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How to Calculate Taxable Income

First Republic Bank
November 5, 2021

Tax season is a crucial, yet stressful, time for tax-paying individuals. Tax season means keeping track of lots of information, and ensuring all expenses and tax documents are accurate can be overwhelming — and sometimes confusing.

A foundational piece of financial information you'll want to understand is taxable income. Taxable income is the backbone of taxes.

Knowing how to calculate taxable income is beneficial for gaining a better understanding of your tax bracket and what you’ll pay during tax season. This knowledge can help you plan the right approach for filing your tax return and potentially take some stress out of tax season.

What Is Taxable Income?

Taxable income is the portion of either an individual's or a business’s income used to calculate the amount of their tax bill in a given tax year. Taxable income is comprised of (but not limited to) wages, salaries, commissions, bonuses and tips, as well as investment income. Taxable income differs from adjusted gross income (AGI), which includes allowable itemized and standard deductions. Taxable income determines what you will pay in taxes; AGI does not.

Calculating your taxable income isn’t difficult to do. You can calculate your taxable income in three simple steps, and doing so will help you get a better picture of what your tax bill will look like when tax season comes around. Developing a financial plan to cover your tax liability will help prevent any restrictions to your cash flow — and also help you avoid unwanted financial surprises.

Step 1: Determine your filing status

Pinpointing your filing status is the first important step in calculating your taxable income. You can choose from several different types of filing statuses, each of which has special considerations.

Familiarize yourself with the five types of taxpayer filing statuses:

●  Single: This status is for individuals (single filers) who do not have financial dependents, such as children.

  Married filing jointly: This status is for married couples. Married filing jointly can enjoy certain benefits over married couples filing separately, including a generally lower tax rate, as well as certain common and often-used tax deductions.

●  Married filing separately: This status is for married individuals who file as single. Although the ultimate tax liability may be higher than filing jointly, there may be some advantages to filing separately, such as if there is a large discrepancy between partners’ total incomes, where the higher-earning spouse will be taxed at a significantly higher rate than the other partner.

●  Head of household: This status is generally for an individual who is unmarried but has dependents. The taxpayer must meet certain requirements in order to use this type of filing status, including the amount of financial support they provide in their household and how long their dependents reside with them.

●  Qualifying widow(er): This status is for individuals who have lost a spouse within the past two years. This enables the taxpayer to get the same standard deduction and tax rates as married couples. There is a time limit to this filing status.

Step 2: Calculate gross wages

You've now determined your filing status, but how is income tax calculated? The Internal Revenue Service (IRS) uses gross wages as a starting point for determining your total tax liability. Gross wages include a few specific components:

  • Salary

  • Overtime

  • Reimbursements

  • Tips

  • Commissions

  • Bonuses

Fringe benefits — compensation or benefits you receive outside of your normal salary — are also included in calculating your gross wages.

Gross wages are calculated prior to deductions, which means your gross wages number will be higher than your net wages number, which does include deductions or taxes. All forms of gross income must be reported to the IRS, even if they are subject to deductions.

Step 3: Identify deductions

Deductions allow taxpayers to deduct expenses such as taxes, insurance and retirement contributions from their taxable income.

Two of the most common deductions taxpayers can choose between are standard and itemized deductions. Simply electing for a standard deduction lowers your taxable income by a fixed amount; itemized deductions comprise a list of eligible expenses that then get summed to an individualized number. As a taxpayer, you’re able to claim whichever comes out to a lower tax bill.

Standard Deduction

Itemized Deduction
  • Available to everyone

  • Convenient and time-saving

  • Easy and straightforward

  • Depending on certain factors, some individuals may be eligible for a larger standard deduction

  • There are a few limitations around who can take a standard deduction that can be helpful to review with a tax professional

  • May ultimately provide less of a deduction versus an itemized approach

  • Includes five main categories (medical/dental expenses, taxes paid, interest paid, charitable contributions, casualty, theft losses and miscellaneous itemized deductions)
  • More complicated and may require professional guidance
  • Time-consuming
  • You can claim more expenses and may be able to save more money
  • There are limitations and caps to consider

 

While standard and itemized deductions are the most common for taxpayers, taxpayers can take advantage of several other deductions and credits, contingent on various factors. These can include education credits, homeowner credits, investment-related deductions and more. Seeking professional guidance can help you make the most of deductions and credits.

What’s the importance of knowing your taxable income?

Knowing your taxable income before tax season is a smart way to reduce stress before filing your income tax return. Additionally, understanding your financial status can build your confidence — you’ll have a better idea of what you’ll pay during tax season and can avoid unwelcome surprises. In turn, this knowledge can help you create a strategy for paying income taxes without disrupting your normal cash flow.

Working with a tax professional can help ensure you’re optimizing your taxable income as much as possible. 

 

First Republic does not provide tax or legal advice. Clients should consult their own attorneys or other tax advisors.

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