Ever wondered how your tax preparer or tax filing software arrives at your final tax bill? The behind-the-scenes math of tax returns can seem tricky, but understanding the factors that influence your tax bill can help you make informed decisions about your taxes throughout the year, and ultimately save you money on taxes in the long run. In this article, we’ll walk through how to calculate your taxable income.
The first step in calculating your tax bill is finding your Adjusted Gross Income (AGI). This is the number that the IRS uses to determine if you qualify for certain tax breaks, especially tax credits. It’s calculated by taking your total amount of income received, and subtracting a list of specific deductions (or “adjustments”) that you may qualify for.
Income - Adjustments = Adjusted Gross Income (AGI)
To find your AGI, you start with reporting your income.
When you’re self-employed, the income that you need to report is your business profit. Your profit is your business income, minus your business expenses. Most purchases that you make explicitly for your business can be counted as business expenses, which will then lower your profit. The lower your profit, the less you’ll pay in taxes.
Let’s say you earned $20,000 in business income from your landscaping business, but spent $5,000 on supplies and advertising to keep your business running. Your business profit would be: $15,000 ($20,000 in business income - $5,000 in expenses)
On top of your business profit, you’ll be asked to report each type of income that you received, including:
Wages, tips, or salary (like W-2 wages from an employer)
Social Security benefits
And a few others
For example, let’s assume you earned $25,000 in wages from a part-time W-2 job at a grocery store on top of your landscaping work. Your total reported income would be: $40,000 ($15,000 in business income + $25,000 in wages).
Next up are adjustments. Adjustments are a list of approved expenses that you can deduct from your income, including:
Student loan interest
The cost of your health insurance (if you’re self-employed)
½ of your self-employment tax
For example, let’s say you paid $1,000 in student loan interest and $1,000 in HSA contributions. You could subtract that $2,000 from your $40,000 in income, which would give you an AGI of $38,000.
After you subtract your adjustments, you’ve found your AGI! Your AGI is what the IRS will use to decide if you qualify for certain tax breaks; for example, if you file as “single” for 2019 and your AGI was less than $15,570, then you may qualify for the Earned Income Tax Credit.
Finding your AGI also marks a change in the kind of deductions that you’re taking. The adjustments taken to find your AGI are called “above-the-line deductions.” Deductions taken in the section that comes after your AGI are “below-the-line deductions.”
Next, you need to find your taxable income, which is the amount of income that you’re taxed on. You find this number by taking two kinds of “below-the-line” deductions off of your AGI.
AGI - “Below-the-line deductions” = Taxable income
One of these below-the-line deductions is the Qualified Business Income Deduction, which lets you deduct 20% of your “qualified business income” (namely, your self-employment income) from your taxable income.
For example, if you reported $15,000 in business profit, your QBI deduction would be: $3,000 ($15,000 x 20% = $3,000).
The second big below-the-line deduction would be the standard deduction. Your standard deduction is a flat rate deduction that’s determined by your filing status.
For example, if you’re filing as single in 2019, your standard deduction would be: $12,200
If your AGI is $38,000, then you’d subtract those two below-the-line deductions to find your taxable income:
$38,000 (AGI) - $3,000 (QBI deduction) - $12,200 (standard deduction) = $22,800 taxable income
Note: In some cases, you may want to “itemize your deductions” instead of taking the standard deduction. Itemizing lets you deduct an approved list of below-the-line deductions, such as medical expenses and charitable donations, which may add up to be greater than the standard deduction.
The next few steps to receiving your final tax bill would be to take your taxable income, and then:
Use your taxable income number to find your federal income tax using the IRS’s income tax tables
Add any additional taxes that you may qualify for (like self-employment tax)
Subtract any tax credits that you qualified for (like the Earned Income Tax Credit, or the Child and Dependent Care Credit)
Subtract any tax that you’ve already paid throughout the year (like quarterly taxes, or taxes withheld from your paycheck)
The number you’re left with is either:
A refund, if you’ve paid too much in taxes throughout the year, or if you’ve qualified for a refundable tax credit, or
A tax bill that you need to pay before the April 15th deadline (Note: For 2021, this due date has been moved to May 17th)
For example, let’s say you’ve run your taxable income of $22,800 through the federal income tax tables and found that you owe $6,000 in income and self-employment taxes, but you qualified for a tax credit of $1,000. Your tax bill would be:
$6,000 (owed tax) - $1,000 (credit) = $5,000
There are a lot of factors that go into your tax bill, but the biggest opportunities that you have for reducing your tax bill are deductions of any kind, so be sure to track any potential deductions carefully! Remember - your biggest deductions to track throughout the year are:
(if you plan to itemize) Below-the-line deductions like medical expenses and charitable contributions
Found can track your business expenses for you, so you don’t miss out on any deductions or leave money on the table. You can download the free Found app here.
Questions about your tax bill, or how to lower it? Email us at firstname.lastname@example.org and we’d be happy to help!