The concept of taxes seems like a pretty easy thing to explain, except when you start looking at it more closely. A ‘tax’ is money that the government collects within its borders in order to pay for everything that government does. Americans work for money, their income, and the government takes a portion of that income as tax. That should be simple, but what counts as income? How much income you make directly impacts how much you pay in taxes, so it’s important to know what the government qualifies as income. It’s time to understand how our tax system really works when it comes to taxable income and adjustments to income.
Understanding the Tax System: Taxable Income and Adjustments to Income
The Tax System
To understand how our tax system really works let’s start at the beginning, with a quick overview. The very first step in calculating taxes is adding up your income from all sources to calculate your total taxable income.
Once you have determined your total income, you are able to subtract a set of specific adjustments to income. These adjustments are available to all taxpayers and can be used whether you itemize your deductions or not. You will subtract your standard deduction or total itemized deduction, whichever deduction is greater, from your total income.
After applying adjustments to income, you can review the table of tax brackets to determine your actual tax rate. From there you can subtract any available tax credits, add any extra applicable taxes, and finally make a payment to the IRS.
Total Taxable Income
Your total taxable income is all the money you make during the year, no matter how you make it. If you work at a job for wages, that is income. If you win the lottery, that is income. If you find a twenty-dollar bill on the street, you’re supposed to declare it as income, too. Basically, the IRS is interested in anything and everything having to do with money that you make, even if it’s made illegally. Your total income will include things like:
- 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 investment and other property
- Income from pensions, IRAs, and annuities
- Alimony paid
- Gambling winnings
Add it all up and you have your total income. Except that nothing is simple, and that includes taxes. Not all income is treated equally. The major exception to how income is treated is capital gains. If you took $1,000 to a casino and successfully gambled it into $100,000, you would have to pay the normal income tax on $99,000 of it. If you took that same $1,000 and bought stocks with it, and then sold the stocks for $100,000 that profit is capital gains which is taxed at a lower rate.
Adjustments to Income
Adding up your total income is just the beginning, the next step is to subtract some adjustments to income. These special adjustments reduce your tax bill but are not itemized deductions. That means that taxpayers can benefit from adjustments to income whether they itemize deductions or take the standard deduction. The amount remaining after deducting these adjustments is your adjusted gross income or AGI.
Some of those most commonly claimed above-the-line deductions include:
- IRA contributions
- Moving expenses for work-related moves
- Educator expenses
- Student loan interest
- Self-employed health insurance
- Self-employed retirement plan contributions
- Alimony you pay
These adjustments are frequently called ‘above the line’ deductions because they are listed on the first page of your tax return before you get around to deciding whether you are going to itemize or claim the standard deduction for your filing status. Adjustments to income are also listed above the line that separates total income from adjusted gross income. This placement is important because personal exemptions and itemized deductions have traditionally phased out as your AGI tops various thresholds and some tax deductions are limited by a person’s adjusted gross income.
Your AGI even has implications beyond your federal income taxes. Many states use your federal adjusted gross income as the starting point for calculating your state taxable income.
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