cost of textbooks be deducted from gross income for tax reporting purposes?
- Can the amount of a scholarship used for tuition be deducted?
- Can living expenses while on scholarship be deducted?
- Is the income and stipend from a teaching fellowship or research assistantship tax-exempt?
- Are the tuition, books, and stipends of ROTC students tax-exempt?
[1] IRS Form IRS Form 1040 2023. www.irs.gov/pub/irs-pdf/f1040.pdf.