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What is Taxable Income?

What is Taxable Income?

In a nutshell, taxable income is the compensation or the amount of income of an individual or a business used towards determining the tax liability. Alternatively, it refers to the portion of the gross income that helps calculate the amount of tax an individual or an enterprise owes to the Government.

Taxable income is gross income or adjusted gross income minus all the deductions and exemptions for a particular year. To understand taxable income, you should know what gross income is.

Gross Income

Taxable income is not just one’s salary but also constitutes other compensations like commission, bonus, allowance, tips, wages and others. All these constitute gross income and, it’s the beginning from where, after making some allowable deductions, the actual taxable income is derived.

In short, gross income is all the income from all the sources before making allowable deductions. Gross income includes:

  • Royalties
  • Government benefits
  • Income from gambling
  • Unearned income like dividends
  • Compensation received for unemployment
  • Income from investments
  • Select withdrawals from retirement accounts
  • Income earned from lottery
  • Miscellaneous income like cancelled debts
  • Income earned from appreciated assets
  • Rent from personal property

However, gross income includes more than these and almost anything not considered tax-exempt by the Internal Revenue Service.

Non-Taxable Income

To calculate taxable income for a financial year, knowing non-taxable income is equally important. There are a select number ofincome streams that are exempt from tax and don’t come under gross income.These comprise of:

  • Child support payments
  • Workers’ compensation
  • Compensatory damages for physical injury
  • Welfare benefits
  • Supplemental security income
  • Veterans’ benefits
  • Employee achievement award [Subject to conditions]
  • Gifts
  • Cash rebates

To gain a complete understanding of taxable income, you should know the factors that affect taxable income. These deductions have a profound impact on the portion of your income that is taxable.

Deductions Affecting Taxable Income

There are two types of deductions that affect taxable income.

Standard Deduction

It’s that part of your income you can use to reduce your tax bill and, is not subject to tax. It’s applicable only when you don’t itemize your deductions [More of this later]. The standard deduction depends on your age, the filing status, and whether you are dependent or disabled.

In layman’s terms, the standard deduction is a single, no-questions-asked reduction in an individual’s adjusted gross income. The advantage is, it’s much faster and easy to claim and, you need not keeptrack of every qualifying expense.

Restrictions to standard deductions

There are limits imposed on whether a taxpayer can qualify for standard deductions. A non-resident individual and his/her spouse cannot claim it. A married person who files separately and whose spouse has filed for itemized deductions cannot file for the standard deduction.

Itemized Deduction

These deductions are eligible expenses; there are several of these, that taxpayers can claim to decrease the taxable income. Which means you can choose from numerous individual tax deductions to itemize instead of the flat-rate, standard deduction.

Since there isa multitude of deductions available, itemized deductions can often be more than standard deductions. However, they require proof, and you need to maintain records and keep everything organized.

It’s also time-consuming as it involves the filling of several tax forms and supporting schedules.

Choosing Between Standard Deduction and Itemized Deduction

Choosing standard deduction or itemized deduction boils down to the total amount of deductions. If the standard deduction is less than itemized deduction, switch to itemize. If the standard deduction is more than itemized deduction, you can stick to the standard deduction.

Remember that you can choose either one of them to reduce your tax liability. You cannot do both.

Expenses that Can be Itemized

There is an extensive list of expenses that can be itemized and, there are limits and conditions applied on most items. In fact, some itemized deductions have been taken off somewhere in the year 2018. The list includes (But not limited to):

  • 401(k) contributions
  • Adoption credit
  • Charitable donations
  • Child tax credit
  • Deduction for state and local taxes
  • Educator expenses
  • Gambling losses
  • Home office expenses
  • Investment interest
  • Ira contributions
  • Medical expenses
  • Mortgage insurance premiums
  • Mortgage interest
  • Student loan interest

If you consider taking the standard deduction, the job is much easier but, you cannot deduct the above expenses. However, if you choose itemized deduction, you probably will save much more but, you need to provide supporting documents for audit purposes.

Taxable Income for Businesses

Businesses don’t consider the revenue generated as business income. They deduct permissible business expenses from gross sales to arrive at gross income. This is the net business income that is taxable.

Procedure Involved in Calculating Taxable Income for Your Business

You have to determine the gross sales

Arriving at gross sales is the first step to determine your business’s taxable income. This includes revenue generated from all the sources for a financial year minus all expenses.

Calculate the cost of sales or goods sold

This is only of those businesses that actually sell goods. You can subtract the value of inventory purchased from the total revenue generated. This also includes all other expenses that come under cost of goods sold. These include overhead costs, direct labour costs, storage, cost of raw materials and others.

