How-to-calculate-taxable-income

How to Calculate Taxable Income from Your Salary

Are you lost during tax season and confused with how your accountant comes up with your taxable income?

Below we will break down the income tax formula into step by step pieces so you can have a simplified view of how taxable income is calculated from your salary.

The basic takeaway is that your accountant will look at different types of income you have and use different forms and tax schedules designed for each income type to determine how much of that income is taxable. Then he will bring those different incomes together on your 1040 form to total up your income.

The 1040 form will also have designated lines where adjustments and deductions get subtracted from the income, and the resulting number gets placed on a final total income line at the bottom, known as your Taxable Income.

Here is the PDF version of the 1040 form from the IRS website.

  • Lines 1 through 7 are the 7 types of incomes the accountant will calculate using other tax forms.
  • Line 8 and 9 are where the accountant subtracts adjustments to income and standard or itemized deductions depending which one makes sense for you to use.
  • Line 10 is for taking a qualified business income deduction amount if you operate a qualifying business.
  • Line 11 is the calculated taxable income amount after adding and subtracting the above lines.

Learn –> How to Increase Your Income and Master Your Money (Saving, Investing, Taxes)

Terminology to Know Before Doing Your Income Taxes

Gross IncomeConsider “gross” income as unadjusted income

Adjusted Gross Income income that has been adjusted by subtracting expenses and other legal adjustments according to the IRS tax code

Net Income – income that is taxable after all adjustments and deductions have been subtracted.

Tax Liability – the amount owed in taxes to the Federal Government and State Governments

Tax Refund – if you’ve had more taxes withheld than the calculated tax liability amount, you may be entitled to a tax refund where the Government sends back the adjusted amount you overpaid.

Tax Credit – a dollar amount given to you (as cash) for qualifying credits from the government and is used to subtract from / pay for your tax liability amount owed. If you have leftover credit after subtracting your tax liability, you’ll get a refund check for the remaining amount of the credit.

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. The IRS requires you to report all income you earn. However, some incomes you report are actually not eligible to be taxed like garage sale money, for example, since you get less than what you paid for the items.

Here is a list of some income sources you may have had to report on your taxes:

  • Your job salary/wages
  • Any compensation for your services, including fees, fringe benefits, commissions, etc.
  • Gross income from business
  • Dividends
  • Rents
  • Gains from dealing with property/real estate
  • Pensions
  • Interest
  • Royalties
  • Income from an interest in an estate or trust
  • Income from the death of a family member
  • Income from life insurance
  • Annuities
  • Alimony
  • 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.” Be safe and report all income to the IRS to avoid trouble, penalties, and tax fraud.

Learn –> How to Increase Your Income and Master Your Money (Saving, Investing, Taxes)

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. Subtracting expenses or the costs incurred to produce income is legal by the IRS.

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 AGI 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  portion of  a 1040 tax form and can be broken down as follows:

  • Domestic Production Activities
  • Moving Expenses
  • Retirement Plan Contributions
  • HSA, MSA Contributions
  • Health Insurance premiums
  • Self-Employed Business Expenses, SE Tax
  • Alimony
  • 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 Deduction
  • Itemized Deductions

You can only select one of these two deduction methods 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 2019 the standard deduction single tax payers could take was $12,200. Married couples can subtract $24,400 which basically is the same as if they had filed separately as individuals.

In 2020, the standard deduction will be a larger amount as the IRS raises it each year to adjust for inflation.

Example:

  • 50,000 Gross Income
  • -10,000 for adjustments
  • – 12,200 for standard deduction
  • 27,800 is your AGI after adjustments and deductions

Learn –> How to Increase Your Income and Master Your Money (Saving, Investing, Taxes)

Itemized Deductions

What about Itemized Deductions? What are those?

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 to cancel out your income so you have a lower net income amount to be taxed.

Here is a list of several different itemized deductions you could use to offset taxable income:

  • Self employed business expenses
  • Car mileage deduction
  • Portion of food expense for business meals
  • Gifts to Charity
  • Interest You Paid
  • Job Expenses
  • Medical & Dental
  • Miscellaneous Expenses
  • Fees paid to your tax accountant
  • Taxes
  • Casualty
  • Theft

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 click here.

If you are running a self employed business as a sole proprietor or single member LLC, you will file a Schedule C listing your income and your expenses and attach it to your 1040.

If the total of all the itemized deductions exceeds the standard deduction amount ($12,200 for single and $24,400 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 $17,000 as a single tax payer. Deduct this from the AGI to get a reduced taxable income of $18,000. If you compare this to the standard deduction ($35,000 – $12,200 = $22,800), then you realize you are saving money because you’ve lowered your taxable income by an extra $4,800 by taking the itemized deductions method.

Step 4: Calculate Your Taxable Income

By now you have:

  • Totaled up gross income
  • Subtracted above the line deductions
  • Subtracted standard or itemized deduction amount

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 may not owe any taxes.

Another tax tip is to utilize asset depreciation as an expense to adjust your income amount lower. For example, calculate the depreciation of an asset like real estate (divide the purchase price by 27.5) and track the depreciation on a real estate tax schedule (ask your accountant to do this).

