fbpx

How is Taxable Income Determined?

Ed Note: With tax time coming up quickly, it’s time to get back to the basics: let’s talk taxable income. According to tax law, how can you calculate your taxable income? Ben Edwards from Money Smart Life breaks it down.

When you file your tax return, you will be asked to report your income. Your income determines how much you owe in federal and state income taxes. As you prepare your tax return, it helps to understand how tax law views your income.

Step 1: Determine Your Filing Status

First, determine your filing status. If you are married, your best option is usually to file jointly. If you file your taxes jointly with your spouse, you are required to add all of your income together to determine the total. You can combine your deductions, and you pay your taxes jointly.

Even if you are married, though, you can decide to file separately. When you file separately, it means each of you adds up your income, and you pay your taxes separately. You have to divide up your deductions, and realize that both of you can’t use the same expenses to calculate the amount of your separate deductions. Some states have property rules that require married couples who file separate returns to combine all income and expenses and then split both the income and expenses equally on the returns. These states are known as community property states.

If you aren’t married, you file as single. In some cases, single people and those that are considered unmarried for tax purposes may file as head of household.

Step 2: Consider Your Types of Income

The IRS requires you to report all of your income. This includes your side income, interest income, and other income on top of what you might have earned from wages and tips. All of this income is reported on your Form 1040, on page 1. Your income is generally classified as either:

Earned income: Wages, tips, salary, and business income from ventures in which you are involved day-to-day are considered earned. You also have to report foreign income you earn, although you may be able to exclude it from taxable income if you meet certain requirements. Alimony is not usually considered earned income. For instance, it is not earned income for earned income credit purposes.

Unearned income: This is income you receive even though you haven’t done active “work” for it. This generally includes income from selling investments, dividends, interest, unemployment benefits, retirement account distributions, debt forgiveness, gambling, and Social Security benefits. If you aren’t actively involved in running a business, the income you receive as a result of your ownership, as well as some types of real estate income, is considered unearned.

There are other categories that determine how your income is taxed: ordinary v. capital income, passive v. nonpassive income, business v. hobby income, and more.

Your total gross income is determined by adding up all types of income that you have received during the calendar/tax year. There are different lines on the front of the Form 1040 for different types of income, but by the time you get to the end of the front of the form, you will have added it all up.

If you file separately instead, you will need to be careful about dividing up the income between you and your spouse. You will need to verify whose name is on which assets, and divvy up the income accordingly. If you live in a community property state, different rules apply and you may each have to report 50% of the income. You will also need good records dividing up deductions, since you both won’t be able to use the same expenses when you calculate your deductions.

Step 3: Figure Taxable Income

Once you report all of your income on the front of your Form 1040 (Lines 7-21, for a total on Line 22), you will then have the chance to adjust it. Using Lines 23-35, you can reduce your income with the help of contributions to qualified Health Savings Account and IRA plans, student loan interest, self employment deductions, and other expenses.

Adding these up on line 36 gives you the total adjustments. Your Adjusted Gross Income (AGI) is then calculated by subtracting the adjustments from your total income.

Your AGI is basically the starting point in figuring out your taxable income. You subtract certain deductions from your AGI resulting in taxable income. This is the amount that is used when determining how much you owe in taxes.  Typically the largest deductions taken are personal exemptions, the standard deduction, or itemized deductions.

After you figure your tax, you may be eligible for certain credits that lower your tax liability, such as the child tax credit and education credits.

It’s possible to run the calculations more than once to decide what would result in the lowest household tax liability. Run the numbers as married filing jointly, as well as for filing separately, and then see which will lead to less money paid in taxes total.

Leave a Reply

Your email address will not be published.