Itemize your business expenses

There are some business expenses that are fully deductible and others, partially. Some of these include (But not limited to):

  • Rent
  • Repairs and maintenance
  • Salaries and wages
  • Utility expenses
  • Printing charges
  • Legal fees
  • Marketing and advertising costs
  • Insurance costs
  • Office supplies
  • Bank and accounting fees

Subtract business deductions

Now, you need to subtract business deductions and credits including business interest, retirement plans and other related expenditure.

Determine the taxable income

In this final step, you subtract all the allowable tax deductions and credits from the gross income. This amount is taxable. In case the figure is in the negative, it means your business has suffered a loss for the particular financial year.

Other Business Expenses Allowed for Deduction

There are some expenses incurred by a business that are both personal and business-related. There are cases where a business owner uses his car for personal and business purposes. In such circumstances, the travelling expenses incurred for business purposes can be deducted.

Similarly, in a home-office set up, only that portion of the home used as office space is deductible. These are categorized under the listed property that serves business and personal uses.

Other Business Deductions

There are capital expenses that actually happen to be business assets. A business should capitalize on these assets and deduct over a specified number of years through depreciation. Most of these include furniture, computers, equipment, vehicles and many others.

Often, businesses give gifts to their clients or employees as a mark of appreciation. The cost of these gifts is also deductible subject to certain conditions. Expenses incurred on meals and entertainment are deductible up to 50 percent.

Taxable Income and Tax Bracket

A tax bracket is determined by and is an important component of your taxable income. Tax brackets are a series of divisions where income tax rates move ahead in a progressive tax system. In such a system, the tax rate increases as and when an individual’s or an enterprise’s income increases.

There are different dollar ranges for single filers, couples’ joint filers and couples filing separately. The inflation rate helps adjust the brackets accordingly every year using the Consumer Price Index.

Tax Rate and Tax Bracket

Every tax bracket has a specific tax rate, which happens to be the percentage at which your income is taxed, attached to it. Tax rates are called marginal tax rates that increase with each additional dollar of income. Your income will be taxed progressively and is subject to different tax rates.

However, the tax bracket doesn’t tell the exact amount you will be paying as tax. The government divides your taxable income into chunks that fall into specific tax brackets. Every portion is then taxed at the corresponding tax rate.

Progressive tax brackets can generate more revenue for the government while also offering tax rebates and tax deductions for individuals and businesses. However, there are arguments that a flat tax structure should be in place. The argument stresses that everyone is equal in the eyes of the law without any discrimination.

Another glaring loophole is the wealthy will possibly spend too much to exploit the law and find ways to pays less tax and, personal savings rate can reduce dramatically. But, considering the numerous benefits this system provides, it’s still the most effective way to plan and work for the welfare of the individuals, the businesses and the nation.

Finance

Teaching children about wealth management and why there has never been a better time

Teaching children about wealth management and why there has never been a better time 1

By Annabel Bosman is Managing Director and Head of Relationship Management at RBC Wealth Management

As we approach the end of week sixteen in lockdown, I am breathing a sigh of relief at having successfully navigated another week of juggling work and client commitments with the increasing demands of my children – age six and nine.

My day job is to lead RBC Wealth Management International’s relationship management efforts in the British Isles, but my toughest challenge right now is educating and entertaining my new junior co-workers each day.

While my children’s school has done a great job at setting up daily tasks and learning activities, there is only so much ‘teaching’ they can take from me without World War III breaking out. So instead of rigidly sticking to the school curriculum each day, I have taken the opportunity to educate my young children about a topic that is often not discussed enough in school — money.

Why now?

What I do for a living has become a central discussion in our co-working space — also known as the dining table. I have found that investment concepts can be grasped quite well by young children and this has led to some interesting conversations about which businesses are doing well in the current situation, and those that are not. Children are often more logical than adults, and in my house, this logic is helping them grasp the basics of an investment philosophy. As a result, I have even passed conversations around stock markets off as maths classes!

For young children like my own, helping them learn the basics of managing money is something that will hopefully set them up well in life. There are some great tools to help them do this – we use GoHenry, which provides children with a pre-paid card to learn about budgeting. Likewise, encouraging conversations around how they spend virtual money whilst gaming on apps like Roblox can give some really important lessons around how you look after the money you have earned – and how if something seems to be too good to be true, it probably is.

The most important thing is not to underestimate your children. Whether it is the application of a “mummy-tax” when they want chocolate or applying interest rates (albeit nominal!) if they want to borrow money, teaching our children the basics around money is something we can all do.

Incorporating new lessons

The first step is to identify the best way to approach teaching these topics in a way they will understand. Resources such as the Usborne Money for Beginners are really helpful to start conversations. There are also several YouTube clips and even TikTok channels dedicated to helping children think about money. I tend to think about what is important to them and use that as a catalyst to start conversations; for example, it could be how they can monetise their love of the gaming app Roblox.

