final copyright 2015 lgutef tax benefits limited by income...

© 2015 Land Grant University Tax Education Foundation, Inc. 1

TAX BENEFITS LIMITED BY INCOME

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Learning Objectives

After completing this session, participants will be able to perform the following job-related actions:

✔✔ Explain the effect of changes in adjusted gross income (AGI) on the IRA deduction, Roth IRA contribution limit, student loan interest deduction, and savings bond interest exclusion, as well as the effect of those items on the taxpayer’s marginal income tax rate

✔✔ Explain the effect of changes in AGI on below-the-line deductions and the AMT exemption; and the effect of those items on the taxpayer’s marginal income tax rate

✔✔ Explain the effect of changes in earned income and AGI on six credits: earned income credit, child tax credit, child and dependent care credit, retirement savings credit, American opportunity credit, and lifetime learning credit

Above-the-Line Deductions and Exclusions � � � � � � � � � � � � � 2

Below-the-Line Deductions and AMT Exemption � � � � � � � 12

Refundable and Nonrefundable Credits � � � � � 24

Introduction

Many benefits in the Internal Revenue Code apply only to filers whose income levels do not exceed a specified income level for the specified benefit. This chapter reviews some adjustments to gross income, deductions from AGI, and non-refundable and refundable credits that are not available to high-income taxpayers.

The effect of these benefits is pronounced. Figure 1.1 shows the IRS’s summary of indi-vidual income statistics for 2012 (the latest year available). The top 50% of taxpayers sorted by AGI paid 97.2% of 2012 individual income taxes, whereas those in the bottom 50% of income paid only 2.8%, with a 3.3% average tax rate. The dividing line between the top 50% and the bot-tom 50% was $36,055 of AGI.

In general, a tax practitioner’s major task with very low income clients is ensuring that the clients’ tax returns claim the credits and deduc-tions for which they qualify. The discussion that

FINAL COPYRIGHT 2015 LGUTEF

2 INTRODUCTION

Three items that factor into AGI are them-selves income-limited, so they must be calculated before AGI is determined. These are the deduc-tions for contributions to individual retirement arrangements (IRAs) and for student loan inter-est, plus the exclusion for certain interest paid on US savings bonds.

IRA Contributions

Anyone under age 70½ who has compensation may fund a traditional IRA, but whether the con-tribution is deductible depends on the taxpayer’s income and filing status. The contribution limit for 2015 is unchanged from 2014: the lesser of

ABOVE-THE-LINE DEDUCTIONS AND EXCLUSIONS Two deductions and one exclusion used to calculate AGI are also phased out by AGI�

The Internal Revenue Code defines the terms gross income and adjusted gross income (AGI). I.R.C. § 61 states that “Except as otherwise provided in this subtitle, gross income means all income from whatever source derived.” (I.R.C. §§ 101 through 140 provide the exclusions from gross income.)

To arrive at AGI, I.R.C. § 62 specifies 21 items that are deducted from gross income. These deductions are taken on page 1 of Form 1040, U.S. Individual Income Tax Return, or on the appropriate schedule that reports the related income.

Income-limited tax benefits often require a calculation of modified adjusted gross income (MAGI). There is no single definition of MAGI: It varies with each benefit and is included in the code section providing the benefit.

follows focuses on the qualifications for several benefits that are limited by a filer’s income.

Practitioners do not often see a need for tax planning for clients with low income, but for clients whose income is in the middle range, these benefits can sometimes be obtained by tax planning to minimize income and maximize deductions.

Affordable Care Act

See the “Affordable Care Act” chapter in this book for a discussion of the effect of income on health care provisions such as the premium tax credit�

FIGURE 1.1 Summary of Federal Income Tax Data, 2012

Number of Returns*

Total AGI (in Millions)

Income Tax (in Millions)

Share of Total AGI

Share of Income Tax

Income Split Point

Average Tax Rate

All 136,080,353 $49,041,744 $1,184,978 100�0% 100�0%

Top 1% 1,360,804 1,976,738 451,328 21�9% 38�1% > $434,682 22�8%

1 to 5% 5,443,214 1,354,206 247,215 15�0% 20�9% 18�3%

Top 5% 6,804,018 3,330,944 698,543 36�8% 58�9% > $175,817 21�0%

5 to10% 6,804,017 996,955 132,902 11�0% 11�2% 13�3%

Top 10% 13,608,035 4,327,899 831,445 47�9% 70�2% > $125,195 19�2%

10 to 25% 20,412,053 1,933,778 192,601 21�4% 16�3% 10�0%

Top 25% 34,020,088 6,261,677 1,024,046 69�3% 86�4% > $73,354 16�4%

25 to 50% 34,020,089 1,776,123 128,017 19�6% 10�8% 7�2%

Top 50% 68,040,177 8,037,800 1,152,063 88�9% 97�2% > $36,055 14�3%

Bottom 50% 68,040,177 1,003,944 32,915 11�1% 2�8% < $36,055 3�3%

* Does not include dependent filers.Source: IRS SOI Tax Stats - Individual Statistical Tables by Tax Rate and Income Percentile, which can be accessed at http://www.irs.gov/uac

/SOI-Tax-Stats-Individual-Statistical-Tables-by-Tax-Rate-and-Income-Percentile#Top..


IRA Contributions 3

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the individual’s taxable compensation or $5,500 ($6,500 if age 50 or more).

If the taxpayer and spouse (if the taxpayer is married) are not covered by a retirement plan at work, the full contribution and deduction are available for a traditional IRA regardless of income amount. Having an employer retirement plan, however, requires calculating the taxpayer’s MAGI to determine eligibility for a full or partial deductible contribution. There is also a differ-ent income limitation in the event that only one spouse is covered by an employer plan. In the case of a Roth IRA, the income limitation for making a contribution applies whether the tax-payer is covered by an employer plan or not.

Covered by Employer Plan

Employer plan coverage includes a variety of types of plans:

■■ Defined contribution plan [profit-sharing 401(k), stock bonus, and money purchase] if any contributions or forfeitures were allocated to the taxpayer’s account for or within the tax year

■■ IRA-based plan (SEP, SARSEP, or SIMPLE IRA) if any amount was contributed to the IRA for or within the tax year

■■ Defined benefit plan if the taxpayer is eli-gible to participate for the tax year

Traditional IRAsThe deduction for a contribution to a traditional IRA may be limited if the taxpayer or the tax-payer’s spouse is eligible to participate in an employer-provided retirement plan. The tax-payer’s deductible amount depends on his or

her filing status, contribution limit, and level of income.

Modified Adjusted Gross IncomeAlthough traditional IRA contributions are an allowable adjustment to gross income in deter-mining AGI, modified adjusted gross income (MAGI) must be used to determine how much can be taken as a deduction. The MAGI is the AGI plus the following:

1. IRA deduction2. Student loan interest deduction3. Tuition and fees deduction4. Domestic production activities deduction5. Foreign earned income exclusion and/or

housing exclusion6. Foreign housing deduction7. Excludable savings bond interest8. Excluded employer-provided adoption

benefits

Deductible AmountFigure 1.2 shows whether the amount contrib-uted to the IRA is limited by income.

The formula for determining the deductible amount when the taxpayer’s MAGI is in the phaseout range is as follows:

(End of phaseout range – MAGI)

× contribution limit = Deductible amount

Phaseout range

FIGURE 1.2 2015 Phaseout of Traditional IRA Deductions

MAGI Phaseout Range

Single and HoH MFJ MFS*

No employer plan No phaseout No phaseout $0 to $10,000

Employer plan $61,000 to $71,000 $98,000 to $118,000 $0 to $10,000

MFJ, spouse has employer plan N/A $183,000 to $193,000 N/A

* If a taxpayer files MFS and did not live with his or her spouse at any time during the year, the taxpayer’s IRA deduction is determined under the “single” filing status.


4 ABOVE-THE-LINE DEDUCTIONS AND EXCLUSIONS

Example 1.1 Both Spouses Covered by Employer Plan

Monica and Mitchell Mayer file a MFJ return with $100,000 of MAGI. Both are covered by an employer plan at work, but they would also like to make a deductible IRA contribution. They are both 45 years old, so they each have contributed the maximum $5,500 to their individual IRAs. Monica’s salary is $50,000, and Mitchell’s sal-ary is $45,000. Neither has any self-employment

income, and neither makes any contributions to self-employed SEP, SIMPLE, or qualified plans.

Monica’s deductible amount is $4,950, as calculated on Worksheet 1-2 from IRS Publica-tion 590-A, Contributions to Individual Retirement Arrangements (IRAs ), shown in Figure 1.3. Mitch-ell’s deductible amount is also $4,950, as calcu-lated in an abbreviated Worksheet 1-2 shown in Figure 1.4.

FIGURE 1.3 Monica’s Deductible Amount


IRA Contributions 5

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Monica and Mitchell must each fill out Form 8606, Nondeductible IRAs, to report a nonde-ductible $550 contribution.

Example 1.2 One Spouse Covered by Employer Plan

Monica and Mitchell from Example 1.1 have the same MAGI and contribute the same amount to their IRAs, but only Monica is covered by an employer plan. The calculation of Monica’s deductible amount is the same as shown in Figure 1.3 in Example 1.1, resulting in the same $4,950 deductible amount. Mitchell does not have to reduce his allowable deductions for his contri-bution because their joint MAGI is less than the $183,000 beginning of his phaseout range.

Effective Marginal Tax RateThe effective marginal tax rate for taxpayers whose MAGI is in the phaseout range for deduct-ing IRA contributions depends on their age and the breadth of their phaseout range, as shown in Figure 1.5.

Worksheet Applies Formula

Worksheet 1-2 from IRS Publication 590-A, Con-tributions to Individual Retirement Arrange-ments (IRAs), applies the formula for computing the deductible IRA contribution and includes the end amount of the phaseout ranges as well as a rounding convention�

FIGURE 1.4 Mitchell’s Deductible Amount

1� End of phaseout range 118,000

2� Modified AGI 100,000

3� Subtract line 2 from line 1 18,000

4� Multiply line 3 by 27�5% (0�275) 4,950

5� Compensation 45,000

6� Contributions to IRA 5,500

7� IRA deduction. Smallest of lines 4, 5, and 6 4,950

8� Nondeductible contribution. Subtract line 7 from lesser of line 5 or 6 550

FIGURE 1.5 Effective Marginal Tax Rates for Taxpayers in IRA Deduction Phaseout Ranges*

Breadth of Phaseout Range Under Age 50 Age 50 or Older

$10,000 1�550 × marginal tax bracket rate 1�650 × marginal tax bracket rate

$20,000 1�275 × marginal tax bracket rate 1�325 × marginal tax bracket rate

* The effective marginal tax rates shown in the table are the average rates. The actual effective marginal tax rates are lumpy because of the rounding convention in Worksheet 1-2 of IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs).

FIGURE 1.6 Monica’s Deductible Amount1� End of phaseout range 118,000



4� Multiply line 3 by 27�5% (0�275) 4,400




8� Nondeductible contribution� Subtract line 7 from lesser of line 5 or 6 1,100

Example 1.3 Effective Marginal Tax Rate

A $2,000 increase in MAGI for Monica and Mitchell from Example 1.2 would reduce Mon-ica’s deductible IRA amount to $4,400, as shown in the abbreviated Worksheet 1-2 in Figure 1.6.

The cumulative effect of the $2,000 increase in MAGI and the $550 ($4,950 – $4,400) decrease in Monica’s IRA deduction is a $2,550 increase in their taxable income. Monica and Mitchell are in the 25% marginal income tax bracket, so the $2,000 increase in MAGI increases their income tax by $637.50 ($2,550 × 25%). The tax increase is 31.875% ($637.50 ÷ $2,000) of the increase in MAGI, which is 1.275 × 25%, as shown in Figure 1.5.



a later date. He can also split the contribution in any manner between the two types of IRAs.

