Distilled to its simplest form, the Individual Federal Income Tax formula can be seen as:
| Gross Income | |
| – | Deductions for Adjusted Gross Income |
| = | Adjusted Gross Income (AGI) |
| – | Standard Deduction OR Itemized Deductions |
| = | Taxable Income |
| x | Tax Rate |
| = | Gross Tax Liability |
| – | Tax Credits and Prepayments |
| = | Tax Due OR Tax Refund |
Gross income – Generally entails ALL income that you earn. Wages, interest income, cancelled debts, gig work, and so many other forms of income get included in gross income.
Deductions for AGI – Also known as “above-the-line deductions,” these are certain deductions such as contributions to retirement plans, alimony, and student loan interest. These items lower the gross income and the total is called Adjusted Gross Income.
Adjusted Gross Income (AGI) – This number is significant because it can determine if you qualify for certain deductions and tax credits.
Itemized Deductions – Also known as “below-the-line deductions,” these are certain deductions such as medical expenses, charitable donations, and state & local taxes paid. These items lower AGI and what calculates taxable income.
Standard Deduction – A deduction of a set number subtracted from AGI if itemized deductions are less than the standard deduction. See our article for more details on standard vs itemized. Currently, the standard deduction is (2019) $12,200 for single filers.
Taxable Income – The amount after subtracting deductions. This number determines the applicable tax bracket that you will fall under. Check out Form 1040 Instruction for current brackets. Once the rate is applied, you get your gross tax liability, or more simply, what you owe to the IRS.
Tax Credits & Prepayments – These items directly lower your gross tax liability. Taxes your employer withheld and qualified tax credits fall in this category.
Once you’ve calculated your gross tax liability against your credits and prepayments, you’ll be able to see how much you still owe, or if you are owed a refund.
While each person’s tax situation can be different and potentially complex, I hope this tax formula presents a good “forest from the sky” snapshot in visualizing where all those deductions and credits get placed in when your preparer puts the income tax return together. As a firm, MiklosCPA is committed to helping our clients with their tax and accounting needs, including explaining complex tax issues in accessible, layman’s terms so they can make effective decisions. Drop us a line to learn how we can help your business. Also, why not make a new friend and follow us on our social media pages?