Article Highlights:
- Filing status.
- Adjusted gross income (AGI).
- Taxable income.
- Marginal tax rate.
- Alternative minimum tax (AMT).
- Tax Credits.
- Underpayment of estimated tax penalty.
When discussing taxes, reading tax related articles or instructions one needs to understand the basic lingo and acronyms used by tax professionals and authors to be able to grasp what they are saying. It can be difficult to understand tax strategies if you are not familiar with the basic terminologies used in taxation. The following provides you with the basic details associated with the most frequently encountered tax terms.
Inflation Adjustments – The standard deductions, tax rates, amounts that can be contributed to retirement plans, virtually all amounts claimed as deductions and credits are annually adjusted for cost-of-living changes from the prior year or other base year as required by the tax code. Thus, when determining an amount, care should be taken to determine the year-specific amount. The numbers used in this article are for the year 2021.
- Filing Status - Generally, if you are married at the end of the tax year, you have three possible filing status options: married filing jointly, married filing separately, or, if you qualify, head of household. If you were unmarried at the end of the year, you would file as single, unless you qualify for the more beneficial head of household status. A special status applies for some widows and widowers.
Head of household is the most complicated filing status to qualify for and is frequently overlooked as well as incorrectly claimed. Generally, the taxpayer must be unmarried AND:
o pay more than one half of the cost of maintaining his or her home, a household that was the principal place of abode for more than one half of the year of a qualifying child or certain dependent relatives, or
o pay more than half the cost of maintaining a separate household that was the main home for a dependent parent for the entire year.
A married taxpayer may be considered unmarried for the purpose of qualifying for head of household status if the spouses were separated for at least the last six months of the year, provided the taxpayer wanting to qualify for the head of household status maintained a home for a dependent child for over half the year.
Surviving spouse (also referred to as qualifying widow or widower) is a rarely used status for a taxpayer whose spouse died in one of the prior two years and who has a dependent child at home. The main benefit of this status is that the widow(er) can use the more favorable married joint tax rates rather than the head of household or single rates. In the year the spouse passed away, the surviving spouse may file jointly with the deceased spouse if not remarried by the end of the year. In rare circumstances, for the year of a spouse’s death, the executor of the decedent’s estate may determine that it is better to use the married separate status on the decedent’s final return, which would then also require the surviving spouse to use the married separate status for that year.
If a taxpayer is married to a non-resident alien, the taxpayer has two options: file as married separate reporting only their income, deductions and credits or elect to file a joint return with the spouse including the world-wide income of both of them on a joint return.
- Adjusted Gross Income (AGI) - AGI is the acronym for adjusted gross income. AGI is generally the sum of a taxpayer’s income less specific subtractions called adjustments (but before certain below-the-line deductions and the standard or itemized deductions). The most common adjustments are penalties paid for early withdrawal from a savings account, and deductions for contributing to a traditional IRA or self-employment retirement plan. Many tax benefits and allowances, such as credits, certain adjustments, and some deductions are limited by the amount of a taxpayer’s AGI.
- Modified AGI (MAGI) - Modified AGI is AGI (described above) adjusted (generally up) by tax-exempt and tax-excludable income. MAGI is a significant term when income thresholds apply to limit various deductions, adjustments, and credits. The definition of MAGI will vary depending on the item that is being limited.
- Taxable Income - Taxable income is AGI less deductions (either standard or itemized). Your taxable income is what your regular tax is based upon using a tax rate schedule specific to your filing status. The IRS publishes tax tables that are based on the tax rate schedules and that simplify the tax calculation, but the tables can only be used to look up the tax on taxable income up to $99,999. The tables for 2021 have not been released yet, but those for 2020 can be found in the 1040 instructions beginning on page 66.
- Marginal Tax Rate (Tax Bracket) - Not all of your income is taxed at the same rate. The amount equal to your standard or itemized deductions is not taxed at all. The next increment is taxed at 10%, then 12%, 22%, etc., until you reach the maximum tax rate, which is currently 37%. When you hear people discussing tax brackets, they are referring to the marginal tax rate. Knowing your marginal rate is important because any increase or decrease in your taxable income will affect your tax at the marginal rate. For example, suppose your marginal rate is 24% and you are able to reduce your income $1,000 by contributing to a deductible retirement plan. You would save $240 in federal tax ($1,000 x 24%). Your marginal tax bracket depends upon your filing status and taxable income. You can find your marginal tax rate for 2021 by using the table below.
