THE SECRET BEHIND YOUR TAXABLE INCOME
We’ve made our way to the second page of the 1040. And believe it or not, the knowledge you acquired from the previous posts will bring the remaining concepts together and make order of your return. This order will lead you to the figure you sought at the outset: your taxable income.
As a review, I’ve discussed two parts of the big math equation that leads to your taxable income:
Gross income – Adjustments = AGI
Now we take some “below the line deductions” to get to that final taxable figure.
Standard Deduction vs. Itemized Deductions
In Part 1, I mentioned that you need to get your filing status right because it affects later parts of your return. We have now arrived at later. The main below-the-line deductions include either the standard or itemized deductions.
The standard deduction is, as the name implies, a standard amount that you get to subtract from your AGI. The following are the amounts allowed for 2014:
- Single or Married Filing Separately – $6,200
- Married Filing Jointly or Qualifying Widower – $12,400
- Head of Household – $9,100
You get to subtract that applicable amount from your AGI simply based on your filing status. In other words, you get to deduct this amount without proving that you spent a specific amount of money; you get it just because you have chosen a filing status.
In the alternative, you can deduct your itemized deductions if those give you a bigger bang for your buck. Your itemized deductions appear on your schedule A and include
- Medical and dental expenses above 10% of your AGI (or 7.5% if you’re above age 65)
- Taxes you’ve paid such as state and local income tax, property taxes, real estate taxes, or personal property taxes
- Interest you’ve paid on your home mortgage, mortgage insurance premiums, or investment interest
- Gifts to charity
- Casualty or theft losses
- Other miscellaneous deductions like unreimbursed employee expenses, tax preparation fees, or investment expenses
You choose to take itemized deductions over the standard deduction if all of the above expenses add up to more than your standard deduction.
Also in Part 1, I mentioned the importance of your dependents and how they help determine the amount of exemptions you can take. At this point on your return, you get to deduct that money from your AGI and reduce your taxable income. For 2014, you can subtract $3950 for each person that you can claim on your return.
For example, if you are single with no dependents you get to deduct $3950. If you are married with two dependents, you subtract $15,800. In addition, you take this deduction on top of your standard or itemized deductions.
Finally, Taxable Income
So from your AGI, you subtract either your standard deduction or your itemized deduction and your personal exemptions. That calculation results in …..wait for it….your taxable income. At this point, our tax-return equation looks like this:
Gross Income – adjustments = AGI
AGI – (standard OR itemized deduction) – personal exemptions = taxable income
From the taxable income figure, the IRS uses its tax tables to determine how much tax you need to pay on your income.
People also refer to this point of their return when they mention their “tax bracket.” For example, a friend may mention, “I’m in the 25% tax bracket.” That simply means he or she is in the 25% marginal tax bracket where the top portion of his or her taxable income is taxed at 25%.
Keep in mind, however, we are in a progressive tax system. That means that our incomes are taxed at increasing rates (for 2014 – 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%). In other words, while the top rate of your income may be taxed at 25%, a portion is also taxed at 10% and 15%. For more information on the different amounts, check out the current IRS tables.
And now that you read through the form 1040 to enhance your understanding of your return, you may have noticed line 45, the alternative minimum tax. That topic will need a post all to itself. For now, just recognize that it represents an alternative form of tax that some taxpayers have to pay.
Just when you thought you were done
I know I’ve made a big deal about getting to that taxable income figure and being able to figure out how much tax you must pay the government. But you’re not done quite yet. There’s still an additional way to lower your final tax burden. We tackle that final step in Part 5.