Income tax is a complex system that can be difficult to understand. But with the right information, you can calculate your taxable income and determine how much you owe in taxes. This guide will explain the income tax formula and provide an overview of the deductions and credits available to reduce your tax burden. First, we calculate your adjusted gross income (AGI) by taking your total household income and reducing it by any deductions or adjustments. This includes deductions for business or business expenses, half of the self-employment tax, alimony, and tax-deductible payments made to a traditional individual retirement account or other tax-deferred retirement accounts.
There is also a limited exclusion for scholarships, grants and Social Security payments. Income earned in foreign territories is also usually taxed by the foreign country. To avoid double taxation, U. S. tax law allows various deductions and credits to offset taxes paid to other countries.
The details of the tax treatment of foreign revenues often depend on tax treaties signed by the United States and other countries. Some countries, such as Hong Kong, tax only income earned within their borders, which is called a territorial tax system. Once you have calculated your AGI, you can subtract any deduction you qualify for (whether itemized or standard) to calculate your taxable income. Taxpayers can reduce their tax burden and the amount of taxes they owe by applying for deductions and credits. The standard deduction, which depends on marital tax status, was created by Congress so that poor people could keep more of their money and reduce the burden on the IRS to audit itemized deductions. Some itemized deductions allow you to deduct expenses related to the production or collection of income, including the management of income-generating properties.
These expenses are called non-business expenses, because taxpayers are not directly involved in the operation of a business. The second type of deduction is for personal expenses, which are not normally deductible, but for which Congress has made exceptions. To take this deduction, the taxpayer has the option of itemizing them or taking the standard deduction. Because the standard deduction is so high, most taxpayers choose the standard deduction, since that gives the highest deduction. Taxpayers also typically request an exemption for each dependent if the taxpayer provides more than half of the dependent's support and no one else claims the dependent. Estimating a tax bill begins with estimating taxable income. Once you have calculated your taxable income, you can apply the corresponding tax category (based on income and marital tax status) to calculate your tax liability.
Tax credits and taxes already withheld from your paychecks could cover that bill for the year. Otherwise, you may have to pay the rest when paying taxes. If you've paid too much, you'll get a tax refund. Deciding how to take your deductions, that is, how much to subtract from your adjusted gross income, thus reducing your taxable income, can make a big difference to your tax bill. If you didn't pay taxes during the year or owe taxes, but you're entitled to one or more refundable tax credits, you'll also receive a refund equal to the refundable amount of the credits. Unlike adjustments and deductions, which apply to your income, tax credits apply to your tax liability, that is, the amount of tax you owe. States that have a state income tax require you to file a separate state tax return since they have their own rules.
These are called “marginal tax rates” meaning that they don't apply to total income but only to income within a specific range. In addition to this most people pay taxes year-round in the form of payroll taxes that are withheld from their paychecks. By understanding how to calculate taxable income using deductions and credits you can reduce your overall tax burden and ensure that you are paying only what is required by law.