Question 1. What is Albert’s IRA deduction if he is covered by a retirement plan at work?

Answer 1. Albert’s $4,550 deductible traditional IRA contri-bution is calculated as shown on the abbreviated Worksheet 1-2 in Figure 1.8.

FIGURE 1.8 Albert’s Deductible Amount




4� Multiply line 3 by 65% (0�65) 1,950




8� Nondeductible contribution. Subtract line 7 from lesser of line 5 or 6 4,550

Now his choices are the following:

■■ Contribute $6,500 to a traditional IRA, of which $1,950 is deductible and $4,550 is nondeductible

■■ Contribute $1,950 to a traditional IRA (all of which is deductible) and contribute $4,550 to a Roth IRA

■■ Contribute $6,500 to a Roth IRA

Example 1.4 Limited Roth Contribution

Cory Carpenter, age 52, files HoH and wants to make a contribution to his Roth IRA this year. His MAGI for this purpose is $117,500. His max-imum contribution is calculated as follows:

($131,000 – $117,500) × $6,500 = $5,850$15,000

The total allowable contribution for IRAs includes both traditional and Roth IRAs. There is not a separate contribution amount for each. While the traditional IRA offers an adjustment to tax, the allowable MAGI, if the taxpayer is cov-ered by an employer plan, may be less than the Roth IRA. The Roth IRA permits the contribu-tion with a higher income, but there is no deduc-tion on the tax return.

Example 1.5 Making the Best IRA Choice in 2015

Albert Alexander, age 52, is single, receives $65,000 of compensation, and has $68,000 of MAGI. He is not covered by an employer retire-ment plan.

Albert’s maximum total traditional IRA contribution and Roth contribution is $6,500. Because there is no income limitation, Albert chooses to contribute to a traditional IRA or a Roth IRA based on whether he prefers the cur-rent-year deduction or the tax-free withdrawal at

employer plan. Figure 1.7 shows the MAGI phaseout ranges for contributing to a Roth IRA.

The formula for determining the contribution limit when the taxpayer’s MAGI is in the phase-out range is as follows:

(End of phaseout range – MAGI)

× maximum contribution = Contribution limit

Phaseout range

Roth IRAsContributions to Roth IRAs are not deductible, so there is no deduction limit to phaseout. However, there is a contribution limit that is phased out as MAGI increases. The MAGI calculation is the same as for the traditional IRA except that it also requires adding back any traditional IRA deduc-tion. The phaseout is not affected by whether or not one or both spouses are covered by an

FIGURE 1.7 2015 MAGI Phaseout Ranges for Contributing to a Roth IRA

Single and HoH MFJ MFS*

$116,000 to $131,000 $183,000 to $193,000 $0 to $10,000

* If a taxpayer files MFS and did not live with his or her spouse at any time during the year, the taxpayer’s Roth IRA contribution limit is determined under the “single” filing status.


Student Loan Interest Deduction 7

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Contribute to Traditional IRA

Taxpayers with a MAGI that exceeds the phaseout for making a Roth IRA contribution can make a nondeductible traditional IRA contribution and then convert it to a Roth IRA� There are no income restrictions for conversions� However, taxpayers must take into account the basis of all of their IRAs when reporting the gain on the conversion�

Student Loan Interest Deduction

The student loan interest deduction allows a tax-payer to deduct up to $2,500 of qualified student loan interest he or she is legally required to pay. The deduction is not available for taxpayers filing MFS. The student loan must have been taken out solely to pay for qualified education expenses and cannot come from a related person or a qualified employer plan. The student must be the taxpayer, taxpayer’s spouse, or taxpayer’s dependent, and be enrolled at least half-time in a degree program.

Student loan interest includes loan origina-tion fees, capitalized interest (if payments were made during the year), and voluntary interest payments. It also includes credit card interest if the credit card is used exclusively for qualified education expenses.

Phaseout RangeThe deduction is phased out over a range of MAGI as shown in Figure 1.10.

FIGURE 1.10 2015 MAGI Phaseout Ranges for Student Loan Interest Deduction

Single, HoH, and QW MFJ MFS

$65,000 to $80,000

$130,000 to $160,000

No deduction

The deduction is phased out pro rata as MAGI increases in the phaseout range. There-fore, the formula for calculating the deduction is the following:

Question 2. Using the Question 1 information, assume Albert is married, and his 50-year-old wife, Annabel, who is not a participant in an employer plan, receives $70,000 in compensation and contributes $6,500 to a traditional IRA. Their joint MAGI is $140,000. What are their deductible IRA amounts?

Answer 2. Their $140,000 joint MAGI exceeds the $118,000 end of Albert’s phaseout range, so he cannot deduct any of his traditional IRA contribution. His and Annabel’s $140,000 joint MAGI is below the $183,000 beginning of Annabel’s phase-out range, so she can deduct her entire $6,500 contribution.

Question 3. What if Albert and Annabel have a $189,000 joint MAGI?

Answer 3. Because their MAGI is in the $183,000 to $193,000 phaseout range, Annabel must use the formula to calculate her $2,600 deductible amount, as shown in Figure 1.9. Albert cannot deduct any of his $6,500 traditional IRA contribution.

FIGURE 1.9 Annabel’s Deductible Amount




4� Multiply line 3 by 32�5% (0�325) 1,300




8� Nondeductible contribution. Subtract line 7 from lesser of line 5 or 6 5,200

Question 4. What if they file MFS?

Answer 4. Neither Albert nor Annabel will be able to make a deductible contribution to a traditional IRA or any contribution to a Roth IRA because their joint MAGI is greater than the $10,000 end of their phaseout ranges for both the traditional IRA deductible amount and the contribution limit for Roth IRAs.



(End of phaseout range – MAGI) × (lesser of student

loan interest or $2,500) = Deduction limit

Phaseout range

Modified Adjusted Gross IncomeMAGI for purposes of the phaseout of the stu-dent loan interest deduction is defined in I.R.C. § 221(b)(2)(C) as AGI determined:

1. without regard toa. the deduction for qualified education loan

interest;b. the domestic production activities deduc-

tion under I.R.C. § 199;c. the deduction for qualified tuition and

related expenses under I.R.C. § 222;d. the foreign earned income exclusion and

foreign housing exclusion or deduction under I.R.C. § 911;

e. the exclusion of income from American Samoa under I.R.C. § 931; and

f. the exclusion of income from Puerto Rico under I.R.C. § 933.

2. and after the application ofa. the inclusion in income of social security

and tier 1 railroad retirement benefits under I.R.C. § 86;

b. the exclusion of income from US sav-ings bonds used to pay higher education expenses under I.R.C. § 135;

c. the exclusion of employer-provided bene-fits under an adoption assistance program under I.R.C. § 137;

d. the deduction for qualified retirement con-tributions under I.R.C. § 219; and

e. the limitations on passive activity losses and credits under I.R.C. § 469.

Effective Marginal Tax RateThe effective marginal tax rate for taxpayers whose MAGI is in the phaseout range for the stu-dent loan interest deduction depends on their fil-ing status and the amount of student loan interest they paid. For example, the taxable income of a taxpayer who files a MFJ return and paid $2,500 or more of student loan interest will increase by $1.0833 [$1 + ($2,500 ÷ $30,000)] for each $1

increase in MAGI in the phaseout range. There-fore, that taxpayer’s effective marginal tax rate is 1.0833 multiplied by his or her marginal bracket tax rate. If the taxpayer is in the 25% tax bracket, a $100 increase in MAGI increases income taxes by $27.08 ($100 × 0.25 × 1.0833) rather than the $25 increase if the phaseout of the student loan interest deduction did not apply.

For taxpayers other than those who file MFJ returns whose student loan interest deduction is phased out by their MAGI, the effective mar-ginal tax rate is 1.1667 [1 + ($2,500 ÷ $15,000)] multiplied by their marginal bracket tax rate, if they paid $2,500 or more of student loan inter-est. If the taxpayer is in the 25% tax bracket, a $100 increase in MAGI increases income taxes by $29.17 ($100 × 0.25 × 1.1667) rather than the $25 increase if the phaseout of the student loan interest deduction did not apply.

Planning Tips■■ The interest paid on student loans is deduct-ible only by the borrower. Because it is an above-the-line deduction, the student often benefits from the deduction. Parents and students should consider who should be obli-gated for the loan, particularly if the parents’ MAGI exceeds the phaseout amount.

■■ Double-dipping is not allowed. If a personal residence is refinanced to help pay for edu-cation expenses, the interest related to the education loan cannot be deducted both as student loan interest (an above-the-line deduction) and as a mortgage interest deduc-tion on Schedule A (Form 1040).

■■ Anyone can make payments on the student loan, but only the borrower gets the deduc-tion. Grandparents, for example, can help pay off the loan, and their payments are treated as if they made a gift to the student who then made the payment on the loan.

■■ The student loan interest deduction may dis-appear completely if not properly structured. If the student makes the payments on his or her legal debt, there is no deduction for the interest if the student was claimed as a dependent on someone else’s return. Unless the “someone else” cosigned the loan, he or she would also not be able to deduct the interest paid by the dependent.


US Savings Bonds Interest Exclusion 9

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Phaseout of Interest ExclusionAll of the interest received from cashing bonds is federal income tax free if the proceeds from the bond are used to pay qualified educational expenses, the filing status on the return is not MFS, and the taxpayer’s MAGI is less than $77,200 ($115,750 if MFJ). A limited exclusion is allowed between $77,200 and $92,200 ($115,750 and $145,750 if MFJ) of MAGI. The exclusion is phased out pro rata as MAGI increases in the phaseout range. Therefore, the phaseout formula is:

(End of phaseout range – MAGI) × qualified US sav-

ings bond interest = Exclusion

Phaseout range

The exclusion is claimed on line 3 of Sched-ule B (Form 1040A or 1040), Interest and Ordi-nary Dividends, but it is calculated on Form 8815, Exclusion of Interest From Series EE and I U.S. Savings Bonds Issued After 1989.

Modified Adjusted Gross IncomeThe MAGI for purposes of figuring the interest exclusion requires adding back any of the follow-ing: foreign earned income exclusion, foreign housing exclusion, foreign housing deduction, exclusion of income by bona fide residents of American Samoa or Puerto Rico, exclusion for adoption benefits received under an employer’s adoption assistance program, deduction for stu-dent loan interest, and deduction for domestic production activities.

Effective Marginal Tax RateThe effective marginal tax rate for taxpayers whose MAGI is in the phaseout range for the US savings bond interest exclusion depends on their filing status and the amount of qualifying interest they received. For example, the taxable income of a taxpayer who files a MFJ return and received $2,500 of qualifying interest will increase by $1.0833 [$1 + ($2,500 ÷ $30,000)] for each $1 increase in MAGI in the phaseout range. Therefore, that taxpayer’s effective marginal tax rate is 1.0833 multiplied by the rate for his or her marginal bracket. If the taxpayer is in the 25% tax bracket, a $100 increase in MAGI increases income taxes by $27.08 ($100 × 0.25 × 1.0833)

■■ If a student loan is refinanced, the interest continues to be an allowable above-the-line deduction. That is not true, however, if refi-nancing includes an additional amount of funding used for anything other than quali-fied education expenses; in that case none of the interest is considered to be student loan interest.

US Savings Bonds Interest Exclusion

Although the interest earned on US savings bonds is usually taxable, there is an exclusion for qualified bonds used to pay qualified educational expenses for the taxpayer, the taxpayer’s spouse, or a dependent claimed on the taxpayer’s return. Qualified bonds are series EE bonds issued after 1989 or series I bonds. The bonds must be either in the name of the taxpayer or in the name of the taxpayer and spouse as co-owners. The owner must be at least 24 years of age on the bond’s issue date, which is printed on the front of the savings bond.

