What is Income?

Generally speaking, income is financial gain derived from labor (work), capital (money) or a combination of the two. Unless specifically exempt or excluded by law, all income is subject to income tax and is reported on the tax return.

Gross income is total worldwide income received in the form of money, property, or services that is subject to the tax. There are two types of gross income:

• Earned income is received for services performed. Some examples are wages, commissions, tips, and generally, farming and other business income.
• Unearned income is taxable income that does not meet the definition of earned income. It includes money received for the investment of money or other property, such as interest, dividends, and royalties. It also includes pension, alimony, unemployment compensation, and other income that is not from performing service.

Non taxable income is by law exempt from tax. Exempt income includes child support, municipal bond interest, welfare benefits, VA benefits, various military allowances, workers' compensation, gifts, and life insurance proceeds paid to the death of the insured.

Gross Income

There are two aspects to determining gross income:

1. Who owns the income, and
2. What income should be reported on a tax return.

Ownership of income is determined by state law. The laws regarding the ownership of income and property in most states are based on British common law. These states are called separate property states. In separate property states, income belongs to the person who earned it or who owns the property that produced the income.

Nine states are community property states. With the exception of Wisconsin, the laws of community property states are based on Spanish civil law. Generally, in community property states, income received by a married couple for services performed is considered to belong half to the husband and half to the wife regardless of which of them earned the income. The laws regarding the ownership of income from property vary among these states. The nine community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Generally, ownership of the income of a married couple needs to be determined only if they file separate returns.

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Filing Requirements

The first step in completing an income tax return is to determine if the taxpayer needs to file a return in the first place. In this section, you'll study the filing requirements for federal income tax purposes.

Individuals who had income tax withheld from their wages or who are eligible for certain credits, which you'll learn about later in this course, should file a tax return, even if not required to do so.

Special filing requirements apply to taxpayers who may be claimed as dependents on another taxpayer's return. First, we'll discuss taxpayers who are not dependents; then we'll look at those who are dependents.

Non dependent Taxpayers

In order to determine if a taxpayer is required to file an income tax return, you need to know his marital status, age, and gross income. You need to know the marital status and whether the taxpayer is age 65 or older because these facts help you determine how much gross income the taxpayer may have before being required to file. Once marital status is determined, you need to know whether a married couple will file a joint return or separate returns because this choice also affects filing requirements with respect to income.

Marital Status

Marital status (married or unmarried) is determined by the taxpayer's status of a person who died during the year, as well as that of his surviving spouse, is determined as of the date of death.

Example:

Maricar and Mario were wed on December 31, 2007. They are considered married for the 2007 tax year.

Rey and Ani's divorce decree became final on December 31, 2007. They are considered unmarried for the 2007 tax year. Arding and Remy were married on the day Arding died, March 27, 2007. Both Arding and Remy are considered married for the year 2007 tax.

Common Law Marriage

A taxpayer is considered married if, at the end of the tax year, he is in a common law marriage that is recognized in the state where the couple is residing, or was at the time recognized by the state where the common law marriage began.

AGE

Taxpayers are considered to be age 65 on the day before 65th birthdays.

Example:

Jacob Martin's 65th birthday is January 1, 2007; for tax purposes, he is considered age 65 for the 2006 tax year.

The age of a person who dies during the year is determined as of the date of death.

For federal income tax purposes, there are five filing statuses:

1. Single;
2. Married filing jointly;
3. Married filing separately;
4. Head of household; and
5. Qualifying widow(er)

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Retirement Benefits

Everyone wants a financially secure retirement, and most people take some steps to provide for their later years. Almost all employed and self-employed Americans are required to contribute to the social security system. In addition, many people belong to retirement plans where they work, contribute to individual retirement arrangements (IRAs), or buy annuities.

SOCIAL SECURITY AND EQUIVALENT RAILROAD RETIREMENT BENEFITS

Many taxpayers who are retired, disabled, or whose spouses or parents are deceased may receive social security or equivalent tier 1 rail road retirement benefits. The maximum benefit amount for 1999 is $1,373 per month. Some of these benefits may be taxable, depending upon the taxpayer's circumstances. Taxpayers above a certain income level will pay tax on a portion  of their social security income, while lower income taxpayers will enjoy tax-free social security benefits.

