Chapter 1: Overview

The very first section (§1) of the tax code imposes an income tax on the taxable income of all individuals.  The tax is based on multiple "brackets", which means that the income within each bracket is taxed at a different rate.

In 2017, there are 7 tax brackets:  10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.

The amount of income in each bracket is determined by whether you are a:

1. Married individual filing a joint return or surviving spouse,
2. Head of a household,
3. Any other unmarried individual, or
4. A married individual filing a separate return.

Let's break that down.  First of all, taxable income"is defined (§63) as your Adjusted Gross Income minus deductions and exemptions.  Everyone is entitled to a standard deduction, and everyone who is not a dependent is entitled to a personal exemption (§151) for themselves (and their spouse if married filing jointly) and each of their dependents.  Some taxpayers may arrive at a lower taxable income by using itemized deductions instead of the standard deduction.  In other words:

• Taxable Income = Adjusted Gross Income - Deductions - Exemptions

Secondly, Adjusted Gross Income is defined (§62) as Gross Income minus certain expenses, including but not limited to:  Business expenses, rental expenses, allowable capital losses, and specific deductions called "adjustments".

• Adjusted Gross Income = Gross Income - Certain expenses - Adjustments

And Gross Income is defined (§61) as "all income from whatever source derived."  There are certain items that are specifically excluded from Gross Income, which we will discuss in a later post.

Let's look at an example:

Mary and Joseph are a married couple. Mary and Joseph have income from their jobs of $60,000 each, and have 1 dependent. They will take the standard deduction. Their Gross Income is $120,000. They have no adjustments, so their Adjusted Gross Income is also $120,000. The standard deduction in 2017 is $12,700, and their personal and dependent exemptions are $4,050 each. Their Taxable Income is $95,150.

The first $18,650 of their taxable income is in the 10% bracket; the next $57,250 of their income is in the 15% bracket, and the last $19,250 is in the 25% bracket.

Their total tax is figured as follows:

$18,650 × 10% = $1,865.00
$57,250 × 15% = $8,587.50

$19,250 × 25% = $4,812.50

Total tax = $15,265.00

A couple of things to note:  Even though this couple is in the 25% bracket, this does not mean they pay 25% of their income in tax.  This couple's tax is only about 13.6% of their income.  Everybody has part of their income taxed at each lower bracket until the bracket is filled up and they move on to the next bracket.  Being in the 25% bracket means that each additional dollar is taxed at 25%, until they get to the next bracket.  Thus, there is no need to fear being "bumped up" into the next bracket by getting a raise, for example, because only the "new money" in the next bracket is taxed at the higher rate.

After determining your tax, you get to take certain nonrefundable credits.  These reduce your tax directly, dollar-for-dollar, but not below zero.  If the couple above had a nonrefundable child tax credit of $500, their tax liability for the year would be reduced to $14,765.  Think of nonrefundable credits as a discount on your taxes.  If you qualify for more nonrefundable credits than you have taxes to pay, the excess is wasted.  In some cases excess credits can be transferred to another tax year or converted to a refundable credit.

There are some additional taxes that may add on to your tax liability.  Examples are the self-employment tax and the 10% additional tax for early distribution of retirement contributions.

Finally, you have what you actually paid throughout the year.  This is normally through withholding, and shows up in Box 2 of your W-2s, but there might also be withholding on any 1099s you received.  In addition, you also get the benefit of refundable credits, which are treated as payments, and can result in a refund even if they exceed your tax liability.

Compare what you paid (including refundable credit) to what your actual liability is.  If you paid less than your liability, you owe the difference.  If you paid more than your liability, the difference comes back to you as your refund!

Changes for 2018

The basic concept is the same.  First, add up all of your income.  Subtract certain special deductions called "adjustments" to arrive at Adjusted Gross Income.  Then subtract deductions to arrive at your Taxable Income.  Apply the tax rates to your Taxable Income to arrive at your tax.  Reduce your tax by your nonrefundable credits and increase it by any special taxes that apply to your situation.  Compare your total tax to your total payment and see how much your refund or balance due is.

The five filing statuses are the same under the new law as the old law.

There are still 7 tax brackets, but the tax rates are:  10%, 12%, 22%, 24%, 32%, 35%, and 37%.  The break points between the first four brackets are about the same as they would have been under the 2017 law.  The break point for the 32% bracket (old 33% bracket) is substantially higher than under the 2017 law.  The break point for the 35% bracket is about the same as it was in 2017.  The break point for the top bracket (37%, old 39.6%) is substantially higher than it was in 2017.  This means that for all taxpayers, the tax on the same taxable income is lower in 2018 than it would have been in 2017.

But most taxpayers will not have the same taxable income under the new law that they would have under the old law.  The standard deduction has almost doubled, but personal and dependent exemptions have disappeared.

There is a new expanded child tax credit, which also encompasses dependents who are not qualifying children.

Let's look at Mary and Joseph's tax situation again.

Mary and Joseph are a married couple. Mary and Joseph have income from their jobs of $60,000 each, and have 1 dependent. They will take the standard deduction. Their Gross Income is $120,000. They have no adjustments, so their Adjusted Gross Income is also $120,000. The standard deduction in 2018 is $24,000. Their Taxable Income is $96,000.

The first $19,050 of their taxable income is in the 10% bracket; the next $58,350 of their income is in the 12% bracket, and the last $18,600 is in the 22% bracket.

Their total tax is figured as follows:

$19,050 × 10% = $1,905.00
$58,350 × 12% = $7,002.00

$18,600 × 22% = $4,092.00

Total tax = $12,999.00

They qualify for a child tax credit of $2,000, reducing their total tax liability to $10,999.  Compared to their 2017 tax (after credits) of $14,765, this couple has saved $3,766 in taxes under the new law.

Their refund will not necessarily be larger, because new withholding rates are going into effect in February 2018.  That $3,766 in tax savings will be spread out through the year in the form of larger take-home paychecks.

Most of the changes for individuals are expiring at the end of 2025, after which (unless Congress passes another tax bill) we will go back to the 2017 law.

There is a good online calculator that you can use to check your tax savings at http://taxplancalculator.com/calc.

Welcome to Tax School!

Like many of you, I am trying to understand what the recent changes in tax law mean for me and my clients.  The "Tax Cut and Jobs Act" (which was renamed to the uninspired and boring "An Act To provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.") is 185 pages long, and changes many fundamental aspects of our tax system.

For me, as a veteran tax preparer, the easiest way to digest the changes is to detail how the old tax system worked, and annotate what has changed.  I have taught a 48-hour tax school every Fall for the past seven years.  This first series of posts will parallel the tax school I teach, giving first the old tax law and describing the changes in the tax law.

The first thing to note is that most provisions of the TCJA are effective in 2018, so when you do your taxes this tax season, we are still using the old 2017 tax code.  So the information that I give for 2017 taxes is still relevant, and the changes I note will be relevant for planning ahead to tax year 2018.

Until the final bill was signed, I have purposely tried to remain "unspoiled" as to what's in the bill, because I know that there are always last minute changes in legislation, and I didn't want to mis-remember what was actually in the bill.

I hope you enjoy this journey as much as I will!