TABLE #1 - Married Individuals Filing Joint Returns and Surviving Spouses
| If Taxable Income Is: | Tax is: | |||||
| Not Over | $19,900 | - | - | - | 10% of T.I. | - |
| Over | $19,900 | but not over | 81,050 | $1,990 | Plus 12% of excess over | $19,990 |
| Over | $81,050 | but not over | $172,750 | $9,328 | Plus 22% of excess over | $81,050 |
| Over | $172,750 | but not over | $329,850 | $29,502 | Plus 24% of excess over | $172,750 |
| Over | $329,850 | but not over | $418,850 | $67,206 | Plus 32% of excess over | $329,850 |
| Over | $418,850 | but not over | $628,300 | $95,686 | Plus 35% of excess over | $418,850 |
| Over | $628,300 | - | - | $168,993.50 | Plus 35% of excess over | $628,300 |
TABLE #2 – Heads of Household
| If Taxable Income Is: | Tax is: | |||||
| Not Over | $14,200 | - | - | - | 10% of T.I. | - |
| Over | $14,200 | but not over | $54,200 | $1,420 | Plus 12% of excess over | $14,200 |
| Over | $54,200 | but not over | $86,350 | $6,220 | Plus 22% of excess over | $54,200 |
| Over | $86,350 | but not over | $164,900 | $13,293 | Plus 24% of excess over | $86,350 |
| Over | $164,900 | but not over | $209,400 | $32,145 | Plus 32% of excess over | $164,900 |
| Over | $209,400 | but not over | $523,600 | $46,385 | Plus 35% of excess over | $209,400 |
| Over | $523,600 | - | - | $156,355.00 | Plus 37% of excess over | $523,600 |
TABLE #3 – Single
| If Taxable Income Is: | Tax is: | |||||
| Not Over | $9,950 | - | - | - | 10% of T.I. | - |
| Over | $9,950 | but not over | $40,525 | $995 | Plus 12% of excess over | $9,950 |
| Over | $40,525 | but not over | $86,375 | $4,664 | Plus 22% of excess over | $40,525 |
| Over | $86,375 | but not over | $164,925 | 14,751 | Plus 24% of excess over | $86,375 |
| Over | $164,925 | but not over | $209,425 | $33,603 | Plus 32% of excess over | $164,925 |
| Over | $209,425 | but not over | $46,385 | $47,843 | Plus 35% of excess over | $209,400 |
| Over | $523,600 | - | $46,385 | $157,804.25 | Plus 37% of excess over | $523,600 |
TABLE #4 – Married Individual Filing Separate
| If Taxable Income Is: | Tax is: | |||||
| Not Over | $9,950 | - | - | - | 10% of T.I. | - |
| Over | $9,950 | but not over | $40,525 | $995 | Plus 12% of excess over | $9,950 |
| Over | $40,525 | but not over | $86,375 | $4,664 | Plus 22% of excess over | $40,525 |
| Over | $86,375 | but not over | $164,925 | 14,751 | Plus 24% of excess over | $86,375 |
| Over | $164,925 | but not over | $209,425 | $33,603 | Plus 32% of excess over | $164,925 |
| Over | $209,425 | but not over | $314,150 | $47,843 | Plus 35% of excess over | $209,425 |
| Over | $314,150 | - | - | $84,496.75 | Plus 37% of excess over | $314,150 |
- Taxpayer & Dependent Exemptions – In the past, taxpayers were able to qualify for an exemption amount for the filer, spouse if filing jointly and each dependent, which was also subtracted from AGI to determine taxable income. However, beginning in 2018 and through 2025 the deduction for the exemption amounts has been suspended and replaced with a higher standard deduction and child tax credit.
- Qualified Child - A qualified child is one who meets the following tests:
(1) Has the same principal place of abode as the taxpayer for more than half of the tax year except for temporary absences;
(2) Is the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual;
(3) Is younger than the taxpayer;
(4) Did not provide over half of his or her own support for the tax year;
(5) Is under age 19, or under age 24 in the case of a full-time student, or is permanently and totally disabled (at any age); and
(6) Was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund).
- Dependents - Even though there’s currently no deduction for dependent exemptions, there are still some significant tax benefits for taxpayers who are able to claim a dependent. To qualify as a dependent, an individual must be the taxpayer’s qualified child or pass all five of the following dependency qualifications: the (1) member of the household or relationship test, (2) gross income test, (3) joint return test, (4) citizenship or residency test, and (5) support test. The gross income test limits the amount an individual can make and still qualify as a dependent if he or she is over 18 and does not qualify for an exception for certain full-time students. The support test generally requires that you pay over half of the dependent’s support, although there are special rules for divorced parents and situations where several individuals together provide over half of the support.
