How Is Income Tax Calculated?

How to Calculate Income Tax

1. Determine Gross Income: Begin by calculating the taxpayer's total gross income, encompassing all sources like wages, self-employment earnings, investments, and rental income for the tax year.

2. Adjust for Adjustments to Income: Subtract specific adjustments from gross income to calculate adjusted gross income (AGI), including retirement contributions, self-employment taxes, alimony, and student loan interest.

3. Calculate Adjusted Gross Income (AGI): Deduct allowable adjustments from gross income to get AGI, which acts as the starting point for taxable income calculation.

4. Apply Standard Deduction or Itemized Deductions: Taxpayers decide between claiming the standard deduction or itemizing deductions, with common deductible expenses like mortgage interest and charitable contributions.

5. Determine Taxable Income: Deduct either the standard deduction or itemized deductions from AGI to find taxable income, the portion of income subject to taxation.

6. Calculate Tax Liability: Taxpayers use tax rates and brackets from the tax laws to calculate income tax liability based on taxable income, with rates potentially increasing for higher income levels.

7. Apply Tax Credits: Taxpayers can qualify for tax credits, like the Earned Income Tax Credit and Child Tax Credit, which directly lower the amount of tax owed.

8. Subtract Withholding and Estimated Payments: Taxpayers subtract income tax withholding, estimated payments, and credits from their total tax liability to determine if they owe taxes or are due a refund.

9. File Tax Return: Taxpayers report income, deductions, credits, and tax liability by filing their income tax return with the authorities annually before the tax filing deadline.