Once taxpayers have determined their taxable income, they are ready to compute their gross tax from a series of progressive tax rates called a tax rate schedule.
Tax Rate Schedules
Congress has constructed four different tax rate schedules for individuals. The applicable tax rate schedule is determined by the taxpayer’s filing status, which we discussed in depth in the Individual Income Tax Overview, Dependents, and Filing Status chapter.
Recall that a taxpayer’s filing status is one of the following:
1. Married filing jointly.
2. Qualifying widow or widower, also referred to as surviving spouse.
3. Married filing separately.
4. Head of household.
5. Single.
As we described in the Introduction to Tax chapter, a tax rate schedule is composed of several ranges of income taxed at different (increasing) rates. Each separate range of income subject to a different tax rate is referred to as a tax bracket. While each filing status has its own tax rate schedule (married filing jointly and qualifying widow or widower use the same rate schedule), all tax rate schedules consist of tax brackets taxed at 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 per- cent, and 37 percent. However, the width or range of income within each bracket var- ies by filing status. In general, the tax brackets are widest and higher levels of income are taxed at the lowest rates for the married filing jointly filing status, followed by the head of household filing status, single filing status, and finally, the married filing separately filing status.
The tax rate schedule for each filing status is provided in Appendix D. Notice that the married filing separately schedule is the same as the married filing jointly schedule ex- cept that the taxable income levels listed in the schedule are exactly one-half the taxable income levels for married filing jointly.
LO 8-1
As we determined in the Individual Deductions chapter, Courtney files under the head of household filing status and her 2018 taxable income is $145,070 (see Exhibit 6-11).
What if: For now, let’s assume that all of Courtney’s income is taxed as ordinary income. That is, as- sume that none of her income is taxed at a preferential rate (some is, but we’ll address this in a bit).
What is the tax on her taxable income?
Example 8-1
For administrative convenience and to prevent low- and middle-income taxpayers from mak- ing mathematical errors using a tax rate schedule, the IRS provides tax tables that present the gross tax for various amounts of taxable income under $100,000 and filing status (it’s imprac- tical to provide a table for essentially unlimited amounts of income). Taxpayers with taxable income less than $100,000 generally must use the tax tables to determine their tax liability.1
Because the tax tables generate nearly the same tax as calculated from the tax rate schedule, we use the tax rate schedules throughout this chapter.
Marriage Penalty or Benefit
An interesting artifact of the tax rate schedules is that they can impose what some refer to as a marriage penalty, but they may actually produce a marriage benefit. A marriage penalty (benefit) occurs when, for a given level of income, a married couple incurs a greater (lesser) tax liability by using the married filing jointly tax rate schedule to determine the tax on their joint income than they would have owed (in total) if each spouse had used the single tax rate schedule to compute the tax on their individual incomes. Exhibit 8-1 explores the marriage penalty in a scenario in which both spouses earn income and another in which only one spouse earns income. As the exhibit illustrates, the marriage penalty applies to couples with two wage earners with high incomes, but a marriage benefit applies to couples with single breadwinners. For couples with two wage earners with moderate to low incomes, there is typically not a marriage penalty.
Exceptions to the Basic Tax Computation
In certain circumstances, taxpayers cannot completely determine their final tax liability from their tax rate schedule or tax table. Taxpayers must perform additional computations to determine their tax liability (1) when they recognize long-term capital gains or receive dividends that are taxed at preferential (lower) rates, (2) when they receive investment income subject to the net investment income tax, or (3) when the taxpayer is a child and the child’s unearned income is taxed using the trusts and estates tax rates. We describe these additional computations in detail below.
Answer: $27,715. Using the head of household tax rate schedule, her taxable income falls in the 24 percent marginal tax rate bracket, in between $82,500 and $157,500, so her tax is computed as follows:
Description Amount Explanation
(1) Base tax $ 12,698 From head of household tax rate schedule for taxpayer with taxable income in 24% bracket.
(2) Income taxed at 62,570 $145,070 – $82,500 from head of household tax
marginal tax rate rate schedule.
(3) Marginal tax rate 24% From head of household tax rate schedule.
(4) Tax on income at 15,017 (2) × (3) marginal tax rate
Tax on taxable income $27,715 (1) + (4), rounded
Example 8-2
As we determined in the Individual Deductions chapter, Gram files under the single filing status. In the Individual Deductions chapter we calculated her 2018 taxable income to be $1,990 (see Exhibit 6-13).
