Calculating Your Taxes

What is total or gross Income?

In general, total or gross income includes all income, unless there is an exception. Your total or gross income can include:

• Earned income, which comes from employment and can take the form of wages, salary, tips, commissions, and bonuses. Earned income may be subject to both income and payroll taxes.
   
• Unearned income, which comes from sources other than employment, such as dividends, interest, capital gains, or U.S. savings bonds. Most unearned income is subject to income taxes.

Important things to remember

• Other sources of taxable income can include alimony, unemployment compensation, gambling winnings, or lottery winnings.
   
• Income that's typically not taxable (these are called exemptions) include: a gift or inheritance, child support, life insurance proceeds following the death of the insured, interest from municipal bonds (may be subject to federal alternative minimum tax, plus state tax for out-of-state bonds), disability income if you paid the premium with after-tax dollars, and certain employee fringe benefits.
   
• If you have stocks, bonds, or other investment assets in a taxable account your profit or loss is known as a capital gain or a capital loss. At the federal level, capital gains are taxed based on several factors including the type of asset, how long you held the asset, and your overall income level. 

• If you only held the investment for a year or less, then the short-term capital gains tax rates will apply. These tax rates and brackets are the same as those applied to ordinary income, like your wages, depending on your income level. On the other hand, if you held the investments longer than a year, long-term capital gains tax rates will apply and any gains are subject to lower preferential tax rates, ranging from 0% to 20% depending on your income level.

   

How to calculate your adjusted gross income

Your adjusted gross income (AGI) is an important part of your tax calculation. To get your AGI, you can subtract certain deductions from your total/gross income to reduce the amount of income that will be taxed.

Some examples of deductions that help determine your AGI:

• Deductible IRA contributions
   
• Contributions to a self-employed retirement plan (like a SEP IRA or SIMPLE IRA)
   
• Self-employed health insurance deductions
   
• One-half of self-employment tax
   
• Paid alimony
   
• Qualified moving expenses
   
• Penalty on early withdrawal of savings
   
• Qualified higher education expenses
   
• Teacher's unreimbursed education expenses (up to annual limits)
   
• Qualified education interest

Choosing standard or itemized deductions

Once you know your AGI, you have the opportunity to lower your taxable income even more by subtracting either the standard deduction or your itemized deductions—whichever is greater. If your deductions (not including those for student loan payments) don't add up to more than the standard deduction, itemizing won't bring you more tax savings. In other words: If you don't have much to deduct, just take the standard deduction.

When to consider the standard deduction

If your financial situation is straightforward, the standard deduction might be the best and simplest choice. The standard deduction typically changes each year. You can find the current standard deduction on the IRS website, based on whether you are single filer, married filing jointly, or head of household.

When to consider itemizing deductions

If you pay a lot in state income taxes, have a mortgage on your home, give a lot to charity, have paid extensive medical bills, you might be better off taking the extra time to itemize your deductions.

Examples of legitimate itemized deductions:

• Property taxes, up to a limit
   
• State and local income taxes (or state sales taxes if your state does not have an income tax)
   
• Specified medical and dental expenses that exceed 10 percent of your AGI (or 7.5 percent if you are 65 or older), including limited amount of premiums paid for long-term care policies
   
• Mortgage interest on first and secondary residences (up to maximum debt of $1 million), plus interest on home equity loans (maximum debt up to $100,000)
   
• Charitable contributions to tax-exempt organizations
   
• Casualty and theft losses (see IRS guideline)
   
• Investment interest expense (e.g., margin interest expense)
   
• Miscellaneous expenses, including impairment-related expenses for persons with disabilities and gambling losses to the extent of gambling winnings

Determining taxable income

Once you know your AGI and the deductions you qualify for, you can calculate your taxable income and your tax due. On the IRS website, you’ll find tips on taxable and nontaxable income.

What's your tax rate?

You pay a proportionately larger amount of taxes on higher amounts of income. This results in two different tax rates:

• Your marginal tax rate is the percentage of tax you pay on your last dollar of taxable income.
   
• Your effective tax rate is your total taxes owed divided by the total taxable income (reduced by deductions).

For example, if you are single and your taxable income is $60,000, your marginal income tax rate is 22 percent, but your average tax rate is likely quite a bit lower.

Making use of tax credits

A tax credit reduces the taxes you owe dollar for dollar. A credit is generally more valuable than a deduction. A $100 credit means that you pay $100 less in taxes. A deduction simply reduces your taxable income.

There are a number of tax credits available, depending on your income and personal situation. A few examples include:

• Child Tax Credit
• Credit for qualified adoption expenses
• Child and dependent care credit
• American Opportunity education tax credit (formerly the Hope credit) for qualified expenses during the first four years of college.
• Lifetime learning credit for expenses related to improving job skills and for pursuing an undergraduate, graduate or professional degree. Learn more at IRS.gov.

How to arrive at your tax due

After you've figured out your taxable income, there are a few more steps to arriving at your actual tax due.

• Subtract any withholding or estimated tax payments and/or credits from your taxes owed.
• Then, you can determine whether you owe taxes or will receive a refund.

If you're getting a big refund, you're probably having too much withheld from your paycheck. In effect, this means you're giving the government an interest-free loan. On the other hand, if you have too little withheld, you may be charged an underpayment penalty.

Payroll taxes 101.

Who pays FICA and Medicare taxes?

• An additional percentage of your income will be paid into Social Security and Medicare on your behalf.

If you're a wage or salaried employee, your employer will pick up half of this tab.