It’s tax time again and accountants are getting lots of questions, especially from young people facing tax bills for the first time. Understandably, they want to know how they can reduce their taxes. While it’s easy to rely on tax software or have a professional do your taxes, it’s important to have an understanding of the basics.
What to report? What not? Should I take the standard deduction or itemize? If you understand these things, it will help you ask smart questions and make sure you’re taking advantage of legitimate breaks. Whether or not you do your own taxes, it helps to brush up on a few fundamental tax concepts. Ultimately, it’s not how much you earn but what you keep that counts.
What’s included in gross income?
Your gross, or total, income includes two things: your earned income (wages, salary, self-employment income, tips, commissions, and bonuses) and your unearned income (dividends, interest, capital gains as well as Social Security or pension income). That may seem to cover just about everything. In addition, alimony payments you received on a divorce settlement and rental income are included in your total income. Fortunately, some types of income are not taxed by the government.
These are called exclusions—things like a gift or inheritance, child support, life insurance proceeds following the death of the insured, municipal bond interest, disability income if you paid the premium with after-tax dollars, and certain employee fringe benefits. Typically, you don’t need to include income or money that you borrow—like student loans or a mortgage—in your total.
That’s the first bit of good news. The second is that once you’ve added up your total income, you can start subtracting.
How do you determine adjusted gross income (AGI)?
The next step is computing your AGI (adjusted gross income), which is done by subtracting “above the line” deductions: Examples include: a deductible contribution to an IRA or 401(k), alimony payments you were required to make, contributions to a Health Savings Account (HSA), qualified moving expenses, and certain educator expenses. If you’re self-employed, you can subtract contributions to a small business retirement plan as well as health insurance premiums and half of the self-employment tax. Your AGI is important because it determines your eligibility for certain deductions and credits, as well as for a Roth IRA.
What is your modified adjusted gross income (MAGI)?
Although you won’t find it on your tax return, another term you might encounter is modified adjusted gross income (MAGI). This is simply a modified (either increased or decreased) version of your AGI to determine if you are eligible for specific deductions such as student loan interest and whether you are eligible to make tax-deductible contributions to individual retirement accounts.
How do you choose between standard and itemized deductions?
Once you know your AGI, the next step is to subtract either the standard deduction or your itemized deductions from your AGI—whichever is greater. If your financial situation is straightforward, the standard deduction might be the best and simplest choice. If you own property, run a business from home, or have paid extensive medical bills, you might be better off itemizing deductions. For a full list of legitimate itemized deductions, go to irs.gov.
What’s the difference between marginal and average tax rates?
Once you’ve done all the subtracting, you’re left with your taxable income—the amount you actually pay taxes on. This also determines your tax bracket. Here’s where more confusion comes in because, in reality, you don’t pay a flat rate on your taxable income. Rather, taxes are graduated. The marginal tax rate is the percentage you pay on the last dollar of your taxable income.
Who qualifies for a tax credit?
When it comes to reducing taxes, there’s one more thing to be aware of: tax credits. A tax credit reduces the taxes you owe dollar for dollar. A $100 credit means you pay $100 less in taxes. There are several tax credits available depending on your income and personal situation, including credits for dependent children, qualified adoption expenses, child and dependent care credit, residential energy credit and credits like the Savers Credit and the Earned Income Tax Credit, which is available to low- to moderate-income workers.
Why it matters
You don’t have to be a CPA or get bogged down in details, but these basics can go a long way in helping you use tax software or talk to a tax professional more knowledgably. Plus, while none of us enjoys paying taxes, feeling confident that you’re not paying more than you owe may make it a little easier.