Ending the taboo

Any conversation that leads to a greater awareness around financial discipline and security has to be a positive, no matter what the age – and there are certainly parallels with my experience and that of my clients. There seems to have been a shift in HNW and UHNW families’ willingness to talk about money. Whereas previously it was seen as very un-British to speak about money, the pandemic has meant that a more open conversation is taking place.

Whatever our financial position, we often bury our heads in the sand when it comes to money, and don’t always have a clear financial plan, but when we start to put down on paper what’s going in and out, we immediately start to feel more in control, thus becoming more engaged. It can be uncomfortable to have that conversation with your family, but we regularly speak with our clients about all manner of sensitive subjects including putting wills in place, inheritance and protecting loved ones. Naturally, this is also bringing conversations to the fore around succession planning, legacy, philanthropy and even one’s own mortality. When times are good, it’s easy to not have these thoughts at the forefront of your mind, but in challenging times like these, it highlights how essential it is to talk. And just as with my children, there are plenty of apps and websites that can help you take the first steps.

Varying generational approaches

There is no one way to educate your children about money — what worked for one generation will not necessarily work for the next. Different generations have had to address the different approaches they might take in thinking about money and try to reach a common language to agree on common goals. Whilst many of us grew up with physical pocket money from our parents after completing household chores, today’s young children rarely even touch money, they receive their allowance on an app.

A 2019 study commissioned by RBC Wealth Management and conducted by The Economist Intelligence Unit found that seven in ten younger affluent respondents think that their beliefs about wealth are very different to those of their parents; with a similar percentage, 78%, believing that wealth is less easily attained or preserved today. Early, open and continuous dialogue can only help confront obstacles head on and smooth the path ahead.

These talks also allow HNW individuals and their families to talk about how they can address their non-financial goals, such as fighting climate change or supporting social agendas – something that the younger generation is acutely focussed on. Indeed, more recent social events have led to an ongoing and overdue debate around what privilege looks like and how society needs to change.

What next?

With the summer holidays fast approaching, the struggle to keep children occupied will continue, but without the pressure of the school curriculum. This is an opportunity to continue discussions with children about where money comes from and where its value lies.

I have found it tremendously empowering to talk to my children about money and getting back to basics — it may not be school learning, but it is real life learning. And as I say to my clients, the initial step to start a conversation is always the hardest.

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Finance

From accountants to advisors: changing roles and expectations

From accountants to advisors: changing roles and expectations 2

By Chris Downing, Director for Accountants & Bookkeepers at Sage

The line between strategic advisor and traditional accountant is blurring. Over the last year, 82% of accountants said their clients were demanding a wider service offering, including business and technology implementation advice. In the current climate this transition has only been accelerated.

Clients increasingly expect their accountants to take a more active role in change management and predicting their cashflow months into an uncertain future. This is enabling businesses to tackle the challenges of day-to-day operations, while keeping an eye on what the post-COVID world will look like, and the support they will need to return to strength.

To solve these new and complex, expectations accountants must develop a different way of working. They will be required to increasingly supplement the traditional, compliance and reporting aspects of their work with business advice and consultancy. To do this, accountants need the ability to move quickly and efficiently, with a firm grounding in technology and data control.

Get straight to the point

The priorities of yesterday are very different to the goals of today. Where businesses once focused on driving growth and efficiency, the objective for many now is continuity – understanding what government support is available and for how long. In the current climate, speed of delivery and client care are top of the agenda.

But the way accountants go about this is very important. Rules are changing every day – the definition of an ‘essential business’, government support and bank loan programmes are constantly in flux. In normal times, an accountant’s role is to ensure their clients are aware of and reactant to these changes. Yet, how much value does this create for them in the ‘now’?

To be valuable, new information must be delivered quickly but it should also be succinct. It isn’t useful for clients to be bombarded with email updates, or reports running into hundreds of pages, trying to explain the week’s changes. With so much present noise, it’s the accountant’s task to break through the information overload and provide the client with crucial resource only.

To understand client pain points and get to the heart of what they really need, a running dialogue is essential. Building individual client relationships will unlock the potential to deliver tailored experiences that meet their business demands. Armed with this insight, accountants can then distil complex information into digestible chunks.

A more entrepreneurial spirit 

Sharing insight is only the start.  The other half of the story relies on consultancy. In the Covid-19 environment, the routine aspects of an accountant’s work are being supplemented with the transformative changes they can make for clients. Cashflow projections for the next six months are crucial, but even more so is the advice an accountant can offer on improving the financial outlook of a business.

Chris Downing

Chris Downing

To provide this balance, accountants should embrace a more entrepreneurial way of thinking. Not only advising on how clients can meet current challenges, but also how they can innovate to drive new revenue streams in the future. Part of this means being willing to step outside of their comfort zone. Many firms are already investing in the skills and technologies they need to service novel demands – like advising on relevant accounting and finance technologies.

