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How Are Taxes Calculated?

December 26, 2018
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It's the beginning of a new year, a time where many people are gathering their W2s and other tax documents to get ready to file their taxes. And while you may not want to be as informed as a CPA or other tax professional, I do think it's a good idea to have a basic understanding of how federal income taxes are calculated. So we're here to give you some of the more foundational elements of how federal income taxes work, and the process of determining how much you'll owe (or get back) at the end of the year.

Step 1: Find Gross Income

Gross income is the total amount of income you made or received that is potentially subject to taxes. There are certain forms of money that are exempted from your gross income, such as child support payments you might have received for any minor children. But any item that is not exempt is included in your gross income for the year. It's important to understand what type of income you've received, because it lets you know who is responsible for putting aside the taxes throughout the year. If you're a W2 employee, your employer helps estimate the amount you should pay in taxes and they withhold it from your income throughout the year. If you're receiving 1099 income, you are responsible for putting aside the necessary taxes and paying them on a quarterly basis

Step 2: Subtract Above The Line Deductions to Find Adjusted Gross Income

Your Adjusted Gross Income is the amount of your income that is subject to taxes. To calculate your AGI, you must take your gross income and subtract your above the line tax deductions. Nothing in that sentence makes sense unless you know what a tax deduction is in the first place, so let's cover that now.

What Are Tax Deductions?

Tax deductions are items that can be used to reduce how much of your income is taxable.  Some tax deductions are considered dollar for dollar deductions, meaning that for every dollar you contribute towards the tax deductible expense, your taxable income is reduced by a dollar as well. As an example, if you make $100,000 and have a $5,000 dollar for dollar tax deduction, your taxable income will be reduced to $95,000.

Example: certain taxpayers can deduct a portion of the interest they pay on federal student loans


Before we cover what above the line tax deductions are, it's important to note that they are the only type of tax deduction that can be applied at this point.

Above The Line Deductions

In a second we'll cover how people decide between the two ways individuals can file their taxes: itemizing, or taking the standard deduction. For now, all you need to know about above the line deductions is that they are tax deductions that can be used to reduce your taxable income, and anyone can take advantage of these deductions now matter how they choose to file.

Example: Individual Retirement Account (IRA) contributions can be taken as an above the line deduction by taxpayers within certain income limits

Step 3: Decide Between Itemizing Or Taking The Standard Deduction

Once you've applied your above the line deductions, it's time to decide whether to itemize your taxes or to take the standard deduction. What does this mean? Essentially, deciding whether or not to itemize your taxes means determining whether or not the below the line tax deductions for which you're eligible are greater than the amount you can take as a standard deduction. That might not make sense now, but it will when we cover the difference between the standard deduction and below the line tax deductions.

Standard Deduction

The standard deduction is a set tax deduction that can be taken by taxpayers each year. For example, the standard deduction for a married couple filing their taxes together in the 2018 tax year is $24,000. This amount means if a married couple had an income of $100,000 after using their above the line deductions, the $24,000 standard tax deduction would reduce their income even further, to $76,000. 

Below The Line Deductions

Below the line tax deductions are tax deductions that can only be claimed if you've decided to itemize your taxes, which means totaling up all the eligible deductions and listing them on your tax return. People itemize their taxes when they've determined that by doing so, they'll get a larger tax deduction than taking the standard one offered by the IRS. So to make it plain, for the married couple in our example, if they total up their below the line deductions and discover that they're more than the $24,000 standard deduction, they should itemize their taxes.

Example: charitable contributions are a below the line tax deduction that can only be used by taxpayers who itemize

Step 4. Use The Federal Tax Brackets To Calculate The Amount You Owe In Taxes

How Do I Find My Tax Bracket?

You've probably heard someone complain about being in a high tax bracket, such as the 32% or 35% tax bracket. And when people say things like that, it's easy to think that this means that every dollar that they earned is taxed at a rate of 32% or 35%; but that's not how federal income taxes work at all. We live under what's called a progressive tax code, which means that different portions of your income are taxed at different rates. For an example, let's use the 2018 tax tables to find the tax bracket for a single person making $100,000.

As you can see, the first $9,525 that they make is taxed at only 10%, while every dollar from $9,526 to $38,700 is taxed at 12%. Their income from $38,701 to $82,500 is taxed at 22%, while each dollar from $82,501 to their one hundred thousandth dollar of income is taxed at 24%. So if this person were to say they're in the 24% tax bracket, what they're actually saying is the highest portion of their income is taxed at 24%, but not all of their income. The 24% represents their marginal tax bracket, while the average percentage in tax they actually paid when you total up all the other income levels, which is called their effective tax rate, might be much lower. Once you've added up the amounts you'd need to pay based on each level of income, you now know what your tax burden is for the year. But before you pay, there's one more thing that's used to potentially lower the amount you owe: tax credits.

Step 5: Apply Tax Credits

What Are Tax Credits? 
It's important to make the distinction between a tax credit and a tax deduction. A tax deduction is a tool that's used to reduce the amount of your income that's used to calculate your taxes. As an example, if you make $50,000 and contribute $5,000 to an IRA, the income used to calculate your tax burden would be reduced to $45,000. A tax credit isn't a reduction in your taxable income, but instead it is a dollar for dollar reduction in the amount of taxes you actually owe. As an example, if after calculating your taxes you find that you owe $3,000 in taxes, a $500 tax credit would mean that you now only owe $2,500.

Example: The American Opportunity Tax Credit is for parents and students who are contributing towards the cost of higher education. In 2018, the credit rises to as much as $2,500 per eligible student.

That's it! While your actual tax return will likely be far more complex, we've covered the basic mechanics of how federal income taxes are calculated. Hopefully by familiarizing yourself with the meaning of terms you've heard in the past, you'll have a better idea of how certain tax deductions, credits and more might impact your finances.