For purposes of the interest exclusion, quali-fied educational expenses include tuition and fees required to enroll at or attend an eligible educa-tional institution, contributions to a qualified tuition program (QTP), and/or contributions to a Coverdell education savings account (ESA).

The qualified educational expenses must be reduced by all of the following tax-free benefits that apply:

■■ Tax-free part of scholarships and fellowship grants

■■ Expenses used to figure the tax-free portion of distributions from a Coverdell ESA

■■ Expenses used to figure the tax-free portion of distributions from a QTP

■■ Any tax-free payments (other than gifts or inheritances) received as educational assis-tance, such as veterans’ educational assis-tance benefits, qualified tuition reductions, and/or employer-provided educational benefits

■■ Any expenses used in figuring the American opportunity and lifetime learning credits



Tuition and Fees Deduction

The tuition and fees deduction expired at the end of 2014, but Congress may rescue it once again� To claim the deduction a taxpayer must pay quali-fied education expenses of higher education for an eligible student who is the taxpayer, his or her spouse, or a dependent claimed on the return� The maximum deduction is $4,000, but the amount is limited if the taxpayer’s MAGI exceeds $80,000 ($160,000 if filing a MFJ return)�

Summary of Deductions and Exclusion Affected by AGI

Figures 1.11 through 1.13 show the phaseout ranges for the deductions and exclusion discussed in this section.

rather than the $25 increase if the phaseout of the savings bond interest exclusion did not apply.

For taxpayers other than those who file MFJ returns whose savings bond interest exclusion is phased out by their MAGI, the effective marginal tax rate is 1.1667 [1 + ($2,500 ÷ $15,000)] mul-tiplied by their marginal bracket tax rate, if they received $2,500 of qualifying interest. If the tax-payer is in the 25% tax bracket, a $100 increase in MAGI increases income taxes by $29.17 ($100 × 0.25 × 1.1667) rather than the $25 increase if the phaseout of the savings bond interest exclusion-did not apply.

US Savings Bond Interest Rates

As the time this was written, the interest rate for series EE bonds was 0�10%, the series I bond vari-able rate was 1�48%, and the series I bond fixed rate was 0�0%� The investment performance of many 529 plans far exceeds the savings bond rates� Taxpayers may want to consider cashing in low-rate savings bonds and putting the money into a 529 plan—the transfer qualifies as a tax-free exchange�

FIGURE 1.11 2015 Phaseout of Deductions and Exclusions: MFJ


Comparative Case Studies 11

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Comparative Case Studies

Barbara Brown, Gloria Green, and Wilma White each file HoH, claiming one child. This year all three children are in college.

Case #1: Barbara BrownBarbara has $28,000 of earned income. Her son Bobby is attending the local community college. She contributed $750 to a traditional IRA because her employer does not offer any type of retirement plan. She also cashed in a $200-face-value US savings bond; the interest on it was $100, and she used it to help her son with his college expenses. The bond meets the qualifications for the exclusion of the interest from income.

Barbara’s IRA deduction is not limited by her AGI because she is not covered by an employer plan. Therefore, her MAGI for calculating her savings bond interest exclusion is $27,250 ($28,000 of earned income minus her $750 IRA contribution). Because her MAGI is below the $77,200 threshold for phasing out the savings bond interest exclusion, the bond interest is not included in AGI or taxable income.

Case #2: Gloria Green Gloria is 47 years old, has $58,000 of earned income, and has $5,400 of net rental income. Gloria has a 401(k) at work, but she also put $3,500 into a traditional IRA. She cashed in $4,000 in US savings bonds to help pay for her son Gary to attend college; the bond interest (not included in

FIGURE 1.12 2015 Phaseout of Deductions and Exclusions: Single and HoH

FIGURE 1.13 2015 Phaseout of Deductions and Exclusions: MFS



FIGURE 1.15 2015 Standard Deductions

Filing Status Deduction Amount

Single $6,300

MFJ or QW $12,600

HoH $9,250

MFS $6,300

Taxpayers can claim an additional $1,250 standard deduction for each spouse on a MFJ return who is age 65 or older and for each spouse who is blind. The amount is increased to $1,550 if the taxpayer is unmarried and not a qualifying

BELOW-THE-LINE DEDUCTIONS AND AMT EXEMPTION Income limitations apply to itemized deductions, the personal and dependent exemptions deduction, and the alternative minimum tax exemption�

As taxpayers’ incomes increase, their personal exemption deduction is phased out and their allowable itemized deductions are reduced (Pease limitation). If the standard deduction is more, taxpayers can choose to use the full stan-dard deduction instead of the reduced itemized deduction. Figure 1.15 reports the 2015 stan-dard deductions.

$2,000 bond interest is not included in AGI or taxable income.

Gloria’s AGI is $60,320 ($58,000 + $5,400 – $3,080) for calculating other deductions and credits.

Case #3: Wilma WhiteWilma has $300,000 of earned income; she also owns an S corporation and has $22,000 of rental income. Her son Wayne is attending college, and Wilma cashed in some qualified US savings bonds to help pay for his expenses. The principal on the bonds was $8,000, and the interest was $4,000. Wilma is a participant in a 401(k) plan at work, and she also contributed $5,500 to a traditional IRA.

Wilma’s MAGI for purposes of her IRA deduction is $326,000 ($300,000 earned income plus $22,000 investment income plus $4,000 interest on the savings bonds). Because her MAGI exceeds the $71,000 phaseout range for deduction, her IRA deduction is zero.

Wilma’s MAGI for purposes of her savings bond exclusion is $322,000 ($300,000 earned income plus $22,000 investment income), which exceeds the phaseout range for excluding that interest.

Wilma’s AGI is $326,000 ($300,000 earned income plus $22,000 investment income plus $4,000 interest on the savings bonds) for calculat-ing other deductions and credits.

her other investment income) is $2,000, and the bond meets the qualifications for the exclusion from income.

Gloria’s MAGI for purposes of her IRA deduction is $65,400 ($58,000 earned income plus $5,400 investment income plus $2,000 of savings bond interest). Her $3,080 IRA deduc-tion and $420 nondeductible contribution are calculated in the abbreviated Worksheet 1-2 shown in Figure 1.14.

FIGURE 1.14 Gloria’s IRA Deduction

1� End of phaseout range $71,000

2� Modified AGI $65,400

3� Subtract line 2 from line 1 $5,600

4� Multiply line 3 by 55% (0�55) $3,080

5� Compensation $58,000

6� Contributions to IRA $3,500

7� IRA deduction. Smallest of lines 4, 5, and 6 $3,080

8� Nondeductible contribution. Subtract line 7 from lesser of line 5 or 6 $420

Gloria’s MAGI for purposes of her savings bond interest exclusion is $60,320 ($58,000 earned income plus $5,400 investment income minus $3,080 IRA deduction). Because her MAGI is below the $77,200 threshold for phas-ing out the savings bond interest exclusion, the


Personal Exemptions Deduction Phaseout (PEP) 13

1

Answer 1. Their itemized deductions are reduced by the lesser of

1. $143,703 [3% × ($5,100,000 – $309,900)], or2. $56,800 (80% × $71,000).

Their remaining itemized deduction is $14,200 ($71,000 – $56,800).

Deduction Is 20% of Total

The $14,200 allowed itemized deduction in Answer 1 is 80% of the $71,000 itemized deduc-tions subject to the Pease limitation� That will be the case whenever 80% of the itemized deduc-tions subject to the Pease limitation is less than 3% of the excess AGI�

Question 2. Using the facts in Question 1, what is their allowable deduction?

Answer 2. Their itemized deduction is $14,200, but their standard deduction is $15,100 ($12,600 plus $2,500 because both of them are over age 65). It is more advantageous for them to claim the stan-dard deduction.

Effective Marginal Tax Rate

The effective marginal tax rate for taxpayers whose AGI is in the Pease phaseout range is 1�03 multiplied by the tax rate for their marginal tax bracket�

Personal Exemptions Deduction Phaseout (PEP)

Unlike the Pease limitation, the personal and dependent exemption deduction can be com-pletely phased out if the AGI is substantial. The beginning threshold amounts are the same as the Pease limitations. The phaseout range is $122,500 ($2,500 × 49) [$61,250 ($1,250 × 49) for MFS], as shown in Figure 1.18.

widow(er). Neither the basic standard deduction nor the additional standard deduction amounts are affected by income limitations.

Pease Limitation on Itemized DeductionsCertain itemized deductions (medical expenses, investment interest expense, and casualty or theft losses) are not subject to the Pease rule, but all others are reduced by the lesser of two amounts:

1. 3% of AGI in excess of the thresholds listed in Figure 1.16, or

2. 80% of all affected itemized deductions.

FIGURE 1.16 2015 AGI Thresholds for Pease Limitation

Filing Status AGI

Single $258,250

MFJ or QW $309,900

HoH $284,050

MFS $154,950

Example 1.6 Pease Limitation

John and Sharon Jefferson file MFJ. They are both over age 65. Their 2015 AGI is $400,000. They have $71,000 of itemized deductions, shown in Figure 1.17.

FIGURE 1.17 Jeffersons’ Itemized Deductions

Itemized Deduction Amount

State and local taxes $ 8,000

Real estate tax 6,000

Mortgage interest 22,000

Charitable contributions 35,000

Total $71,000

All of their itemized deductions are subject to the Pease limitation. Therefore, their $71,000 of itemized deductions is reduced by the lesser of

1. $2,703 [3% × ($400,000 – $309,900)], or2. $56,800 (80% × $71,000).

Their remaining itemized deduction is $68,297 ($71,000 – $2,703).

Question 1. How much of their itemized deductions is not allowed if their AGI is $5,100,000?


14 BELOW-THE-LINE DEDUCTIONS AND AMT EXEMPTION

5. $4,000 – $800 = $3,200 allowable deduction for each personal and dependent exemption


The effective marginal tax rate for taxpayers whose AGI is in the PEP phaseout range is lumpy because the deduction is reduced by 2% when AGI increases by the $1 that increases AGI into the next $2,500 increment� That $1 increases tax-able income by $81 [$1 + ($4,000 × 2%)] for each exemption, which is an 8,100% ($81 ÷ $1) increase in taxable income for each exemption� However, the effective marginal tax rate is not affected by the next $2,499 increase in AGI�

A $2,500 increase in AGI increases taxable income by $2,580 [$2,500 + ($4,000 × 2%)] for each exemption, which is a 103�2% ($2,580 ÷ $2,500) increase in taxable income� For each $2,500 increase in AGI, the effective marginal tax rate is the tax rate for the taxpayer’s marginal income tax bracket, multiplied by 1�032 multiplied by the number of exemptions�

Question 1.How does a $1 increase in Heather’s AGI affect her personal exemption deduction?

Answer 1.Heather’s personal exemption deduction would be $3,120, calculated as follows:

1. $283,251 (AGI) – $258,250 (beginning phase-out amount) = $25,001

2. $25,001 ÷ $2,500 = 11 (10.0004 rounded up)3. 11 × 2% = 22% reduction4. $4,000 (personal and dependent exemption

deduction) × 22% = $880 reduction5. $4,000 – $880 = $3,120 allowable deduction

for each personal and dependent exemption

Question 2.How much does the $1 increase in AGI affect increase Heather’s income tax if she is in the 33% marginal income tax bracket?

Answer 2.Her taxable income increases by $81 ($1 + $80), and her income tax increases by $26.73 ($81 × 33%). The effective marginal income tax rate is 2,673% ($26.73 ÷ $1 × 100).

