When you file your individual income tax return (Form 1040), you must report your income items. The income amount reported determines your federal and state income tax liability; therefore, it is essential to understand how the tax laws affect your income items. Additionally, even if you utilize a tax return software, it is helpful to have a basic understanding of the income concepts in order to optimize the tax return preparation process. Below, I detail the major components of the individual income tax formula. I also provide examples of items for each major taxable income formula component. Lets begin.
Guide to Taxable Income for Individuals
As you can see from the table above, the major components of the taxable income formula are gross income, adjustments, AGI, standard deduction/itemized deductions, QBI deduction, taxable income, income tax liability, tax credits, and tax payments. It is important to understand each component, including examples of the items that make up the taxable income formula components.
Individual Taxable Income Formula Components
Gross Income
Gross income includes all your taxable income items. The list of income items is extensive. You should report income from all sources derived at the amounts before any deductions. Some common gross income items include:
- wages, salary, & other compensation (bonuses, commissions)
- interest
- dividends
- flow-through business income
- capital gains/losses
- retirement account income
- unemployment compensation
- other income
Adjustments
Adjustments include above the line deductions. In other words, you decrease gross income by adjustment items to arrive at your adjusted gross income (AGI). Above the line adjustments are beneficial in that the tax adjustments lower your taxable amount. Additionally, tax law tends to utilize AGI to assess thresholds and phase-outs. The common above the line tax adjustments include:
- Educator expenses
- IRA/401(k) contributions
- Student loan interest expenses
- HSA contributions
- Self-employment taxes
AGI
AGI = Gross Income - Adjustments
You may utilize your AGI to determine eligibility for various tax applications. Understand both gross income items and adjustments in order to properly calculate the AGI total.
You may utilize your AGI to determine eligibility for various tax applications. Understand both gross income items and adjustments in order to properly calculate the AGI total.
Standard Deduction OR Itemized Deductions
Taxpayers may choose between taking the standard deduction or itemizing deductions. The choice depends upon the actions of the taxpayer for the tax year.
In 2019, the standard deduction is $12,200 (Single) and $24,400 (MFS). You should take the standard deduction unless your itemized deductions exceed $12,200 or $24,400.
TCJA changed the rules relating to several itemized deductions. It is important to know the itemized deduction tax rules to determine the best deduction option. The common itemized deductions include:
- Non-reimbursed medical expenses
- State/local taxes - property & income/sales
- Interest expense
- Charity
- Casualty & theft
QBI Deduction
The QBI deduction allows a deduction of up to 20% of qualified business income for eligible flow-through entities. The deduction is available to all taxpayers other than regular C Corps. Please see the following posts for more information on the Sec. 199A QBI deduction:
- How to calculate the Sec. 199A QBI deduction in 2019?
- Sec. 199A QBI Deduction for Taxpayers Between the Threshold Amounts
- How to calculate the Sec. 199A QBI deduction in 2019?
- Sec. 199A QBI Deduction for Taxpayers Between the Threshold Amounts
Taxable Income
Taxable Income = AGI - Standard deduction/Itemized deductions - QBI deductionYou use the taxable income amount to calculate your tax liability. You then adjust your tax liability by tax credits and tax payments to determine your taxes owed or your tax refund.
In conclusion
You adjust your gross income by the stated adjustments and deductions in order to arrive at taxable income. Gross income tends to include most sources of income. If you are unsure about an income item, research the income type to determine if its taxable or nontaxable. Additionally, a basic understanding of the adjustments and deductions should help lower your tax liability.I hope the following improved your understanding about your tax return. Please share to help others learn how to calculate their taxable incomes. Please comment below for any and all questions and concerns relating to the individual taxable income calculation!
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