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Finance

Finance 101: Understanding Taxable Income in the US

Finance 101: Understanding Taxable Income in the US

Taxes are important to all of us. A big chunk of our paychecks goes to the government in the name of taxes. It is one of the most important sources of revenue for the nation. Most of the taxes that we pay during our employment years, often come back to us as future Social Security benefits. Be it a businessman, a freelancer, or a service holder, everyone is expected to pay taxes according to their income. Mind you, no one is exempted from paying tax. Even the President’s salary isn’t tax-free!

While many of us know what tax is and what it is used for, only a few know how to calculate the correct taxable income. Technically, tax is only a percentage of our taxable income. In this article, we will discuss how to calculate the exact taxable income so as to save that doughnut from getting slipped into the monthly deductions.

In this article, we will discuss:

1.    What is Taxable Income?

2.    What are the Components of Taxable Income?

3.    What is Unearned Income?

4.    What is Non-taxable Income?

5.    How do Deductions Work?

6.    What is Standard Deduction?

7.    What is Itemized Deduction?

8.    Which Deduction Should You Choose?

9.    How to Calculate Taxable Income

10.  Common Mistakes in Taxable Income Sources

Bring out your notepad – here we go!

What is Taxable Income?

Before branching into the details, let’s address the definition of taxable income. Simply put, it is the total of the earned income and unearned income. Find more on unearned income below. Don’t raise your brows yet, taxable income is your total income from all sources minus the permitted deductions put forward by the IRS for a particular financial year. It includes wages, any kind of bonus or tips, earnings from investments, or practically, anything that you have earned through your work and in addition to your unearned income if any. 

If you’re having tax trouble, you can head over to Tax Group Center or LibertyTax for help and guidance.

What are the Components of Taxable Income?

Taxable income is the common term that technically refers to AGI (Adjusted Gross Income) minus itemized deductions you’re allowed to claim or the standard deduction. AGI is calculated by taking into account certain “above-the-line” adjustments like student loans, money put in health savings accounts, retirement funds, etc. To be more specific,

Taxable Income equals the sum of earned and unearned income minus the deductions you’re eligible for. While summing your total income for filing in the return, you can skip non-taxable income. There’s more on that later in this article.

What is Unearned Income?

Earned income, as we know, is the source through which we make our living, basically income from our work. It can be service, business, or freelance work. And, unearned income is the income that we receive from any other sources than our work. It may include –

     Canceled debts

     Any kind of alimony payments or child support receiving from your ex-partner

     Any disability payments

     Any kind of strike benefits

     Any lottery payments

     Profits earned through selling off assets (sale of a property or car)

     Social Security / Medicare benefits

     Severance pay

     Any kind of rent received from a personal source

     Stock dividends/ Gains from investments

     Any bonus

The total of the above-mentioned incomes is calculated as unearned income.

You’re required to sum up the income from your work and the unearned income to get your gross income. Next, the deductible non-taxable income is then taken away from your gross income to generate your taxable income, thereby arriving at the exact tax figure you got to shell out every month.

If you don’t think you have the time or patience to handle this yourself, you can outsource the work to Visor or TaxActinstead. All three offer everything you need to deal with taxes, hassle-free.

What is Non-taxable Income?

Knowing the rules can always give you an edge over others! And that’s why, before approaching your taxes you must be fully aware of all the taxable and non-taxable components of your income. Here’s a list of deductibles that the IRS clearly labels as non-taxable income sources –

     Inheritances of any kind, cash or property

     Cash discounts from retailers or businesses

     Any kind of welfare income

     Any kind of damages from bodily injury or illness or any disability

     Child support payments made

     Hotel and restaurant services during your business time

     Cost of living adjustments under the Social Security

     Any kind of non-cash income

     Collegiate scholarships

     Life insurance that you are paying for

     Any tax refunds from local or state

How do Deductions Work?