When you sell the asset later on, you may have capital gains to pay taxes on, but in the meantime you can use the asset to help lower your tax liability each year by subtracting depreciation.

Okay, once you have a taxable income number, you’ll use the US tax bracket to calculate the taxes owed in the next step.

Step 5: 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.

tax bracket 2020 taxes

As mentioned, the US uses a progressive tax system so the first $9,700 of taxable income will be taxed at 10%, meaning you would owe $970 of it in taxes or less.

Anything you earn above $9,700 gets taxed at 12% up to $39,475 and so on according to the bracket photo above for single filers.

Let’s calculate your taxes if you had a taxable income of $35,000 after all adjustments and deductions.

  • $35,000 taxable income
  • $9,700 of it taxed at 10% = $970
  • $25,300 remaining get taxed at 12% = $3,036
  • Add these together and you owe = $4,006 tax liability

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 $4,000, you now have a tax liability of only $2,500.

Then if you have children you could earn $2,000 in tax credits per child from the Child Tax Credit. Let’s say you have 2 children, qualifying you for $4,000 in tax credits.

Subtract this $4,000 from the remaining $2,500 tax liability and you are now at a surplus of $1,500 the government will owe you as a tax refund check. Pretty nice deal huh?

Tax credits are dollar for dollar deductions unlike the deductions and exemptions you made earlier, so they get applied directly to your tax liability like cash.

Next, let’s take a look at the different income tax forms and schedules.

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Income Tax Forms Explained:

W2 – If you work as an employee for an employer, this will be the form that is used. Your employer should provide it to you.

  • How much income you made
  • How much your employer withheld (federal tax, state tax, social security, medicare)

1099 – a form for independent contractors that the contractors will receive from their clients.

W9 – This is an information gather form for employers. They can use it for verification purposes and it usually is never mailed to the IRS. They’ll transfer the information from this form onto a 1099 form which will be the actual form used for income reporting.

990 – This form is for non-profit organizations. A non-profit organization will lose its tax status if it fails to file this form for 3 consecutive years. In other words, if your organization hasn’t filed in the last 2 years you better file this year before you lose tax status as a non-profit.

5500 – This is a form for the reporting of your Employee Benefit Plan if you are a business owner. It protects the rights of participants and beneficiaries.

Business Entity Returns

1065 – Partnerships must file this form
1120 – C Corporations must file this form
1120S – S Corporations must file this form
1120C – Cooperative Associations must file this form
1120H – Homeowners Associations must file this form
1041 – Estates & Trusts must file this form

Employment Payroll Taxes

940 – Employers annual federal unemployment tax return
941 – employers quarterly federal tax return

Transfer Taxes

706 – U.S. Estate Tax Return to report estate taxes
709 – U.S. Gift Tax Return to report gift taxes

1098 Series Forms

1098 – Report mortgage interest (which is an itemized deduction)
1098E – Report student loan interest (which is an above the line adjustment on your 1040)
1098T – Tuition statement that may provide you an above the line adjustment or tax credit

You’ll likely come across several of these tax forms throughout your lifetime and for business owners and entrepreneurs, you’ll see some different forms than most people so it’s important to learn what forms will be used in your respective fields of work.

What Are Tax Schedule Forms?

The formal definition: A form required by the IRS that you must prepare in addition to your tax return when you have certain types of income or deductions.

When it’s time to file taxes each year you must submit an income tax form to the government along with any required schedule forms. A tax schedule is basically just a form where you’ll list certain items and dollar amounts.

The income tax form you fill out will either be the 1040 (most common) or in special cases you may fill out a 1040A or 1040EZ. And then attached to it will be a schedule which we list below for different types of uses.

Types of Tax Schedules

Schedule A – You must attach this form with your 1040 if you decide to itemize deductions. This form lists out all of your itemized deductions. If you total your deductions up and it is less than the standard deduction the government is allowing you to deduct, then throw out your schedule A and take the standard deduction so that you reduce your taxes owed.

Schedule B – This is an income schedule where you’ll list sources of interest and dividend payments you receive during the year. You need to fill it out if your income exceeds the IRS threshold – $1,500 (2015)

Example: If you earn $900 in dividend income, you must include it in your taxable income but since you didn’t reach the $1,500 threshold, filling out a schedule B won’t be necessary.

Schedule C and C-EZ – this tax form is for listing self-employment income. You’ll need to calculate your business net income by including all business earnings and deductions. Your net income or loss you calculate on this schedule will then need to be added as income on your 1040 in the gross income section.

*C-EZ is a more simple form for businesses that meet IRS qualifications.

Schedule D – this form is for reporting the sale of an asset. You may have sold stocks, your home, or a car. These sales are broken into short term and long term because each is taxed differently due to capital gains rules.

Learn about Capital Gains Taxes and their effect on building wealth

Schedule EIC – this form is to report qualifications for earning the Earned Income Tax Credit. The EITC is a tax credit for low income families with qualifying children.

Schedule SE – This is the form you self-employed business owners must fill out to report their social security payment.

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