FIGURE 1.18 2015 Personal Exemptions Deduction Phaseout Ranges

Filing StatusPhaseout Begins

When AGI IsPhaseout Ends When AGI Is

Single $258,250 $380,750

HoH $284,050 $406,550

MFJ or QW $309,900 $432,400

MFS $154,950 $216,200

The personal and dependent exemption deduc-tion is decreased by 2% for each $2,500 ($1,250 if MFS) of excess over the threshold amount. If the AGI reaches the ending amount in the chart shown above, there is no deduction for any per-sonal exemptions.

Example 1.7 Phasing Out Exemptions Deduction

The Jeffersons from Example 1.6 have $400,000 of AGI and file a MFJ return. Their allowable deduction for each personal and dependent exemption is calculated as follows:



deduction) × 74% = $2,960 reduction5. $4,000 – $2,960 = $1,040 allowable deduction


The PEP cost the Jeffersons $5,920 ($2,960 × 2) for two exemptions. If they had four chil-dren claimed as dependents, it would have been a $17,760 ($2,960 × 6) reduction.


Heather Hobbs is single, has no dependents, and her AGI is $283,250. Her allowable personal exemption deduction is $3,200, calculated as follows:


2. $25,000 ÷ $2,500 = 103. 10 × 2% = 20% reduction4. $4,000 (personal and dependent exemption

deduction) × 20% = $800 reduction


Other Itemized Deductions Affected by Income Limitations 15

1


The effective marginal income tax rate for tax-payers whose medical and dental expenses are subject to the 10%-of-AGI reduction is 110% of the rate for their marginal income tax bracket� For taxpayers subject to the 7�5%-of-AGI reduc-tion, the effective marginal tax rate is 107�5% of the rate for their marginal income tax bracket�

Mortgage Insurance The Department of Veterans Affairs (VA) and the Rural Housing Service (RHS) provide mort-gage insurance, which is commonly known as a funding fee (VA) or guarantee fee (RHS). These amounts are fully deductible in the year the mortgage insurance contract was issued. Mort-gage insurance provided by the Federal Housing Administration and private mortgage companies must be allocated over the shorter of the stated term of the mortgage or 84 months from the date the mortgage insurance contract is issued. The premiums are treated as paid in the year to which they are allocated. If the mortgage is paid off early, there is no provision for deducting the remaining amount.


As with the PEP discussed earlier, the effective marginal income tax rate for taxpayers whose AGI is in the phaseout range for the mortgage insur-ance premium deduction is lumpy because the deduction is reduced by 10% when AGI increases by the $1 that increases AGI into the next $1,000 increment� The next $999 increase in AGI does not reduce the deduction� Because the reduction of the deduction is a percentage of the mortgage insurance premium, the marginal effective tax rate depends on the amount of the mortgage insurance premium�

Question 3.How does a $2,500 increase in Heather’s AGI affect her personal exemption deduction and her income tax?

Answer 3.Heather’s personal exemption deduction would be $3,120, calculated as follows:


2. $27,500 ÷ $2,500 = 113. 11 × 2% = 22% reduction4. $4,000 (personal and dependent exemption

deduction) × 22% = $880 reduction5. $4,000 – $880 = $3,120 allowable deduction


Heather’s taxable income increases by $2,580 ($2,500 + $80), and her income tax increases by $851.40 ($2,580 × 33%). The effective marginal income rate is 34.056% ($851.40 ÷ $2,500 × 100), which is 1.032 × 33%.

Other Itemized Deductions Affected by Income Limitations

Itemized deductions for medical and dental expenses, mortgage insurance, charitable contri-butions, casualty and theft losses, and miscella-neous itemized deductions are affected by AGI.

Medical and Dental ExpensesMedical and dental expenses can be claimed as an itemized deduction, but the deduction is reduced by 10% of AGI, which makes it difficult for higher-income people to benefit from the deduction. If at least one of the spouses on a MFJ or MFS return is age 65, the medical and dental expense deduction is reduced by 7.5% of AGI. This lower threshold applies only for years 2013 through 2016. Most practitioners have learned that it takes a lot of medical and dental expense for high-income earners to be able to get over the percentage of AGI floor.



FIGURE 1.19 Eichmanns’ Mortgage Insurance Premium Deduction

Mortgage insurance premium $ 2,000

AGI $107,200

Beginning of phaseout range (100,000)

Excess AGI $ 7,200

Rounded to next higher multiple of $1,000

$8,000

$8,000 divided by $10,000 80%

Disallowed deduction 80% × $2,000) (1,600)

Mortgage insurance premium deduction

$ 400

Gifts to CharityTaxpayers generally can deduct the contribu-tions they make to religious, charitable, educa-tional, scientific, or literary organizations as an itemized deduction. Gifts to federal, state, or local government agencies are deductible if they are made solely for public purposes. Taxpayers can make contributions in the form of cash or prop-erty. Although the value of an individual’s time or services is not deductible, donors can deduct as cash contributions their out-of-pocket expenses incurred in doing volunteer work for qualified organizations. (Volunteers using their own vehi-cles for charitable work may deduct actual vehi-cle expenses or a 14¢-per-mile standard mileage rate.)

Limits on DeductionsA taxpayer’s AGI limits the amount of his or her charitable contribution deduction in any tax year. Generally, the limit is 50% of AGI, but it can be a lesser percentage (20% or 30% of AGI) depend-ing on the type of property that was donated and the type of organization that received the prop-erty. A special provision applies to the deduction for qualified conservation contributions.

Whether the insurance is an allowable deduc-tion in a single year or must be allocated, the tax-payer is subject to an AGI limitation. If the AGI exceeds $109,000 ($54,500 if MFS), no deduc-tion is allowed. If the AGI is more than $100,000 ($50,000 if MFS) but not more than $109,000 ($54,500 if MFS), the deduction is limited. The calculation for other than MFS requires subtract-ing $100,000 from the AGI, increasing the excess to the next higher multiple of $1,000, and divid-ing the result by $10,000. An excess of $4,100, for example, would increase to $5,000 just the same as an excess of $4,900. The net result would be a disallowance of 50% of the deduction.

Example 1.9 Limited Specific Itemized Deductions

Earnest and Eileen Eichmann are both over age 65 and have $107,200 of AGI. Their medical expenses totaled $8,000. The mortgage insurance premium on their house is $2,000.

Question 1. The Eichmanns meet the over-age-65 requirement to qualify for the 7.5%-of-AGI floor for medical and dental expenses. Can they take a medical deduction?

Answer 1. No. Their medical deduction floor is $8,040 ($107,200 AGI × 7.5%), so the only medical and dental expenses they could deduct would be any allowable expenses in excess of $8,040. If they had not been over 65, their floor would have been $10,720.

Question 2. How much of their mortgage insurance premium is deductible in 2015?

Answer 2. Because their AGI is greater than $100,000 but less than $109,000, their mortgage insurance pre-mium deduction is limited. Their $400 deduction is calculated as shown in Figure 1.19.


Other Itemized Deductions Affected by Income Limitations 17

1

AGI Increases Deduction

Unlike the other deductions discussed in this chapter, the deduction limit for charitable contri-butions increases as AGI increases�

If a donor’s contributions are subject to more than one of the limits, an ordering rule applies. Contributions subject only to the 50% limit are deducted first, then contributions subject to the 30% limit, followed by contributions subject to the 20% limit. Qualified conservation contribu-tions are the last priority.

If a taxpayer’s total contributions exceed the applicable limits, any excess amounts carry over for up to 5 years, subject to the same AGI limits in the carryover years. (Excess qualified conser-vation contributions for donations after 2005 and before 2014 carry over for up to 15 years.) In the carryover years current-year charitable contri-butions generally are deducted first. Carryover amounts are then deducted up to the contribution limits, using the oldest carryovers first. However, a carryover of a contribution to a 50%-limit orga-nization must be used before deducting a current-year contribution to organizations that are not 50%-limit organizations.

Deduction Deferred

Unlike the other deductions discussed in this chapter, a charitable contribution in excess of the AGI limit is only deferred rather than perma-nently denied—unless the taxpayer does not have enough AGI to use it up in the 5-year carryover period�

Effective Marginal Tax RateThe effective marginal tax rate for taxpayers whose charitable contributions exceed the appli-cable AGI limit depends on which limit applies. If the 50%-of-AGI limit applies, the taxpayer’s effective marginal tax rate is 50% of the rate for the taxpayer’s marginal income tax bracket. Sim-ilarly, the effective rates are 30% and 20% of the rate for the taxpayer’s marginal tax bracket if the 30%- or 20%-of-AGI limit applies.

Casualty and Theft LossesCasualty and theft losses of personal use prop-erty are calculated in Section A of Form 4684, Casualties and Thefts, before they are reported on Schedule A (Form 1040). The loss from each casualty or theft event is reduced by $100, and the total remaining loss is then reduced by 10% of AGI.

Losses from business and income-producing property are calculated in Section B of Form 4684, where neither the $100 reduction nor the 10%-of-AGI reduction applies. Losses of business property are not itemized deductions except for an employee’s casualty and theft losses, which are included as miscellaneous itemized deductions subject to the 2%-of-AGI floor. Losses of income-producing property are included on Schedule A (Form 1040), but they are deducted as other mis-cellaneous deductions not subject to the 2%-of-AGI floor.


The effective marginal income tax rate for tax-payers whose casualty and theft losses are subject to the 10%-of-AGI reduction is 110% of the rate for their marginal income tax bracket�

Miscellaneous Itemized DeductionsExpenses related to generating taxable income that are not deductible elsewhere may be eli-gible itemized deductions. In most cases these expenses are deductible only to the extent that the total amount of such deductions reported on the taxpayer’s return exceeds 2% of the taxpay-er’s AGI.

Employee Business ExpensesEmployees can deduct the business expenses they incur in performing their duties if their employer does not reimburse the expenses. The employer does not have to specifically require the employee to pay an expense, but the expenses must be ordinary (common and accepted) and necessary (helpful and appropriate) for the employee’s job. Examples of employee expenses include costs for the following items:



Other ExpensesExamples of other expenses paid to produce or collect taxable income, or to manage or protect property held for earning income, that are miscel-laneous itemized deductions subject to the 2%-of-AGI floor include the following items:

1. Legal and accounting fees2. Clerical help and office rent3. Investment expenses such as custodial and

trust account fees (but not those allocable to tax-exempt income)

4. Safe deposit box rental if the box is used to store taxable income-producing stocks, bonds, or investment-related papers and documents

5. Losses on deposits in insolvent or bankrupt financial institutions

Effective Marginal Tax RateFor taxpayers who itemize deductions and have miscellaneous itemized deductions, the 2%-of-AGI floor increases their effective marginal tax rate by 2% of the rate for the bracket in which their taxable income falls until the miscellaneous itemized deduction is reduced to zero. For exam-ple, if their taxable income is in the 25% bracket, their effective marginal tax rate is 25.5% (1.02 × 25%).


Figure 1.20 shows Ted and Tess Thomas’s 2015 AGI, below-the-line deductions, taxable income, and $22,288 income tax.

1. Travel and transportation (excluding com-muting), using the actual cost of operating a personal vehicle or the standard business mileage rate

2. Necessary safety equipment, small tools, and supplies

3. Uniforms required by the employer that are not suitable for ordinary wear

4. Protective clothing5. Licenses and regulatory fees6. Medical examinations required by the

employer if the cost is not deducted as a med-ical expense

7. Dues paid to unions and professional societies (and to chambers of commerce if the mem-bership helps the employee do his or her job)

8. Subscriptions to professional journals and trade magazines

9. Qualifying home office expenses10. Job-related educational expenses11. Fees paid to employment agencies and other

costs to look for a new job in the employee’s same occupation

Tax Preparation FeesTax preparation fees are includable as a miscel-laneous itemized deduction subject to the 2%-of-AGI floor. They include not only the fees paid to a tax preparer for preparing the income tax return but also any additional cost of electronic filing.