This is perhaps the happiest part of doing taxes. While calculating the taxable income, it is important to look for the deductions or the exemptions determined by the IRS.

Mainly, there are two types of deductions. The Standard Deduction is the one type that is the same for everyone. It includes a few expenses that you can simply claim back. And the second, more complicated type is called, Itemized Deduction. The taxpayer gets to choose between these two types of deductions before filing their return.

What is Standard Deduction?

Following this suit, your taxable income will get reduced by a specific amount. Let’s say in the year 2019, it was $12,200 for single filers, $18,350 for heads of household and $24, 200 for married couples filing jointly. This means in the 2019 tax season, above mentioned specific amounts must be deducted from your Taxable Income, as per your filing status.

This deduction is preferred if you do not have an exhaustive list of itemized deductions. Most of the Americans prefer this over itemized deductions as it’s easy and completely hassle-free. Itemized deductions generally require a lot more calculations and technicalities. For those who have regular earning scenarios, this is a convenient option.

What is Itemized Deduction?

Itemized Deductions covers a wide range of assets as well as expenses. It is applied according to the usage or expenses incurred on particular items.

Here’s a quick rundown of the deductions that can be included through itemized deduction:

     Property taxes

     Mortgage interests

     The investment interest expenses

     Health care

     Charity

     Tax preparation fee

     Other State and Local taxes

Which Deduction Should You Choose?

As a taxpayer, you should look for the most beneficial deductions. If you already have an organized list of expenses, then going for itemized deductions makes sense. This way you would save up more on taxes. But, if you have a restricted list or an unorganized audit of the expenses then standard deductions will work better. It has very few calculations and it is fairly simple. Clearly, you can’t opt for both types of deductions.

If you’re finding this confusing and prefer not to get into the headache of sorting through all this, we have a few options for you. E-file and FreeTaxUSA can both help you understand your taxes; they can even file the same on your behalf.

How to Calculate Taxable Income

Calculation of taxes is definitely not an easy chore. It requires you to be a little systemized and sorted with your expenses and income sources. Having a simple tracker for these calculations is of great help while doing the taxes. To make taxes easier for you, here’s a quick step-by-step approach of calculating your net taxable income –

Step 1: Mind your filing status – Unlike on Facebook, while doing taxes your marital status does matter! Tax brackets are different for filers who are single, married and filing jointly, and of course, for heads of households. Determining and hence filling out the correct status while filing your returns holds importance.

Step 2: Calculate your Total Income- The combined sum of your earned as well as unearned income makes for your gross total income. If the IRS finds a discrepancy in your income, you might be in for a little trouble. It’s recommended to add income from all sources.

Step 3: Figure out the AGI (Adjusted Gross Income) – Minus the permitted exemptions from your gross total income, this will give you your adjusted gross income.

Step 4: Decide between the two deductions – Opt for either standard or itemized deductions, based on your expenses and income sources. This will help cut down your tax payment.

Step 5: Subtract other eligible exemptions – Look out for any other eligible exemption allowed by the IRS and deduct it.

Hurray!!! The final figure after all these subtractions and adjustments is your Net Taxable Income.

Common Mistakes in Taxable Income Sources

Most of the income sources are declared taxable by the IRS but there are a few types of incomes that still fall under the non-taxable income category. People often get confused and make mistakes like considering taxable income as non-taxable or vice versa. Here are a few things to help clear that up for you.

Money received as life insurance upon the death of the person insured is non-taxable. If you are doing something for society, then it is usually taken as a non-taxable income. Suppose you are a member of an institution avowed to serve humanity, your income from that institute will be regarded as non-taxable. Another example is any appreciation award for your work, etc. Primarily, the value of such rewards is not non-taxable, but it may qualify as tax-free if it meets certain conditions.

Conclusion

We understand that the American tax system can be a tough terrain to navigate on your own. The aim of this article was to try and simplify that process a little for you. We hope it has done so!

Global Banking & Finance Review

 

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