How to Calculate Taxes on Income
Understanding how to calculate taxes on income is essential for managing personal finances and minimizing tax liabilities. This article will provide a step-by-step guide to help you navigate the process of calculating your taxes based on income earned.
Step 1: Determine Your Filing Status
Your filing status helps dictate the tax rates and deductions applicable to your income. The five types of filing statuses are:
1. Single
2. Married Filing Jointly or Qualifying Widow(er)
3. Married Filing Separately
4. Head of Household
5. Qualifying Widow(er)
Choose the appropriate category that reflects your personal circumstances as they apply under IRS guidelines.
Step 2: Identify Your Taxable Income Sources
Whether you are an employee, self-employed, or freelancer, list all the sources of money generated throughout the year, including:
1. Wages
2. Sales or profits from a business
3. Interest earned on savings accounts or investments
4. Dividends from stocks and shares
5. Capital gains from property sales or other asset disposals
6. Rental income
7. Pensions
8. Social Security benefits (may be partially taxable)
9. Alimony
Exclude non-taxable income sources like gifts, inheritances, and life insurance payouts.
Step 3: Calculate Your Adjusted Gross Income (AGI)
Deduct any allowable adjustments from your total income to arrive at your AGI:
1. Contributions to traditional IRA,
2.Student loan interest payments,
3.Educator expenses,
4.Alimony payments (for divorce decrees finalized before January 1, 2019),
5.Health Savings Account (HSA) contributions and
6.Self-employed retirement plan contributions.
Your final AGI will form the basis for determining your taxable income.
Step 4: Apply Deductions and Exemptions
There are two methods to reduce taxable income: the standard deduction and itemized deductions. Most taxpayers choose the standard deduction, which depends on their filing status:
1. Single: $12,400 (as of 2020)
2. Married Filing Jointly: $24,800
3. Head of Household: $18,650
4. Married Filing Separately: $12,400
Itemized deductions include mortgage interest, charitable donations, medical and dental expenses exceeding 7.5% of AGI, and other qualified expenses limited or capped by the IRS.
Subtract either the standard or itemized deduction from your AGI to calculate taxable income.
Step 5: Determine Your Tax Liability
Use the IRS tax brackets for your filing status to calculate the taxes due on your taxable income. The progressive tax system employs multiple tax brackets with corresponding rates increasing as income rises:
1. 10%
2. 12%
3. 22%
4. 24%
5. 32%
6. 35%
7. 37%
Apply each bracket’s tax rate to the portion of your income that falls within its range and sum them up to find your total tax liability.
Step 6: Account for Tax Credits
Tax credits directly reduce your overall tax bill as they do not impact taxable income calculations. Common tax credits include:
1. Earned Income Tax Credit (EITC)
2. Child Tax Credit
3. American Opportunity Tax Credit (AOTC)
4. Lifetime Learning Credit
Subtract any eligible credits from your tax liability to determine your final taxes owed or refundable.
Conclusion
Calculating taxes on income may seem daunting, but following these six steps can simplify the process and help you accurately determine your tax obligations. Always consult a tax professional if you are unsure or seek advice.