None of her income is taxed at a preferential rate. What is the tax on her taxable income using the tax rate schedules?
Answer: $199 ($1,990 × 10%)
1Exceptions to this requirement include taxpayers subject to the kiddie tax, with qualified dividends or capital gains, or claiming the foreign-earned income exclusion. You may view the tax tables in the instructions for Form 1040 located at www.irs.gov/.
Preferential Tax Rates for Capital Gains and Dividends As we described in detail in the Investments chapter, certain capital gains and certain dividends are taxed at a lower or preferential tax rate relative to other types of income. In gen- eral, the preferential tax rate is 0 percent, 15 percent, or 20 percent.2 The preferen- tial tax rates vary with the taxpayer’s taxable income. See Appendix D for the tax brackets by filing status that apply to preferentially taxed capital gains and divi- dends. Taxpayers with income subject to the preferential rate (long-term capital gains and qualified dividends) can use the following three-step process to determine their tax liability.
Step 1: Split taxable income into the portion that is subject to the preferential rate and the portion taxed at the ordinary rates.
Step 2: Compute the tax separately on each type of income. Note that the income that is not taxed at the preferential rate is taxed at the ordinary tax rates using the tax rate schedule for the taxpayer’s filing status.
Step 3: Add the tax on the income subject to the preferential tax rates and the tax on the income subject to the ordinary rates. This is the taxpayer’s regular tax liability.
EXHIBIT 8-1 2018 Marriage Penalty (Benefit): Two-Income vs. Single-Income Married Couple*
Tax If Filing Tax If Filing Marriage Penalty Taxable Jointly Single† (Benefit) Married Couple Income (1) (2) (1) − (2) Scenario 1: Two wage earners
Wife $350,000 $ 98,189.50
Husband 350,000 $ 98,189.50
Combined $700,000 $198,379 $196,379 $2,000 Scenario 2: One wage earner
Wife $700,000 $224,689.50
Husband 0 0
Combined $700,000 $198,379 $224,689.50 $(26,310.50)
*This analysis assumes the taxpayers do not owe any alternative minimum tax (discussed below).
†Married couples do not actually have the option of filing as single. If they choose not to file jointly they must file as married filing separately.
Courtney’s taxable income of $145,070 includes $700 of qualified dividends from GE (Example 5-8).
What is her tax liability on her taxable income?
Answer: $27,652, computed at head of household rates as follows:
Description Amount Explanation
(1) Taxable income $145,070 Exhibit 6-11
(2) Preferentially taxed income 700 Exhibit 5-4 (3) Income taxed at ordinary rates $144,370 (1) − (2)
Example 8-3
2As we discovered in the Investments chapter, some types of income may be taxed at a preferential rate of 28 percent or 25 percent. In addition, as we discuss later in this chapter, dividends and capital gains for higher income taxpayers are subject to the 3.8 percent net investment income tax.
3However, the income, gain, or loss attributable to invested working capital of a trade or business is subject to the net investment income tax. §1411(c)(3).
Description Amount Explanation
(4) Tax on income taxed at $ 27,546.80 [$12,698 +
ordinary rates ($144,370 − $82,500) × 24%]
(5) Tax on preferentially taxed income 105 (2) × 15% [Preferential tax rate for taxpayer filing head of household with income between $51,701 and $452,400]
Tax on taxable income $27,652 (4) + (5), rounded
In this example, what is Courtney’s tax savings from having the dividends taxed at the preferential rate rather than the ordinary rate?
Answer: $63. $700 × (24% – 15%). This is the amount of the dividend times the difference in the ordinary and preferential tax rates.
What if: Assume that Courtney’s taxable income is $462,400, including $15,000 of qualified dividends taxed at the preferential rate. What would be Courtney’s tax liability under these circumstances?
Answer: $133,638, computed using the head of household tax rate schedule as follows:
Description Amount Explanation
(1) Taxable income $ 462,400
(2) Preferentially taxed income 15,000
(3) Income taxed at ordinary rates 447,400 (1) – (2)
(4) Tax on income at ordinary tax rates $ 130,888 $44,298 + [($447,400 – $200,000)
× 35%] (See tax rate schedule for head of household.)
