Do you know how the tax system really works? They say that the way to beat a system is to understand it from the inside out. With that in mind, here’s a quick primer on how your taxes are calculated.

Add Up Total Income

First, add up all sources of your income:

  • Earned income from wages, salaries, bonuses, and commissions
  • Profits and losses from your own business
  • Interest and dividends from bank accounts, stocks, bonds, and mutual funds
  • Capital gains from sales of investments and other property
  • Income from pensions, IRAs, and annuities
  • Alimony paid to you
  • Gambling winnings

Once you add all of your income up, you have Total Income.

Subtract Adjustments to Income

Once you’ve added up Total Income, it’s time to start subtracting “adjustments to income.” This is a group of special deductions that you can take whether you itemize deductions or not. Total Income minus any adjustments to income equals “Adjusted Gross Income” or AGI.

Specific adjustments to your Total Income can include:

  • IRA contributions
  • moving expenses for work-related moves
  • half of your self-employment  tax
  • self-employed health insurance
  • self-employed retirement plan contributions
  • alimony you pay
  • “educator expenses” (i.e., money spent on classroom supplies)
  • student loan interest

Standard Deductions or Itemized?

Once you’ve determined your adjusted gross income, you can subtract a standard deduction based on your filing status or your total itemized deductions, whichever is greater.

The standard deduction for 2017 was $6,350 for single taxpayers, $9,350 for heads of households, $12,700 for joint filers, and $6,350 each for married couples filing separately. Standard deductions are high enough that most taxpayers just take them and call it good.

However, the tax code lets you choose to itemize if your total itemized deductions are going to be greater than your standard deductions, such as:

  • Medical and dental expenses (exceeding 10% of your adjusted gross income)
  • State and local income taxes or sales taxes, whichever is higher
  • Property taxes on your primary residence and any number of additional personal homes,
  • Foreign taxes you pay on business or investment income
  • Mortgage interest you pay on up to $1 million of ”acquisition indebtedness” on your primary home plus one additional home
  • Home equity interest you pay on up to $100,000 of home
  • Equity debt not used to improve your primary residence
  • Casualty and theft losses (exceeding $100 plus 10% of your adjusted gross income)
  • Charitable gifts
  • Miscellaneous itemized deductions like unreimbursed employee business expenses, tax preparation fees, investment expenses, and gambling losses.

Once you’ve subtracted deductions and personal exemptions, you’ll have taxable income. At that point, the table of tax brackets tells you how much to pay.

2018 Tax Brackets

Your Tax Rate For Unmarried Individuals, Taxable Income Over For Married Individuals Filing Joint Returns, Taxable Income Over For Heads of Households, Taxable Income Over
10% $0 $0 $0
12% $9,525 $19,050 $13,600
22% $38,700 $77,400 $51,800
24% $82,500 $165,000 $82,500
32% $157,500 $315,000 $157,500
35% $200,000 $400,000 $200,000
37% $500,000 $600,000 $500,000

Tax Credits

Finally, you’ll subtract any available tax credits. They fall into five main categories:

  • Family credits (i.e., Child Tax Credit and Dependent Care Credit)
  • Education credits (i.e., American Opportunity Credit and Lifetime Learning Credit)
  • Foreign tax credits for taxes paid to foreign countries
  • General business credits for all sorts of business expenses (i.e., R&D, hiring   employees from disadvantaged groups, pension plan startup expenses, etc.)
  • Real estate credits, like the low-income housing credit and renovation credit.

So, those are the basics of how the tax system works.

The real challenge isn’t understanding how those rules work. The real challenge is planning to take advantage of those rules. How can we keep income from reaching our return in the first place? How can we create deductible employee benefit programs for our businesses? How can we make the most of adjustments to income and deductions? Where can we find more of those valuable tax credits?

Request a Strategic Tax Assessment Today

Financial Gravity understands the tax code and how to best take maximum advantage of the benefits it offers you and your business. Be sure to request a free copy of our book The New Tax Law and then Let’s Talk and request a strategic tax assessment from one of our Financial Gravity team members. Start making your strategic tax plan today!

Let's Talk - Has your CPA Warned You about the Self-employment Tax?

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