When you prepare a federal income tax return such as IRS Form 1040, you calculate three levels of income: total income, adjusted gross income and taxable income.
Taxable income is used to calculate your tax liability, the amount of federal income taxes you owe for the tax year.
Calculating taxable income is straightforward: Add up all sources of income to determine total income. Next, take any allowed "above-the-line" adjustments to calculate adjusted gross income. Finally, take any allowed deductions and exemptions to arrive at taxable income.
Total income is shown on line 22 of the 2008 Form 1040. It includes all sources of income, such as:
Wages, salaries and tips. Income from these sources is reported on a W-2. Your employer is required to send you a W-2 by Jan. 31, 2009. If you earn any additional income not shown on a W-2, the IRS expects you to voluntarily report it.
Interest and dividends. Banks, brokerages and other financial institutions that pay you interest or dividends mail a 1099-INT, 1099-OID or 1099-DIV at the end of every tax year. If you earn more than $1,500 in either taxable interest or ordinary dividends, you are required to submit Schedule B with your 1040.
Capital gains. If you earn capital gains, you may have to submit Schedule D of Form 1040. See the instructions of your 1040 to see whether you have to complete the schedule.
Income earned outside of the U.S. The IRS allows you to exclude up to $91,400 (for 2009) of foreign-earned income on your tax return. For more information, see IRS Pub. 54
Social Security benefits. The IRS requires that you report some or all of your Social Security benefits as taxable income. To calculate how much to report, use the Social Security Benefits worksheet found in the instructions of your 1040.
Adjusted gross income is shown on line 37 of the 2008 Form 1040. Adjusted gross income is total income minus certain allowable deductions, including:
Contributions to IRAs. Some or all of your contributions to an IRA may be tax-deductible. For more information, see IRS Pub. 590.
Interest on student loans. Interest on student loans (up to $2,500) used to pay for qualified educational expenses is tax-deductible. For taxpayers filing a single return in 2009, the deduction begins to phase out when modified adjusted gross income (MAGI) reaches $60,000. The allowable student-interest deduction phases out completely when your MAGI reaches $75,000. For married taxpayers filing a joint return, the increased income limits are $120,000 and $150,000, respectively. For more information, see IRS Pub. 970.
Alimony payments. Alimony payments may be deducted from total income. For more information, see IRS Pub. 504.
Retirement and health insurance-related expenses. If you are self-employed, you may deduct from total income all of your health insurance premiums. You may also deduct contributions you make to a SEP, SIMPLE or other small-business retirement plan. For more information, see IRS Pub. 560.
Moving expenses. You may be able to deduct your moving expenses if moving to take a new job. See IRS Pub. 521.
Health savings account contributions. You may deduct contributions made to a health savings account. For 2009, the maximum deduction for those with family coverage is $5,950. For those with single coverage, the maximum deduction is $3,000. Higher education expenses. You may deduct up to $4,000 in higher education expenses if your income is not more than $65,000 ($130,000 if married filing joint). The deduction is $2,000 if your income is greater than $65,000 but less than $80,000 ($160,000 if married filing joint). This deduction is scheduled to expire after 2009.
Because tax deductions lower your taxable income, they create tax savings. The amount of tax savings is equal to the amount of the deduction times your marginal income tax rate. For example, if you're in the 25% tax bracket, every $1,000 of allowable deductions lowers your tax liability by $250.
Taxable income is the narrowest measure of income on Form 1040, which is shown on line 43 on the 2008 form. To calculate taxable income, subtract from your adjusted gross income the larger of your itemized deductions or standard deduction.
Subtract the value of your exemptions from this amount and you have taxable income. That's all there is to it. For 2009, each exemption is worth $3,650.