6.13 Income Tax

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 is not the full story. When you add all the money you earned from your job, freelance work, interest from savings, and other sources, you have your gross income. 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.

Before you determine how much you owe in taxes, you will make certain adjustments to that gross income. You will deduct, or subtract, some of income from the gross income. That’s your adjusted gross income, or AGI. That is still not what you are taxed on. Next, you need to apply exemptions to your income. These are pieces of income that the government does not tax. After that is done, you reach your taxable income. We will look at each of these parts of the taxable income.

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.

Your adjusted gross income (AGI) is computed before your taxes are determined. It begins with the gross income, and then subtracts from that income any deduction. Deductions are expenditures on your part that the government won’t tax. These deductions include money deposited into tax-deferred investments, and mortgage interest that you paid, charitable contributions if you made any, medical bills over a threshold, medical insurance under certain circumstances, and property taxes. If you add all these up, and they are all legal deductions, the sum is subtracted from your gross income, leaving the AGI.

Remember that your AGI is not your taxable income. Exemptions need to be subtracted from the AGI to reach your taxable income. Exemptions are income that the government does not tax. Some examples of exempt income are disbursements from health savings accounts for qualified medical expenses, bond interest, some IRA distributions, and gifts given that are under $16,000. Note that exemptions are different from deductions: exemptions are excused incomes, whereas deductions are excused expenditures.

Tax Credits

Another piece of the tax puzzle is tax credits. This is money subtracted from the tax you owe.

Tax credits are very different from deductions or exemptions. Deductions and exemptions are taken away from your gross income before the tax you owe is calculated. A tax credit, is subtracted, dollar for dollar, from your tax bill. Once the tax you owe is calculated, subtract the any tax credits from that calculated tax.

Some of the tax credits are refundable. This means that if subtracting them from your tax results in a negative number, you receive a tax refund. For more details, see this article about tax credits.

The federal government has placed income limits and restrictions and on those eligible to receive tax credits because their value is so high. Here is a partial list of tax credits that you might qualify for:

• Earned income credit is a refundable tax credit for low- to moderate-income workers and ranges from $560 to $6,935 depending on dependents and income. This is refundable
• American opportunity credit is a credit taken by parents who have children enrolled in college at least half time and pursuing a degree. This credit is worth $2,500 per student for the first 4 years of undergraduate school, subject to income limits. This is a refundable tax credit.
• Lifetime learning credit is a credit is equivalent to 20% of educational expenses, up to $2,000 per year, subject to income limits. There is no cap to how many years you can apply for this credit.
• Child tax credit is worth $2,000 per child under the age of 17 if that child lives at home at least half the year, subject to income limits. This is a refundable tax credit.
• Child and dependent care tax credit was designed to help pay for child care while the parent works. The amount of the credit is dependent on your income. However, the maximum amount that can be received is, in 2022, $4,000 for one eligible person, or $8,000 for two or more qualifying people. A dependent qualifies if they are a child under 13 years old, a spouse who is unable to care for themselves, or some other qualifying person. This is a refundable tax credit.
• Premium tax credit was created by the Affordable Care Act, and it is one that is received by many people throughout the year. In essence it is a health insurance premium subsidy. The amount of the credit is based on your income and the price of health insurance in your area. This is a refundable tax credit.

Computing FICA Taxes

FICA stands for the Federal Insurance Contributions Act of 1935. FICA taxes are used solely to fund Social Security and Medicare and are separate from federal income tax. It amounts to 7.65% of your gross pay, which is withheld from your paycheck automatically. Your employer is required to match the 7.65% amount. Of the 7.65%, 6.2% goes to Social Security (SSI), and 1.45% goes to Medicare.

As of 2022, SSI tax only applies to the first $147,000 of earnings. Any gross income above that is not taxed for social security. This limit changes every year.

Medicare tax, on the other hand, applies to the entirety of your gross income.

Calculating Your Income Tax

Your income tax bill and your income tax rate are based on your taxable income. The tax system in the United States is progressive, meaning that the tax rates are marginal so the higher your taxable income the higher the tax rate you will pay. Taxable income is broken into brackets, or ranges of income. Each bracket has a different tax rate. The tax brackets and rates for single filers as of 2022 are given below:

So if your taxable income is $76,500 and you are filing as a single filer, your tax bill will be 22% of that $76,500, right?

Wrong. Your income is split among those brackets and the money in each bracket is taxed at that bracket’s tax rate. Seems confusing. Here is a list of steps to follow to find the tax owed.

Step 1: Find the bracket for the income.

Step 2: For each bracket below the income bracket, the tax from that bracket is:

Step 2a: Find the difference between the upper limit of that bracket and upper limit of the next lower bracket. If this is bracket 1, use 0 as the upper limit of the previous bracket.

Step 2b: The tax from that bracket is the bracket tax rate applied to the difference from Step 2a.

Step 3: For the bracket that the income belongs to, find the income minus the lower limit for the bracket.

Step 4: The tax for the bracket of the income is tax rate for that bracket applied to the difference found in Step 3.

Step 5: Add these various tax values to get the total income tax.

There are various tax brackets, and the rates may change in any given year. The income limits may also change. For all examples going forward, we will use the single filer tax brackets, even if those brackets are not appropriate (e.g., married or head of household filers).

Key Terms

• Gross income
• Adjusted gross income
• Exemption
• Taxable income
• Deduction
• Tax credit
• Earned income credit
• American opportunity credit
• Lifetime learning credit
• Child tax credit
• Child and dependent care tax credit
• Premium tax credit

Key Concepts

• Federal income tax is based on income after certain adjustments.
• Gross income is income from all sources, including gifts and winnings.
• Before taxes are calculated, the taxable income is found by subtracting deductions and exemptions from gross income.
• Income tax is progressive, increasing in rate as income increases.
• Being in the 32% tax bracket means some of your income is taxed at 10%, some at 12%, some at 22%, some at 24%, and the rest at 32%.
• Income in each tax bracket is taxed at that bracket’s rate, which means in 2022 the first $10,275 earned is taxed at 10% only.
• Tax credits are subtracted from the taxes that are owed.
• Some tax credits are refundable, which means they can make the amount you owe negative, which results in a refund.

Video

• Deductions Versus Credits
• Tax Brackets

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