“Stacking” approach is applied to calculate tax on LTCG/Qualified dividends. Ordinary income is taxed first at ordinary rates, filling up the lower tax brackets. Then, LTCG and qualified dividends are “stacked” on top and taxed at the applicable capital gains rate based on where your total income lands. This means that if your ordinary income pushes you into a higher bracket, your LTCG/qualified dividends may be taxed at a higher capital gains rate.

Ordinary income tax rates are depending on filing status and taxable income (See Federal income tax rates and brackets).  As ordinary income goes up, the tax rate on the next layer of income is higher. When taxable income jumps to a higher tax bracket, higher tax rate only applies to the portion that’s in the new tax bracket. Net short-term capital gains are taxed as ordinary income.

Long-term capital gains and qualified dividends are separated from ordinary income because they are eligible for relatively lower tax rates. However, the tax rates are depending on overall taxable income (See Federal capital gain tax rates). Capital gains can be grouped into the following categories.

• Long-term capital gains and qualified dividends can be taxed at 0%, 15%, or 20% depending on taxable income and filing status.
• The taxable portion of a gain from selling section 1202 qualified small business stock is taxed at a maximum 28% rate.
• Net capital gains from selling collectibles (such as coins or art) are taxed at a maximum 28% rate.
• The portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25% rate.

Taxes for Certain Children Who Have Unearned Income (Kiddie tax)

The kiddie tax applies to certain children who have unearned income (e.g., investment income like interest, dividends, and capital gains) above a specific threshold. It was established to prevent parents from shifting income to their children to take advantage of the child’s lower tax bracket. If the kiddie tax applies, the child may need to file their own tax return using Form 8615, “Tax for Certain Children Who Have Unearned Income.” In some cases, parents may elect to include the child’s income on their own tax return using Form 8814, “Parents’ Election To Report Child’s Interest and Dividends,” if certain conditions are met.

Other Taxes from Form 1040 Schedule 2

In addition to income tax calculated based on ordinary income and capital gain taxes, there are other tax liability integrated into the calculation of final tax liability.

Other taxes which can be reduced by nonrefundable credit (Schedule Part I):

Alternative Minimum Tax (AMT) (§55 et seq.)

The Alternative Minimum Tax (AMT) is a parallel tax system designed to ensure that certain taxpayers pay at least a minimum level of tax. It was enacted to prevent high-income individuals from using excessive deductions, exclusions, or tax preferences to avoid paying a fair share of federal income tax. The AMT calculation begins with regular taxable income and makes adjustments by adding back specified preference items to arrive at Alternative Minimum Taxable Income (AMTI). From AMTI, an exemption amount is subtracted, and the remaining balance is subject to AMT rates of 26 percent and 28 percent. If the resulting tentative minimum tax is greater than the taxpayer’s regular tax liability, the difference is owed as AMT. The AMT is reported and calculated on Form 6251, Alternative Minimum Tax—Individuals.

Other taxes which cannot be reduced by nonrefundable credit (Schedule Part II):

Employment Taxes Catch-Up:

Self-Employment Tax (§ 1401 et seq.):

The self-employment tax applies to individuals who work for themselves as independent contractors, sole proprietors, or members of partnerships. It covers both the employer and employee portions of Social Security and Medicare taxes. In a traditional employer-employee relationship, the employer and employee each pay half of these taxes. Self-employed individuals, however, are responsible for paying both portions. The combined rate is generally 15.3 percent, consisting of a Social Security portion and a Medicare portion. The Social Security portion (12.4 percent) applies only up to an annual wage base limit, which is adjusted each year for inflation. The Medicare portion (2.9 percent) applies without a cap. Self-employed individuals compute this tax on Schedule SE (Form 1040), based on their net earnings from self-employment. To help equalize the burden, one-half of the self-employment tax is deductible as an adjustment to gross income under §62(a)(14).

Additional Medicare Tax (§ 3101(b)(2) and § 1401(b)(2)):

The Additional Medicare Tax is imposed at a rate of 0.9 percent on wages, compensation, and self-employment income that exceeds certain threshold amounts based on filing status. These thresholds are set by statute and remain fixed; they are not indexed for inflation and therefore do not change annually. The statutory thresholds are $200,000 for single filers, heads of household, and qualifying widow(er)s; $250,000 for married taxpayers filing jointly; and $125,000 for married taxpayers filing separately. This tax is in addition to the regular 1.45 percent Medicare tax withheld from wages or paid through self-employment tax. Taxpayers report the Additional Medicare Tax on Form 8959, Additional Medicare Tax.

Surtaxes on Specific Income Types or Income Levels:

These are additional taxes imposed on particular types of income or when income surpasses certain levels.

Net Investment Income Tax (NIIT) (§ 1411): This is a 3.8% tax on the net investment income of individuals, estates, and trusts with income above certain threshold amounts. Investment income includes items like interest, dividends, capital gains, rental and royalty income, and passive income from businesses. The thresholds are the same as those for the Additional Medicare Tax: $200,000 for single filers, heads of household, and qualifying widow(er)s; $250,000 for those married filing jointly; and $125,000 for those married filing separately. This tax is reported on Form 8960, Net Investment Income Tax.

Tax Credits

Once the initial income tax liability has been computed based on taxable income and the applicable tax rates, the final amount owed or potentially refunded is significantly influenced by tax credits. These credits directly reduce the amount of tax a taxpayer owes, dollar for dollar. Understanding the various types of tax credits available and how they are applied is a critical final step in accurately determining an individual’s total tax obligation or potential refund. These credits are often aimed at encouraging specific behaviors or providing relief for certain expenses.

Nonrefundable Credits

Nonrefundable credits are credits that can reduce a taxpayer’s income tax liability down to $0, but not below $0. In other words, if the total amount of nonrefundable credits exceeds the tax liability before credits, the excess credit is generally lost; the taxpayer will not receive it as a refund.