While many businesses remain closed to the public, even as lockdown eases, they have increased capacity and flexibility to shift operations towards what will be most effective and profitable. Clients will be open to changing their business focus to meet demand spikes in other areas as they do not have to account for a disruption to customer service. For example, many distillers shifted production from beverages to hand sanitiser while bars and restaurants were closed.

With their contextual understanding of client finances, accountants are uniquely placed to advise their clients on change and guide them through the transformation process. Though this requires a more innovative model of accounting, and one that is willing to embrace the latest technologies.

Truth in the cloud

Business advice needs to be backed by data, especially for accountants engaging directly with the CFO. Scenarios need to be modelled, analysed, tracked and compared over time to arrive at the most effective proposal for the client. This is outside the wheelhouse of traditional accounting, but it’s becoming necessary in an industry heavily disrupted by new technologies.

To keep up with the ever-growing need for rapidly available data and analytics capabilities, more and more accountants are turning to the cloud to consolidate and use their data estate, while automating the time-consuming tasks of data management. Indeed, the majority (91%) of accountants have said new technology has delivered fresh value to their business in the last year, whether it increases productivity or frees up more time to focus on client needs.

Against the backdrop of coronavirus and technological disruption, a new breed of accountant is quickly emerging. Innovation is possible for those who stay ahead of client expectations and are aware of their needs, embrace an entrepreneurial mindset and adopt the latest cloud and automation technologies. In this way, an accountant becomes an integral part of their client’s business.

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Finance

Preparing for the new normal and building a financial plan

Preparing for the new normal and building a financial plan 3

By Donna Torres, director of small business at Xero UK

There is some light at the end of the tunnel for small businesses. As the lockdown continues to ease many retailers and hospitality businesses are now opening up again, or preparing to return soon.

Preparing for what’s around the corner has always been key to business success. Whilst there is still much uncertainty, it’s more important than ever that businesses get in control of their finances and create a solid plan.

Having a strong understanding of your cash flow and a plan for the months to come is vital to helping you prepare for what’s ahead. If you’re unsure where to begin, here are five ways to start:

Take stock

Financial experts Lauren Harvey (Founding Director of Full Stop Accounts) and Jonathan Graunt (Founder of accountancy firm FD Works and Xavier Analytics) recently spoke with Xero about the uplift in businesses taking an interest in their finances and understanding their financial position.

Businesses should be using this time to review their processes and really understand their numbers. It can be helpful to reflect on your original statement – what do you really want your business to do? And has the pandemic changed this? Use this as the fuel to drive your business vision forward.

Consider the risks

The government has provided SMEs with a number of support schemes, but the conditions and capital being offered is changing.

For example, the Furlough Scheme will currently only run until the end of October and the deadline to furlough new employees has now passed. The government will also gradually be reducing the amount it pays under this scheme. Make sure you’ve accountanted for this in your financial plan so you have a clear picture of how furlough tapering off will impact your business and any adjustments you might need to make.

If you’ve taken out one of the Government backed loans, now is the time to start building repayments into your financial plan. Building a solid plan will also help to ensure that you use the money in the best way to support your business in the long-term. It can be tempting to fight the most immediate fires with your capital, but try to think about the longer term health of your business – and where the money is going to have the most impact.

Adapting to a change in demand

Covid-19 has forced businesses to adapt to a lot of changes and SMEs should be thinking carefully about how their customer demand has changed. What do customers expect from you now? For example, many are still apprehensive of shopping on the high street. This might mean some of the options you offered during lockdown like deliveries or online services should remain.

Communicate with your customers as much as possible to get an accurate view of what they need from you now and in the future. How can you fulfil this? Then it’s important to look at the numbers and scrutinise which areas are going to provide the most return on investment.

Financial Planning: where to start?

For financial planning to be effective, it’s helpful to get into habits that will provide an accurate snapshot of how your business is performing. Reconciling bank transactions daily, creating a daily simple cash flow check-in habit and examining your profit and loss statements weekly will give you a better understanding of where your business stands.

Apps like Float or Fluidly will help to give you an accurate look at your cash flow in an easy to read visual. And the recently launched Xero Short-term Cash Flow tool can help you project your bank balance 30 days into the future, showing you the impact of existing bills and invoices if they’re paid on time. You can then work out which invoices you should follow up on.

Some people can find this task daunting, but your accounts aren’t just being kept for reporting to HMRC, they are also there to give you invaluable insight into your business and to plan for the future.

Ask for help

Your accountant is there to help you to understand your finances. This is likely to be one of the biggest economic challenges you have ever faced as a small business owner. Now, more than ever, it is time to lean on your accountant to help create a robust plan.

If you do not understand something, or need guidance or clarification, get in touch and ask for their expertise and advice. If their advice doesn’t help, ask them to explain it again.

You can also check out Xero’s online guide to managing cash flow here.

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