Income Tax and Paycheck Deductions: Learn It 1

  • Determine gross income, adjustable gross income, taxable income and calculate federal income tax
  • Apply exemptions, deductions, and credits to basic income tax calculations
  • Calculate federal income tax
  • Determine social security and Medicare taxes

No one enjoys paying income tax, but it is a reality of life. Before the start of the American Civil War in 1861, most of the country’s revenue came from tariffs on trade and excise taxes (taxes imposed on certain products, services and activities). However, this fell far short of the high cost of the war. Because of this, the federal government enacted the nation’s first income tax with the Revenue Act of 1861, which created the Internal Revenue Service as we know it today.

The U.S. tax code may change from year to year. Because of this, this section includes examples of how taxes, deductions, and exemptions might be computed.

Gross, Adjusted Gross, and Taxable Income

Your income drives how much you pay in taxes. The more you earn, the more you are likely to pay. But your income alone does not tell the full story of what you will pay come tax time. Grasping how to determine your gross income, adjustable gross income (AGI), and taxable income is a fundamental aspect of managing your finances and preparing for tax season. 

Gross Income

Gross income is your total earnings before any taxes or deductions are applied. It encompasses wages, salaries, bonuses, tips, investment income, and any other money you receive for services rendered or from assets.

Your gross income gets reported on a specific tax form depending on how the income was earned. If you are an employee, your income from your job will be reported on a W-2, which is sent to you by your employer. Income from freelance work will be reported on a 1099-MISC form, and is sent by the company that paid you. Income from interest is reported on a 1099-INT form and comes from the entity that paid the interest.

gross income

Gross income refers to the total amount of income or earnings a person receives before any deductions or taxes are taken out. It includes all sources of income, such as wages, salaries, tips, bonuses, commissions, rental income, and any other forms of earnings.

Did you know, money given as a gift may be taxed if the gift amount is high enough? If you give a family member a large cash gift, that gift will be subject to a tax provided that the gift exceeds the federally set limits. Also, if you win [latex]$50,000[/latex] in the lottery, that money is taxed as income. Any lottery or gambling winnings are considered taxable income.
Roger is preparing to do his taxes. He worked two jobs, with reported income of [latex]$27,500[/latex] and [latex]$13,200[/latex]. His two CDs yielded [latex]$327[/latex] interest earned together. He also won a raffle for [latex]$2,000[/latex]. What was Roger’s gross earnings?

Adjusted Gross Income

Before you determine how much you owe in taxes, you will make certain adjustments to your gross income known as adjusted gross income, or AGI.

Adjusted gross income, also known as (AGI), is defined as total income minus deductions, or “adjustments” to income that you are eligible to take. 

What Counts as an Adjustment?

Examples of adjustments include:

  1. Educator Expenses: Teachers and educators can deduct up to [latex]$250[/latex] spent out-of-pocket on classroom supplies.
  2. Health Savings Account (HSA) Contributions: Contributions made to an HSA are deductible, helping to lower your taxable income.
  3. IRA Contributions: Money you contribute to an Individual Retirement Account (IRA) can be deducted, with limits varying based on age and income.
  4. Student Loan Interest Deduction: You can deduct the interest paid on student loans up to a certain amount, beneficial for recent graduates or those paying off educational debt.
  5. Self-Employed Deductions: Self-employed individuals can deduct various expenses, including half of the self-employment tax, health insurance premiums, and business expenses.

adjusted gross income, and deductions

Adjusted Gross Income, commonly referred to as AGI, is the total income earned by an individual or household after certain deductions have been subtracted from their gross income.

Alex’s has received the following income amounts this year:

  1. [latex]$60,000[/latex] from a full-time job
  2. [latex]$15,000[/latex] in freelance graphic design work
  3. [latex]$6,000[/latex] wages earned as a part-time Uber driver
  4. [latex]$3,000[/latex] from interest from bonds

Alex has the following adjustments from their gross income:

  1. [latex]$500[/latex] in educator expenses
  2. [latex]$3,000[/latex] in interest from a student loan

Compute Alex’s gross income and adjusted gross income.

Your AGI is calculated before you take your standard or itemized deduction.

Taxable Income

Taxable income is the amount of income that is actually subject to tax, calculated by subtracting deductions from your AGI. There are two types of deductions: the standard deduction, a set amount based on filing status, and itemized deductions, which are qualified expenses like mortgage interest, state taxes paid, and charitable contributions. You can claim one type of deduction or the other to lower your taxable income.

taxable income

Taxable income is the portion of an individual’s income that is subject to taxation after adjustments. 

 

Taxable income = Adjusted gross income (AGI) – (Standard Deduction or Itemized Deductions)

For the 2023 tax year, the standard deduction for single filers is [latex]$12,550[/latex].

Using our example from earlier, if Alex opts for the standard deduction, their taxable income would be:

[latex]$80,500[/latex] (AGI) [latex]- $12,550[/latex] (standard deduction) [latex]= $67,950[/latex].
You will notice that your paycheck already has taxes taken out of it. Your employer will withhold some of your income, sending it directly to the federal, state, and local governments. It is an estimate of how much you will owe in income tax. In the end, it reduces how much you will pay when your taxes are due. If they withhold too much income, you will receive the extra they withheld in the form of a refund.