FIGURE 1.20 Thomases’ Income Tax before AGI Increase

AGI $140,000

Itemized deductions

All but miscellaneous itemized deductions $15,000

Miscellaneous itemized deductions $5,000

2%-of-AGI floor ($140,000 × 2%) (2,800)

Allowed miscellaneous itemized deductions 2,200

Total itemized deductions (17,200)

Personal exemptions deduction ($4,000 × 2) (8,000)

Taxable income $114,800

Income tax $20,288


Alternative Minimum Tax 19

1

Alternative Minimum Tax

The Internal Revenue Code provides favorable treatment for certain types of income, deductions, and credits that can significantly reduce a taxpay-er’s regular tax liability. In an attempt to ensure that the taxpayers who receive these benefits still pay their fair shares of income taxes, I.R.C. § 55 imposes the alternative minimum tax (AMT) on both corporate and noncorporate taxpayers. The AMT limits the use of specified benefits to reduce total tax.

To arrive at alternative minimum taxable income (AMTI, the tax base for the tentative min-imum tax), the taxpayer’s regular taxable income is

■■ increased by certain preference items,■■ increased or decreased by certain adjust-ments, and

■■ reduced by an exemption amount that varies based on the taxpayer’s filing status (see the next section for these amounts).

If their AGI increases by $1,000, their income tax increases to $20,543, as shown in Figure 1.21. The effective marginal tax rate is 25.5% [($20,543 –$20,288) ÷ $1,000].

FIGURE 1.21 Thomases’ Income Tax after AGI Increase

AGI $141,000

Itemized deductions

All but miscellaneous itemized deductions $15,000

Miscellaneous itemized deductions $5,000

2%-of-AGI floor ($141,000 × 2%) (2,820)

Allowed miscellaneous itemized deductions 2,180

Total itemized deductions (17,180)

Personal exemptions deduction ($4,000 × 2) (8,000)


Income tax $20,543

AMTI then is multiplied by the applicable AMT rate to arrive at a tentative minimum tax. The 2015 AMT rates are 26% for AMTI that does not exceed $185,400 ($92,700 if MFS) and 28% for AMTI in excess of $185,400 ($92,700 if MFS). The taxpayer’s regular tax liability is then sub-tracted from his or her tentative minimum tax to determine his or her AMT.

AMT Is an Add-On Tax

Although it is called an alternative tax, the AMT is an add-on tax to the regular tax rather than being a replacement for the regular tax liability� It does have the effect of being an alternative tax in that taxpayers pay the higher of their regular tax liability or an amount equal to their tentative minimum tax�

Figure 1.22 summarizes the 2015 AMT information.


Figure 1.25 shows that if their AMTI increases by $100, their tentative minimum tax increases by $35 ($101,852 – $101,817), which means their effective marginal tax rate is 35% ($35 ÷ $100).

FIGURE 1.25 Donovans’ Increased AMT Liability

AMTI $400,100

AMT exemption amount $(83,400)

Phaseout [($400,100 – $158,900) × 25%] 60,300 (23,100)

AMT base $377,000

Tentative minimum tax

[($185,400 × 26%) + ($377,000 – $185,400) × 28%] $101,852


Example 1.11 Effective AMT Rate

Derek and Denise Donovan file a MFJ return. Their AMTI is $400,000. Their $101,817 tenta-tive minimum tax calculation is shown in Figure 1.24.

FIGURE 1.24 Donovans’ AMT Liability

AMTI $400,000


Phaseout [($400,000 – $158,900) × 25%] 60,275 (23,125)

AMT base $376,875


[($185,400 × 26%) + ($376,875 – $185,400) × 28%] $101,817

AMT ExemptionBecause the AMT exemption is phased out as AMTI increases, the effective marginal tax rate of taxpayers who owe the AMT increases by 25% when their AMTI is in the AMT exemption phaseout range. Figure 1.23 reports the 2015 effective tax rates for ranges of AMTI.

FIGURE 1.22 2015 AMT Information

2015 Filing StatusAMTI Threshold for

28% AMT RateAMT Exemption

AmountAMT Exemption Phaseout Range

MFJ or QW $185,400 $83,400 $158,900–$492,500

Single or HoH $185,400 $53,600 $119,200–$333,600

MFS $92,700 $41,700 $79,450–$246,250

Estates and trusts $185,400 $23,800 $79,450–$174,650

FIGURE 1.23 2015 Effective Tax Rates for Ranges of AMTI of Taxpayers Who Owe AMT

AMTI Range for:

Effective Marginal Tax Rate MFJ or QW Single MFS Estates and Trusts

26�0% $0–$158,900 $0–$119,200 $0–$79,450 $0–$79,450

32�5% $158,901–$185,400 $119,201–$185,400 $79,451–$92,700 $79,451–$174,650

35�0% $185,401–$492,500 $185,401–$333,600 $92,701–$246,250 N/A

28�0% Above $492,500 Above $333,600 Above $246,250 Above $174,650


Alternative Minimum Tax 21

1

Bunch AMTI

Taxpayers whose AMTI regularly phases out most or all of their AMT exemption could reduce their total tax liability by bunching their AMTI into every other year and keeping their AMTI below the exemption phaseout range in the intervening years� By increasing their AMTI above the exemp-tion phaseout range in the bunching years, some of the AMTI will be taxed at the 28% effective marginal tax rate rather than the 35% effective marginal tax rate in that year� If their AMTI is reduced below the beginning of the exemption phaseout range in the intervening years, none of their AMTI will be taxed at the 32�5% or 35% rates in those years�

Example 1.12 Bunching AMTI

Assume that without any bunching of AMTI, Derek and Denise Donovan from Example 1.11 would have $400,000 of AMTI in 2016 as they did in 2015. Using the 2015 exemption and AMT tax brackets to estimate their 2016 tenta-tive minimum tax, their total tentative minimum tax liability (and total income tax liability if they owe AMT for both years) for 2015 and 2016 is $203,634 ($101,817 × 2).

If they could defer $241,100 of AMTI from 2015 into 2016, their 2015 AMTI would be $158,900 ($400,000 – $241,100) and their 2016 AMTI would be $641,100 ($400,000 + $241,100). Their tentative minimum tax for 2015 would be $19,630, as shown in Figure 1.26, and their ten-tative minimum tax for 2016 would be $175,800, as shown in Figure 1.27. The total tentative min-imum tax (and total income tax liability if they owe AMT for both years) for 2015 and 2016 is $195,430 ($19,630 + $175,800), which is $8,204 ($203,634 – $195,430) less than the total for the 2 years without bunching the AMTI.

FIGURE 1.26 Donovans’ 2015 AMT Liability

AMTI $158,900


Phaseout [($158,900 – $158,900) × 25%] 0 (83,400)

AMT base $75,500


[($75,500× 26%) $19,630

FIGURE 1.27 Donovans’ 2016 AMT Liability

AMTI $641,100


Phaseout (fully phased out because AMTI exceeds the phaseout range) 83,400 (0)

AMT base $641,100

[($185,400 × 26%) +

($641,100 – $185,400) × 28%] $175,800

AMT Preferences and AdjustmentsFiguring the AMTI requires some adjustments to regular taxable income. Many of those adjust-ments are to deductions that are reduced as AGI increases.

1. For clients over age 65 who deduct medical expenses in excess of 7.5% of AGI, the per-centage must be changed to 10%, decreasing the allowable medical expenses deduction for computing AMTI by 2.5% of AGI.

2. Taxes that are deducted on Schedule A (Form 1040) cannot be deducted for computing AMTI (except generation-skipping transfer taxes on income distributions).

3. Home equity mortgage interest cannot be deducted for computing AMTI.

4. The Pease limitation for itemized deductions does not apply to the itemized deductions that are allowed in computing AMTI.

5. The personal and dependent exemptions deduction and the standard deduction are not allowed for computing AMTI.



Below-the-Line Deductions and AMT Exemption Summary

FIGURE 1.28 2015 Below-the-Line Deductions and AMT Exemption Phaseout: MFJ & QW

FIGURE 1.29 2015 Below-the-Line Deductions and AMT Exemption Phaseout: HoH

FIGURE 1.30 2015 Below-the-Line Deductions and AMT Exemption Phaseout: Single

Figures 1.28 through 1.31 show the phaseout ranges for the deductions and exemption dis-cussed in this section.


Comparative Case Studies 23

1

tax table amounts. The tax is 12.66% ($3,554 ÷ $28,070) of taxable income.

FIGURE 1.33 Gloria’s Regular Income Tax

AGI $60,320

Standard deduction (24,250)

Exemptions deduction (8,000)


Income tax $3,554

Case #3: Wilma WhiteWilma’s AGI is $326,000. Her itemized deductions are as follows: $28,000 of taxes, $18,000 of mortgage interest, and $30,000 of charitable contributions. She has two exemptions.

Wilma is subject to both the Pease limitation and the PEP because of her AGI.

Pease LimitationAll of Wilma’s itemized deductions are subject to the Pease limitation. Therefore, her $76,000 of itemized deductions are reduced by the lesser of

1. $1,259 [3% × ($326,000 – $284,050)], or2. $60,800 (80% × $76,000).

Her remaining itemized deduction is $74,741 ($76,000 – $1,259).

Personal Exemption PhaseoutWilma’s allowable deduction for each personal and dependent exemption is calculated as follows:

Comparative Case Studies

Continuing with the AGIs calculated in the previ-ous section for Barbara, Gloria, and Wilma, the goal this time is to see how the potential exemp-tions and deductions affect the tax. Recall that these taxpayers each file HoH, claiming one child, and all three children are in college.

Case #1: Barbara BrownBarbara’s AGI is $27,250. Her itemized deductions are less than her $9,250 standard deduction, so she claims the standard deduction. She has two exemptions.

Figure 1.32 shows the calculation of Barba-ra’s $1,003 regular income tax liability using the 2015 tax table amounts.

FIGURE 1.32 Barbara’s Regular Income Tax

AGI $27,250

Standard deduction (9,250)

Exemptions deduction (8,000)


Income tax $1,003

Case #2: Gloria Green Gloria’s AGI is $60,320. Her itemized deductions are as follows: $10,500 of taxes, $8,500 of mortgage interest, and $5,250 of charitable contributions. She has two exemptions.

Figure 1.33 shows the calculation of Gloria’s $3,554 regular income tax liability using the 2015

FIGURE 1.31 2015 Below-the-Line Deductions and AMT Exemption Phaseout: MFS



almost 28 million taxpayers received in excess of $66 billion in EIC. The average amount was $2,407. Slightly more than half of the recipi-ents indicate their highest level of education as high school or less. The top five occupations of EIC recipients are clerical, sales, food services, transportation, and construction. Almost half file HoH, with a quarter filing MFJ, and another quarter filing single. The credit is not available for MFS taxpayers.

The EIC is designed for low-income taxpay-ers who have taxable earned income from wages, salaries, tips, union strike benefits, net earnings from self-employment, or long-term disabil-ity benefits received prior to minimum retire-ment age. Other benefits such as Social Security



deduction) × 34% = $1,360 reduction5. $4,000 – $1,360 = $2,640 allowable deduction


Wilma has two exemptions and there-fore a $5,280 ($2,640 × 2) personal exemption deduction.

Regular Income TaxFigure 1.34 shows the calculation of Wilma’s $61,115 regular income tax liability. Her tax is 24.85% ($61,115 ÷ $245,979) of taxable income.

FIGURE 1.34 Wilma’s Regular Income Tax

AGI $326,000

Pease limited itemized deductions (74,741)

Limited exemptions deduction (5,280)


Income tax $61,115

Alternative Minimum TaxFigure 1.35 shows the calculation of Wilma’s AMT liability. Her $70,240 total tax is 28.56% ($70,240 ÷ $245,979) of taxable income.

