Taxable Income: Understanding the Basics
As tax season approaches, it’s essential to understand taxable income. Taxable income is the amount of money you earn that is subject to federal and state income taxes. This includes wages, salaries, tips, bonuses, and other forms of compensation received from your job or self-employment.
In this article, we’ll cover everything you need to know about taxable income, including how it’s calculated, what deductions are available to reduce your tax bill, and how different types of income affect your taxes.
Calculating Your Taxable Income
The first step in understanding taxable income is knowing how to calculate it. The Internal Revenue Service (IRS) uses a formula called Adjusted Gross Income (AGI) to determine your taxable income.
AGI is calculated by taking all sources of taxable income for the year and subtracting any adjustments or deductions allowed by the IRS. These can include things like student loan interest paid during the year or contributions made to a traditional IRA account.
Once you have calculated your AGI, you can then subtract either the standard deduction or itemized deductions from that amount. The standard deduction varies depending on filing status but was increased significantly under recent tax reform legislation passed in 2017.
For example, if you’re single with an AGI of $50k and claim the standard deduction for 2020 ($12.4k), then your taxable income would be $37.6k ($50k – $12.4k).
Deductions That Reduce Your Taxable Income
There are many deductions available that can help lower your tax bill by reducing your taxable income. Here are some common ones:
1) Medical Expenses – If you have high medical expenses not covered by insurance (over 7.5% of AGI), they may be deductible.
2) State Taxes – You may be able to deduct either state/local sales taxes paid OR state/local income taxes paid.
3) Charitable Contributions – If you donate to a qualified charity, you can deduct the amount on your tax return. (Beware of new limits set by the Tax Cuts and Jobs Act)
4) Mortgage Interest – The interest you pay on your mortgage is generally deductible, but there are some limits based on the size of your loan.
5) Business Expenses – Self-employed taxpayers may be able to deduct many expenses related to their business operations, such as rent for an office or equipment purchases.
6) Tuition and Fees – You may be able to take a deduction for tuition and fees paid if you meet certain eligibility requirements.
Different Types of Income
Not all types of income are treated equally when it comes to taxation. Understanding how different types of income affect your tax bill can help you plan accordingly. Here’s a rundown:
1) Wages and Salaries – This is the most common type of taxable income, and it’s taxed at ordinary income tax rates.
2) Investment Income – This includes things like dividends from stocks or mutual funds, capital gains from selling investments held longer than one year (taxed at lower long-term capital gain rates), interest earned on savings accounts or bonds, etc.
3) Retirement Income – Withdrawals from traditional IRAs/401(k)s are taxed as ordinary income. Roth IRA/401(k) withdrawals aren’t taxed at all if they’re “qualified” distributions (age 59 ½+ AND account open at least five years).
4) Social Security Benefits – These benefits may be taxable depending on how much other taxable income (including investment & retirement contributions/distributions plus 50% of SS benefits received during that year).
5) Rental Income – Any rental property profit is subject to being taxed similarly as wage/salary compensation
Conclusion
In conclusion, understanding taxable income is crucial in managing your finances effectively. Knowing how much money will go towards taxes helps you budget and plan for the year ahead. The good news is that there are deductions available to reduce your taxable income, so make sure to take advantage of them by working with a tax professional or using reputable online resources like IRS.gov.
By understanding different types of income and how they’re taxed, you can also make strategic financial decisions such as investment choices or retirement planning. Remember to stay up-to-date on any changes in tax laws that may affect your situation and seek out professional help if needed.
Overall, taking the time to educate yourself about taxable income will pay off in the long run by helping you keep more money in your pocket come tax season.