Federal Income Tax: Basic Tax Formula
Students: Make sure you have the basic tax formula memorized by this point! You’ll now learn more details on each individual section.
Individuals: Understanding exclusions, adjustments, and a standard vs itemized deduction can be immensely helpful when completing for your current taxes and future planning.
Advisors/Professionals: Many of our recommendations to clients impact items in the basic tax formula. It is critical to understand how!
Basic Tax Formula
Gross income (not counting “exclusions”)
Subtract “Adjustments”
Equals “Adjusted Gross Income” or “AGI”
Subtract EITHER a “standard deduction” or “itemized deductions”
Equals your “taxable income”
Apply against your tax brackets for your filing status. This provides you with your “tax liability”
Finally, subtract any CREDITS you are eligible to receive
Getting to Gross income… What are “exclusions?”
Some things aren’t counted in gross income? Why? The government believes these items to not be necessary to tax for various reasons…
1) They could’ve already been taxed (gifts, alimony (after 2019))
2) They are to provide basic welfare/care (child support, social security benefits (within lower income limits), forgiven debt income, etc…)
3) They are to indemnify (or make one “whole” from a loss - injury/sickness, death benefit, etc…)
4) They are providing minor benefit (to a group) to not deal with tracking taxation (employee fringe benefits)
5) They are encouraging socially desirable behavior (adoption, foster care, higher education, etc…)
Here is a list of the more popular exclusions (but not exhaustive). For the full list you can view the IRC code26 part 3 section 101-140 (for the CFP test you don’t need to know the section #s though you should be able to identify the main exclusions!)
Certain Death Benefits (Section 101)
Gifts and Inheritances (Section 102)
State/Local Bond Interest (Section 103)
Injury /Sickness Compensation (Section 104)
Amounts Received (and Employer Contributions) under Accident and Health Plans (Sections 105-106)
Certain Forgiven Debt Income (Section 108)
Qualified Scholarships (Section 117)
Gain from Sale of Principal Residence (Section 121) - more on this in a future section - applies to most personal home sales…
Employer-provided Educational Assistance (Section 127) and Dependent Care (Section 129) Programs
Certain Foster Care Payments (Section 131)
Certain Employer-provided Fringe Benefits (Section 132)
Certain Military Benefits (Section 134)
US Bond Income used to pay Higher Education Tuition (Section 135)
Adoption Assistance Programs (Section 137)
Not much on the web or YouTube on exclusions.
“Adjusting” your Gross income (adjustments or “above-the-line deductions”)
There are a number of adjustments that can reduce your gross income. Adjustments are also called “above-the-line deductions” as we consider one’s AGI to be “the line".”
List of the more popular adjustments (matches the schedule 1)
Student Loan Interest deduction (limits apply)
Self-employed health insurance deduction
Alimony paid (if divorce prior to 1/1/19 - rules changed after)
Educator/Biz expenses not reimbursed or captured on a schedule C.
Traditional IRA contributions (income limitations apply)
Self-employed retirement contributions
Health Savings Account (H.S.A) contributions
Keep in mind there are many other deductions that may have come off prior (already adjusted in your “gross income” number)…
If you own a business your expenses come out on the SCHEDULE C and you are only reporting net business income.
If you are employed and have group health insurance and/or a workplace retirement plan (401k/403b), your employee premiums/contributions are “adjusted” out before receiving your W2 (end of year tax slip) so your reported income is lower.
This is why when you get your W2 at the end of the year you’ll notice your “taxable income” is different for federal/state then mMedicare/social security (which is also different from your actual pay received throughout the year).
If you have investment real estate your expenses are come out on the SCHEDULE E (similar to business income on a Schedule C or farm income on a Schedule F)
We’ve arrived at your AGI!! (adjusted gross income)
Why is AGI such an important number? (or actually “MAGI” - see below)
There are a lot of other important items that are BASED on your AGI/MAGI:
One of the factors in if (and how much) one can contribute to a Roth IRA.
One of the factors in determining if a traditional IRA contribution is deductible (or not).
Sets maximum deduction limits on charitable giving deductions (excess can carryforward)
Determines if you receive full/partial tax credits including child tax credit, education credits, and many other credits.
For relief items (such as stimulus payments in 2020), your AGI determined if you were eligible for a full/partial payment.
