Ch2. Individual Income Tax — Comprehensive Tax Structure and Computation

Individual Income Tax Overview

Individual income tax characteristics:
- Taxpayer: Individual person
- Assessment unit: Each individual separately
  (married couples may file jointly or separately)
- Tax rate: Progressive (graduated rates, higher income = higher rate)
- Annual filing: Form 1040 due April 15

Types of federal individual income tax:
① Ordinary income tax: Six categories of income taxed at graduated rates
② Capital gains tax: Preferential rates for long-term capital assets
③ Self-employment tax: Social Security + Medicare on business income

The Six Categories of Gross Income

Wages, salaries, tips (IRC § 61(a)(1)):
- W-2 income from employment
- Bonuses, commissions, stock compensation
- Reported on Form W-2 by employer

Interest income:
- Bank and savings account interest
- Bond interest (corporate, Treasury)
- $1,500+ reported to IRS by financial institutions on Form 1099-INT

Dividend income:
- Ordinary dividends: taxed at ordinary income rates
- Qualified dividends: taxed at 0%/15%/20% preferential rates
- Reported on Form 1099-DIV

Business / self-employment income:
- Schedule C: Sole proprietors and single-member LLCs
- Schedule E (partnership/S-corp K-1): Pass-through entities
- Subject to self-employment tax (15.3%) on net earnings

Retirement / pension income:
- IRA distributions (Traditional = taxable; Roth = generally not)
- 401(k)/403(b) distributions: taxable as ordinary income
- Social Security: Up to 85% may be taxable based on combined income

Other income:
- Rental income (Schedule E)
- Alimony (pre-2019 divorce decrees only)
- Gambling winnings, prizes, awards
- Cancellation of debt income
- Other income (Form 1099-MISC / 1099-NEC)

Computing Taxable Income

Gross Income (all income from whatever source derived — IRC § 61)
  − Adjustments to Income (above-the-line deductions — IRC § 62)
= Adjusted Gross Income (AGI)
  − Standard Deduction (or Itemized Deductions — Schedule A)
  − Qualified Business Income (QBI) Deduction (§ 199A, up to 20%)
= Taxable Income
  × Tax Rate
= Tentative Tax
  − Tax Credits (nonrefundable and refundable)
= Tax Liability
  − Withholding and Estimated Payments
= Amount Due (or Refund)

Above-the-Line Deductions (Adjustments to Income)

Common adjustments to income:
① Educator expense deduction (up to $300)
② Health Savings Account (HSA) contributions (Form 8889)
③ IRA deduction (up to $7,000; $8,000 if 50+)
④ Student loan interest (up to $2,500)
⑤ Self-employment tax deduction (50% of SE tax)
⑥ Self-employed health insurance
⑦ Alimony paid (pre-2019 divorce decrees)

2024 Federal Income Tax Rate Schedule

Single Filer:
Taxable Income        Rate    Tax on Bracket
$0 – $11,600          10%     $1,160
$11,601 – $47,150     12%     $4,266
$47,151 – $100,525    22%     $11,745
$100,526 – $191,950   24%     $21,948
$191,951 – $243,725   32%     $16,569
$243,726 – $609,350   35%     $127,975
Over $609,350         37%     ——

Tax calculation method:
Taxable income × marginal rate − bracket offset

Example: Taxable income $60,000 (single):
$1,160 (10%) + $4,266 (12%) + ($60,000 − $47,150) × 22%
= $1,160 + $4,266 + $2,827 = $8,253

Tax Credits

Non-refundable credits (reduce tax to zero, but not below):
Child Tax Credit ($2,000/child):
- Partially refundable: up to $1,700 refundable per child

Education credits:
- American Opportunity Tax Credit (AOTC): up to $2,500
  (40% refundable — up to $1,000 refunded)
- Lifetime Learning Credit: up to $2,000 (non-refundable)

Retirement Savings Contributions Credit (Saver's Credit):
10%–50% of contributions to 401(k), IRA (income-limited)

Refundable credits (can create a refund even if no tax owed):
Earned Income Tax Credit (EITC):
- Up to $7,830 (3+ qualifying children, 2024)
- Fully refundable

Additional Child Tax Credit (ACTC):
- Up to $1,700 per child (refundable portion of CTC)

Premium Tax Credit:
- Subsidizes health insurance purchased through ACA marketplace

Six categories of gross income ★★★★★ : Wages/salary, interest, dividends, business, retirement, other. Plus rental and capital gains. Memory tip: W-I-D-B-R-O → Wages, Interest, Dividends, Business, Retirement, Other

AGI computation order ★★★★★ : Gross income → above-the-line deductions → AGI → standard/itemized deduction → taxable income → rate → credits → tax due. Memory tip: Always remember that AGI is the key “gateway” number — many phase-outs and credit limits use AGI

Interest + dividends threshold ★★★★☆ : Ordinary dividends taxed at ordinary rates; qualified dividends at 0%/15%/20%. Interest always at ordinary rates (14% flat withholding not applicable in US like it is elsewhere). Memory tip: Qualified dividends = preferential rate; interest = ordinary rate always

Practice Quiz

Q. If taxable income is $50,000 (single filer, 2024), what is the federal income tax?

$1,160 (10% on first$ 11,600) + $4,266 (12% on$ 11,601– $47,150) + ($ 50,000 − $47,150) × 22% =$ 1,160 + $4,266 +$ 627 = $6,053.

Q. Why are capital gains taxed separately from ordinary income?

Capital gains arise from appreciation over potentially many years. If lumped into ordinary income and taxed in the year of sale, the one-year tax hit at high marginal rates would be disproportionate relative to the long holding period. Preferential long-term rates recognize this multi-year nature and encourage long-term investment.