(5) Tax on preferentially taxed income 2,750 [($5,000 × 15%) + ($10,000 × 20%)]*
Tax $133,638 (4) + (5)
*Courtney had $15,000 of preferentially taxed income. $10,000 of her dividends fall in the 20 percent preferential tax bracket ($462,400 taxable income − $452,400 end of 20 percent preferential tax bracket; see preferential tax rate schedule for head of household). The remaining $5,000 is taxed at 15 percent (15 percent bracket for preferen- tially taxed income extends from $51,701 to $452,400 for head of household).
Net Investment Income Tax Higher-income taxpayers are required to pay a 3.8 percent tax on net investment income. For purposes of the net investment income tax, net investment income equals the sum of:
1. Gross income from interest, dividends, annuities, royalties, and rents (unless these items are derived in a trade or business to which the net investment income tax does not apply).
2. Income from a trade or business that is a passive activity or a trade or business of trading financial instruments or commodities.
3. Net gain from disposing of property (other than property held in a trade or business in which the net investment income tax does not apply).3
4. Less the allowable deductions that are allocable to items 1, 2, and 3.
Tax-exempt interest, veterans’ benefits, excluded gain from the sale of a principal resi- dence, distributions from qualified retirement plans, and any amounts subject to self- employment tax are not subject to the net investment income tax.
The tax imposed is 3.8 percent of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over $250,000 for married joint filers and sur- viving spouses, $125,000 for married separate filers, and $200,000 for other taxpayers.
Modified adjusted gross income equals adjusted gross income increased by income ex- cluded under the foreign-earned income exclusion less any disallowed deductions associ- ated with the foreign-earned income exclusion.4
Courtney’s AGI (and modified AGI) is $187,000, and her investment income consists of $321 of taxable interest, $700 of dividends, and $5,000 of rental income. How much net investment income tax will Courtney owe?
Answer: $0. Because Courtney’s modified AGI ($187,000) is less than the $200,000 threshold for the net investment income tax for a taxpayer filing as head of household, she will not be subject to the tax.
What if: Assume that Courtney’s AGI (and modified AGI) is $225,000. How much net investment income tax will Courtney owe?
Answer: $229, calculated as follows:
Description Amount Explanation
(1) Net investment income $ 6,021 $321 interest + $700 dividends +
$5,000 rental income
(2) Modified AGI 225,000
(3) Modified AGI threshold 200,000
(4) Excess modified AGI above threshold 25,000 (2) – (3)
(5) Net investment income tax base 6,021 Lesser of (1) or (4) Net investment income tax $ 229 (5) × 3.8%
Example 8-4
Kiddie Tax Parents can reduce their family’s income tax bill by shifting income that would otherwise be taxed at their higher tax rates to their children whose income is taxed at lower rates. However, as we described in the Gross Income and Exclusions chapter, under the assignment of income doctrine, taxpayers cannot simply assign or transfer income to other parties. Earned income, or income from services or labor, is taxed to the person who earns it. Thus, it’s difficult for a parent to shift earned income to a child. However, unearned income or income from property such as dividends from stocks or interest from bonds is taxed to the owner of the property. Thus, a parent can shift unearned income to a child by transferring actual ownership of the income- producing property to the child. By transferring ownership, the parent runs the risk that the child will sell the asset or use it in a way unintended by the parent. However, this risk is relatively small for parents transferring property ownership to younger children.
The tax laws reduce parents’ ability to shift unearned income to children through the so-called kiddie tax. The kiddie tax provisions apply (or potentially apply) to a child if (1) the child is under 18 years old at year-end, (2) the child is 18 at year-end but her earned income does not exceed half of her support, or (3) the child is over age 18 but under age 24 at year-end and is a full-time student during the year, and her earned income does not exceed half of her support (excluding scholarships).5 The kid- die tax does not apply to a married child filing a joint tax return or to a child without living parents. In general terms, if the kiddie tax applies, children must pay tax on a
4Taxpayers compute the net investment income tax using Form 8960.
5§1(g)(2)(A).
certain amount of their net unearned income (discussed below) at tax rates that apply to trusts and estates (see Appendix D) rather than at their own marginal tax rate.6
The kiddie tax base is the child’s net unearned income. Net unearned income is the lesser of (1) the child’s gross unearned income minus $2,1007 or (2) the child’s taxable income (the child is not taxed on more than her taxable income).8 Consequently, the kid- die tax does not apply unless the child has unearned income in excess of $2,100. Thus the kiddie tax limits, but does not eliminate, the tax benefit gained by a family unit when parents transfer income-producing assets to children.
