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Calculating taxable income
When you prepare a federal income tax return such as IRS Form 1040, you calculate three levels of income: total income, adjusted gross income and taxable income.
(Note: IRS publications and forms are also available in Portable Document Format. If you do not have a PDF reader installed on your computer, you can download a version of Acrobat Reader for free at Adobe Systems' Web site.)
Taxable income is used to calculate your tax liability, the amount of federal income taxes you owe for the tax year.
Calculating taxable income is straightforward: Add up all sources of income to determine total income. Next, take any allowed "above-the-line" adjustments to calculate adjusted gross income. Finally, take any allowed deductions and exemptions to arrive at taxable income.
Total income is shown on line 22 of Form 1040. It includes all sources of income, such as:
- Wages, salaries and tips. Income from these sources is reported on a W-2. Your employer is required to send you a W-2 by Jan. 31, 2005. If you earn any additional income not shown on a W-2, the IRS expects you to voluntarily report it.
- Interest and dividends. Banks, brokerages and other financial institutions that pay you interest or dividends mail a 1099-INT, 1099-OID or 1099-DIV at the end of every tax year. If you earn more than $400 in either taxable interest or ordinary dividends, you are required to submit Schedule B with your 1040.
- Capital gains. If you earn capital gains, you may have to submit Schedule D of Form 1040. See the instructions of your 1040 to see whether you have to complete the schedule.
- Income earned outside of the U.S. The IRS allows you to exclude up to $80,000 of foreign-earned income on your tax return. For more information, see IRS Pub. 54
- Social Security benefits. The IRS requires that you report some or all of your Social Security benefits as taxable income. To calculate how much to report, use the Social Security Benefits worksheet found in the instructions of your 1040.
Adjusted gross income is shown on line 36 of Form 1040. Adjusted gross income is total income minus certain allowable deductions, including:
- Contributions to IRAs. Some or all of your contributions to an IRA may be tax-deductible. For more information, see IRS Pub. 590.
- Interest on student loans. Interest on student loans used to pay for qualified educational expenses is tax-deductible. For taxpayers filing a single return, the deduction begins to phase out when modified adjusted gross income reaches $50,000. It phases out completely when income reaches $65,000. For married persons filing a joint return, the respective amounts are $105,000 and $135,000. For more information, see IRS Pub. 970.
- Alimony payments. Alimony payments may be deducted from total income. For more information, see IRS Pub. 504.
- Retirement and health insurance-related expenses. If you are self-employed, you may deduct from total income up to half of your self-employment taxes. Beginning in 2003, you may deduct all of your health insurance premiums. You may also deduct contributions you make to a SEP, SIMPLE or other small-business retirement plan. For more information, see IRS Pub. 560.
- Moving expenses. You may be able to deduct your moving expenses if moving to take a new job. See IRS Pub. 521.
Because tax deductions lower your taxable income, they create tax savings. The amount of tax savings is equal to the amount of the deduction times your marginal income tax rate. For example, if you're in the 25% tax bracket, every $1,000 of allowable deductions lowers your tax liability by $250.
Taxable income is the narrowest measure of income on Form 1040, which is shown on line 42. To calculate taxable income, subtract from your adjusted gross income the larger of your itemized deductions or standard deduction.
Subtract the value of your exemptions from this amount and you have taxable income. That's all there is to it. For 2005, each exemption is worth $3,200.
Next, we look at amounts for standard deductions for 2005.
Next Topic: Current standard deductions
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