Note: For purposes of this section, the term "benefits" applies only to those payments made under the Old-Age, Survivors, and Disability Insurance program (OASDI), which is funded through the social security payroll tax and based on prior earnings. Social security benefits do not include SSI (Suplemental Security Income), which is federally funded program of income assistance based on financial need for the aged, blind, and disabled. The Social Security Administration administers both programs, but SSI benefits are not taxable. 

For 1999, up to 85 percent of a taxpayer's social security and equivalent tier 1 railroad retirement benefits may be taxable. Generally, however, if these benefits are the only source of a taxpayer's income, they won't be taxable. This also holds true if the taxpayer's other income is small.

Forms SSA-1099 (for social security) and RBB-1099 (for railroad retirement) are used to notify the taxpayer of total benefits received during the year. Also indicated is the amount of repayment of benefits the taxpayer made, if any.

Each individual recipient of social security and tier 1 railroad retirement of social security and tier 1 railroad retirement receives Form SSA-1099 or RRB-1099. For example, if a widowed parent receives one monthly benefits check that includes benefits for that parent as well as two minor children, each of them will receive a separate Form 1099 reporting his share of the year's benefits.

Computing Taxable Benefits

The amount of a taxpayer's social security or tier 1 railroad retirement benefits that is subject to federal income tax varies from zero to 85 percent of the taxpayer's benefits, depending on the taxpayer's income level and filing status. None of the benefits are taxable unless the taxpayer's modified adjusted gross income (defined below) plus half the taxpayer's benefits exceeds $32,000 (MFJ), $25,000 (S.HH, QW, or MFS and the taxpayer didn't live with his spouse at any time during the year), or $0 (MFS and the taxpayer lived with his spouse at any time during the year).

Note: the above amount is subject to change.(The amount it depend of current year stated)

Social security and equivalent railroad retirement benefits may be nontaxable or partially taxable, depending on the taxpayer's other income and filing status. 

PENSION AND ANNUITIES

Contribution - When a person puts money into retirement plan.

Distribution -When a person takes or receives money from a retirement plan.

When a taxpayer receives a distribution from a pension or annuity, he must sometimes determine how much of the amount he receives is taxable and how much is not.

If the taxpayer made no contribution to the pension plan or annuity (for example, his employer paid all the costs), or if the taxpayer made only pre-tax contributions to a plan such as a 401(K) plan, the entire amount received during the year is taxable.

If the taxpayer did make after-tax contributions to the pension plan or to the cost of the annuity, part of the amount received is a return of his cost (investment) and is nontaxable. The balance represents a return of his employer's cost and and amounts earned from the investment of the pension plan's funds.

Simplified and Special Averaging Methods

Simplified Method

The simplified method may be used to compute the taxable portion of a pension or annuity with a starting date after July1, 1986. The pension or annuity must meet the following three conditions:

• The payments are for either the annuitant's life or the joint lives of the annuitant and a beneficiary;
• The payments must be from a qualified pension, profit-sharing, or stock bonus plan; a qualified employee annuity plan; or a tax-sheltered annuity; and
• The annuitant must be under 75 years of age when the payments begin, or if 75 or older, there must be fewer than five years of guaranteed payments.

Pension and annuity income is fully taxable if the taxpayer did not contribute after-tax money to the cost of the pension or annuity or, in some cases, if the taxpayer has recovered his entire cost  in previous years. Use of the simplified method for computing the taxable portion of a pension or annuity is generally mandatory for pensions starting after November 18, 1996. 

SPECIAL AVERAGING METHODS

When a taxpayer receives a lump-sum distribution he has some choices to make. He may choose to roll over all or part of the distribution into a traditional IRA or other eligible retirement plan within 60 days. Any amount the taxpayer rolls over isn't currently taxable.

Ten-Year Averaging

Ten-year averaging may be used to compute the tax on a lump-sum distribution only if the emplyee or self-employed person

1. Was born before January 1, 1936, and
2. Was an active participant in a qualified plan for at least five full years (except in the case of death) before the year of the distribution. If the distribution was made due to the death of the plan participant, the beneficiary may use special 10-year averaging if the distribution otherwise qualifies.

Qualified higher education expenses

The expenses must be paid for the taxpayer, his spouse, or the child or grandchild of the taxpayer or spouse.