6§1(g). Both the ordinary tax rates and preferential tax rates for trusts and estates apply to taxpayers subject to the kiddie tax. Consequently, for preferentially taxed capital gains and dividends, the 0 percent rate applies to taxable income between $0 and $2,600, the 15 percent rate applies to taxable income between
$2,601 and $12,700, and the 20 percent rate applies to taxable income over $12,700.
7The $2,100 consists of $1,050 of the child’s standard deduction (even if the child is entitled to a larger stan- dard deduction) plus an extra $1,050. See the Individual Deductions chapter for a discussion of the standard deduction for the dependent of another taxpayer. If the child itemizes deductions, then the calculation becomes more complex and is beyond the scope of this text.
8§1(g)(4).
THE KEY FACTS Tax Rates
• Regular tax rates
• Schedule depends on filing status.
• Progressive tax rate schedules with tax rates ranging from 10 percent to 37 percent.
• Marriage penalty (benefit) occurs because dual-earning spouses pay more (less) com- bined tax than if they each filed single.
• Preferential tax rates
• Net long-term capital gains and qualified dividends generally taxed at 0 percent, 15 percent, or 20 percent.
• Net investment income tax
• 3.8 percent tax on lesser of (a) net investment income or (b) excess of modified AGI over applicable threshold based on filing status.
• Kiddie tax
• Unearned income in excess of $2,100 is taxed at trust and estate tax rates if child is (1) under age 18, (2) 18 but earned income does not exceed one-half of support, or (3) over 18 and under 24, full-time student, and earned in- come does not exceed one-half of support.
What if: Suppose that during 2018, Deron received $5,100 in interest from the IBM bond, and he received another $2,200 in interest income from a money market account that his parents have been contributing to over the years. Is Deron potentially subject to the kiddie tax?
Answer: Yes, Deron is younger than 18 years old at the end of the year and his net unearned income exceeds $2,100.
What is Deron’s taxable income and corresponding tax liability?
Answer: $6,250 taxable income and $996 tax liability, calculated as follows:
Description Amount Explanation
(1) Gross income/AGI $ 7,300 $5,100 interest from IBM bond + $2,200 interest.
All unearned income.
(2) Standard deduction 1,050 Minimum for taxpayer claimed as a dependent on another return (no earned income, so must use minimum). See the Individual Deductions chapter.
(3) Taxable income $6,250 (1) – (2) (4) Gross unearned 5,200 (1) – 2,100
income minus $2,100
(5) Net unearned income $ 5,200 Lesser of (3) or (4)
(6) Kiddie tax $ 891 [{$255 + ([((5) – $2,550) × 24%])}], see trust and estate tax rate schedule in Appendix D.
(7) Taxable income taxed 1,050 (3) – (5) at Deron’s rate
(8) Tax on taxable income $ 105 (7) × 10% (See single filing status, $1,050 taxable using Deron’s tax rates income.)
Deron’s total tax liability $ 996 (6) + (8)
(continued on page 8-8)
Example 8-5
What if: Assume Deron’s only source of income is qualified dividends of $5,200 (unearned income).
What is his taxable income and tax liability?
Answer: Taxable income is $4,150; tax liability is $75, computed as follows:
Description Amount Explanation
(1) Gross income/(AGI) $ 5,200 Qualified dividends, all unearned income.
(2) Minimum standard 1,050 Minimum for taxpayer claimed as a dependent deduction on another return (all unearned income, so must use minimum). See the Individual Deductions chapter.
(3) Taxable income $4,150 (1) – (2) (4) Gross unearned income 3,100 (1) – $2,100 minus $2,100
(5) Net unearned income $ 3,100 Lesser of (3) or (4)
(6) Kiddie tax $ 75 [($2,600 × 0%) + ((5) – $2,600) × 15%)], see trust and estate tax rate schedule for preferentially taxed dividends.
(7) Taxable income taxed at 1,050 (3) – (5) Deron’s rate
(8) Tax on taxable income $ 0 (8) × 0%, see single tax rate schedule for using Deron’s tax rates preferentially taxed dividends.
Deron’s total tax liability $ 75 (6) + (8)
As we’ve just described, all individual taxpayers must pay federal income taxes on their federal taxable income. However, taxpayers may be liable for other federal taxes in addition to the regular tax liability. Many taxpayers are also required to pay the alterna- tive minimum tax, and some working taxpayers are required to pay employment or self- employment taxes. We delve into these additional taxes below.