- Qualified Child - A qualified child is one who meets the following tests:
(1) Has the same principal place of abode as the taxpayer for more than half of the tax year except for temporary absences;
(2) Is the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual;
(3) Is younger than the taxpayer;
(4) Did not provide over half of his or her own support for the tax year;
(5) Is under age 19, or under age 24 in the case of a full-time student, or is permanently and totally disabled (at any age); and
(6) Was unmarried (or if married, either did not file a joint return or filed jointly only as a claim for refund).
- Deductions - A taxpayer generally can choose to itemize deductions or use the standard deduction. The standard deductions is illustrated below.
| Filing Status | Standard Deduction |
|---|---|
| Single | 12,550 |
| Head of Household | 18,800 |
| Married Filing Jointly | 25,100 |
| Married Filing Separately | 12,550 |
The standard deduction is increased by multiples of $1,700 for unmarried taxpayers who are over age 64 and/or blind. For married taxpayers, the additional amount is $1,350. The extra standard deduction amount is not allowed for elderly or blind dependents. Those with large deductible expenses can itemize their deductions in lieu of claiming the standard deduction. The standard deduction of a dependent filing his or her own return will oftentimes be less than the single amount shown above.
For 2021 only, taxpayers claiming the standard deduction are also allowed to deduct from their AGI up to $300 ($600 for joint filers) of cash contributions made to qualified charitable organizations. Normally, charitable contributions are deductible only when itemizing the deductions described next.
Itemized deductions generally include:
(1) Medical expenses, limited to those that exceed 7.5% of your AGI.
(2) Taxes consisting primarily of real property taxes, state income (or sales) tax, and personal property taxes, but limited to a total of $10,000 for the year.
(3) Interest on qualified home acquisition debt and investments; the latter is limited to net investment income (i.e., the deductible interest cannot exceed your investment income after deducting investment expenses).
(4) Charitable contributions, generally limited to 60% of your AGI, but in certain circumstances the limit can be as little as 20% or 30% of AGI. For 2020 and 2021 the limit was increased to 100% of AGI for cash contributions.
(5) Gambling losses to the extent of gambling income, and certain other rarely encountered deductions.
- Alternative Minimum Tax (AMT) - The AMT is another way of being taxed that has often taken taxpayers by surprise. Even though the AMT was originally intended to ensure that wealthier taxpayers with large write-offs and tax-sheltered investments pay at least a minimum amount of tax, it sometimes snares lower income taxpayers. Your tax must be computed by the regular method and also by the alternative method. The tax that is higher must be paid. The following are some of the more frequently encountered factors and differences that contribute to making the AMT greater than the regular tax.
o The standard deduction is not allowed for the AMT, and a person subject to the AMT cannot
itemize for AMT purposes unless he or she also itemizes for regular tax purposes. Therefore, it is
important to make every effort to itemize if subject to the AMT.
o Itemized deductions:
- Taxes are not allowed at all for the AMT.
- Interest paid for loans to purchase non-conventional homes such as motor homes and boats is not allowed as an AMT deduction but is deductible for regular tax. For years 2018–2025, interest paid on home equity debt is also not allowed for either AMT regular tax purposes.
o Nontaxable interest from private activity bonds is tax free for regular tax purposes, but some is taxable for the AMT.
o Statutory stock options (incentive stock options) when exercised produce no income for regular tax purposes. However, the bargain element (difference between grant price and exercise price) is income for AMT purposes in the year the option is exercised.
o Depletion allowance in excess of a taxpayer’s basis in the property is not allowed for AMT purposes.
A certain amount of income is exempt from the AMT, but the AMT exemptions are phased out for higher-income taxpayers.
AMT EXEMPTIONS & PHASE OUT
| Filing Status | Exemption Amount | Where Exemption Is Totally Phased Out |
|---|---|---|
| Married Filing Jointly | $114,600 | $1,505,600 |
| Married Filing Separate | $57,300 | $752,800 |
| Unmarried | $73,600 | $818,000 |
AMT TAX RATES
| AMT Taxable Income | Tax Rate |
|---|---|
| 0 – $199,900 (1) | 26% |
| Over $199,900 (1) | 28% |
(1) $99,950 for married taxpayers filing separately
Your tax will be whichever is the higher of the tax computed the regular way and by the Alternative Minimum Tax. Anticipating when the AMT will affect you is difficult, because it is usually the result of a combination of circumstances. In addition to those items listed above, watch out for transactions involving limited partnerships, depreciation, and business tax credits only allowed against the regular tax. All of these can strongly impact your bottom-line tax and raise a question of possible AMT. Fortunately, due to tax reform that increased the AMT exemption amounts and the phaseout thresholds, fewer taxpayers are paying AMT. Tax Tip: If you were subject to the AMT in the prior year, you itemized your deductions on your federal return for the prior year, and had a state tax refund for that year, part or all of your state income tax refund from that year may not be taxable in the regular tax computation. To the extent that you received no tax benefit from the state tax deduction because of the AMT, that portion of the refund is not included in the subsequent year’s income.