Student loan interest deduction
Sets floor on allowable medical expense deductions (as itemized deductions)
Banks often use your AGI as your “income” for loan applications and amount of debt a household should be able to handle.
NOTE: There is also “MAGI” (Modified AGI) which is similar to AGI but a few deductions/exclusions are NOT permitted. Many of the items listed above are actually calculated against MAGI (not AGI) but for the majority of taxpayers these numbers are the same (or very close). MAGI doesn’t appear on your form 1040 (tax return - it is more of an internal calculation).
For MAGI take your AGI and
Add back IRA deduction
Add back Student Loan Interest deduction
Add back 1/2 self employment tax
Add back tax exempt interest (state muni bond interest and EE bonds that were used “tax-free” for higher education)
Add back social security benefits that were received tax-free
(There are a few others but the above ones are the main ones)
Interesting that looking at multiple “first page” sources on the web (when googling) came up with a lot of discrepancies on what is/isn’t included in MAGI.
Students: For the CFP - you need to know MAGI (and be able to calculate) BUT the CFP doesn’t test on which of these items is calculated against AGI or MAGI (they tell you which one it is)
Typically the questions would have municipal bond interest to add back (in a multi-step problem they’d mention calculating answer against MAGI, then list AGI but somewhere in the problem mention muni bond interest - you’d have to remember that this is added back to AGI for MAGI and calculate accordingly)
Next we reduce your AGI by either a standard or itemized deduction.
As of 2018, you now can either take a (larger) standard deduction or itemize your “below-the-line” deductions. Now about 90% of tax payers take the standard deduction while only 10% itemize deductions.
You get to take the larger of either one! (to your benefit)
Prior to the Tax Cuts and Jobs ACT (TCJA - the 2017 tax reform) we had smaller standard deductions but then had “personal and dependency exemptions” and there were additional allowable itemized deductions. See IRS newsroom article on the changes. In the old system, about 70% of tax payers would claim standard deduction and 30% would itemize.
Standard Deduction - based on your filing status
Amounts are indexed every year (CFP students - make sure you have the correct tables for the year your exam is testing)
For 2021:
Single - $12,560
Head of Household - $18,800
Married Filing Jointly - $25,100 (double the single)
If you are over 65 and/or blind there is an “additional standard deduction” for each person
For 2021:
Single - $1,700
HoH - $1,700
MFJ - $1,350
Note: if you are older than 65 and blind you get the additional deduction x2 (common CFP test problem)
Note: the additional standard deduction applies to each person - so for a married couple where both are over 65 you’d add two additional standard deduction amounts. If only one spouse is over 65, you’d only add one.
Itemized Deductions
IRS Schedule A (Itemized Deductions) - check out the tax form to see exactly what this looks like!
There are a number of itemized deductions but the BIG THREE are:
Mortgage Interest (limits apply)
State and Local Taxes (SALT) - now limited to $10,000 per tax return (mainly state income tax and local property tax)
Prior to 2018, there wasn’t a limit on SALT taxes (a lot of higher income earners itemized)
Charitable Giving (limits apply)
There are a couple more that aren’t common but do come up: (and you’ll need to know for the CFP test)
Medical Expenses - only amounts in excess of 7.5% of your AGI
So if AGI is $100,000 and you have $9,000 in medical expenses (not including insurance premiums), you’d be able to deduct $1,500 (amount over 7.5% if AGI).
Outside of extreme cases (high medical expenses), most of the time the AGI floor keeps people from claiming and they’d take a standard deduction over itemizing anyways…
Investment Interest expense - under the new TCJA rules - this is mainly limited to leveraged loan expense (margin borrowing cost)
Here is a more comprehensive list of itemized deductions from the doughroller.net
Bottom line: typically unless you have a house with a big mortgage and/or are charitably inclined - your itemized deductions likely aren’t bigger than the standard deduction offered. DO NOTE - these itemized deductions may still be used on your state taxes (most states that have income tax don’t have large standard deductions) - but this isn’t relevant to your federal taxes (or on the CFP test)
Credits (more info to come soon on credits)
Credits reduce your tax liability dollar-for-dollar.
TurboTax Article on the 5 biggest credits on might qualify for (not counting the child tax credit)
Child Tax Credit
Education Credit for College
AOTC vs Lifetime Learning Credit