Qualified first-time home-buying expenses

For the purpose of exception 9, are any costs of acquiring or construction a principal residence for a firs-time homebuyer. The term first-time homebuyer is misleading; what it really means is someone who has not owned a home during the two-year period prior to the acquisition of the home to which this exception applies.

The distribution must be used to pay qualified expenses within 120 days of the date of distribution. The expenses must be paid for the taxpayer, his spouse, child, or grandchild, or parent or grandparent.

SIMPLE Distributions

Early withdrawals from a SIMPLE IRA are generally subject to the usual 10-percent penalty, but a 25  percent penalty applies to withdrawals made during the first two years in which an employee participates in the plan.

Rollovers can be made from one SIMPLE IRA to another. Rollovers to traditional IRAs are permitted at the end of two years of participation in the plan.

See: Self-employment income

CREDIT FOR THE ELDERLY OR THE DISABLED

The credit for the elderly or the disabled is a nonrefundable credit available to low-income taxpayers who are age 65 or older or who are permanently and totally disabled at the end of the tax year. This credit has not been adjusted for inflation since 1983. Due to the numbers involved, nowadays it is a fairly rare occurrence when a taxpayer actually gets the credits, but we'll discuss it briefly for your awareness.

To be eligible for the credit, a taxpayer must be:

• A qualified individual (define below);
• A U.S. citizen or resident for the entire year (or a nonresident alien who is married to and filing a joint return with a U.S. citizen or resident); and
• Filing a joint return if married at the end of the tax year, unless the taxpayer and his spouse did not live together at any time during the tax year or the taxpayer qualifies to be considered unmarried.

A qualified individual is one who is 65 or older; or, if under age 65

1. is retired because of permanent and total disability,
2. had not reached the mandatory retirement age for his employer's retirement program at the beginning of the tax year, and
3. has received taxable disability benefits during the year.

 Disability Pensions

If a taxpayer under 65 is retired because of a disability and received a taxable disability pension due to this disability during the year from an employer-funded disability plan or a disability provision of a retirement plan, he is eligible to claim the credit for the elderly or disabled if he was permanently and totally disabled at the time he retired and is still permanently and totally disabled.

CREDIT FOR THE ELDERLY OR THE DISABLED

The credit for the elderly or the disabled is a nonrefundable credit available to low-income taxpayers who are age 65 or older or who are permanently and totally disabled at the end of the tax year. This credit has not been adjusted for inflation since 1983. Due to the numbers involved, nowadays it is a fairly rare occurrence when a taxpayer actually gets the credits, but we'll discuss it briefly for your awareness.

To be eligible for the credit, a taxpayer must be:

• A qualified individual (define below);
• A U.S. citizen or resident for the entire year (or a nonresident alien who is married to and filing a joint return with a U.S. citizen or resident); and
• Filing a joint return if married at the end of the tax year, unless the taxpayer and his spouse did not live together at any time during the tax year or the taxpayer qualifies to be considered unmarried.

A qualified individual is one who is 65 or older; or, if under age 65

1. is retired because of permanent and total disability,
2. had not reached the mandatory retirement age for his employer's retirement program at the beginning of the tax year, and
3. has received taxable disability benefits during the year.

 Disability Pensions

If a taxpayer under 65 is retired because of a disability and received a taxable disability pension due to this disability during the year from an employer-funded disability plan or a disability provision of a retirement plan, he is eligible to claim the credit for the elderly or disabled if he was permanently and totally disabled at the time he retired and is still permanently and totally disabled.

Permanent and Total Disability

To be considered permanently and totally disabled, a taxpayer must be unable to engage in any substantial gainful activity because of a medically determined physical or mental impairment that is expected to result in death, or that has lasted or is expected to last for a continuous period of at least 12 months.

Substantial gainful activity means performing significant physical or mental work for pay or profit (or intended for profit). Part-time work may constitute substantial activity. The fact that the work activity may pay less than the one in which the taxpayer was engaged prior to the disability is immaterial.

The following nontaxable income must be taken into account and will reduce the maximum amount on which the credit is computed:

• Nontaxable social security and equivalent tier 1 railroad retirement benefits;
• Nontaxable veterans' pensions; and
• Any other pension, annuity, or disability benefits excluded from gross income (but not the cost recovery portion of a pension or annuity).