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to $366) and $135 in the refundable portion of the child tax credit (from $1,664 to
$1,529).
5
In other words, each dollar of the bonus would reduce these credits by about
48 cents. In contrast, taxpayers in the highest income tax bracket generally pay the IRS
only 35 cents of each additional dollar they earn.
6
Example 2: Social Security Benefit Exclusion and Hope Credit
If a 63-year-old retiree with $15,000 in social security benefits, $10,000 in wage income,
$23,000 in taxable pension income and two children in college received the same $500
bonus in 2005, he could face an effective marginal tax rate of more than 83 percent.
7
Because the nontaxable portion of his social security benefits is phased-out as his
income increases, the $500 bonus would increase his taxable income by $925. Since he
is in the 15 percent tax bracket, the additional income would increase his federal income
tax by $135 (approximately 15 percent x $925).
8
Because the taxpayer is also in the
phase-out range for the Hope credit for educational expenses, the bonus would reduce
his Hope credit by $279 (from $2,994 to $2,715).
9
Thus, at the end of the year, after
completing an additional worksheet and tax form, the taxpayer would discover that his
$500 bonus increased his income tax liability by about $414 ($135 + $279) so he would
only get to keep $86 (or 17 percent).
10
In contrast, if the $500 bonus were paid to
5
See id; IRC § 24. The reduction in the refundable portion of the child tax credit is caused, in part, by the
phase-out of the dependent care tax credit, as reflected on lines 48, 52, 66, and 68 of Form 1040. For a
discussion of how to figure the EITC, see Publication 596, Earned Income Credit (2005) and Form 1040,
Instructions (2005). The taxpayer is directed to the following forms, schedules, and worksheets: Form 2441,
Child and Dependent Care Expenses; Form 1040 Instructions, Child Tax Credit Worksheet; Form 1040 Instruc-
tions, Worksheet A-Earned Income Credit or Worksheet B-Earned Income Credit; and Schedule EIC, Earned Income
Credit.
6
IRC § 1. Further, many taxpayers probably fill out additional forms, schedules, and worksheets only to
find out they are not eligible for the benefits and some who are eligible may not bother to find out. Com-
mentators have suggested that one of the benefits of the child tax credit is that it ameliorates the effect
of the EITC phase-out in some cases. See, e.g., Lawrence Zelenak, Redesigning The Earned Income Tax Credit
As A Family-Size Adjustment To The Minimum Wage, 57 Tax L. Rev. 301, 307 (Spring 2004). Even if it does,
complicating the law with another credit that has its own phase-out requires more forms, worksheets and
schedules, which will undoubtedly lead to mistakes involving over- and under-claims.
7
This analysis assumes that before computing the Hope credit phase-out, each child would qualify for the
full $1,500 credit. It also ignores employment taxes, which would increase the taxpayer’s marginal tax
rate by another 7.65 percent, as well as state income taxes and college financial aid computations based on
income. See, e.g., IRC § 3101. Such taxes and aid reductions could easily mean that the bonus generates
liabilities that exceed 100 percent of the bonus.
8
See Form 1040, Instructions 68 (2005) (tax tables).
9
For taxpayers in the phase-out range, the Hope credit can be computed by multiplying the tentative
credit of $3,000 by a fraction the numerator of which is $53,000 minus the taxpayer’s modified adjusted
gross income (MAGI) and the denominator of which is $10,000. In the first scenario with no bonus, the
taxpayer’s MAGI is $43,025, so the fraction is .998 (($53,000-$43,025)/$10,000)), and the credit is $2,994
($3,000*.998). In the second scenario a bonus that increases the taxpayer’s MAGI by $925 to $43,950, so
the fraction is .905 (($53,000-43,950)/$10,000) and the credit is $2,715 ($3,000*.905).
10
The taxpayer would have to fill out Form 1040, Social Security Benefits Worksheet, the worksheets in Publica-
tion 590, or the worksheet in Publication 915 to determine how the bonus would affect the tax treatment
of his social security benefits. He would need to fill out Form 8863, Education Credits, to determine the
amount of his Hope credit.