How to Calculate Taxable Income from Your Salary
Are you lost when it comes tax season and how your accountant comes up with your taxable income?
Let’s see if we can break down the formula into simple, understandable, pieces today. Enjoy
If you’re new to money terminology, there are two terms, gross income & net income, you’ll hear a lot in the finance world. Consider “gross” income as unadjusted income and “net” income as adjusted income. You’ll also hear “adjusted gross income” which we will cover shortly and it falls in between gross income and net income during the tax formula below.
Step 1: Calculate Gross Income
The first step is to add up all of your income you’ve earned for the past tax year to get a gross income total.
Here is a list of some income sources you may have had:
- Any compensation for your services, including fees, fringe benefits, commissions, etc.
- Gross income from business
- Gains from dealing with property/real estate
- Income from an interest in an estate or trust
- Income from the death of a family member
- Income from life insurance
- Income earned from your distributive share of a partnership
The IRS defines gross income in 26 USC 61 as “all income from whatever derived source.”
So is there an income that isn’t taxed or doesn’t need to be listed on the gross income section of the 1040 tax form?
Sure, see our list of income sources that are excluded from gross income tax forms.
Step 2: Subtracting Above the Line Deductions that Reduce Gross Income
In order to get from gross income (unadjusted) to net income (adjusted income) we must make adjustments right?
Above the line deductions are the first set of adjustments we must make to our income. These deductions get subtracted from the gross income leaving you with an Adjusted Gross Income also referred to often as AGI.
Investopedia explains “Above-the-line deductions constitute those expenses that are deducted for AGI, while itemized deductions are deducted from this number. The “line” is the taxpayer’s AGI, which is the bottom number on the front of the 1040. Above-the-line deductions are listed on the bottom half of the front of the 1040 and can be broken down as follows.”
Here are some above the line deductions you should consider:
- Domestic Production Activities
- Moving Expenses
- Retirement Plan Contributions
- HSA, MSA Contributions
- Health Insurance premiums
- Self-Employed Business Expenses, SE Tax
- Educator Expenses
- Early Withdrawal Penalties
- Student Loan Interest
- Tuition and Fees
Step 3: Calculate Total Deductions & Subtract from AGI
Now that you’ve calculated your Adjusted Gross Income by subtracting above-the-line deductions, the next step is to subtract “below-the-line” deductions.
You have two options:
- Standardized Deductions
- Itemized Deductions
You can only select one of these two methods for calculating deductions so it’s important to understand what each is so that you can select the method that will reduce your taxable income the most.
The Standard Deduction is a flat amount the IRS allows you to subtract from your adjusted gross income.
For example, in 2015 the standard deduction single tax payers could take was $6,300. Married couples can subtract $12,600 which basically is the same as if they had filed separately as individuals.
In 2016, the standard deduction will be a larger amount as the IRS raises it each year to adjust for inflation.
What about Itemized Deductions? What is that?
Itemized deductions are eligible expenses that individual taxpayers in the United States can report on their federal income tax returns in order to decrease their taxable income.
Think of them as expenses the IRS allows you to count against your income. Here is a list of several different itemized deductions you could use to offset taxable income:
- Gifts to Charity
- Interest You Paid
- Job Expenses
- Medical & Dental
- Miscellaneous Expenses
There is a long list of itemized deductions so pause a second if needed to check it out. Also check with your tax accountant for a comprehensive list of expenses you can deduct or questions regarding certain expenses you may have incurred.
You’ll need to fill out a Schedule A and submit it with your 1040. The Schedule A is a form where you list all of your itemized deductions. To learn more about all the different tax schedules and forms I highly recommend this article: What Are Each of The Tax Forms & Schedules For
If the total of all the itemized deductions exceeds the standard deduction amount ($6,300 for single and $12,600 for married) then it makes sense to use the itemized deductions to subtract from your adjusted gross income.
Example: You have an adjusted gross income of $35,000. Your itemized deductions total $10,000 as a single tax payer. Deduct this from the AGI to get a reduced taxable income of $25,000. If you compare this to the standard deduction ($35,000 – $6,300 = $28,700), then you realize you are saving money because you’ve lowered your taxable income by an extra $3,700 by taking the itemized deductions method.
Step 4: Personal & Dependent Exemptions
Along with deductions, the IRS allows you to subtract even more money off your taxable income total through “exemptions.”
Exemption is the process of freeing an individual from paying taxes on a certain amount of income.
In 2015, the personal exemption amount was $4,000. For married couples it was $8,000 as each spouse could take a personal exemption.
If you have dependents, then you can take another $4,000 exemption for each. Dependents are basically your kids or other family members who are dependent on your income for survival. If you claim someone as a dependent, they cannot claim a personal exemption on their tax form because you’ve already been granted their exemption amount on your tax form.
So once your kids reach a certain age where they are ready to live on their own income, they’ll begin claiming themselves as a personal exemption and you’ll no longer claim them as a dependent on your 1040 form.
You’re a single tax payer with no wife or kids: $4,000 personal exemption
You’re a married tax payer filing jointly: $8,000 exemption for you and your spouse
You’re claiming yourself and 2 dependents (i.e. kids): $4,000 x 3 = $12,000 in exemptions
You’re claiming you, your spouse, and 3 kids: $4,000 x 5 = $20,000 in exemptions
On the tax form you’ll fill in your personal exemption on the required line and then fill in the number of dependents on a separate line. It will have a line where you total the two amounts to get your total exemption you can subtract from the Adjusted Gross Income.
Step 5: Calculate Your Taxable Income
By now you have:
- Totaled up gross income
- Subtracted above the line deductions
- Subtracted standard or itemized deduction amount
- Subtracted exemptions
This leaves you with a final amount of income that is left to be taxed by the government.
If you’ve already subtracted your income down to 0 or negative, then you don’t owe any taxes.
Step 6: Calculate Your Tax Liability
The final step is to take your taxable income and calculate your tax liability that you owe to the government.
Depending on how much taxable income remains after all the subtractions, you’ll fall under one of the tax brackets.
The U.S uses a progressive tax system which taxes different amounts of income at different rates, starting as a smaller % and increasing.
Example: Let’s say your taxable income ends up at $21,000 as you started with $35,000 but subtracted $10,000 for itemized deductions and then a $4,000 personal exemption.
2015 Tax Brackets:
- The first $9,225 is taxed at 10% = ($922.50)
- Income from $9,225 to $$37,450 is taxed at 15% + 922.50 for income taxed at 10%.
Since you have a taxable income of $21,000 you fall in the 15% bracket. The first $9225 will get taxed at 10% leaving you with $11,775 to be taxed at 15%.
Let’s calculate these now:
- $9,225 x 10% = $922.50
- $11,775 x 15% = $1,766.25
- Total = 2,688.75
But wait, you’re not done.
There may also be tax credits given to you by the government that you can apply to your tax liability.
For example, let’s say you installed some green energy sources into your home such as solar panels and a geothermal water heater.
The government gave you a tax credit of $1,500 for these improvements so after subtracting it from your tax liability of $2,688.75 you now only owe $1,188.75.
Tax credits are dollar for dollar deductions unlike the deductions and exemptions you made earlier.
For more tips, tools, and time-savers, visit our Resources Section through the menu bar at the top of the page or access each of our resource pages through these individual links:
- Online Entrepreneur/Website Resources
- Real Estate Investing Resources
- Personal Finance & Wealth Building Resources
Be great today,
P.S. Check out these tax credits you may be eligible for.
Learn Real Estate Investing in 10 Days
Learn the 10 basic steps to becoming a real estate investor by signing up for my free 10 day email course. Each day I'll send you the next lesson.