Taxable income is calculated by starting with gross income, subtracting excluded income and exemptions, and subtracting allowable deductions. In determining what items of income and deductions should be taken into account for any taxable year, the taxpayer’s method of accounting must be taken into account. For almost all individuals, that method is the cash receipts and disbursement method. In other words, income has to be received and deductions have to be spent. Some business activities can use other methods of accounting, and if you think that might apply to you, consult with a tax adviser or accountant.
What is taxable income?
Taxable income is every penny of income you have received in the past year. This includes employment compensation, gifts, inheritances, large barter exchanges, bonuses, independent contracting work, and prizes. Each of the these categories of income has a different percentage of tax responsibility. For example, bonuses from your employer have a 50% tax responsibility. This means that half of the bonus will be paid in taxes.
How do deductions and credits affect tax withholding?
You may be thinking that you are going to lose a lot of money in taxes if you follow the above rules. Thankfully, the government also provides deductions and credits that reduce the amount of income that they consider taxable. Examples of these reductions include dependant credits, medical costs, business losses and mortgage interest. Deductions will reduce your overall tax debt by a certain percentage, credits will eliminate dollar for dollar amounts.
After all of the the income, deductions and credits are listed a final amount is calculated. This is your actual taxable income. The tax debt owed for income is then divided into groupings based on the total amount. The first grouping (usually the first $10,000) of your income will not be taxed at all. After that, amounts are taxed at increasingly larger percentages.
If you feel overwhelmed by the calculations required to determine your taxable income, or have advanced credits and deductions such as capital gains consider hiring a tax specialist to assist you with your taxes.