Welcome back. So, let's take what we've learned from our first seven modules and tackle a comprehensive example. Meet Jerry and Elaine. Both are age 40. They are married, and they file a joint tax return, and they have two children, Kramer and George, ages 16 and 12. Jerry and Elaine have the following items of income: They have a combined $150,000 of wages. They have interest from a city of Chicago bond for $4,000. They have interest from a US Treasury Bond of $5,000. They received a gift from Elaine's mother of a new automobile, which has a fair market value of $15,000. They received a refund of $5,000 from the State of Illinois for state and local income taxes they had previously deducted on a prior year tax return; and they have a short-term capital loss of $10,000 from the sale of stock, and this particular stock does not qualify for special treatment under Section 1244. They also incurred the following expenses during the year. They have contributions of $3,500 each to Jerry and Elaine's traditional IRAs, so that's $7,000 in total, and neither Jerry nor Elaine is covered by a qualified retirement plan at work. They have qualified medical expenses of $15,000, which were not reimbursed by insurance or any other party. They have personal credit card interest expense of $3,000, charitable contributions of $6,000. They have a speeding violation ticket they paid that was $300. They have mortgage interest on their principal residence of $10,000. The mortgage debt itself is $300,000, and they pay property taxes on their principal residence of $6,000, and they paid income taxes to the State of Illinois totaling $8,000. So, looking at these facts, let's calculate Jerry and Elaine's gross income, deductions for AGI, AGI deductions from AGI, taxable income, federal tax liability, their average tax rate, their effective tax rate, and their marginal tax rate. So, the first place to start is gross income. What items are includable in gross income versus excludable or excluded from gross income? First, let's look at wages. These are going to be includable in gross income. The interests from the US Treasury bonds are also includable in gross income. You'll recall that interests from federal bonds, those issued by the United States government, are taxable. However, the interest from the city of Chicago bond is not includable in gross income, and that's because municipal bond interest is excluded from gross income, and as a reminder, municipal bonds or bonds issued by a state or local government, for example, the State of Illinois or the city of Champaign. Moving on down, the value of the car is excluded from gross income because it is a gift. Gifts are non-taxable to the recipient. The Illinois tax refund is included because it was deducted in the prior year. This is an application of the tax benefit rule. We took a deduction for a payment that we made, so when that payment is refunded, we must reverse out the deduction by including the refund and gross income when we receive it. Finally, we get to the $10,000 capital loss. Since this is the only item on Jerry and Elaine's return that involves a capital or Section 1231 asset, those are things we'll learn about in a later course, we don't need to do any netting. But, you will recall that taxpayers are only allowed to deduct a net capital loss of up to $3,000. That means that $7,000 of this loss cannot be used in the current year and will instead become a carryover. So, we include in gross income just $3,000 of the loss. So, when we add up wages, the federal bond interests, the taxable state refund, and the $3,000 capital loss, we come up with a taxable gross income of $157,000. Next, let's look at deductions for AGI. First, let's look at the traditional IRA contributions that Jerry and Elaine made. Because Jerry and Elaine are not covered by a retirement plan at work, there are no AGI restrictions on their ability to deduct a traditional IRA contribution. So, they can both contribute to their IRA up to the contribution limit, which in 2018 is $5,500 per taxpayer. Here, they contributed $3,500 each. So, that's $7,000 in total, it's below the limit, and it's a for AGI deduction or an above-the-line deduction. Looking down the list, there are no other for AGI deductions. So, this is going to make our AGI $150,000, that is $157,000 of gross income minus the $7,000 for AGI deduction for the IRAs. Next, we'll move on to calculate our from AGI deductions. So first, we'll need to compare the size of the standard deduction to our taxpayers' itemized deductions. So here, how are Jerry and Elaine filing their tax return? Probably married filing jointly, since that usually but not always generates the best tax results for a married couple. So, we'll go ahead and assume the couple is filing married filing jointly. So, that would put their standard deduction in 2018 at $24,000. This means, if we can get our itemized deductions to