Here are some examples of common nonrefundable credits with their relevant Internal Revenue Code references:

Child and Dependent Care Credit (§ 21):

This credit helps taxpayers pay for the care of a qualifying child or other dependent so they can work or look for work. The amount of the credit is a percentage of the work-related expenses, up to a certain limit, and the percentage is based on the taxpayer’s adjusted gross income (AGI). This credit recognizes the financial burden of childcare for working families.

Lifetime Learning Credit (§ 25A):

This credit is for qualified tuition and other related expenses paid for courses taken towards a degree or to acquire job skills. Unlike the American Opportunity Tax Credit (discussed later), the Lifetime Learning Credit can be claimed for an unlimited number of years. It is designed to support ongoing education and skill development.

Retirement Savings Contributions Credit (Saver’s Credit) (§ 25B):

This credit helps individuals with modest incomes save for retirement. Eligible taxpayers contributing to an IRA or employer-sponsored retirement plan may qualify for this credit. The amount of the credit depends on the taxpayer’s AGI and contribution amount. It encourages retirement savings, especially among lower-income individuals.

Foreign Tax Credit (§ 901):

This credit is available to taxpayers who have paid or accrued foreign income taxes on income earned abroad. It prevents double taxation on the same income by allowing taxpayers to offset their U.S. tax liability with the amount of taxes paid to foreign governments.

General Business Credit (§ 38):

This credit is an amalgamation of numerous smaller business-related credits, such as the work opportunity credit, the credit for increasing research activities, and the renewable energy credit. These credits incentivize various business activities.

Adoption Credit (§ 36C):

This credit helps taxpayers with the expenses related to adopting an eligible child. The amount of the credit is limited and may be nonrefundable or refundable depending on the tax year and specific circumstances. It assists families with the costs associated with adoption.

Refundable Credits

Refundable credits, on the other hand, can reduce a taxpayer’s income tax liability below $0. If the total amount of refundable credits exceeds the tax liability before credits, the taxpayer will receive the excess as a tax refund. These credits often serve as a form of direct financial assistance to eligible individuals and families.

Here are some examples of common refundable credits with their relevant Internal Revenue Code references:

Earned Income Tax Credit (EITC) (§ 32):

This credit is for low-to-moderate income working individuals and families. The amount of the credit depends on the taxpayer’s income and the number of qualifying children they have. It is designed to supplement the earnings of low-income workers. 

Child Tax Credit (§ 24):

While a portion of the Child Tax Credit is nonrefundable, a significant portion can be refundable as the Additional Child Tax Credit. This credit is for taxpayers with qualifying children under age 17. It helps families with the costs of raising children. 

American Opportunity Tax Credit (§ 25A):

This credit is for expenses paid for the first four years of higher education. Up to $1,000 of this credit is refundable for eligible students. It helps make higher education more affordable.

Excess Social Security and Medicare Tax Withheld (§ 31):

If an individual has multiple employers during the year and the total amount of Social Security and Medicare taxes withheld exceeds the legal limit, the excess amount is treated as a refundable credit. This ensures that individuals don’t overpay these taxes.

Premium Tax Credit (§ 36B):

This credit helps eligible individuals and families with low to moderate income afford health insurance purchased through the Health Insurance Marketplace (also known as the exchange). The amount of the credit is based on the taxpayer’s household income, the cost of the benchmark silver plan in their area, and the premium for the plan they actually choose. The credit can be taken in advance to lower monthly premiums or claimed when filing the tax return using Form 8962, Premium Tax Credit (PTC).

The tax liability calculation is the process of determining the total amount of income tax an individual is legally obligated to pay to the government for a specific tax year. This calculation involves assessing gross income, subtracting allowable deductions to arrive at taxable income, and then applying the relevant tax rates, potentially including various other taxes like capital gains tax, AMT, and NIIT. Tax credits are then subtracted from this calculated liability.  In contrast, the tax due (or refund) represents the final outcome after considering the tax liability and the payments the taxpayer has already made throughout the year (such as withholding from wages or estimated tax payments). If the total tax liability is greater than the payments made, the taxpayer has a tax due and must pay the remaining balance. Conversely, if the total payments exceed the tax liability, the taxpayer is entitled to a tax refund for the overpaid amount. Therefore, the tax liability calculation is a crucial step in determining the total tax obligation, while the tax due or refund is the final reconciliation between that obligation and the payments already remitted.

Estimated tax payments and underpayment penalties

Individuals who expect to owe at least $1,000 in tax and whose withholding will be less than 90 percent of the current year’s tax liability or 100 percent of the prior year’s tax liability (110 percent for certain higher-income taxpayers) are generally required to make estimated tax payments. The statutory framework for estimated tax payments is established in IRC §§ 6654 and 6655. This requirement often applies to self-employed individuals, investors, and retirees whose income is not subject to sufficient withholding. Estimated taxes are calculated by projecting annual income, deductions, and credits, and are typically paid in four installments due in April, June, September, and January. Payments may be made electronically, by mail, or through other IRS-approved methods. The safe harbor rules, which base payments on the prior year’s tax liability, help taxpayers avoid penalties even if their current year’s liability is higher.

Failure to pay enough tax throughout the year through withholding and estimated payments may result in an underpayment penalty. The penalty provisions are found in IRC § 6654, which calculates the charge on the amount underpaid, for the period it remained unpaid, using an interest rate set by the IRS. However, exceptions apply: small underpayments, certain timing situations, or having no tax liability in the prior year may exempt a taxpayer from the penalty. To avoid underpayment penalties, taxpayers should adjust their withholding or make timely and adequate estimated tax payments in line with the safe harbor provisions.