For most of us, the only income we care about is the amount that hits our account on payday. When it comes to taxes, you find out that there are all kinds of incomes to worry about. Fear not, for we’re about to demystify your monies!
First things first, we start with total income. This is the whole meghilla – wages, dividends, capital gains, income from rentals or self-employment (here we’re talking about net not gross, more on that later) and any other income you got (jury pay, lottery winnings, etc). We start here, but don’t worry, we have a ways to go before we try to tax those dollars.
Once we have our total income (line 9 on Form 1040), we have some adjustments to make. These are done on Schedule 1, and are what we like to call “above the line” deductions. Here you’ll find student loan interest deductions, contributions to traditional IRA accounts, and some deductions for self-employed folks. We total up all our adjustments, subtract them from our total income, et voila! Adjusted Gross Income, known by fans of acronyms as AGI.
You want to get real familiar with AGI, since many of the credits and deductions phase out based not on total income or even taxable income, but AGI.
Now that we have our AGI, we can get down to the bottom line. From here, we take either the standard deduction ( more on that here) plus any charitable contributions ($300 if you’re single, $600 if you’re married filing with your spouse), or the total of your itemized deductions (read about that here), plus any deduction for Qualified business income. Once we subtract these from our AGI, we finally have our taxable income.
The taxable income is, predictably, the total we pay taxes on. Good tax planning can help to lower taxable income and stay out of higher brackets.
TLDR Summary
We don’t pay tax on every dollar we earn, rather we take out adjustments and deductions to arrive at our taxable income.
Soapbox Moment
Sure, it’s great to lower your taxable income when you can, but think of it this way: if your effective rate is 15%, you have to spend a dollar to save fifteen cents. I don’t know about you, but I’d rather pay the fifteen cents and keep the other eighty five.
In other words, don’t throw money at deductions just to save, you really lose.
