Determining taxable income
You know your filing status, you have the forms and instructions, the pencils are sharpened and the calculator has new batteries. Now it’s time to do the math and see exactly what your earnings will cost you in taxes.
Although it may be hard to believe, the government doesn’t tax every cent you make. Instead, taxes are assessed only on your taxable income.
So what is taxable income? Basically, it’s your total, gross income minus allowable personal exemptions and deductions. The individual tax forms — 1040EZ, 1040A or 1040 — act as filters here to help you to reach the smallest taxable income level.
Gathering your gross income
The first step in the taxable income computation process is to add up all your income. There are two types of income: earned and unearned.
Earned income is money you are paid for work. This includes your salary, wages, tips, commissions and bonuses. But it also includes money that you collected in other forms, such as unemployment benefits and sick pay. And some noncash fringe benefits your employer provides — a company car, discounts on property or services, country club memberships, tickets to entertainment or sporting events, life insurance coverage of more than $50,000 — also are considered earned income.
Unearned income is the money you get from interest and dividend payments, as well as the profit from assets you sold, business and farm income, rents, royalties, gambling winnings and alimony payments. Earnings from your retirement fund are considered unearned income, as are Social Security payments. The sum of your earned and unearned income is your gross income. Once you get that figure, it’s time to whittle it down.
Tallying your taxable income
The IRS allows you to use various adjustments, or subtractions, depending on your filing status and the form you choose to file. When these amounts are subtracted from your gross income level, you’ll arrive at as your adjusted gross income (AGI).
But there’s more. After you’ve got your AGI, you can reduce it further by taking deductions, certain expenses the IRS allows you to subtract from your income. The IRS sets a standard dollar amount each year for the five filing categories. You can use this preset amount (called the standard deduction) or, if you have tax-allowable expenses (such as mortgage interest, charitable contributions, large medical expenses) that are greater than the standard deduction amount, you’ll want to use Form 1040 and itemize these deductions on Schedule A and then subtract that amount from your AGI.
You also get to reduce your income one more time using exemptions. Exemptions represent those people who depend upon you for financial support, such as your spouse, your kids, possibly your parents and yourself. The IRS allows you to multiply this number of people by a dollar amount (adjusted for inflation annually) and then subtract it from your income.
At the end of this mathematical process, you’ll have your taxable income. This is the dollar amount you look for in the tax tables to see what your tax bill is.
If you file Form 1040EZ, you’ll see that this is the end of the tax line. However, filers of 1040A or 1040 are only about halfway through. These two forms also include several tax credits (coming up shortly in another Tax Basics) that could ultimately reduce your final tax amount or even give you a refund.