- Tax Credits - Once your tax is computed, tax credits can reduce the tax further. Credits reduce your tax dollar for dollar and are divided into two categories: those that are nonrefundable and can only offset the tax, and those that are refundable. In addition, some credits are not deductible against the AMT, and some credits, when not fully used in a specific tax year, can carry over to succeeding years. Although most credits are a result of some action taken by the taxpayer, there are some commonly encountered credits that are based simply on the number or type of your dependents or your income. These and another popular credit are outlined below.
o Child Tax Credit - Thanks to the American Rescue Plan Act, the child tax credit for one year only (2021) has been increased to $3,000 for a child under age 18 ($3,600 if under age 6), up from $2,000 in 2020. Unlike other years, the credit is fully refundable and there is no requirement for the taxpayer to have earned income.
The credit has two phaseouts for higher income taxpayers. Phaseout is $50 for each $1,000 of MAGI above the thresholds. The threshold phases out the increase in child credit for 2021 over $2,000 per child. The first phaseout threshold is $150,000 for married filing joint filers, $112,500 for those filing as head of household and $75,000 for others. The second phaseout applies to the $2,000 portion of the credit with thresholds of $400,000 for married filing taxpayers and $200,000 for others.
Congress mandated that the IRS estimate this credit for taxpayers based upon their 2020 returns and pay half of the estimated credit in monthly installments beginning July 2021. Taxpayers will need to reconcile the advance payments with the actual credit determined when they complete their 2021 return; repayment of excess advance amounts may be required depending on AGI.
o Dependent Credit – A nonrefundable credit is also available to taxpayers with a dependent who isn’t a qualifying child. The $500 dependent credit is not refundable and subject to the second phaseout discussed above for child tax credits.
o Earned Income Credit - This is a refundable credit for a low-income taxpayer with income from working either as an employee or a self-employed individual. The credit is based on earned income, the taxpayer’s AGI, and the number of qualifying children. A taxpayer who has investment income such as interest and dividends in excess of $10,000 is ineligible for this credit. The credit was established as an incentive for individuals to obtain employment. It increases with the amount of earned income until the maximum credit is achieved and then begins to phase out at higher incomes. The table below illustrates the phase-out ranges for the various combinations of filing status and earned income and the maximum credit available.
EIC PHASE-OUT RANGE
| Number of Children | Joint Return | Others | Maximum Credit |
|---|---|---|---|
| None | $17,560 – $27,380 | $11,610 – $21,430 | $1,502 |
| 1 | $25,470 – $48,108 | $19,520 – $42,158 | $3,618 |
| 2 | $24,470 – $53,865 | $19,520 – $47,915 | $5,980 |
| 3 | $25,470 – $57,414 | $19,520 – $51,464 | $6,728 |
o Residential Energy-Efficient Property Credit - This credit is generally for energy-producing systems that harness solar, wind, or geothermal energy, including solar-electric, solar water-heating, fuel-cell, small wind-energy, and geothermal heat-pump systems. These items currently qualify for a 26% credit with no annual credit limit. Unused residential energy-efficient property credit is generally carried over through 2022.The credit rate reduces to 22% in 2023 The credit expires after 2023.
- Withholding and Estimated Taxes - Our “pay-as-you-go” tax system requires that you make payments of your tax liability evenly throughout the year. If you don’t, it’s possible that you could owe an underpayment penalty. Some taxpayers meet the “pay-as-you-go” requirements by making quarterly estimated payments. However, when your income is primarily from wages, you usually meet the requirements through wage withholding and rely on your employer’s payroll department to take out the right amount of tax, based on the withholding allowances shown on the Form W-4 that you filed with your employer. To avoid potential underpayment penalties, you are required to deposit by payroll withholding or estimated tax payments an amount equal to the lesser of:
1) 90% of the current year’s tax liability; or
2) 100% of the prior year’s tax liability or, if your AGI exceeds $150,000 ($75,000 for taxpayers filing as married separate), 110% of the prior year’s tax liability.
If you had a significant change in income during the year, we can assist you in projecting your tax liability to maximize the tax benefit and delay paying as much tax as possible before the filing due date.
Please call if this office can be of assistance with your tax planning needs.