exceed $24,000, we'll itemize. If not, we'll stick with the standard deduction. So, looking back at Jerry and Elaine's expenditures, let's see if we can spot any allowable itemized deductions. First, medical expenses. They incurred $15,000 of qualified medical expenses that were not reimbursed by insurance or any other third party. Qualified medical expenses are an itemized deduction, but they are limited. We can only deduct those qualified medical expenses, which exceed the AGI floor, which in 2018 is 7.5% of AGI. We previously computed the couple's AGI to be $150,000, 7.5% of $150,000 is $11,250. So, only those qualified medical expenses that exceed $11,250 can be deducted, $15,000 minus $11,250 gives us our deduction, $3,750. The next from AGI deduction, is for charitable contributions of $6,000. Charitable deductions have an AGI ceiling for individuals. Meaning that the total deduction for charitables, cannot exceed some percentage of AGI, depending on the type of contribution. In the case of cash contributions, it's a 60% of AGI ceiling starting in 2018. But, we can see here based on our taxpayer's AGI and the amount of their charitable contributions, we're not even close to any applicable ceiling. So, the whole $6,000 in contributions are going to be deductible as an itemized deduction. The next from AGI deduction is for mortgage interest on the couple's primary residence, and this is $10,000. And because the mortgage balance is below the applicable cap, they are going to be able to deduct the full $10,000. Next, let's take a look at the couple's state and local taxes paid. First, we have local property taxes on the residents of $6,000, as well as state income taxes paid to the state of Illinois of $8,000. These are both from AGI itemized deductions. But you'll recall, that there's currently from tax year 2018 through tax year 2025, a $10,000 cap on the amount of state local taxes that can be deducted as an itemized deduction. So, they paid $14,000, but $10,000 is all we can deduct. I'll note here that the speeding violation ticket at $300 is not going to be deductible, and the $3,000 in personal credit card interests is also not going to be deductible. So, when we add up all of the itemized deductions, we come up to $29,750, which is higher than the standard deduction for a married couple filing jointly. So, for Jerry and Elaine, we'll go ahead and itemize, since it's the larger of the two. So, let's take what we've done so far and put it into our tax calculation. We have includable gross income of $157,000. We then subtracted out $7,000 of IRA contributions as a for AGI deduction, which gave us an AGI of $150,000. We then deduct our itemized deductions of $29,750. And because we don't have any income from a sole proprietorship or a pass-through business, we don't need to worry about that 20% qualified business income deduction. So, this gives us taxable income of $120,250. Let's take this amount to the tax table to see what Jerry and Elaine's total tax is going to be. On the married filing jointly tax table, we'll look for the interval that contains the couple's taxable income, which we'll find on the third row of the table. We'll then plug in our taxable income number into the calculation and find that the couple's total tax is going to come out to $18,334. But, we're not going to stop there. Remember, that Jerry and Elaine had some dependents living on their household. They had two children under the age of 17. So, assuming that George and Kramer meet all the other requirements of being a qualifying child, and because the couple was below the applicable AGI phase-out threshold, they're going to be eligible for a child tax credit. That credit is going to be worth $2,000 per child. So, this is going to reduce their total tax bill by $4,000, taking it down to $14,334. So, now that we know the couple's total tax, let's compute their average tax rate, effective tax rate, and marginal tax rate. First, let's calculate the average tax. You'll recall that the average tax rate is the federal tax liability divided by the tax base or here taxable income. So, here Jerry and Elaine's federal tax liability is $14,334. If we divide that by their taxable income, $120,250, we get an average tax rate of approximately 11.9%. The effective tax rate is their total tax divided by total income. So, here we're going to use $169,000 as total income, which is the sum of all their income items, including the excluded municipal bond interests, the excluded value of the gift, and the full value of their capital loss. This is going to give us an effective tax rate of approximately 8.5%. Finally, what is Jerry and Elaine's marginal tax rate? Here, the marginal tax rate is going to be the rate applied on the next dollar of income earned. If Jerry and Elaine were to earn one more dollar of income, the tax rate that would apply would be 22%. We can infer that right off the tax table.
