Other articles in this series:
Tax Tips for Troops and Families: Overview
Determining Adjusted Gross Income
Tax Deductions
Taxable Income and Credits
[For tax preparation options and discounts for military families and veterans, see the Military.com Tax Prep section.]
Once all the available deductions have been taken from Adjusted Gross Income (AGI), the result is Taxable Income. This is the number from which the IRS will determine your actual tax liability, and it encompasses not only annual salary, but also items like stock and cash interests / dividends, and capital gains from investments.
Taxable Income (Apply Ordinary / Capital Gains Tax Rates)
= Tax Liability
- Tax Credits
Tax Owed
There are two different tax schedules to examine for Tax Liability: Marginal tax rates for Ordinary Income and Capital Gains Tax Rates for investments.
Ordinary Income. There are seven 2013 Marginal Tax Rate income brackets. Table 1 provides a Married Filing Jointly (MFJ) and Single scenario to illustrate general tax liability determination and how marginal tax rates are used.
Table 1: Tax Liability Determination Example (MFJ and Single)
Married Filing Jointly
| Total Household Salary | $150,000.00 |
| Itemized Deductions | $25,000.00 |
| Taxable Income | $125,000.00 |
| 10% Bracket ($0-$17,850) | $1,785.00 |
| 15% Bracket ($17,851-$72,500) | $8,197.50 |
| 25% Bracket ($72,500-$146.400) | $13,125.00 |
| 28% Bracket ($146,400-$223,050) | $0.00 |
| 33% Bracket ($223,050-$398,350) | $0.00 |
| 35% Bracket ($398,350-$450,000) | $0.00 |
| 39.6% Bracket (over $450,000) | $0.00 |
| Total Tax Liability | $23,107.50 |
| Percentage of Taxable Income | 18.49% |
Single
| Total Household Salary | $150,000.00 |
| Itemized Deductions | $25,000.00 |
| Taxable Income | $125,000.00 |
| 10% Bracket (0-$8,925) | $892.50 |
| 15% Bracket ($8,950-36,250) | $4,098.75 |
| 25% Bracket ($36,250-$87,850) | $12,900.00 |
| 28% Bracket ($87,850-$183,250) | $10,402.00 |
| 33% Bracket ($183,250-$398,350) | $0.00 |
| 35% Bracket ($398,350-$450,000) | $0.00 |
| 39.6% Bracket (over $450,000) | $0.00 |
| Total Tax Liability | $28,293.25 |
| Percentage of Taxable Income | 22.63% |
Two key points is that the use of adjustments to AGI and itemized deductions (summed up in an example Itemized Deductions Line in Table 1) as discussed in Part 2 plays a significant role in reducing tax liability exposure. In the Married Filing Jointly case, it saved $5,350 in tax liability at the 25% bracket and eliminated exposure to an added $1,008 in tax liability at the 28% bracket rate. Second, the marginal tax brackets are the rates for income than falls in the range depicted. A household where AGI falls in the 28% bracket does not equate to all of the income now being taxed at 28%.
Capital Gains / Losses. Collectables such as art and jewelry are taxed at 28% and real estate is at 25%. For most investment gains, time of possession determines whether a gain on sale is long-term (15% rate if held longer than 12 months) or short term (28% rate if held for 12 months or less).(1) The process of netting gains and losses across the various categories can be somewhat complex to come up with a final determination, but the bottom line is that the maximum deduction that can be claimed by a household is a $3,000 Capital Loss. Losses above that threshold can be carried over to a subsequent tax year(s).
With Ordinary and Capital Gains tax liability is complete, tax credits can be applied. Tax Credits are dollar for dollar reductions in the actual tax owed to the Government. Put another way, they are the coupons applied to the final grocery bill. Take note of how AGI plays into income phase-outs. Some common tax credits are explained below.
Qualifying Child. A $1,000 tax credit can be claimed for each child, subject to a phase out of this benefit between $110,000-$129,000 AGI (MFJ); $75,000-$95,000 AGI (Single).
Dependent Care Credit. Provides relief to taxpayers who incur child and dependent care expenses to enable them to remain gainfully employed. Those with qualifying day care expenses for children under the age of 13 as well as for dependents unable to care for themselves can claim between 20-35% of up to $3,000 per individual(2) and $6,000 maximum based on AGI. Households with income of $15,000 AGI or less can claim 35% of eligible expenses; households with income exceeding $43,000 can claim a credit of 20% of their eligible expenses(3). Household AGI between $15,000 and $43,000 have a 1% reduction for each $2,000 over $15,000 AGI.
Tax Credit for Adoption Expenses. This is a complex topic because expenses can cover more than a single tax year and there are additional credits for the adoption of more than one child and children with special needs. Be aware that credits do exist and that it is worth talking to a CPA or tax attorney about your specific situation.
American Opportunity and Lifetime Learning Education Credits. The credits cannot be claimed together for the same student, but each can help defray education expenses. The American Opportunity Tax Credit is for qualified expenses paid to an eligible student for the first four years of higher education.(4) The amount of the credit is 100% of the first $2,000 in expenses and 25% of the next $2,000 (max of $2,500). The household income phase out to claim the full credit is between $160,000-$180,000 AGI (MFJ) and $80,000-$90,000 (Single).
The Lifetime Learning Credit doesn’t contain a limit on the number of years that it can be claimed and is worth up to $2,000 per tax return on expenses toward undergraduate, graduate, and professional degree or job skill improvement. The household income phase out to claim the full credit is between $104,000-$124,000 AGI (MFJ) and $52,000-$62,000 (Single).(5)
After all your eligible credits have reduced your computed tax liability dollar for dollar, the amount remaining is the tax owed. This amount that is compared to the taxes withheld throughout the year. If your calendar year pay period withholdings exceed the tax owed, you will receive a refund from the IRS. If not, the difference is the amount owed. While it can be painful to write a check to the IRS, it is worth noting words of wisdom once provided to me from a former Commanding Officer. The only thing worse than a tax problem…is not having a tax problem.
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Todd Severance is a 1992 graduate of the U.S. Naval Academy with an MBA from the University of Arizona. He is a naval officer (Selected Reserve) with nearly 15 years active-duty experience. Todd is pursuing his Certified Financial Planner and is a business consultant with Echelon Group in Boise, Idaho.
Echelon Group provides Employee Benefits, Retirement Plans, Investment Management; Financial Planning and additional services to companies, its employees, and individuals.
1. Fundamentals of Income Taxation, Tenth Edition, Christopher P Woehrle and Thomas M. Brinker, The American College Press 2011, p. 14.6.
2. Fundamentals of Income Taxation, Tenth Edition, Christopher P Woehrle and Thomas M. Brinker, The American College Press 2011, p. 10.7.
3. Official 2013 H&R Block Tax software information
4. www.irs.gov/individuals/AOTC
5. www.irs.gov/individuals/LLC