FIGURE 1.35 Wilma’s AMT Liability


Taxes deducted on Schedule A (Form 1040)

28,000

Pease reduction of itemized deductions

(1,259)

Allowed exemptions deduction 5,280

AMTI $278,000


Phaseout [($278,000 – $119,200) × 25%] 39,700 (13,900)

Tentative minimum tax base $264,100

Tentative minimum tax [($185,400 × 26%) + ($264,100 – $185,400) × 28%] $70,240

Regular income tax (61,115)

Alternative minimum tax $9,125

REFUNDABLE AND NONREFUNDABLE CREDITS Many credits are limited or eliminated as a taxpayer’s income increases�

Deductions inherently favor taxpayers in higher tax brackets because they reduce taxes at the taxpayer’s marginal tax rate. By contrast, credits reduce taxes by the same amount for low-bracket taxpayers as for high-bracket taxpayers. Con-gress designed several credits to further favor lower-income taxpayers by imposing income restrictions. The credits discussed in this section are aimed at helping lower-income taxpayers.

Earned Income Credit

According to the 2013 profile of the earned income credit (EIC), which is available at www.brookings.edu/research/interactives/eitc,


Earned Income Credit 25

1

Taxpayers with more than $3,400 in invest-ment income for the year cannot claim the EIC. This limitation is not phased in as income increases. A $1 increase in investment income from $3,400 to $3,401 bars the entire EIC.

Income LimitationsThe EIC encourages taxpayers to work by increasing the credit over a range of earned income. It is then phased out over a higher range of income. The credit also increases as the tax-payer’s number of children increases from zero to three. Figure 1.36 reports the credit rate, income range for the maximum credit, phaseout range, phaseout rate, and maximum credit for taxpay-ers other than those filing MFJ or MFS returns in 2015. Figure 1.37 reports the same information for taxpayers filing a MFJ return in 2015.

Disability Insurance, SSI, or military disability pensions do not count as earned income.

Taxpayers are often confused about what type of income actually counts for purposes of claiming the EIC. The following list, while not all-inclusive, gives some good examples of what does not count as earned income.

■■ Pay received for work while an inmate in a penal institution (including work release pro-grams and halfway houses)

■■ Interest and dividends■■ Retirement income■■ Social security benefits■■ Unemployment benefits■■ Alimony■■ Child support

Qualifying Children

Credit Rate (%)

Income for Maximum

Credit PhaseoutPhaseout Rate (%)

Maximum Credit

None 7�65 $ 6,580–$8,240 $8,240–$14,820 7�65 $503

One 34�00 $9,880–$18,110 $18,110–$39,131 15�98 $3,359

Two or more 40�00 $13,870–$18,110 $18,110–$44,454 21�06 $5,548

Three or more 45�00 $13,870–$18,110 $18,110–$47,747 21�06 $6,242

Qualifying ChildrenCredit

Rate (%)

Income for Maximum

Credit PhaseoutPhaseout Rate (%)

Maximum Credit

None 7�65 $ 6,580–$13,750 $13,750–$20,330 7�65 $503

One 34�00 $9,880–$23,630 $23,630–$44,651 15�98 $3,359

Two 40�00 $13,870–$23,630 $23,630–$49,974 21�06 $5,548

Three or more 45�00 $13,870–$23,630 $23,630–$53,267 21�06 $6,242

FIGURE 1.36 2015 EIC Rate and Earned Income or AGI Phaseout Range for Taxpayers Not Filing as MFJ or MFS

FIGURE 1.37 2015 EIC Rate and Earned Income or AGI Phaseout Range for Taxpayers Filing as MFJ


26 REFUNDABLE AND NONREFUNDABLE CREDITS

nontaxable combat pay, which may increase the EIC. The nontaxable combat pay can be found in the Form W-2, box 12, code Q. If both spouses receive combat pay, each one can choose whether or not to make the election.

There are other types of military compen-sation and/or benefits that do not qualify for EIC. These include basic allowance for housing (BAH), basic allowance for subsistence (BAS), and veterans’ benefits (including VA rehabilita-tion payments).

Example 1.14 Combat Pay Election

Kelly and Kathy Dominguez have three chil-dren still in school, all of whom are qualifying children for the EIC. In 2015 Kelly was in the navy and earned $22,000, of which $15,000 was nontaxable combat pay. Kathy drew $5,000 in unemployment before finding a job that paid her $20,000 by the end of the year.

Question 1. Will including Kelly’s nontaxable combat pay increase their EIC?

Answer 1. No. Because their $27,000 earned income (shown in Figure 1.38) is in the phaseout range without the combat pay included, adding combat pay could only decrease their EIC. Without the com-bat pay their EIC is $4,474, as shown in Figure 1.38. Including combat pay reduces their EIC to $2,368, as shown in Figure 1.39.

FIGURE 1.38 Dominguezes’ EIC without Combat Pay

Item Amount EIC

Kelly’s taxable navy income $ 7,000

Kathy’s wages 20,000

Earned income $27,000 $5,527

Unemployment income 5,000

AGI $32,000 $4,474

EIC allowed $4,474

Qualifying without a ChildTaxpayers without children must meet three additional requirements to qualify for the EIC. The taxpayer

1. must have lived in the United States for more than half the tax year (applies to both spouses on a MFJ return),

2. must be at least age 25 but under age 65 (applies to only one spouse on a MFJ return), and

3. cannot qualify as a dependent of another person.

Example 1.13 EIC without Children

Michael Davis is 28 years old and has no chil-dren. He receives nontaxable VA disability as the result of a combat injury. During 2015 he worked in a clerical position for a short time and earned $8,000. His AGI is also $8,000 because he has no adjustments for computing AGI. His income is in the range for the $503 maximum credit for taxpayers without qualifying children.

Qualifying ChildTaxpayers with qualifying children can claim a higher EIC. To be a qualifying child, an individual

■■ must have a social security number;■■ must be the taxpayer’s child (including adopted child, stepchild, foster child) or descendant (such as a grandchild); or must be the taxpayer’s sibling, half sibling, step-sibling, or a descendant of these (such as a niece or nephew);

■■ must be younger than the taxpayer (or spouse of the taxpayer if MFJ) and younger than 19 (younger than 24 if a full-time stu-dent), or any age if permanently and totally disabled; and

■■ must live with the taxpayer in the United States for more than half the year.

Military IncomeA person serving in the US military may be sta-tioned in an area that qualifies for nontaxable combat pay. Although nontaxable income does not normally qualify for EIC, servicemembers can elect to calculate the credit by including the


Earned Income Credit 27

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FIGURE 1.41 Dominguezes’ EIC with Combat Pay

Item Amount EIC


Kelly’s combat pay 15,000

Kathy’s wages 0


Kelly’s combat pay (15,000)


AGI $12,000 N/A

EIC allowed $6,242

Question 3. What if Kelly was in a combat zone all year, his pay was $22,000, and Kathy had no income at all, not even unemployment? During the year she cashed in some stock she had been given by her grandparents and realized a $4,000 net capital gain.

Answer 3. If Kelly included his combat pay, the Domin-guezes’ EIC based on their earned income would be the maximum $6,242 EIC. However, their investment income exceeds the $3,400 limit, and they do not qualify for the credit. If the gain had been only $3,350, they would qualify for the maximum $6,242 credit. See Figure 1.42.


Item Amount EIC

Kelly’s taxable navy income $ 0




Capital gain net income 3,350

AGI $ 3,350 N/A

EIC allowed $6,242


Item Amount EIC



Kathy’s wages 20,000




AGI $32,000 $4,474

EIC allowed $2,368

Question 2. What if Kathy had no wages for the year?

Answer 2. As shown in Figure 1.40, without Kelly’s com-bat pay, the Dominguezes’ AGI is below their EIC phaseout range. Therefore, their $3,161 EIC is based only on their $7,000 earned income. Including Kelly’s combat pay increases their earned income, as shown in Figure 1.41. The EIC based on their earned income is increased to $6,242 (the maximum EIC for 2015). Because that is more than the $3,161 EIC without the com-bat pay, Kelly should elect to include his combat pay to calculate their EIC.

FIGURE 1.40 Dominguezes’ EIC without Combat Pay

Item Amount EIC


Kathy’s wages 0



AGI $12,000 N/A

EIC allowed $3,161



a descendent of these (such as a niece or nephew);

■■ not have provided more than half his or her own support;

■■ be claimed as a dependent on the taxpayer’s return;

■■ be a US citizen, US national, or US resident alien; and

■■ have lived with the taxpayer for more than half of 2015.

PhaseoutThe amount of the child tax credit phases out as a taxpayer’s AGI increases, as shown in Figure 1.43.

FIGURE 1.43 2015 AGI Phaseout Ranges for the Child Tax Credit

Filing Status Phaseout Range

MFJ $110,000–$129,001

Single, HoH, or QW $75,000–$94,001

MFS $55,000–$74,001

The phaseout ranges are set by statute, so they are not affected by inflation changes. Although it will not apply in most cases, for purposes of the child tax credit any exclusion of income from Puerto Rico, foreign earned income, or exclusion of income for residents of America Samoa must be added back into income.

The credit phases out by $50 for each $1,000 or part of $1,000 that the AGI exceeds the limits.

Effect on Marginal Tax RateAlthough the phaseout is lumpy—$1 of additional income that pushes AGI into the next $1,000 increment in the phaseout range decreases the credit by $50—on average, the phaseout adds 5% ($50 ÷ $1,000) to the taxpayer’s effective mar-ginal tax rate.

Example 1.15 Child Tax Credit Phaseout

Darwin Dunphy had $86,000 of AGI in 2015 and filed as HoH. He has three qualifying children. Figure 1.44 shows the calculation of his $1,350 child tax credit.

Effect on Marginal RateFor taxpayers in the phasein range of the EIC, the credit reduces the taxpayer’s effective marginal income tax rate on earned income by the credit rate, and often reduces the effective marginal tax rate below zero. For example, a taxpayer with earned income in the phasein range and taxable income in the 10% income tax bracket and one qualifying child has a negative 24% effective mar-ginal tax rate on earned income. Each $100 of additional income increases income taxes by $10 but also increases the EIC by $34, for a net $24 tax savings.

For taxpayers in the phaseout range, the credit increases their effective marginal income tax rate by the phaseout rate. For example, a tax-payer with earned income or AGI in the phase-out range and taxable income in the 10% income tax bracket has a 25.98% effective marginal tax rate on AGI, whether the AGI increase is due to earned income or other income. Each $100 of additional income increases income taxes by $10 and decreases the EIC by $15.98, for a net $25.98 increase in taxes.

Planning TipsSelf-employed taxpayers with earned income in the phasein range for the EIC for a tax year may be able to increase their EIC by deferring expenses from and accelerating income to that tax year. Choosing the optional method for pay-ing self-employment tax increases earned income and may increase the EIC.

Taxpayers in the phaseout range of the EIC may be able to accelerate deductions and defer income to qualify for a higher EIC.

Child Tax Credit

The child tax credit can be as much as $1,000 per qualifying child.

Qualifying ChildTo be a qualifying child the child must

■■ be age 16 or younger at the end of 2015;■■ be the taxpayer’s child (including adopted child, stepchild, foster child) or descendent (such as a grandchild); or must be the tax-payer’s sibling, half sibling, stepsibling, or


Child Tax Credit 29

1

the tax liability or 15% of the earned income that exceeds $3,000.

There is also a special calculation of the addi-tional child tax credit for taxpayers who have three or more children. The refundable portion is the smaller of two amounts:

1. The unused portion of the child tax credit, or2. The larger of either

a. 15% of a person’s earned income over $3,000, or

b. the net of (1) FICA taxes plus 50% of self-employment taxes the taxpayer paid, minus (2) the earned income credit

Example 1.16 Additional Child Tax Credit

Jason and Amanda Jackson have two children and file MFJ. Their AGI, all from earned income, is $30,000, and their income tax liability based on $1,400 of taxable income in 2015 is $141.

