In this week’s post, I review the basic income tax formula.
This post will be the first in a new series covering a variety of tax topics. I plan to cover the taxation of:
Rental property
Renting out a room in your house
Capital gains
Dividends
Explanation of various tax forms
And more!
If you have a particular tax topic that you would like to learn about, please let me know and I will write a post about it!
This post will quickly review the basic federal income tax formula. If you would like a more in-depth explanation with examples, please read my post from several months ago, Basics of Federal Income Taxes.
I want to emphasize that this post will be very simplified. The tax code has many exceptions that result in things getting complicated quickly. This review will keep things simple, and many exceptions will not be mentioned.
Filing status
Before we look at the basic tax formula, it is important to understand that there are different “filing statuses” when filing a federal tax return. A filing status is a classification that impacts many different parts of a taxpayer’s return, including: bracket/rate schedule, standard deduction, certain itemized deduction thresholds. Filing status depends on marital status and number of dependents. There are five different filing statuses: single, married filing jointly, married filing separately, head of household (single with dependents), qualifying widower.
Simplified federal income tax formula
As mentioned, the tax code has many exceptions and intricacies. However, here is the basic formula:
Here are brief explanations of each term:
Income. Income includes money received from a variety of sources, including: compensation for work, interest, dividends, capital gains, business income, real estate.
Adjustments. Adjustments reduce adjusted gross income (AGI). They are referred to as “above the line” deductions.
Adjusted gross income (AGI). AGI is the difference between income and adjustments. The availability of some other deductions and credits depends on the level of AGI.
Deductions. The larger of the standard deduction or total itemized deductions is used. The standard deduction is a set amount a taxpayer can deduct if they do not have many itemized deductions. Itemized deductions are certain expenses or other transactions that are deductible.
Taxable income. Subtracting all deductions from AGI results in taxable income.
Calculate using brackets. The taxable income would then be run through the brackets to calculate tax before credits. There are different brackets for the different filing statuses. There are exceptions for special types of income.
Tax before credits. As just mentioned, tax before credits is calculated by running taxable income through the brackets.
Credits. Tax credits reduce tax liability dollar-for-dollar. A credit is different from a deduction, because a credit reduces tax and deductions just reduce taxable income.
Tax after credits. Tax after credits is the actual amount that the taxpayer is paying in tax, even though the amount owed or refund received when filing may differ based on the amount of prepayments.
Payments already made. Payments are typically made throughout the year by withholdings from paychecks and making estimated tax payments.
Amount due or refund owed. Amount due or refund owed is calculated by subtracting payments already made from tax after credits.
As mentioned above, this formula is overly simplified and in reality it can be much more complicated. However, this still gives us a good basic structure to build on. It can be more exciting (as exciting as taxes can be) to jump straight to the parts of the tax code that apply to your situation. However, it is important to first have a firm grasp of the high-level fundamentals.
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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