Income Tax Formula – Basic Overview


Taxes can be complicated.  I think Albert Einstein was quoted as saying “The hardest thing in the world to understand is the income tax”.   Apparently however there exist people who make a career out of dealing with taxes at various levels ranging from tax preparation to litigation to mergers and restructuring.  So this suggests that taxes are a manageable thing.  In addition, although it is a broad subject, the area affecting you is probably much more narrow.

With that said, to begin understanding taxes you need two be aware of two things.  The basic equation used to arrive at your taxable income and tax liability and the economic and political reasons taxes are created.  I will not get into the latter in this post but will in the future.

First the general tax equation:

Total income (income from all sources)

Less: Exclusions (such as loans, tax-exempt bond interest, etc . . .)

==============================================================

Equals: Gross Income (a.k.a. Total income)

Less: Deductions (business expenses, itemized deductions, student loan interest, etc . . . )

Less: Exemptions (Exemptions for you, spouse and children)

==============================================================

Equals: Taxable Income

Income Tax = Taxable Income * Applicable Tax Rate

Less Tax Credits:  (Child tax credit, new home credits, etc . . .)

==============================================================

Equals: Tax Liability

Balance due or Tax Refund = (Tax Liability – Prepayments)

So as the formula suggests, you start out with total income which basically all the cash you received during the year which you are filing your return (salary, interest on savings acct, gifts, etc. . .).

From your total income you can exclude monies that are not subject to tax such as tax-free bond interest, loans and the like.

You then arrive at gross income.  This is where the fun begins.  After you have gross income, you can begin looking for deductions.   If you went to school and are paying interest on school loans, this is a deduction you can take.  If you are a teacher and use your own money to purchase school supplies, you can also take deduction on this expense.  If you are a homeowner who pays interest and taxes on your home, you can also deduct these.  Homeowner deductions fall under itemized deductions and not everyone may be able to itemize their deductions.  However the former two examples are not itemized deductions and can apply to anyone.  Deductions are not fixed and subject to change.  Everything is contingent on the laws passed.  After you account for your deductions, the next step is to subtract your exemptions.

Once deductions and exemptions are taken, you will be left with your taxable income.  Take your taxable income and multiply it against the applicable rate (or rates depending on your tax bracket).   The easier thing to do is to reference the IRS tax tables.  Now you will have your tax liability.  Don’t be alarmed however because if you can still take credits.

Credits that will help offset your tax liability include child care expenses credits, education credits, earned income tax credits (subject to income requirements) and child tax credits.  Credits can often be more useful than deductions as they offset your liability dollar for dollar and are often the reason for receiving a refund.  After you finish offsetting your liability with your credits, subtract your payments from your tax liability.  This will be the balance that is due to the IRS (if the number is positive) or your refund (if negative).

You can see that the equation is straightforward.  The complexities lie in keeping up with tax law changes.  With so much information it is easy to miss deductions and credits.  But if you determine that year after year the variables that affect your return are constant, then you may want to prepare your taxes yourself or do a mock return.   Understanding taxes is also beneficial for estate planning regardless of how large or small your estate is.  You can also mitigate the amount of taxes you pay by understanding the behaviors that tax laws are rewarding at any given time.

Also, keep in mind that returns are not structured to flow as the formula above.   However, after preparing a few returns you will begin to notice the simplicity of the equation.

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