Because their $30,000 AGI is less than the $110,000 phaseout threshold, their $2,000 ($1,000 × 2 children) child tax credit is not reduced by the phaseout rules. However, their child tax credit is limited to their $141 income tax liability. They can claim the $1,859 ($2,000 – $141) remainder as additional child tax credit because it is less than the $4,050 [15% × ($30,000 – $3,000)] earned income limit.

Question 1. What if their earned income was only $10,000 of their $30,000 AGI?

Answer 1. The earned income limit would reduce their addi-tional child tax credit to $1,050 [15% × ($10,000 – $3,000)].

Question 2. What if all of the facts are the same as in Question 1, except that the Jacksons have three children?

Answer 2. Their taxable income would decrease by an addi-tional $4,000 exemption deduction, giving them a negative taxable income. They would not be entitled to any child tax credit because they have no tax liability. The earned income limit would still be $1,050. Because it is greater than the $765 ($10,000 × 7.65%) of social security and Medicare taxes withheld from their wages, their additional child tax credit would still be limited to $1,050.

FIGURE 1.44 Darwin’s Child Tax Credit with $86,000 AGI

AGI $ 86,000

Beginning of phaseout (75,000)

Excess over threshold $11,000

Excess ÷ $1,000 11

Maximum credit per qualifying child $1,000

Credit reduction (11 × $50) ( 550)

Remaining credit per qualifying child $ 450

Qualifying children × 3

Total child tax credit $1,350

Question.What is the effect of a $1 increase in AGI on Darwin’s child tax credit?

Answer.As shown in Figure 1.45, a $1 increase in Dar-win’s AGI reduces his child tax credit to $1,200—a $150 reduction.

FIGURE 1.45 Darwin’s Child Tax Credit with $86,001 AGI

AGI $ 86,001

Beginning of phaseout (75,000)

Excess over threshold $11,001

Excess ÷ $1,000 (rounded to next whole number) 12

Maximum credit per qualifying child $1,000

Credit reduction (12 × $50) ( 600)

Remaining credit per qualifying child $ 400

Qualifying children × 3

Total credit $1,200

Additional Child Tax CreditIf a taxpayer cannot claim part or all of the child tax credit because no tax is due or the tax is less than the allowable credit, the taxpayer may be able to claim an additional refundable credit if the taxpayer’s earned income is more than $3,000. The additional child tax credit is equal to the lesser of the allowable credit that exceeded



d. the amount from Form 2555, Foreign Earned Income, line 43, or Form 2555-EZ, Foreign Earned Income Exclusion, line 18; and

e. any Medicaid waiver payment excluded from income.

Child and Dependent Care Credit

Taxpayers who pay someone to care for a child or dependent while the taxpayer is working can qualify for a tax credit, but there are specific rules as to who can qualify for the credit. Two income limits apply. Qualifying expenses are limited by earned income, and as AGI increases expenses used to calculate the percentage is gradually reduced from 35% to a low of 20%. Taxpayers who file a MFS tax return cannot claim the credit.

Qualifying IndividualThe care must be provided for a qualifying individual, which is a person who is one of the following:

1. A dependent child of the taxpayer under age 13 at the time the care is provided

2. A spouse of the taxpayer who is physically or mentally incapable of self-care and lived with the taxpayer for more than half the year

3. A person who is physically or mentally inca-pable of self-care; lived with the taxpayer for more than half the year; and is either a depen-dent or would have been but for the follow-ing circumstances: the person’s gross income is the over the limit, the person files a MFJ return, or someone else claims the taxpayer as a dependent on his or her return

A person who is incapable of self-care can-not handle his or her own hygiene or nutritional needs. It can also apply when a person requires full-time attention for his or her own needs or the safety of others.

Qualifying PurposeThe reason for the care must be to allow the taxpayer (and spouse if MFJ) to either work or actively look for work. The expenses must be for the well-being and protection of the individual and not for any other reason.

Earned Income for the Additional Child Tax CreditSeveral special rules apply to the calculation of the earned income used to complete Schedule 8812 (Form 1040A or 1040), Child Tax Credit, for purposes of the additional child tax credit.

1. If there are net earnings from self-employ-ment and an optional method was used to figure the self-employment tax, the earned income must be calculated using the earned income worksheet in IRS Publication 972, Child Tax Credit.

2. If Worksheet B in the Form 1040 instructions was used to claim the EIC on the return, thena. the earned income is the income from

Worksheet B plus all nontaxable combat pay that was not already included, and

b. the earned income for a minister is the income from Worksheet B reduced by the rental value of the home or the nontaxable portion of an allowance for a home pro-vided to the minister, and reduced by the value of meals and lodging provided by the employer for his or her convenience.

3. If Worksheet B was not completed but EIC was claimed on the return, the earned income is the amount from Step 5 of the EIC work-sheet for Lines 66a and 66b (in the Form 1040 instructions) plus all nontaxable combat pay not already included.

4. If EIC was not taken on the return, and the taxpayer is self-employed, church-employed, or a statutory employee, the earned income is figured on the earned income worksheet in IRS Publication 972.

5. In all other cases, earned income is the income on line 7 (Form 1040 and 1040A) or line 8 (Form 1040NR) increased by all nontaxable combat pay from Forms W-2, Wage and Tax Statement, box 12, code Q, and reduced bya. any taxable scholarship or grant not

reported on a W-2;b. any amount received while an inmate in a

penal institution;c. any amount received as a pension or annu-

ity from a nonqualified deferred compen-sation plan or a nongovernmental section 457 plan;


Child and Dependent Care Credit 31

1

FIGURE 1.46 Child and Dependent Credit Percentage Based on AGI

If Your Adjusted Gross Income Is: Then the Percentage Is:Over: But Not over:

$ 0 $15,000 35%

15,000 17,000 34%

17,000 19,000 33%

19,000 21,000 32%

21,000 23,000 31%

23,000 25,000 30%

25,000 27,000 29%

27,000 29,000 28%

29,000 31,000 27%

31,000 33,000 26%

33,000 35,000 25%

35,000 37,000 24%

37,000 39,000 23%

39,000 41,000 22%

41,000 43,000 21%

43,000 No limit 20%

Effect on TaxesBecause the base for the child and dependent care credit is qualified expenses, the credit’s effect on taxes depends on the amount of qualifying expenses as well as the applicable percentage.

The effect of the AGI phasedown on taxes due is lumpy. For a given amount of qualifying expenses, a $1 increase in AGI that pushes AGI into the next $2,000 increment increases income taxes due by 1% of the qualifying expenses. The next $1,999 increase in AGI does not change the credit. On average, a $1 change in AGI in the phasedown range changes the credit by 0.0005% (1% ÷ $2,000) of the qualifying expenses.

If earned income limits the qualifying expenses [earned income is less than the lesser of (a) actual care expenses or (b) $3,000 ($6,000 for two or more qualifying individuals)], then a change in earned income that does not change the AGI phaseout bracket changes the credit by the applicable percentage for that bracket.

Because the credit is nonrefundable, the tax-payer’s effective income tax rate is zero if the credit exceeds the taxpayer’s income tax liability. Each $1 increase in tax liability is offset by $1 of credit that would otherwise be lost.

Qualifying Care ProviderThe care provider cannot be the taxpayer’s spouse, child under age 19, or a dependent claimed as a dependent on the return, nor can the provider be the parent of the qualifying indi-vidual. The care can be provided in the taxpay-er’s home or in the provider’s place of business. However, the services cannot be provided at a camp where the qualifying individual stays over-night or certain dependent care centers unless the center complies with all applicable state and local laws. Taxpayers must identify the care provider by name, address, and either social security num-ber or employer identification number, but they are eligible for the credit without the appropriate number if they can document a serious effort to secure the information.

Qualifying ExpensesThe maximum amount of expenses that qualify for the credit is $3,000 for one qualifying individ-ual or $6,000 for two or more qualifying individu-als. However, qualifying expenses cannot exceed the taxpayer’s earned income. For taxpayers fil-ing a MFJ return, qualifying expenses are limited to the lesser of their earned incomes. However, if one spouse is either disabled or a full-time stu-dent, he or she is deemed to have $250 of earned income ($500 if there are two or more qualifying individuals) for each month he or she is a student or is disabled during the tax year.

Example 1.17 One Spouse Is a Student

Peter and Jenny Smith are married and file a MFJ return. Jenny earned $20,000 of wages for the year. Peter earned nothing but was a full-time student for 8 months. They have two young chil-dren and paid $10,000 in child care expenses. Although Peter had no earned income; he is deemed to have $4,000 ($500 × 8 months) for purposes of the child and dependent care credit. Therefore, their maximum allowable credit is $4,000 for the two children.

Credit AmountThe credit is a percentage of the qualifying expenses. Figure 1.46 shows that the percentage amount decreases from 35% as AGI increases above $15,000. When AGI reaches $43,000, the percentage is reduced to 20% and remains at that level for AGI above $43,000.



to a retirement plan. Having the opportunity to contribute and actually contributing are two dif-ferent things, however. According to the same source, in private industry, as a whole, 65% of employees could contribute to a plan, but only 48% did contribute. The percentages are much higher in state and local government: 89% could contribute and 81% did contribute.

Contributions to a traditional or Roth IRA, a 401(k), SIMPLE IRA, SARSEP, 403(b), 501(c)(18), or governmental 457(b) plan qualify some taxpayers for the retirement savings con-tribution credit, also known as the saver’s credit. Qualified contributions also include voluntary after-tax employee contributions to qualified retirement and 403(b) plans. Merely rolling money from one plan to another will not qual-ify, and eligible contributions may be reduced by recent distributions from a retirement plan or IRA.

Eligibility for the CreditThe eligible taxpayer must be age 18 or older, not a full-time student, and not claimed as a dependent on another person’s return. A student is someone enrolled full-time at a school during any part of 5 calendar months during 2015, or someone who took a full-time on-farm training course given by a school or state, county, or local government agency.

Amount of the CreditThe maximum allowable credit is a percentage of up to $2,000 ($4,000 for MFJ returns) of qualified retirement savings contributions. The percentage is 50%, 20%, or 10% depending on the taxpayer’s AGI, as shown in Figure 1.47.

Zero Effective Marginal Tax Rate

If the credit exceeds the taxpayer’s income tax liability, shifting deductions from the current year to another year or shifting income from another year to the current year could reduce taxes in the other year without increasing current-year taxes� Similarly, shifting deductions to or income from another taxpayer could reduce the other taxpayer’s income taxes without increasing the income taxes of the taxpayer claiming the child and dependent care credit�

Planning TipsTwo planning tips may help maximize this tax credit in certain situations.

■■ It is a good idea to compare the benefits of taking the child and dependent care credit versus taking the medical expense deduc-tion. The same expenses cannot be used for both.

■■ Nontaxable combat pay can be included in income for this credit even if it is not included for the EIC or the exclusion or deduction for child and dependent care benefits.

Retirement Savings Contribution CreditAccording to the Bureau of Labor Statistics (BLS) in USDL-14-1348, issued July 25, 2014, 74% of full-time workers in private industry had access to a retirement plan. In small establishments 50% of workers and in medium and large establishments 82% of workers had the opportunity to contribute

FIGURE 1.47 2015 Saver’s Credit Percentages

Credit Rate MFJ HoH All Other Filers

50% of qualified contribution

AGI not more than $36,500




AGI $36,501–$39,500

AGI $27,376–$29,625

AGI $18,251–$19,750


AGI $39,501–$61,000

AGI $29,626–$45,750

AGI $19,751–$30,500


AGI more than $61,000




Education Credits 33

1

an IRA inherited from her mother?

