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We all know the challenges behind preparing a tax return every year. This section will help you understand how the federal tax is calculated. It will also help you estimate your tax liability to better manage your finances. You are taxed on your Adjusted Gross Income (AGI). The formula to calculate your AGI is fairly simple.

AGI = Gross Income - Exclusions - Allowable Deductions

Once you have determined your AGI, finding your taxable income is a straight forward process.

Taxable Income = AGI - Standard or Itemized deductions - Personal Exemptions ...Show details

In this formula, you have a choice of subtracting either the standard deduction or the itemized deductions. You can calculate both the standard and the itemized deductions in your particular situation and choose the one which is higher in value in order to reduce your taxable income.

More details on the terms used in these two formulas are explained below. The IRS Publication 17  provides in-depth details of federal taxes. The tax liability itself is based on your AGI and your tax filing status. There are 5 different types of filing status: Single, Married Filing Jointly, Married Filing Separately, Qualified Widow or Widower, and Head of Household. For each filing status, there are 6 different federal income tax brackets or tiers. Each year, the IRS specifies the limits for each of these tiers.

  • Tier 1 is taxable income between $0 and the upper limit of tier 1. This portion of taxable income is taxed at 10%.
  • Tier 2 is taxable income starting the upper limit of tier 1 and going up to the limit of tier 2. This portion of income is taxed at 15%.
  • Tier 3 is taxable income starting the upper limit of tier 2 and going up to the limit of tier 3. This portion of income is taxed at 25%.
  • Tier 4 is taxable income starting the upper limit of tier 3 and going up to the limit of tier 4. This portion of income is taxed at 28%.
  • Tier 5 is taxable income starting the upper limit of tier 4 and going up to the limit of tier 5. This portion of income is taxed at 33%.
  • Tier 6 is taxable income starting the upper limit of tier 5 and going up to the limit of tier 6. This portion of income is taxed at 35%.

Tax tables for different filing status and income brackets are also available in the IRS Publication 17.

The gross income is basically your income from all sources. Some common sources of income are: ...Show details

  • Salary
  • Unemployment benefit (if received)
  • Interest Income
  • Dividend Income
  • IRA Distribution
  • Net Business Income (self proprietor or limited partner)
  • Rental income (Rent – cost of running rental property – property tax on rental property)
  • Net Long Term Capital Gain
  • Net Short Term Capital Gain
As the name indicates, an exclusion is an amount that is outright excluded from total income for tax purposes. Items that fall under exclusions include: ...Show details
  • Gifts received
  • Life insurance proceeds
  • Certain scholarships
  • Certain eligible employee fringe benefits
  • Child support received
  • Interest received from municipal bonds.
There is no dollar limit on exclusions. As a result it is always beneficial to have as much and as many exclusions as possible.

Once you have calculated your exclusions, the next step would be to determine deductions that lead to the calculation of AGI. This is why, these deductions are also referred to as 'above the line deductions' to differentiate them from the itemized deductions, which are different and covered below. Allowable deductions for AGI include: ...Show details

  • Limited contributions to the IRA (Check the eligibility)
  • Certain payments to Keogh or SEP retirement plans
  • Qualified business expenses. These may include a limited cost of work related parking currently limited to $250 and work related transit passes up to $130.
  • Net capital loss (limited to $3,000)
  • Ordinary and necessary expenses incurred in a trade of business (proprietors)
  • One half of the self employment tax paid
  • Alimony paid to an ex spouse
  • Qualified moving expenses
  • Health insurance premiums (for now)
  • Any early withdrawal penalty that is paid on time deposits e.g. a CD
  • Qualifying higher education expenses for a taxpayer
  • A limited amount of interest paid on qualifying education loans (tax payer)
  • Limited educator expenses (up to $300) etc.

The standard deduction is a dollar amount that reduces the amount of income on which you are taxed. It is a benefit that eliminates the need for many taxpayers to itemize actual deductions. Your standard deduction is based on your tax filing status. Here are current standard deduction amounts by tax filing status: ...Show details

  • $12,400 for Married Filing Jointly
  • $6,200 for Single
  • $6,200 for Married Filing Separately
  • $9,100 for Head of Household

Compared to exclusions and deductions for the AGI, calculating itemized deductions is a bit challenging process. Individual items under itemized deductions have their own limits. On top of that, the total itemized deductions also have phaseouts (i.e. as your income goes up, the value of itemized deductions you claim goes down). If the value of itemized deductions as a percent of AGI is high, it may trigger AMT (Alternate Minimum Tax). Since itemized deductions are taken out of AGI they are also called as ‘below the line’ deductions. Here are some commonly used itemized deductions: ...Show details

  • Interest expenses. They include interest on home mortgage, interest on a home equity line of credit up to $100,000, and investment interest paid when you buy a property for investment (e.g. margin interest). Paying extra points on home mortgage to reduce mortgage interest also falls in this category. However, you can not deduct any personal interest that you pay on an auto loan or on a loan from a friend.

  • Taxes paid. This includes state and local taxes, property taxes on home and other properties, and excise tax on the vehicles you own.
  • Charitable contributions
  • Casualty or theft
  • Medical expenses over 7.5% of AGI
  • Miscellaneous job related expenses up to 2% of AGI
  • Miscellaneous other expenses. There are several common expenses that fall in this category. They include gambling loss up to gambling income, expenses related to estate, income in respect of a decedent/IRD (e.g. a paycheck received after someone dies in which case both recipient and estate of deceased person pay taxes on it, but estate can deduct such taxes in estate tax).

Itemized deductions have a phaseout range. That means, the phaseout starts at a certain level of AGI and gradually reduces the itemized deductions until a given level of AGI is reached. Past this level, there are no itemized deductions to claim. Here are AGI phaseout start amounts by tax filing status.

The phaseout for itemized deduction starts at AGI level of:

  • $305,050 for Married Filing Jointly
  • $254,200 for Single
  • $254,200 for Married Filing Separately
  • $279,650 for Head of Household
Beyond these AGI phaseout amounts, the itemized deductions are reduced at the rate of 3% of AGI above these values. Having an idea about itemized deductions and their tax implication helps you better plan a tax effective strategy.

There are two types of exemptions: tax filers' personal exemptions and exemptions for the dependents. While each exemption is worth the same amount, $3,950 per person, different rules apply to them. You are generally allowed one exemption for yourself unless you can be claimed as a dependent by another taxpayer. If you are married and filing taxes jointly, then you can claim one additional exemption for your spouse.
You are allowed to claim one exemption for each person you claim as a dependent. This exemption can be claimed even if your dependent files a return. But that depend is required to state this on his/her tax return. A dependent could be a qualifying child, or a qualifying relative. However, a qualifying child or qualifying relative must meet three tests. ...Show details

  • Dependent taxpayer test.
  • Joint return test.
  • Citizen or resident test.

To learn more on these tests check the  IRS Publication 17. Personal exemptions also have phaseout ranges. That means the phaseout starts at a certain level of AGI and gradually reduces the exemption amount until a given level of AGI is reached. Past this level, there is no personal exemption to claim. Here is the phaseout schedule by tax filing status.

  • It starts at $305,050 and ends at $427,550 for Married Filing Jointly
  • It starts at $254,200 and ends at $376,700 for Single
  • It starts at $152,525 and ends at $213,775 for Married Filing Separately
  • It starts at $279,650 and ends at $402,150 for Head of Household