Answer 2. No, she will still get the credit because she was not a spousal beneficiary.

Effect on TaxesThe effect of the AGI phasedown of the retire-ment savings credit on taxes due is lumpy. For a $2,000 qualifying contribution, a $1 increase in AGI that pushes AGI from the 50% bracket to the 20% bracket reduces the credit by $600 [$2,000 × (50% – 20%)]. The next $1,500 ($3,000 for MFJ and $2,300 for HoH) increase in AGI does not change the credit. The $1 increases in AGI that push AGI into the 10% and 0% brackets decrease the credit for the $2,000 qualifying contribution by $200 ($2,000 × 10%) each.

Planning TipsCareful planning may allow the taxpayer to claim the saver’s credit.

■■ Contributions to new or existing IRAs can be made until the due date of the return, but elective deferrals to employer plans must be made by the end of the year. Practitioners should encourage eligible participants to consider making contributions via payroll withholding to take advantage of this credit in 2016.

■■ Contributions result in a double benefit if the contribution reduces taxable income and the taxpayer is eligible for the saver’s credit.

Education Credits

There are two education credits: the American opportunity tax credit and the lifetime learning credit. Each has its own requirements, but both require the following:

■■ Qualified education expenses paid by the taxpayer, a qualifying student who is a dependent, or a third party

■■ Enrollment at an eligible education insti-tution (eligibility of the institution can be determined by checking with the institution or http://ope.ed.gov/accreditation/)

Distributions from Retirement PlansDistributions received after 2012 and before the due date of the 2015 return (including extensions) reduce the allowable amount of saver’s credit. This includes distributions from any of the quali-fied plans listed previously. It does not include the following:

■■ Nontaxable rollovers or trustee-to-trustee transfers

■■ Taxable distributions that result from an in-plan rollover to a designated Roth account

■■ Distributions from an eligible retirement plan rolled over or converted to a Roth IRA

■■ Loans from a qualified employer plan treated as a distribution

■■ Distributions of excess contributions or deferrals and income allocable to either or both

■■ Distributions of IRA contributions made and returned along with any income allocable to such contributions on or before the due date (including extensions) for that tax year

■■ Distributions of dividends paid on stock held by an employee stock ownership plan under I.R.C. § 404(k)

■■ Distributions from a military retirement plan■■ Distributions from an inherited IRA by a nonspousal beneficiary

Example 1.18 Saver’s Credit

Marcia Mansfield files MFS. Her AGI is $16,500. Her employer offers a profit-sharing plan to which he contributed $1,000 on her behalf last year.

Marcia does not qualify for the credit because she made no contributions. She could qualify if she made contributions via payroll withholding.

Question 1. Marcia opened a Roth IRA and made a $500 contribution in 2015. How much is her credit?

Answer 1. Marcia falls into the category of “all other filers” and will receive a $250 ($500 × 50%) credit.

Question 2.Is the answer different if Marcia funded her contribution to the Roth with a distribution from



An eligible student for the AOTC must be enrolled at least half-time in a college program leading toward a degree, certificate, or other recognized educational credential for at least one academic period during the tax year. The student cannot have completed the first 4 years of postsecondary education at the beginning of the tax year. Taxpayers cannot claim the Hope or AOTC credits for more than 4 years. By the end of the tax year, the student cannot have been convicted of a federal or state felony drug offense.

Income LimitationThe AOTC is phased out over a range of modi-fied adjusted gross income (MAGI). For most taxpayers MAGI is the same as the AGI, but the following must be added back if claimed on the return: foreign earned income exclusion, foreign housing exclusion, foreign housing deduction, and/or exclusion of income by bona fide resi-dents of American Samoa or Puerto Rico. The AGI phaseout range is $160,000 to $180,000 for MFJ filers and $80,000 to $90,000 for all other taxpayers. The credit is phased out pro rata over the AGI phaseout range. Therefore, the phaseout formula is as follows:

(End of phaseout range – MAGI) × qualifying credit = Allowable

creditAGI phaseout range

Example 1.19 AGI Reduction

David and Sandra Hope paid $3,000 of quali-fying educational expenses for their daughter. Their AGI is $165,000. Based on the qualifying expenses, their AOTC credit would be $2,250 [($2,000 × 100%) + ($1,000 × 25%)]. The AGI reduces their credit as follows:

($180,000 – $165,000) × $2,250 = $1,688$20,000

Effect on TaxesFor taxpayers who file a MFJ return, a $1 increase in AGI in the phaseout range increases their tax due by 0.005% ($1 ÷ $20,000) of their qualify-ing credit. For all other taxpayers a $1 increase in

■■ An eligible student (taxpayer, spouse, or dependent listed on the tax return)

If an individual is eligible for both credits, either credit can be claimed, but not both for the same person.

Neither credit can be claimed if the taxpayer is filing MFS or if the taxpayer can be claimed as a dependent on anyone else’s return (such as a parent’s). Education credits are also not allowed if either spouse is a nonresident alien who does not elect to file as a resident alien.

Education Credits

See the “Education Provisions” chapter in the 2013 National Income Tax Workbook for more information on education credits�

American Opportunity Tax CreditThe American opportunity tax credit (AOTC) has been extended through December 31, 2017. It is the temporary replacement for the Hope credit, but it can be claimed for 4 years instead of 2, offers credit for books and supplies not pur-chased at the educational institution, and pro-vides that up to 40% of the credit is refundable.

The credit is 100% of the first $2,000 of expenses plus 25% of the next $2,000 for a $2,500 maximum credit. This means the maximum refundable amount is $1,000 ($2,500 × 40%). Expenses paid during the year must be for an academic period that begins in the same tax year or one that begins in the first 3 months of the fol-lowing year.

Expenses that do not qualify for the credit include:

■■ Room and board■■ Transportation■■ Insurance■■ Medical expenses■■ Student fees not required as a condition of enrollment or attendance

■■ Expenses paid with tax-free educational assistance

■■ Expenses used for any other tax deduction, credit, or educational benefit


Education Credits 35

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Income LimitationThe MAGI phaseout ranges are lower than those for the AOTC: $110,000 to $130,000 for MFJ fil-ers and $55,000 to $65,000 for all other taxpay-ers. The credit is phased out pro rata over the AGI phaseout range. Therefore, the phaseout formula is the same as for the AOTC.

Effect on TaxesThe effect of the AGI phaseout is the same as for the phaseout of the AOTC. For taxpayers who file a MFJ return, a $1 increase in AGI in the phaseout range increases their tax due by 0.005% ($1 ÷ $20,000) of their qualifying credit. For all other taxpayers a $1 increase in AGI in the phaseout range increases their tax due by 0.01% ($1 ÷ $10,000) of their qualifying credit.

AGI in the phaseout range increases their tax due by 0.01% ($1 ÷ $10,000) of their qualifying credit.

Lifetime Learning CreditTaxpayers can claim a lifetime learning credit equal to 20% of the first $10,000 of qualified education expenses (tuition, fees, and expenses that must be paid to the institution as a condition of enrollment) for all eligible students. There is no limit on the number of years taxpayers can claim the credit. There is no degree requirement to qualify: courses taken to acquire or improve job skills also meet the requirements. Unlike the AOTC, the lifetime learning credit is not refund-able, and felony drug convictions do not make a student ineligible.

FIGURE 1.48 2015 Phaseout of Credits: MFJ

FIGURE 1.49 2015 Phaseout of Credits: HoH



She used $100 of tax-exempt bond interest to help pay for her son Bobby’s schooling. He also got a $1,200 Pell grant, a $500 scholarship, and an $800 loan. He lived at home. His allowable education expenses for 2015 totaled $3,200.

American Opportunity Tax Credit Bobby’s expenses for computing Barbara’s AOTC are $1,400: $3,200 reduced by $100 of US savings bond interest, a $1,200 Pell grant, and $500 of scholarships. Therefore, her total AOTC is $1,400 (100% × $1,400), but her nonrefund-able amount is limited to her $1,003 income tax liability. Because the remaining $397 ($1,400 – $1,003) is less than 40% of $1,400 ($1,400 × 40% = $560), she can claim the remainder as a refund-able credit.

Summarizing the Credits

Figures 1.48 through 1.51 show the phaseout ranges for the credits discussed in this section.

Case Studies

Picking up with Barbara, Gloria, and Wilma again, this time we can see how the credits affect their returns.

Case #1: Barbara BrownBarbara’s earned income is $28,000, her AGI is $27,250, and her income tax liability is $1,003.

FIGURE 1.51 2015 Phaseout of Credits: MFS

FIGURE 1.50 2015 Phaseout of Credits: Single


Conclusion 37

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■■ Gloria’s $60,320 AGI exceeds the phaseout range for the EIC.

■■ Gary is not a qualifying child for the child tax credit.

■■ Gary is not a qualifying individual for the child and dependent care credit.

■■ Gloria’s $60,320 AGI is in the 0% bracket for the retirement savings credit.

Case #3: Wilma WhiteWilma’s earned income is $300,000, her AGI is $326,000, and her total tax is $70,240 ($61,115 regular and $9,125 AMT). She used $4,000 in savings bond interest to help pay her son Wayne’s college expenses, but she had to report the $4,000 in income. Wayne’s total college costs in 2015 were $73,000, including $12,000 for room and board. He received scholarships totaling $18,000. The remaining cost was paid with the proceeds from a 529 plan.

Wilma’s $326,000 AGI exceeds the phase-out range for all of the credits discussed in this section except the child and dependent care credit. She cannot claim the child and depen-dent care credit because she does not have a qualifying individual.

Conclusion

Ultimately in the case of the credits, the taxpay-ers who qualify for the EIC have the most benefit because it is a refundable credit; beyond that they are at a disadvantage because they usually do not have the tax liability to offset the credit. The ones who fall more into the middle income range (between $50,000 and $150,000 AGI, depending upon the filing status) get the most benefit with the individual credits because they have enough tax to take advantage of them. Once taxpayers get beyond that AGI range, most of the credits are no longer viable for them. The real problem areas, such as PEP and Pease reductions, come into play only with incomes above $250,000 and, in most cases, do not actually do a lot of damage.

Earned Income CreditBecause Bobby is still a full-time student, Barbara qualifies for the EIC. Her $28,000 earned income is in the phaseout range for the EIC. The 2015 EIC table shows that her EIC is $1,775. All of it is refundable.

Retirement Savings CreditBarbara’s $27,250 AGI is in the 50% retirement savings credit bracket. She could have claimed a $375 (50% × her $750 IRA contribution) credit, but her AOTC reduced her tax liability to zero, so she cannot claim the retirement savings credit.

Child Tax Credit and Child and Dependent Care CreditBarbara cannot claim the child tax credit or the child and dependent care credit because she does not have a qualifying child for the child tax credit and does not have a qualifying individual for the child and dependent care credit. Bobby is over the age limit for both credits.

Refundable CreditsBarbara can claim a $2,172 ($397 AOTC + $1,775 EIC) refundable credit.

Case #2: Gloria Green Gloria’s earned income is $58,000, her AGI is $60,320, and her income tax liability is $3,554. She used $2,000 in tax-exempt savings bond interest to help pay for her son Gary’s college in 2015. Gary received a $10,000 tuition scholarship, and his total qualified costs were $14,000. He also had $8,000 of room and board expenses.

American Opportunity Tax CreditGary’s qualifying expenses for Gloria’s AOTC do not include the $8,000 room and board expenses. His $14,000 of qualified costs are reduced by his $10,000 scholarship and Gloria’s $2,000 exempt savings bond interest, resulting in $2,000 ($14,000 – $10,000 – $2,000) to compute Gloria’s AOTC. Therefore, her AOTC is $2,000 ($2,000 × 100%).

Other CreditsGloria does not qualify for any of the other credits discussed in this section.


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